Privilege or Curse?

The dollar is still the world's most accepted currency, meaning low interest rates and a high dollar price even with a large trade deficit. But is this good or bad for America?

In the 1960s, the French Finance Minister Valéry Giscard d'Estaing coined the term "exorbitant privilege" to describe the US dollar's position as the world's reserve currency. A reserve currency is one that central banks like to keep in their vaults in case of crises because it may be more widely accepted than the currency they print themselves. I'll first go over how the "exorbitant privilege" works for the US and then discuss whether it really is a privilege -- or whether the costs of this position make up for, or even outweigh, its benefits.

What privileges does the US have in the global economy? To understand this, let's look at what life is like for a smaller, poorer country whose currency is not bought, held, and traded by people around the world. Let's say our country is called Zinj. It's a small country so its economy doesn't carry much weight. It's currency, the zinjoleon, is pretty much only accepted within Zinj itself (this is the way things are for most currencies, really).

If Zinj wants to trade with the rest of the world, or invest outside Zinj, it must convert its currency to another one, very often the dollar. If you run an export business, you will need to exchange currency a lot. Luckily your local banks, as well as the central bank, hold a good deal of foreign currency to facilitate exchanges. Because the dollar is the "gold standard" so to speak, banks have bought US treasury bonds and will have cash on reserve at America's Federal Reserve.

This all works very well, really. You list your goods in dollars so that customers around the world know what they cost (they probably have no idea what a zinjoleon is worth and where to buy one). You ship your goods, receive payment in dollars, and then convert most of them into zinjoleons in order to pay your workers, rent, utilities, etc. You might keep some dollars to buy imports with.

The problem comes when there's a crisis. Maybe when the world economy was doing well, and your economy was too, cash flowed into your country. Zinj citizens and businesses had access to cheap capital from abroad. Then the crisis hit.

Regardless of how things are going in Zinj (maybe Zinj has nothing to do with the crisis), investors panic and pull their cash out of the country, converting zinjoleons to dollars en masse to do so (they do this in part because the dollar is accepted everywhere and is therefore less risky). The price of a zinjeon, euro, dollar, or any other currency is based on supply and demand, just as it is for any other good or service. So what happens when loads of people sell zinjoleons (that few people want to buy) to buy dollars? You probably guessed it: the price of a zinjoleon falls.

Suddenly, 1 zinjoleon no longer buys you $1 worth of goods. Maybe it only buys you $0.80 worth now. That means prices for imported goods (listed in dollars) and goods that rely on imports rise sharply (in zinjoleon terms, the currency that people in Zinj actually earn). At the same time, foreign investment has disappeared, cutting funding for projects. Banks have fewer depositors and creditors, meaning they have to raise interest rates. In addition, the central bank may raise interest rates to stamp out inflation and try to stop the currency's fall. All this means that the economy will most likely stumble, perhaps slipping into a severe recession -- even though there was nothing wrong within Zinj itself! Seem totally unfair?

Would something like that happen in America? If the crisis happens outside of America and the dollar is still the reserve currency, no. In fact, even in 2008, when the crisis WAS in America, this didn't happen. Flip the above scenario on its head: folks are buying dollars all over the place and investing their money in the world's largest, most liquid economy and bond market: America. So what happens? Money flows into the US and the dollar rises in value. These combine to make goods cheaper and lower interest rates, pushing the US economy forward! Does that sound like an exorbitant privilege? Yeah, it kinda does!

But wait, the story doesn't end here. I left out the flip side of both stories. Let's revisit Zinj.

A crisis will generally mean recession -- less investment, less consumption, less money being spread around. If that's happening in the countries you trade with, your exports will fall. Luckily for Zinj, though, its currency has also fallen by 20%, meaning its exports are also up to 20% cheaper. This will make Zinj more competitive in world markets during the crisis, boosting its exports even as world consumption slows. Exports bring money into the economy. They may very well bring in enough to make up for the investment cash flowing out, too. After the initial panic and devaluation, therefore, Zinj's economy may start growing quite quickly again, led by exports, as well as domestic businesses competing more easily with imports that are now more expensive.

Flip that around in America. The cash flowing into the country has made the dollar more expensive. That means America's exports have gotten pricier even as the world economy slows and people are buying less. That really kills American exports. At the same time, imports have gotten cheaper, which turns up the heat on American companies that compete against imported goods to sell to American consumers. So we have cheap credit (loans and whatnot), higher investments in stocks and higher prices for companies (meaning they can buy and pay more even if they aren't necessarily doing better), and investments flowing into all kinds of other things, like housing. At the same time, American exporters are having a heck of a time trying to sell their goods and services abroad and other American companies are having a hard time competing against cheap imports from places like Zinj. Sound familiar?

All those cheap loans, high company valuations, and a higher dollar value mean that American consumers, companies, and its government have tended to spend and borrow more than they should have. It also means that outside of finance, in the world of actually selling goods and services, America has had a hard time -- in no small part due to the "exorbitant privilege" provided by the reserve currency that it controls and prints.

Clearly, this is a knife that cuts both ways. Sure, America may have more time than other countries to sort out its budget issues because investors tend not to lose faith (America's debt was downgraded and investors responded -- by buying even more of it). At the same time, there is constant pressure to borrow more and it is ever harder to sell anything. A country like Zinj may feel itself a victim to the winds of the global economy, unable to influence the global currency or exchange rates in any way. True, and America can do a lot to influence the global currency and its value compared with others. But this privilege is also a curse, as I think I have shown. (And I haven't even mentioned the costs of printing the money and the interest payments the Federal Reserve has to make on all the money foreigners have deposited with it.)

Given this double-edged sword, Americans need not fear the dollar's eventual loss of reserve currency status. It will bring a loss of power and prestige, but it may also lighten America's shoulders a bit.


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