Analyzing the Exorbitant Burden
by Michael Pettis, China Financial Markets
This may be excessively optimistic on my part, but there seems to be a slow change in the way the world thinks about reserve currencies. For a long time it was widely accepted that reserve currency status granted the provider of the currency substantial economic benefits. For much of my career I pretty much accepted the consensus, but as I started to think more seriously about the components of the balance of payments, I realized that when Keynes at Bretton Woods argued for a hybrid currency (which he called “bancor”) to serve as the global reserve currency, and not the US dollar, he wasn’t only expressing his dismay about the transfer of international status from Britain to the US. Keynes recognized that once the reserve currency was no longer constrained by gold convertibility, the world needed an alternative way to prevent destabilizing imbalances from developing.
This should have become obvious to me much earlier except that, like most people, I never really worked through the fairly basic arithmetic that shows why these imbalances must develop. For most of my career I worked on Wall Street – at different times running fixed income trading, capital markets and liability management teams at various investment banks, usually focusing on Latin America – and taught classes at Columbia’s business school on debt trading and arbitrage, emerging markets finance and financial history. Both my banking work and my academic work converged nicely on the related topics of global capital flows, financial crises and the structure of balance sheets. My 2001 book, The Volatility Machine, was my attempt to construct a balance sheet analysis of capital-flow volatility and financial crises.
When I moved to China in 2002, its huge savings and investment imbalances forced me to extend my “balance sheet” approach to consider the structure of the overall balance of payments rather than just the capital flows component. Like most balance sheet guys, I tend to think more easily in terms of “systems” than of components of a system, and by forcing me to focus on the way policies and institutional constraints affect the relationship between savings and investment within China and globally, thinking about China opened up for me a whole new way of thinking about the role of the US dollar as the dominant reserve currency.
Until then, like most people, and because of its role in Latin America, I had pretty much taken the role of the dollar as a given, and assumed vaguely that its dominance gave the US some ill-defined but important advantage – after all they did call it the “exorbitant privilege”. But after a few years in China (I moved to Beijing in 2002) I became increasingly suspicious of the value of this exorbitant privilege.
Frankly it shouldn’t have taken so long. After all it didn’t take much to see evidence of countries that did all they could to avoid receiving any part of this privilege. Capital controls have historically been as much about preventing foreigners from buying local government bonds as it has been about preventing destabilizing bouts of flight capital, and living in China, where an aggressive demand for the privileges of reserve currency status coincide with equally aggressive policies that prevent the RMB from achieving reserve currency status (and that transfer ever more of the “benefits” to the US) made clear the huge gap in rhetoric and practice. After all the US demand that China revalue the RMB is also a demand that the PBoC stop increasing US dollar reserves.
In fact trade disputes are almost always couched in terms of trade, but the balance of payments identities make it clear that they can be equally expressed in terms of capital flows. If a country takes steps to expand its trade surplus, it is also taking steps to expand its net export of savings – these are one and the same thing. The constant trade disputes between the US and Japan in the 1980s over the undervaluation of the yen can be recast as disputes about Japan’s insistence on its right to give the US more of the exorbitant privilege and the US refusal to accept Japan’s seeming generosity. Trade disputes between China and the US in the 2000s were more of the same.
The creation of the euro provided another illuminating variation on the impact of reserve currency status. When German institutions – government, businesses and labor unions – negotiated among themselves at the turn of the century a sharp reduction in wage growth for its workers, they were obviously attempting to reduce German’s high domestic unemployment by gaining trade competitiveness. Because these polices forced up the savings rate, and perhaps also explain why the investment rate dropped, they resulted in huge current account surplus (or which is the same thing, excesses of savings over investment) that were counterbalanced within Europe. These policies “worked”, and they worked probably far better than anyone expected. The sick man of Europe, with its high unemployment and large current account deficits, turned the corner almost immediately.
Global imbalances emerge
It turns out that it wasn’t just good luck or brilliant economic policy-making that accounted for the speed of the turnaround. Without anyone’s realizing it, the simultaneous imposition of a single currency on a group of countries that clearly did not belong in a currency union had reduced or even eliminated the monetary adjustment mechanisms in those countries, mechanisms that would have automatically counterbalanced the resulting increase in German capital exports. Instead of multiple currencies slowing the impact of German wage policies, the creation of the euro gave these policies far more traction than they would have otherwise had.
