Reserve Currency

Cheap dollar "overshooting"

Washington Post columnist David Ignatius spells out in "Fiddling while the dollar drops" a scenario where the dropping value of the dollar against other currencies (particularly the euro) could drive Asian central banks to hedge by diversifying their reserves, which in turn could further weaken the dollar on exchange markets, which could drive the Fed to boost interest rates to protect the currency, which in turn could drive down the stock market. Ignatius' thesis is that the cheap dollar is politically expedient at present, and thus there is concern by a number of experts that the market value of the dollar could "overshoot" as it declines, triggering these undesirable consequences.

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."