Reserve Currency Status–A Mixed Blessing

I was recently invited to give a talk in China on the topic of reserve currency status for the Chinese currency, the Reminbi or Yuan. I had to decline, but the invitation got me thinking about what I might have said in such a speech. The predominate thought that came to mind was probably not what the Chinese would want to hear, which was, watch what you pray for.

The advantages of reserve currency status for the dollar are well known. The world’s willingness to accumulate dollar reserves in the post World War II period first removed and later reduced the requirement of maintaining balance of payments equilibrium, or, more specifically, current account balance. By removing or weakening this restraint, U.S. policymakers had more freedom than policymakers in other countries to pursue strictly domestic objectives. We ran current account deficits year after year, balanced, or paid for, by capital inflows from our trading partners. The good side of that was that we could import real goods and services for domestic consumption or absorption and pay for them with paper, or the electronic equivalent. In other words, our contemporary standard of living was enhanced by others’ willingness to hold our currency without “cashing it in” for goods and services, or, before 1971, gold.

The bad side of our reserve currency status, although seldom recognized, was that the very leeway that enhanced our current standard of living built up debt (and/or reduced foreign assets) to dangerous levels. I remember well when, in 1985, the United States ceased being a net creditor nation to the rest of the world and, instead, became a net debtor nation. Our net indebtedness has only grown over the years, and hangs over us like the legendary sword of Damocles.

One might argue that with floating exchange rates we need not be concerned with such matters—that whatever combination of imports, exports, capital inflows and capital outflows that result is what the market has determined and we shouldn’t argue with the market. I buy that argument to some degree, but the outcome really does seem perverse when one of the richest nations on earth borrows year after year from poorer nations. It would seem more “natural” for capital to flow from rich countries to poorer countries rather than vice versa.

Once upon a time, textbooks described international economics with trade in goods and services as the driving force and with capital flows accommodating or financing that trade. A current account surplus would be financed with a capital outflow and a current account deficit would be financed with a capital inflow. Some time between then and now, capital flows took on a life of their own, with trade financing capital flows as much as capital flows financing trade. Hence, as our current account (mostly trade in goods and services) deficit became larger in recent years, independently motivated capital inflows prevented the dollar depreciation necessary to reduce the current account deficit. There has been no day of reckoning—yet.

Anyway, while the Chinese may long for the prestige and other benefits that go with reserve currency status, they should be aware that it may come at a price.

Comments (11)

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  1. Chris says:

    So what will/could trigger “a day of reckoning”?Tapering?

  2. Paige says:

    “It would seem more “natural” for capital to flow from rich countries to poorer countries rather than vice versa.”

    Rich countries can do more with the capital than the poorer countries can… Or so we think.

  3. Connor says:

    They pegged our currency in order to better link our economies. They now rely on our prosperity, in turn they risk our downfalls.

    • James says:

      but why would they risk so much?

      • Paige says:

        Is it really risking that much? No matter what, the global economy relies on the success of the U.S.

        Little risk in my book

        • James says:

          because the risked the recession the same as we did. Had they had floating currency, it is possible they could have continued to grow and become a stronger global superpower.

  4. Connor says:

    They do it because the US is seen as stable, and if their currency relies on us then they don’t have to worry about the fluctuations of the world market.

    • James says:

      Still a large risk to take when our economy leans vastly towards free market.

      • joan says:

        Hey, it’s my first time to post on here. Great article.

        I wish our economy leaned more vastly towards a free market, but yes, it certainly is more free than many others. Don’t you think that being a free market is less risky than the alternative? (gov’t controlled, monopolized, etc)

  5. Toby says:

    Bob, what do you think of Ed Conard’s book? He has IMHO some interesting views on foreign trade and the resulting capital flows, and the whole economy and economic crisis as well. edwardconard.com See articles, interviews, speeches, reviews, and the first chapter of his book.

    I sure miss Jerry Clower and think of him whenever I hear Haley Barbour, who grew up not far from Jerry, and sounds about identical to him.