Currency wars and dollar’s reserve role

‘Exorbitant privilege’ versus ‘indestructible curse’

The daily deluge of President Donald Trump’s tweets about unfair currency practices has raised questions about whether the dollar’s reserve currency and financing roles boost the dollar and harm US trade accounts. Putting a positive spin on it, Trump said, ‘Massive amounts of money from China and other parts of the world is pouring into the US for reasons of safety, investment and interest rates.’ But the Washington Post noted recently that growing recession concerns had prompted the White House to discuss a currency transaction tax to cheapen the dollar.

One approach to determine if the dollar’s reserve currency and financing roles harm US trade accounts is to examine the International Monetary Fund’s current account ‘norms’ in its external sector report. A country’s norm aggregates many factors: soundness of its policies, demographics, strength of institutions, net foreign asset positions, growth prospects and reserve currency status.

The Fund finds the US current account ‘norm’ is a deficit of almost 1% of GDP, versus the country’s actual deficit of around 2.5%. The US, given its fiscal debt and deficits, should run more desirable policies, according to the IMF. That would boost national saving, pushing the US norm toward surplus. But the large deviation between the country’s current fiscal stance and what is desirable explains much of the difference between the present deficit and the ‘norm’. Part of the actual US deficit is explained by the counterpart to countries with surpluses greater than their norms.

The dollar’s reserve currency role pulls down the US current account norm by around two percentage points of GDP in the deficit direction, much more so than any other country. This is because the depth and liquidity of US capital markets increase global dollar demand, strengthening the dollar and allowing the country to run larger current account deficits.

‘Exorbitant privilege’ refers to the dollar’s reserve currency role allowing the US to run bigger external deficits. Proponents of this view argue the dollar’s role allows the US to escape economic disciplines, harming the global economy.

But others suggest the dollar’s reserve role is also an ‘indestructible curse’, insofar as it means that the US is prone to run persisting trade deficits, hurting domestic jobs and workers.

On balance, the country benefits from the dollar’s reserve status. It derives substantial seigniorage. Financing costs are lower, especially for the Treasury. Americans are somewhat shielded from exchange risk.

How a currency transaction tax would weaken the dollar is unclear. Presumably, such an initiative would be a unilateral US act. In that regard, perhaps – as some have suggested – the country could tax foreign inflows or foreign earnings on US assets. Or one might contemplate capital controls.

On balance, the dollar’s reserve and financial roles benefit the US, but the opposite could be true of currency transaction taxes. These could be particularly detrimental to the openness of the country’s financial system. It is important, however, to remain mindful of the costs to American workers.

The global economy faces enormous challenges. Focusing heavily on currency values or monetary policy is too narrow an approach. Monetary policy is already overburdened and cannot be the sole tool for stabilisation. A weaker dollar will not regenerate US growth, let alone when global demand is weak and the US remains a closed economy.

While the US is slowing, its relative performance is favourable. Euro area growth is falling and Germany may be headed toward recession. Italian uncertainties and the UK’s departure from the European Union further cloud the outlook. Japan faces persistent low growth and inflation. China’s sustainable growth rate is falling amid large domestic imbalances. The IMF, G7 and G20 need to co-operate to find a path to strong, sustainable and balanced growth.

The US should not cast doubt on the dollar’s reserve and financing roles and the openness and depth of our capital markets. Doing so would add to market volatility. As the IMF ‘norms’ show, the country could improve substantially domestic economic policies, especially fiscal policy, to achieve an external position more in line with US underlying fundamentals. As a society, it needs raise the educational and skill levels of its workforce to enhance competitiveness.

The dollar appreciates on risk-off developments. Every time trade wars are heightened, the dollar rises. While the president is justified in criticising Chinese practices on intellectual property, statism and industrial policy, ending the trade wars would immediately reduce global economic uncertainties, reduce market volatility and curb dollar appreciation.

Mark Sobel is US Chairman of OMFIF.

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