Reserve Currency

Krugman: no big deal

Princeton Economics professor and New York Times columnist Paul Krugman says there's not really anything to be concerned about in changes to the use of the US dollar as an international reserve currency. His opinion is that the dollar's reserve currency status doesn't really have much effect on the US. The number of dollars going into central bank coffers as reserves is tiny compared to GDP:

Well, then, you may say, surely the international role of the dollar forces people out there to hold dollars for transaction purposes. Yes, but not so you'd notice. When Daewoo repays a dollar loan from Sanwa, it writes a check on its account with some international bank. True, that bank itself surely maintains an account in New York, backed in part by non-interest-bearing reserves held at the Fed. So the U.S. does in effect get a zero-interest loan out of the dollar's international role--but it probably amounts to only a few billion dollars, small change for an $8 trillion economy.

More significant than currency reserves, Krugman says, is the use of US cash worldwide as a medium for illegal transactions:

Where the U.S. does get a significant free ride is from the willingness of foreigners to accept our currency--actual bills. Foreigners hold more than $200 billion of American money. Guess what kind of business requires payments of large sums in cash, by people unconstrained by official restrictions on possession of foreign exchange? That's right: the dollar is the world's premier medium of illicit exchange. Every year the U.S. ships foreigners $15 billion in cash (about 0.2% of GDP), and gets real goods and services in return. Better not ask what kind.

But still, he says this is a tiny proportion of GDP.

Is he right that the small proportion of GDP of these transactions means that there is naught to worry about?

I wonder, what is the total value of US dollar currency reserves worldwide, and what is the total value of US currency in circulation abroad? What proportion of GDP are we talking about then? What proportion of the total amount of US dollars worldwide are we talking about?

No answers yet, just lots of questions.

The Dollar Bubble

Arnold Kling on the overvaluation of the US dollar:

Even though the dollar is overvalued, it is impossible for the United States to suffer a currency crisis of the sort experienced by Asian countries in the late 1990's or Latin American countries seemingly once a decade. The reason is that the United States has the luxury of having its debts denominated in its own currency....

The beauty of having dollar-denominated debts in a world of currency fluctuations is that the United States is fairly insulated. If the foreign currency crashes, foreign borrowers take the hit. If the dollar crashes, foreign lenders take the hit. Foreigners are screwed either way....

If you are waiting for a financial-market disaster to come crashing down on the evil Americans and their evil Republican administration, I would not hold your breath. If the dollar bubble bursts, it will reduce our wealth a bit (because of the rise in the cost of foreign goods), but the improvement in our trade competitiveness will help to increase output and employment.

Definitions

Now for some definitions:

A reserve currency is "a foreign currency held by a central bank or monetary authority for the purposes of exchange intervention and the settlement of intergovernmental claims."

Special Drawing Rights (SDRs): "Created in 1969 by the International Monetary Fund (IMF) as a supplemental international monetary reserve asset, SDRs are available to governments through the IMF and may be used in transactions between the IMF and member governments. IMF member countries have agreed to regard SDRs as complementary to gold and reserve currencies in settling their international accounts. The unit value of an SDR reflects the foreign exchange value of a "basket" of currencies of several major trading countries (the U.S. dollar, the German mark, the French franc, the Japanese yen, and the British pound). The SDR has become the unit of account used by the IMF and several national currencies are pegged to it. Some commercial banks accept deposits denominated in SDRs."

Seignorage is "the difference between the value of money and the cost of its production."

Euro v. Dollar

Take a look at the two-year chart of the euro-dollar exchange rate.

Composition of Foreign Exchange Reserves

Now for some real data: the International Monetary Fund's working paper from July 2000 entitled The Currency Composition of Foreign Exchange Reserves (warning: big .pdf file) includes some hard data and offers some educated conclusions. Based on past practice throughout the 70s, 80s, and 90s, it seems that changes to reserve currency composition at central banks have tended to be gradual over time and not precipitous. In addition, there are other good reasons to believe that a shift from the US dollar and toward the euro would also be gradual. For example, reliance on a reserve currency has been greatly motivated in the past on stable economic policies by the issuing country's central bank, so it would take some time for the European Central Bank's policies to inspire such confidence.

Iraq Invasion

Let's start with something provocative. Project Censored's Top 25 Censored Media Stories of 2002-2003 includes U.S. Dollar vs. the Euro: Another Reason for the Invasion of Iraq. In November 2000, Iraq began selling its oil in euros. Their thesis is that the US invasion of Iraq was at least in part motivated by the need to force Iraq back to the dollar -- to prevent movement away from the dollar by Iraq's trading partners and to dissuade other OPEC countries from switching to the euro for their oil sales (especially Iran).

Now why would this matter so much? The US dollar is the world's reserve currency, meaning that central banks all over the world hold huge amounts of dollars in reserve. In the post-WWII world this was a sound bet because the US dollar was backed up by gold. Since 1971 it has not been convertible to gold, and since 1973 the US has been off the gold standard entirely. The US dollar, like other currencies, is a fiat currency, backed up by nothing more (or less) than the word of the US government. The bottom line is that the value of the US dollar, the euro, and other fiat currencies, is entirely determined by market rates, government action, or some combination, to the extent that they are not backed up by some valuable reserve.

Oil makes up a significant part of international trade. If countries have to start converting some of their reserve dollars to euros in order to balance their oil trading accounts, and at the same time the euro is gaining against the dollar in foreign exchange markets (up approx. 20% in the last year alone), there is a real concern that central banks will start converting their ongoing reserves in greater quantities from dollars to euros (or a mixture of dollars and euros). If this were to happen precipitously it could trigger a massive sell-off of dollars. An overabundance of dollars in the market is, I believe, by definition inflation, but this is where my understanding of macroeconomics starts to get on very shaky ground....

The long and the short of it is that Iraq switched to the euro for oil sales, the US invaded, and the US immediately moved Iraq back to the dollar. Most of the talk in OPEC of switching to the euro stopped for a while. How much of this is coincidence, and how much conspiracy?

Welcome

Welcome to the Reserve Currency blog.

I am not an economist, and I really don't know much about macroeconomics, but I am a reasonably well-educated and intelligent person, and I have recently developed a fascination with the topic of reserve currencies. The surprising thing to me is how little this topic is discussed (especially in the US), and yet how far-reaching its effects may be.

This blog will be a place where I can post links to articles relating to the topic, ask questions about things that puzzle me, and ruminate on my own opinions. I have no idea if anyone else out there shares this fascination, but just in case they do, this blog will be a handy repository of links to useful information.

In the interests of full disclosure: my political philosophy is small 'l' libertarian, I find the so-called Austrian school of economics generally to be persuasive, I lean toward an international rather than nationalistic viewpoint, and in law school I did more than a little bit of research on international trade issues.

-- mg