In this Edition
Is reserve currency status an economic blessing or a curse? The answer might seem obvious, as reserve currencies have been shown to confer lower borrowing costs on their issuers. But what of the borrower who, enticed by low interest rates, borrows more than they can pay back? Naturally the result will be a default. However, for the issuer of a reserve currency that is unbacked by a marketable commodity, such as gold, in the event that they borrow too much, they can just print more currency. While this avoids default indefinitely, it also hollows out the economy, erodes the capital stock, reduces the potential growth rate and, eventually, leads to a dramatic devaluation of the currency and loss of reserve status. History has not been kind to countries that have followed this path. In my view, the grave investment risks associated with the US dollar’s inevitable and potentially imminent loss of reserve status are not priced into financial markets.
Reserve Currencies, Trade Imbalances and the 'Triffin Dilemma'
Having written a book about international monetary regime-change past, present and future, I weigh in again in this Amphora Report on what is gradually becoming a more mainstream debate about whether or not the US dollar is at risk of losing reserve currency status, what currencies, if any, might replace it, and, should it happen, what general economic and financial market implications this would likely have.
As it happens, I have a rather strong opinion on all of these matters. But first, let’s consider what a reserve currency is and what it is not. Second, let’s distinguish carefully between reserve currencies that are backed by a marketable commodity, such as gold or silver, and those that are not. Third, let’s take a look at shifting global economic power and monetary arrangements. Then we can move into what I think is going to happen in future, what this implies for financial and commodities markets, and what investors can and should do to prepare.
What, exactly, is a reserve currency? It is an international money that is used to pay for imports from abroad and is then subsequently held in ‘reserve’ by the exporting country, as it does not have legal tender status outside of its country of issuance. In the simple case of two countries trading with one another, with one being a net importer and one a net exporter, over time these currency ‘reserves’ will accumulate in the net-exporting country. In practice, as reserves accumulate, they are invested in some way, for example, in bonds issued by the importing country. In this way the currency reserves earn some interest, rather than sit as paper scrip in a vault.
Beyond a certain point, however, accumulated reserves will be perceived as ‘excessive’ by some in the exporting country, in that they would prefer to purchase something with this accumulated savings instead. In this case they have a choice: Either they can purchase more imports from the net-importing country, thereby narrowing the trade imbalance, or they can exchange their reserves with another entity at some foreign-exchange rate. For this reason, other factors equal, as reserves accumulate, the reserve currency will depreciate in value.
As trade imbalances and reserve balances grow, so does the natural downward pressure on the value of the reserve currency as described above. This leads to what Belgian economist Robert Triffin called a ‘dilemma’: For unbalanced trade to continue to expand, the supply of reserves must increase. Yet this implies a chronically weak reserve currency, which leads to price inflation. Indeed, under the Bretton Woods system of fixed exchange rates, the supply of dollar reserves grew and grew, price inflation increased and, eventually, as one European central bank after another sought to exchange its ‘excess’ dollar balances for gold, this led to a run on the official US gold stock and the demise of that particular monetary regime.
While hailed as an important insight at the time, Triffin was pointing out something rather intuitive: Printing a reserve currency to pay for net imports is akin to owning an international ‘printing press’, the use (or abuse) of which causes net global monetary inflation and, by association, some degree of eventual, realized price inflation.
'Cantillon Effects' and the Non-Neutrality of International Reserves
Now let’s combine Triffin’s insight with that of Richard Cantillon, a pre-classical 18th century economist, that money is not ‘neutral’: New money enters the economy by being spent. But the first to spend it does so BEFORE it begins to lose purchasing power as it expands the existing money supply. The money then gradually permeates the entire economy, driving up the overall price level. Those last in line for the new money, primarily everyday savers and consumers, eventually find that, by being last in line for the new money, their accumulated savings are being de facto ‘diluted’ and the purchasing power of their wages diminished.
Extropolated to the global level, this non-neutrality of money implies that an issuer of a reserve currency is the primary beneficiary of the ‘Cantillon effect’. First in line for the new international money are the owners of capital in the reserve issuing countries, who use the new money to accumulate more global assets, and at the end you have workers the world over who receive the new money last, after it has placed general upward pressure on prices. Greater global wealth disparity is the inevitable result.
Another way to think about the benefits of issuing the reserve currency is that it generates global seignorage income. Federal Reserve notes pay no interest. However, they can be used to purchase assets that DO bear interest. No wonder the Fed always turns a profit: It issues dollars at zero interest and collects seignorage income on the assets it accumulates in return. But in a globalised economy, with the US a large net importer and issuer of the dominant reserve currency, this seignorage income is partially if indirectly sourced from abroad, via the external accounts.
This becomes particularly notable in the event that domestic credit growth is weak relative to abroad. The Fed may print and print to stimulate domestic credit growth but if that printing does not get traction at home, it will instead stimulate credit growth abroad and, eventually, contribute to higher asset and consumer price inflation around the world.
Over time, this will impact the relative competitiveness of other economies, where nominal wage growth is likely to accelerate, eventually making US labor relatively more competitive. That may sound like good news, but all that is really happening here is that US wages end up converging on those elsewhere, something that should happen in any case, over time, between trading partners as their economies become more highly integrated. But to the extent that this wage convergence process is driven by reserve currency inflation, rather than natural, non-inflationary economic integration, the Cantillon effects discussed earlier result in wages converging downward rather than upward, implying a global wealth transfer from ‘owners’ of labor—workers—to owners of capital.
So-called anti-globalists disparaging of free trade are thus not necessarily barking mad—well, perhaps some are—but they are barking up the wrong tree. The problem is not free trade; the problem is trade distorted by monetary inflation. If you want workers around the world to get fairer compensation for their labor, shut down the reserve currency printing press. And if you also want them to have access to the largest possible range of consumer goods at the lowest possible cost, remove trade restrictions, don’t raise them.
Reserve Currencies: Gold-Backed, and Unbacked
As it happens, prior to the First World War, the bulk of the world was on the classical gold standard. Although the British pound sterling was the dominant reserve currency, it was not possible to print an endless amount of pounds to pay for endless imports, as external reserve currency balances were regularly settled in gold. The British pound thus held its value over time, as did other currencies on the gold standard, and there was not a ‘Triffin Dilemma’ resulting in growing, unsustainable trade imbalances. Moreover, absent monetary inflation, there were no insidious Cantillon effects taking place. Industrial wages were generally stable through these decades, which were characterised by mild consumer price deflation. This implied an increase in workers’ purchasing power and standards of living. So while there are certain parallels between sterling’s previous, gold-backed role as a reserve currency and that of the unbacked, fiat dollar today, there are even greater differences.