Once China and Europe forced me to think more systematically about the balance of payments and its components, I realized how poorly economists understood trade and capital flow mechanisms. It was as simple as recognizing that an excess of savings over investment in one part of an economic system requires an excess of investment over savings in another. When country A exports net savings to Country B, if Country B suffers from underinvestment because it is constrained by insufficient access to domestic and foreign savings, Country A’s net export of savings would cause an increase in wealth in Country B. Otherwise it would cause either an increase in debt or an increase in unemployment or, what is more often the case, an increase in debt followed by an increase in unemployment. This process is pretty automatic.
Few economists, however, let alone to the general public, had realized how ambiguous are the benefits of reserve currency status, which I called in a 2011 article in Foreign Policy and in a chapter of my 2013 book, The Great Rebalancing, the “exorbitant burden”. A statement that is true by definition, that an excess of savings over investment in one part of an economic system requires an excess of investment over savings in another, was usually treated as politics, and anyone who thought that by pointing this out he was merely pointing out something as simple and obvious as 2 + 3 = 5 instead found himself being attacked from the right as a Keynesian who thinks infinite deficits are good and savings are evil, and from the left as a hard money guy who blames his problems on the poor.
The one thing both sides agreed on, however, was that the US enjoyed an advantage because of the reserve currency status of the US dollar, with some people even assuming that the US was somehow repressing the ability of Europe, China and Japan to gain the advantage for themselves. No matter how many times the US engaged in policies that tried to shift the benefits to those countries, or these countries engaged in policies that prevented them from receiving the benefits, it was somehow clear to both sides that reserve currency status is a wonderful thing that everyone wants but only the US is allowed to have.
And yet it is actually quite easy to list the conditions under which reserve currency status encourages growth and the conditions under which it forces a rise either in debt or in unemployment. In advanced countries with deep and flexible financial markets, except in the case in which capital has become severely constrained by the need for money to be backed by gold, or real interest rates have been forced up to extremely high levels in order to break inflation (as was the case in the late 1970s and early 1980s), the net inflows associated automatically with reserve currency status will not result in an increase in productive investment. They only result in an increase either in debt or in unemployment.
This is not an argument in favor of returning to gold, by the way. It is completely neutral on the issue. This argument simply restates the Keynesian insight that eliminating the discipline imposed by the gold standard is likely to become destabilizing unless there is another way to impose discipline. Robert Triffin proved this quite clearly in the 1960s, and yet for some reason, perhaps because at the time the potentially destabilizing effect was pretty distant, his insight was never developed in ways that modified the current regime of global trade and capital flows.
Conditions have changed however, and the potentially destabilizing effect is no longer so distant. In a recent essay I tried to show that if we have not already reached the point at which the dominant reserve currency status of the US dollar is harmful to the US and potentially destabilizing to the world, logically we will inevitably reach that point, and probably soon.
At the start of this essay I said that I am optimistic that we are seeing a change in the way the world thinks about the role of the US dollar, and I think this is because the 2007-08 crisis in Europe and the US, the start of Abenomics, and the extremely difficult adjustment that China faces have all focused attention on the nature and structure of savings imbalances and their effect on the global balance of payments. It is becoming increasingly obvious, I think, that Keynes was right.
The political spectrum
Several years ago, I received an email from Kenneth Austin, a Treasury Department economist who had read one of my articles. He himself was working on the same set of ideas and over the years we have had a running conversation about this topic.
Austin recently published what I think is a very important paper in the latest issue of The Journal of Post Keynesian Economics (“Systemic equilibrium in a Bretton Woods II-type international monetary system”) which explains why currency war is really a battle over where to assign excess savings, and must lead to unemployment in the country whose assets are most assiduously collected by central banks. You need to subscribe to read the full article, but the abstract tells you what Austin set out to prove:
This article develops a model, based on balance-of-payment identities, of the new international monetary system (Bretton Woods II or BWII). It shows that if some countries engineer current account surpluses by exchange-rate manipulation and foreign-reserve accumulation, the burden of the corresponding current account deficits falls first on the reserve-issuing countries, unless those savings inflows are diverted elsewhere. The imbalances of the BWII period result from official, policy-driven reserve flows, rather than market-determined, private savings flows. The struggle to divert these unwanted financing flows is at the root of the “currency wars” within the system.
