By
Fowler W. Martin
In the body of the article, Krugman didn’t mention political stability as a factor underling the dollar’s long-standing preeminent role as a store of value for what amounts to the savings foreign governments accumulate largely because their countries export more than they import. Rather, he pointed to the depth, breath and liquidity of U.S. financial markets, an absence of capital controls, and a reliable legal system.
In my experience as a financial journalist reporting on such matters for many years, those are, indeed, the time-tested explanations for this phenomenon. Some would add the enormous size of the U.S. economy relative to other nations although that is arguably captured in the nature of U.S. financial markets. Others point to military power: the U.S. is unlikely to suddenly fall victim to an expansionist foreign nation that might (among other things) impose capital controls and change critical laws and the manner in which they are implemented.
I personally would add that the U.S. political system, where to date power has been reliably transferred in a transparent fashion at regular intervals, is a major source of foreign confidence as well.
This isn’t the first time questions have arisen as to whether the dollar should continue to enjoy its privileged position. But when they have, a quick answer has been: “What are the alternatives?” and in that vein, Krugman in his column advanced that notion, citing China’s problematic policies and practices as the prime example.
But the situation may be changing. Earlier this month, Christine Lagarde, head of the European Central Bank and former head of the International Monetary Fund, told the U.S. Council on Foreign Relations that at present, about 60% of international reserves are held in dollars, 20% in the Euro and the remaining 20% in the Chinese renminbi, the yen, the pound sterling, the Canadian dollar, the Australian dollar and a few others.
So alternatives are out there with the Euro having gained the most ground against the dollar during the recent past.
“We are also seeing increased accumulation of gold as an alternative reserve asset, possibly driven by countries much closer geopolitically to China and to India,” she said.
The thrust of Lagarde’s remarks was that the world economy appears to be fragmenting into competing blocs – a development, she said, that “is likely to have first-order implications for central banks.” That would, of course, include the U.S. Federal Reserve.
In his column, Krugman argued that even if the dollar were to lose its reserve currency status, it wouldn’t matter much. Pointing to other countries – principally Britain – where this has happened, he said non-reserve currencies “do just fine at home, continuing to serve the traditional roles of money: medium of exchange, store of value, unit of account.”
While that statement is perfectly true as far as it goes, it doesn’t go far enough. The balance of payments is a complicated and difficult topic, but in a nutshell, because of very large inflows of capital from foreign governments who want to hold their reserves in dollars, mainly in the form of U.S. government securities – inflows not offset by comparable outflows of capital – the U.S. has not just been enabled, but arguably required, to run significant deficits the trade of goods and services for decades.
Simply put, we have been long living beyond our means by consuming more than we produce. Another way of describing it is that because the dollar is the key reserve currency, our standard of living (in economic terms) has been higher than otherwise would have been the case.
What if foreign governments decide to sell all or a significant part of their holdings of U.S. government securities – securities that help finance U.S. budget deficits? Interest rates could rise in order to attract other buyers, which, all other things being equal, would also adversely impact U.S. living standards. Or the federal government might be faced with cutting spending and/or raising taxes.
Leaving governments out of picture for a moment, Krugman said foreigners in general “probably hold more than a trillion dollars in U.S. currency, mainly in the form of $100 bills.” To the extent they tried to convert such holdings into other denominations, the Fed, he said, would have to sell off some of its massive securities holdings, but to whom? If conversions of $100 bills took place as a result of a loss of confidence by foreign government in the dollar’s reserve status, the securities would have to be priced to attract domestic investors away from alternatives. In other words, higher interest rates and presumably less capital for commercial uses.
How important is the latter? Well, Krugman just had another column celebrating a revival of investment in U.S. manufacturing that in his view stems from recent, very large government spending bills signed by President Biden – the CHIPS Act and the mis-named Inflation Reduction Act.
“Goldman Sachs predicts that the Inflation Reduction Act will involve substantially higher government outlays than was initially projected, but will also induce trillions of dollars in private investment,” Krugman said. That would mean the government would have to sell more securities at the same time private demand for capital funding was increasing substantially.
Suppose foreign government and private funding were diminishing or “pulling out” as a result of questions over the dollar’s value as a reliable store of value, possibly as a result of a debt-ceiling default? American living standards could be at risk from that direction as well.
The reserve status of the dollar is far from inconsequential.
(During more than 30 years as a financial journalist, Mr. Martin was the Managing Editor of the AP-Dow Jones Economic Report, an international financial newswire, and Washington Bureau Chief of Dow Jones News Services. He currently lives in Seattle in retirement.)
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