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Why dollar hegemony is considered unhealthy

The excessive reliance on the U.S. currency carries a risk of hurting all

— FILE PHOTO

GREENBACK'S SUPREMACY: A Korean Exchange Bank staffer checks U.S. dollars in the bank's office in downtown Seoul. — FILE PHOTO

WITH THE U.S. Federal Reserve chairman warning about inflation, the dollar is in the news these days, and there is a sense that the world economy has become excessively reliant on the dollar. This reliance smacks of dysfunctional co-dependence whereby the U.S. and the rest of the world both rely on the dollar's strength, but neither is well served by it.

The U.S. dollar is the world's premier currency, with approximately two thirds of world official foreign-exchange holdings being dollars. Moreover, many countries appear willing to run sustained trade surpluses with the U.S., supplying everything from t-shirts to Porsches in return for additional dollar holdings. This willingness to exchange valuable resources for paper IOUs represents a form of dollar tribute.

U.S. special advantage

Many foreign policymakers complain about the special advantage for the U.S., allowing the nation to run enormous trade deficits without apparent market sanction. Whereas balance-of-payments considerations constrain other countries to run tight economic policies, no equivalent constraint appears to hold for the U.S. This advantage is rooted in the dollar's special role as the world's reserve currency.

For the U.S., one major benefit of the dollar's reserve-currency role is that it increases the demand for U.S. financial assets. This drives up prices of stocks and bonds and lowers interest rates, thereby increasing household wealth and lowering the cost of borrowing money. Additionally, the U.S. government gets seignorage, or an interest-free loan, from the hundreds of millions in dollar bills held offshore.

Mixed blessing

Increased foreign demand for U.S. assets also appreciates the dollar, which is a mixed blessing. On one hand, consumers benefit from lower import prices.

On the other, it makes U.S. manufacturing less competitive internationally because an overvalued dollar makes U.S. exports more expensive and imports cheaper. Reserve-currency status therefore promotes trade deficits and de-industrialisation.

The conventional explanation of the dollar's reserve-currency status is a "medium of exchange'' story. The U.S. has historically been the largest and richest currency area, with the largest share of world output and trade. This has provided incentives for other countries to hold and use dollars.

A second theory of reserve currencies, associated with the political left, is based on U.S. military power and the Pax Americana. The argument is that U.S. military power provides the security that protects the global market system, and New York is the new Rome. Countries, such as Saudi Arabia, hold reserves in dollars because New York is a political safe haven and because that helps cover the costs of enforcing the Pax Americana.

These two theories are mutually reinforcing. Thus, to the extent that the dollar is widely used and is also a safe haven, investors tend to rush into dollars in times of uncertainty. Consequently, central banks in other countries need to accumulate large dollar-reserve holdings to protect against financial disruptions that result from sudden exits by investors, as happened in East Asia in 1997.

There is a third unrecognised theory that can be labelled the "buyer of last resort'' theory of reserve currencies. Put bluntly, the tribute other countries pay the U.S. through their trade surpluses is the result of their failure to generate adequate consumption spending in their own markets.

The logic of this third theory is easily illustrated. Over the last decade, while Europe and Japan stagnated, the U.S. has grown on the back of robust consumer spending. This spending has sucked in imports, helping growth in Europe, East Asia and Latin America, and making the U.S. the major engine of global growth.

Conventional theory says the dollar will lose its dominance only when countries become saturated with dollar holdings. At that stage they will cease buying and may even sell dollars, causing the currency to fall. The problem with this story is that countries have no incentive to sell dollars, as this would kill the golden goose of export-led growth.

The buyer-of-last-resort story suggests a different take. One reason the dollar could topple is if countries finally manage to develop their own consumption markets.

Countries in the Euro zone are most capable of doing this, but for the moment they are gripped by policymaking that is obsessed with inflation and afraid of growth. China needs to improve its income distribution in a way that links income distribution to productivity. Unions are the natural way to do this, but are blocked by China's totalitarian political system that fears such organisation.

An alternative source of collapse is if American consumers reduce spending because they feel overextended, the Fed raises interest rates too high or American banks tighten lending standards. In this event, the U.S. economy would stall and the dollar could fall owing to diminished economic prospects in the U.S..

All three theories have merit, but in today's economic environment the buyer-of-last-resort theory is especially relevant. As long as other countries fail to generate sufficient demand in their own markets, they will be compelled to rely on the U.S. market and pay dollar tribute.

Thomas I. Palley

Reprinted with permission fromYaleGlobal Online

(http://yaleglobal.yale.edu), a publication of the Yale Center for the Study of Globalization. Copyright © 2006 Yale Center for the Study of Globalization.

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