The United States’ current fiscal and monetary policies areunsustainable. The US government’s net debt as a share of GDP has doubled inthe past five years, and the ratio is projected to be higher a decade from now,even if the economy has fully recovered and interest rates are in a normalrange. An aging US population will cause social benefits to rise rapidly,pushing the debt to more than 100% of GDP and accelerating its rate ofincrease. Although the Federal Reserve and foreign creditors like China are nowfinancing the increase, their willingness to do so is not unlimited.
Likewise, the Fed’s policy of
large-scale asset purchases has increased commercial banks’excess reserves to unprecedented levels (approaching $2 trillion), and hasdriven the real interest rate on ten-year Treasury bonds to an
unprecedented negative level. As the Fed acknowledges, thiswill have to stop and be reversed.
While the future evolution of these imbalances remainsunclear, the result could eventually be a sharp rise in long-term interestrates and a substantial fall in the dollar’s value, driven mainly by foreigninvestors’ reluctance to continue expanding their holdings of US debt. Americaninvestors, fearing an unwindingof the fiscal and monetary positions, might contribute to these changes byseeking to shift their portfolios to assets of other countries.
While I share these concerns, others frequently rely on twokey arguments to dismiss the fear of a run on the dollar: the dollar is areserve currency, and it carries fewer risks than other currencies. Neitherargument is persuasive.
Consider first the claim that the dollar’s status as areserve currency protects it, because governments around the world need to holddollars as foreign exchange reserves. The problem is that foreign holdings ofdollar securities are no longer primarily “foreign exchange reserves” in thetraditional sense.
In earlier decades, countries held dollars because theyneeded to have a highly liquid and widely accepted currency to bridge thefinancing gap if their imports exceeded their exports. The obvious candidatefor this reserve fund was US Treasury bills.
But, since the late 1990’s, countries like South Korea,Taiwan, and Singapore have accumulated very large volumes of foreign reserves,reflecting both export-driven growth strategies and a desire to avoid a repeatof the speculative currency attacks that triggered the 1997-1998 Asianfinancial crisis. With each of these countries holding more than $200 billionin foreign-exchange holdings – and China holding more than $3 trillion –these are no longer funds intended to bridge trade-balance shortfalls. They aremajor national assets that must be invested with attention to yield and risk.
So, although dollar bonds and, increasingly, dollarequities are a large part of these countries’ sovereign wealth accounts, mostof the dollar securities that they hold are not needed to finance tradeimbalances. Even if these countries want to continue to hold a minimum core oftheir portfolios in a form that can be used in the traditional foreign-exchangerole, most of their portfolios will respond to their perception of differentcurrencies’ risks.
In short, the US no longer has what Valéry Giscardd’Estaing, as France’s finance minister in the 1960’s, accurately called the “exorbitant privilege”that stemmed from having a reserve currency as its legal tender.
But some argue that, even if the dollar is not protected bybeing a reserve currency, it is still safer than other currencies. If investorsdon’t want to hold euros, pounds, or yen, where else can they go?
That argument is also false. Large portfolio investorsdon’t put all of their funds in a single currency. They diversify their fundsamong different currencies and different types of financial assets. If theyperceive that the dollar and dollar bonds have become riskier, they will wantto change the distribution of assets in their portfolios. So, even if thedollar is still regarded as the safest of assets, the demand for dollars willdecline if its relative safety is seen to have declined.
When that happens, exchange rates and interest rates canchange without assets being sold and new assets bought. If foreign holders ofdollar bonds become concerned that the unsustainability of America’s situationwill lead to higher interest rates and a weaker dollar, they will want to selldollar bonds. If that feeling is widespread, the value of the dollar and theprice of dollar bonds can both decline without any net change in the holding ofthese assets.
The dollar’s real trade-weighted value already is more than25% lower than it was a decade ago, notwithstanding the problems in Europe andin other countries. And, despite a more competitive exchange rate, the UScontinues to run a large
current-accountdeficit. If progress is not made in reducing the projected fiscalimbalances and limiting the growth of bank reserves, reduced demand for dollarassets could cause the dollar to fall more rapidly and the interest rate ondollar securities to rise.
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