While recognition of the exorbitant burden had been growing in recent years, Austin’s article focused a lot of new attention on this topic, and it seems that finally Keynes’s insight is attracting the kind of acceptance that might eventually modify future policy. In August in a much-commented-upon article in the New York Times, Jared Bernstein explained one of the corollaries of Austin’s model, pointing out that
Americans alone do not determine their rates of savings and consumption. Think of an open, global economy as having one huge, aggregated amount of income that must all be consumed, saved or invested. That means individual countries must adjust to one another. If trade-surplus countries suppress their own consumption and use their excess savings to accumulate dollars, trade-deficit countries must absorb those excess savings to finance their excess consumption or investment.
Note that as long as the dollar is the reserve currency, America’s trade deficit can worsen even when we’re not directly in on the trade. Suppose South Korea runs a surplus with Brazil. By storing its surplus export revenues in Treasury bonds, South Korea nudges up the relative value of the dollar against our competitors’ currencies, and our trade deficit increases, even though the original transaction had nothing to do with the United States.
This is a key and much misunderstood point. The inexorable balance of payments accounting mechanisms make Bernstein’s claim – that “Americans alone do not determine their rates of savings“ – both necessarily true and joltingly shocking to most economists. How many times, for example, have you heard economists insist that the US trade deficit was “caused” by the fact that Americans refuse to save, or, even more foolishly, that “no one held a gun to the American consumer’s head and forced him to buy that flat-screen TV”?
The fact is that if foreign central banks buy trillions of dollars of US government bonds, except in the very unlikely case that there just happen to be trillions of dollars of productive American investments whose backers were unable to proceed only because American financial markets were unable to provide capital at reasonable prices, then either the US savings rates had to drop because a speculative investment boom unleashed a debt-funded consumption boom (i.e. household consumption rose faster than household income) OR the US savings rate had to drop because of a rise in American unemployment. There is no other plausible outcome possible.
Americans cannot wholly, and sometimes even partly, determine the American savings rate.
This mistaken belief that American savings are wholly a function of American household preferences arises because most economists – and, it seems, policymakers – can only imagine American households as autonomous economic units, and are seemingly incapable of imaging them as units within a system in which there are certain inflexible constraints.
The same is true about households elsewhere. Because flexible exchange rates prevent Europe from running massive surpluses, German capital exports to countries like Spain created the same constraints, meaning that Spanish households too faced the choice only of speculative investment booms, consumption booms, and unemployment.
The fact that both Spain and the US experienced first booms in consumption and speculative investment and then steep rises in unemployment is just a requirement of the arithmetic, and has nothing to do with local cultural vice finally succumbing to the cultural virtue of foreigners. Rather than try to understand how systems constrain choice, economists and bankers, most of them quite wealthy, preferred to lecture and wag their fingers at ineluctably stupid middle- and working-class households.
Is it time?
And its not just traditionally “liberal” economists who understand that trade imbalances are not caused by lazy workers. Analysts who retain sympathy for the gold standard, like self-confessed “gold bug” John Mauldin, have always understood that the main argument in favor of gold is that it imposes an unbreakable trade and capital flow discipline – indeed that is also the main argument against gold – but many of them have tended to de-emphasize reserve currency economics mainly, I think, because this particular problem is to them subsumed under their more general concerns about money.
I don’t know if Ralph Benko is one of them, but he has written on this subject before and very recently wrote two articles (here and here) in Forbes, which has traditionally been sympathetic to the gold cause, in which he too cites Austin’s paper and adds to the chorus:
The mechanics of the reserve currency system preempt these funds’ ready availability for “the maintenance of industry.” The mechanics of the dollar as a reserve asset, therefore, finance bigger government while insidiously preempting productivity, jobs, and equitable prosperity.
This columnist agrees wholeheartedly with Bernstein on what seem his three most important points. The reserve currency status of the dollar causes American workers, and the world, big problems. The exorbitant privilege deserves and demands far more attention than it receives. Moving the dollar away from being the world’s reserve currency would be a great deal easier than many now assume.
