And so it was inevitable that the coming of the euro –the common European currency that seems set to be introduced next year, and that may eventually challenge the dollar’s dominance–would inspire irrational fear. Sure enough, a few weeks ago the intellectual fashion victims at one of those other business magazines ran an editorial entitled “The euro makes trade a new game.” “Thanks to the dollar’s role as reserve currency in world financial markets,” they opined, “the U.S. has been able to do what no other country can– consistently import more goods than it exports…. The U.S. owes some $5 trillion to dollar holders abroad, thanks to three decades of trade deficits.” Gosh, what happens if those people switch to euros?
Well, not to worry. It just isn’t true that America’s ability to import more than it exports is unique. Since 1980 the U.S. current- account deficit (which includes services and investment income as well as goods) has averaged 1.5% of GDP. That’s about the same as Britain’s average, less than Canada’s 2.2%, and nothing like Australia’s 4.2%. These countries paid for their excess imports the same way we did: by selling foreigners stocks, bonds, real estate, and so on. The only difference is that because their deficits were bigger, their debts are also bigger as a share of GDP. Ours, it turns out, aren’t that large–at least on a net basis. While it’s true we owe foreigners about $5 trillion, they owe us more than $4 trillion; the difference is about $800 billion, or 10% of GDP.
But doesn’t the dollar’s special role give us some advantage? Most of the international role of the dollar comes from its use as a “unit of account”–the measuring stick for international business. When a Japanese refiner buys Kuwaiti oil, say, the contracts are in dollars. This is a testament to U.S. economic influence, but flattery aside, it’s hard to see what we get out of it.
What about our ability to borrow in dollars, to sell dollar- denominated bonds to foreigners? Hey, other countries do that too. But our debts are in our own currency! So? We still pay interest on them. True, we could inflate away our foreign debt. But we won’t–and if investors thought we would, they would demand higher interest rates.
Well, then, you may say, surely the international role of the dollar forces people out there to hold dollars for transaction purposes. Yes, but not so you’d notice. When Daewoo repays a dollar loan from Sanwa, it writes a check on its account with some international bank. True, that bank itself surely maintains an account in New York, backed in part by non-interest-bearing reserves held at the Fed. So the U.S. does in effect get a zero-interest loan out of the dollar’s international role–but it probably amounts to only a few billion dollars, small change for an $8 trillion economy.
Where the U.S. does get a significant free ride is from the willingness of foreigners to accept our currency–actual bills. Foreigners hold more than $200 billion of American money. Guess what kind of business requires payments of large sums in cash, by people unconstrained by official restrictions on possession of foreign exchange? That’s right: the dollar is the world’s premier medium of illicit exchange. Every year the U.S. ships foreigners $15 billion in cash (about 0.2% of GDP), and gets real goods and services in return. Better not ask what kind.
So the threat to the U.S. from the rise of the euro is this: five years from now, when wise guys in Vladivostok make offers you can’t refuse, the payoffs may be in 100- euro notes instead of $100 bills. The loss of such business might cost the U.S. economy as much as 0.1% of GDP. Somehow, I think we can live with that.
I can’t tell for sure what year this was written, but the MIT page it is on was last changed in August, 1999 (It’s April 27, 1998). I’d be interested to know to what extent, if any, his views have changed since this was written.
Update: I should have also noted this recent Paul Krugman column: China’s Dollar Trap:
…Aside from a late, ill-considered plunge into equities (at the very top of the market), the Chinese mainly accumulated very safe assets,… U.S. Treasury bills… T-bills are as safe from default as anything on the planet… But … any future fall in the dollar would mean a big capital loss for China. Hence Mr. Zhou’s proposal to move to a new reserve currency along the lines of the S.D.R.’s, or special drawing rights, in which the International Monetary Fund keeps its accounts. …
S.D.R.’s aren’t real money. They’re accounting units whose value is set by a basket of dollars, euros, Japanese yen and British pounds. And there’s nothing to keep China from diversifying its reserves away from the dollar, indeed from holding a reserve basket matching the composition of the S.D.R.’s — nothing, that is, except for the fact that China now owns so many dollars that it can’t sell them off without driving the dollar down and triggering the very capital loss its leaders fear.
So what Mr. Zhou’s proposal actually amounts to is a plea that someone rescue China from the consequences of its own investment mistakes. That’s not going to happen….
Originally published at the Economist’s View and reproduced here with the author’s permission.