It is hard to construct a economics “tradition” that combines Austin, Bernstein, Mauldin and Benko, and so the fact that they are all in agreement suggests that the discussion about the role of the US dollar as a reserve currency may be emerging from the broader monetary discussion that pits two very opposing economics traditions virulently against each other. Maybe it is just a coincidence that in the last year more and more economists have been questioning conventional wisdom about the benefits of dominant reserve currency status, but once this happens, the logic against the automatic assumption of exorbitant privilege is so powerful that it will be hard ever to believe again. Perhaps we have reached that tipping point.
For readers who are interested, I suggest that you might want to read the various articles, papers and blog entries I have cited above, along with my 2011 article in Foreign Policy and chapters 7 and 8 of my 2013 book, The Great Rebalancing, which Jared Berstein on his blog was kind enough to say presented “an awfully strong argument”. My insistence that Keynes was right, and Robert Triffin was right, but both of them were perhaps right far too early, is quite straightforward and involves only the most basic arithmetic, although it does require you to think in terms of systems and the constraints they impose rather than about autonomous economic entities whose aggregate behavior is simply the sum of unconstrained individual decisions.
We need to keep this argument in mind. As US policymakers take steps to extend free trade through various bilateral and multi-lateral agreements, it is important both that the exorbitant burden is addressed before it becomes much more destabilizing but it is also important that the exorbitant burden not become an argument against free trade. To argue in favor of constraining unlimited purchases of US or other government bonds is not the same as arguing that the US or other countries should not engage in international trade, as many commentators have bizarrely claimed.
Like most people who think about these things I largely accept the conventional views on the advantages of free trade, although unlike some free traders I do not believe that comparative advantage is static, and I would argue, instead, that there is a lot of historical evidence that countries can successfully intervene to transform their comparative advantage in ways that generate higher productivity growth, one of the outstanding cases being Alexander Hamilton’s USA. I think it is pretty well substantiated that global output increases as more countries join the global trade and currency regime and I list the reasons why in my September 28 blog entry. But I think there are two important points that must be part of any discussion of the benefits of free trade.
- First, significant trade and capital flow imbalances are the consequences of institutional or policy distortions and can in some cases destabilize the overall system (they were the causes, for example, of the 2007-08 crisis). In a well-functioning system there will always be temporary imbalances, and even some very long-running but healthy imbalances, like the current account deficits that the US ran for most of the 19th century. As a general rule, however, many years of excessively high or excessively low savings rates are almost always the consequence either of institutional distortions in one country or of their automatic obverse in another. A well functioning trading system must have a mechanism that constrains the destabilizing distortions. Once the world went off gold, it cannot be a surprise that it lost the discipline imposed by gold. Keynes tried but failed to create an alternative form of discipline, but one way or the other it must be re-established.
- Second, the frequently-made argument that any intervention in trade automatically reduces global output is nonsense and completely illogical. If we were at an optimal equilibrium, for example, and this equilibrium were disturbed when one entity introduced a distortion that moved the system away from equilibrium, and if this were followed by a retaliatory intervention that moved it back to equilibrium, either the first intervention or the second intervention must have increased total output. To put it in meat and potato terms, if the Brazilian central bank intervened to force down the level of the Brazilian real against the Mexican peso by 20%, and Mexico intervened successfully by threatening sanctions unless the Brazilian central bank allowed the real to rise back to its original level, one or the other intervention must have caused output to rise. Beggar-thy-neighbor interventions, in other words, can reduce the benefits of global trade. Counter-interventions might reduce them further or might restore them to their original value. It depends on the kind of intervention.
Because I have written about this topic so many times before, I won’t make the full argument, but it might be useful to remind readers why reserve currency status is an exorbitant burden:
- Because, for a variety of reasons, dollars are the preferred form of foreign currency reserve, or of any “risk-off” kind of trade, in order to combat uncertainty or to increase domestic employment, foreign countries are most likely to accumulate reserves by buying US government bonds or other liquid, low-risk US dollar assets. This reserve accumulation might be formally classified as reserves, and accumulated by the central bank, or other institutions, some of which are referred to as sovereign wealth funds, might accumulate these reserves.
- When it is the private sector that accumulates dollars, there are likely to be too many potential reasons and consequences to try to summarize them. But when governments systematically accumulate huge amounts of dollars, the reason has almost always to do with creating or expanding the trade or current account surplus, which is just the obverse of expanding the export of net domestic savings. The mechanism involves suppressing domestic consumption by taxing households (usually indirectly in the form of currency undervaluation, financial repression, anti-labor legislation, etc) and subsidizing exports. These mechanisms force up the savings rate while making exports more competitive on the international markets, the net effect of which is to reduce domestic unemployment.
- If these savings are exported to the US, for example if the central bank buys US government bonds, the US must run the corresponding trade deficit. This has nothing to do with whether the exports go to the US or to some other country. It is astonishing how few economists understand this, but if Country A is a net exporter of savings to Country B, the former must run a surplus and the latter a deficit, even if the two do not trade together at all.
- Does the US benefit from importing foreign savings and foreign investment? The local state or country that receives the investment may benefit, but any country only benefits from importing foreign capital under one or more of three conditions:
- When a country has high levels of potentially productive investment but domestic savings are insufficient to satisfy domestic demand, the country benefits from importing foreign capital to fund these productive investments. As long as the total economic return on these investments, including all externalities, exceeds the cost of the foreign borrowing, or is funded by foreign equity investment, foreign capital inflows are wealth creating for the recipient.
- When during a crisis major borrowers, including the government, face severe short-term liquidity constraints and domestic capital is, for whatever reason, unwilling or unable to fund maturing debt, foreign capital inflows can help bridge the gap. In this case foreign investors fulfill the classic role of a central bank, lending to creditworthy borrowers or against acceptable assets in order to prevent a liquidity crisis from forcing the borrower into insolvency.
- For countries that lack technology, that have weak business and management institutions, or that suffer from low levels of social capital, foreign investment can bring with it the technology and management skills that allow the economy to grow.
- In the days of the gold standard it was possible for an advanced economy like the US to suffer from the first condition. Today it suffers from none of the three conditions.
- It can increase productive investment.
- It can increase nonproductive investment, especially in real estate, as foreign inflows unleash a stock and real estate market bubble, or it can increase consumption, as these bubbles unleash a wealth effect which causes ordinary Americans to increase their consumption relative to their income (i.e. reduce their savings). In either case US debt rises faster than US debt-servicing capacity.
- Unemployment can rise as the expansion in imports relative to exports causes American factories to cut back on production and fire workers. Of course fired workers no longer produce but they still must consume, so the savings rate drops.
These are the only three possible outcomes.If productive investment in the US has been constrained by the lack of American access to capital – domestic or foreign – as was the case in the 19th Century, it is possible that reserve currency status increases American employment and wealth creation. But in advanced economies productive investment is never constrained by lack of capital. It is almost always the case, in other words, that an increase in net foreign investment to the US (and to most advanced countries by the way) must result in some combination of a speculative investment boom, a consumption boom or a rise in unemployment. What typically happens is that in the beginning we get the first two, until debt levels become too high, after which we get the third.
6. Bryan Riley and William Wilson, two economists from the Heritage Foundation, in their response to Jared Bernstein’s article, provided their reasons in a blog entry last month for arguing that in principle the benefits of use of the dollar as the dominant reserve currency exceed the cost to the US of this higher debt or higher unemployment. Their piece was fairly short, and so I don’t want to suggest that I am representing the full scope of their disagreement, but they suggest that the benefits are:
Seignorage. The largest benefit has been “seignorage,” which means that foreigners must sell real goods and services or ownership of the real capital stock to add to their dollar reserve holdings.
Low Interest Rates. The U.S. has been able to run up huge debts denominated in its own currency at low interest rates. The dollar’s role as the world’s reserve currency reduces U.S. interest rates because foreign investors like to invest in the relatively safe U.S. economy.
Lower Transaction Costs. U.S. traders, borrowers, and lenders face lower transaction costs and foreign exchange risk when they can deal in their own currency. It’s easier to do business with people who take dollars.
Power and Prestige. The dollar’s dominant reserve status gives the United States political power and prestige. Britain’s loss of reserve-currency status in the 20th century coincided with its loss of political and military preeminence.
7. I think this is a pretty fair summary of the arguments generally used in favor of supporting “king dollar”, and I think they are worth addressing specifically. To address seniorage, the benefits of seniorage are really what the whole debate is about. If the US believes that it is important for the global trading system that the US produce enough reserves for a growing global economy, and if the global trading system benefits the US, it should do so. As long as the growth in global reserves is less than the growth in the US economy, the associated rise in debt is sustainable.
But, and this is the Triffin Dilemma, if reserves and other government accumulation of US assets grow faster than US GDP, seniorage results in an unsustainable increase in US debt (or unemployment). In my previous blog entry I argued that the former may have been the case in the 1950s, but as global GDP growth exceeds US GDP growth, as more countries and regions join in the global trading system, and as there is convergence between advanced and backward economies, the growth in US debt needed to capture these benefits either becomes unsustainable or, to restrain the growth in debt, requires a rise in US unemployment.
8. To address lower interest rates, I showed in my book why foreign purchases of US government bonds do not lower US interest rates. At best they simply distort the US yield curve and in the long term even raise them. I will not repeat the full explanation here, especially as there is a bit of circularity in the argument and counterargument: If the exorbitant burden causes unemployment to rise, as Austin and Bernstein argue, fiscal revenues must drop and fiscal expenses must rise, causing total government debt to rise by the same, or more (because most of us would agree that demand created by government spending is less efficient than demand created by trade) than the capital inflows available to fund government debt. So the additional supply of funding is only equal to or less than the additional demand for funding. But if you think unemployment doesn’t rise, as Riley and Wilson might argue (I am not sure if they do or don’t), then total debt doesn’t rise, or it doesn’t rise much, and the additional funding should cause interest rates to decline. In order to keep this short I would suggest simply that we consider the following.
The larger a country’s foreign current account deficit, by definition the greater the inflow of foreign money to purchase its assets, mainly government bonds in the case of the US and many other countries. The higher a country’s current account surplus, by definition the greater the outflow of money to purchase foreign assets, and the less domestic money available to purchase domestic assets. Is it reasonable, then, to assume that the larger a country’s current account deficit, the lower its interest rates, while the larger a country’s current account surplus, the higher its interest rates? This is what the low-interest-rate argument implies.
9. To address transaction costs, while it is true that trading in US dollars reduces transaction costs for American businesses, it is hard to believe that these transaction costs are not priced into the imports and exports of their foreign counterparts. More importantly, it is not clear that reducing central bank purchases of US government bonds will cause transaction costs to rise. The vast bulk of trading volume does not consist of central bank purchases of US government bonds. It is trade and investment related. If foreign central banks were limited in their ability to stockpile US dollar reserves, foreign exchange transaction costs would barely budge.
10. To address power and prestige, while it may be true that Britain’s loss of reserve-currency status in the 20th century coincided roughly with its loss of political and military preeminence, I think it is incorrect to imply that Britain lost power and prestige after the Great War mainly or even partly because sterling lost its status as the dominant reserve currency (which in fact really occurred some time in the 1930s and 1940s). It was the destruction, during the first two years of the Great War, of London’s role in trade finance (which formed the vast bulk of international lending at the time, with nearly the entire trade finance market moving to neutral Amsterdam and New York), followed by its aerial pounding in WW2, that caused London to lose its financial pre-eminence.
Even today it is hard to associate London’s current role as either the first or second most important financial center in the world, depending on how you measure it, with the status of sterling as a reserve currency. What is more, the US dollar only became the pre-eminent reserve currency in the 1930s and 1940s, but the US was the leading economic power – nominally, per capita, and technologically – by the 1870s. I would argue that US power and prestige probably has more to do with the size and dynamism of its economy, with the creativity of Hollywood and New York in entertainment and fashion, with technological innovation in San Francisco, Boston, New York, Austin, and elsewhere, with its composers and artists in New York, San Francisco, and elsewhere, with its overwhelming military superiority, with its universally-valued ideal of ethnic inclusiveness and individualism, with its Ivy League and elite universities, with its think tanks, with its astonishing scientists, and with a host of other factors more important than the currency denomination of central bank reserves.