Michael Pettis Discusses the US Dollar Reserve Currency Burden and Systemic Suppressed Savings

Michael Pettis discusses the burden on the United States for having the US dollar as the World’s reserve currency.

There seems to be a slow change in the way the world thinks about reserve currencies. For a long time it was widely accepted that reserve currency status granted the provider of the currency substantial economic benefits. Pettis started to think more seriously about the components of the balance of payments and realized that when Keynes at Bretton Woods argued for a hybrid currency (which he called “bancor”) to serve as the global reserve currency, and not the US dollar, he wasn’t only expressing his dismay about the transfer of international status from Britain to the US. Keynes recognized that once the reserve currency was no longer constrained by gold convertibility, the world needed an alternative way to prevent destabilizing imbalances from developing.

The creation of the euro provided another illuminating variation on the impact of reserve currency status. When German institutions – government, businesses and labor unions – negotiated among themselves at the turn of the century a sharp reduction in wage growth for its workers, they were obviously attempting to reduce German’s high domestic unemployment by gaining trade competitiveness. Because these polices forced up the savings rate, and perhaps also explain why the investment rate dropped, they resulted in huge current account surplus (or which is the same thing, excesses of savings over investment) that were counterbalanced within Europe. These policies “worked”, and they worked probably far better than anyone expected. The sick man of Europe, with its high unemployment and large current account deficits, turned the corner almost immediately.

The US dollar dominance is vaguely assumed to give the US some ill-defined but important advantage – after all they did call it the “exorbitant privilege”. But after a few years in China, Pettis became increasingly suspicious of the value of this exorbitant privilege.

Frankly it shouldn’t have taken so long. After all it didn’t take much to see evidence of countries that did all they could to avoid receiving any part of this privilege. Capital controls have historically been as much about preventing foreigners from buying local government bonds as it has been about preventing destabilizing bouts of flight capital, and living in China, where an aggressive demand for the privileges of reserve currency status coincide with equally aggressive policies that prevent the RMB from achieving reserve currency status (and that transfer ever more of the “benefits” to the US) made clear the huge gap in rhetoric and practice. After all the US demand that China revalue the RMB is also a demand that the PBoC stop increasing US dollar reserves.

We are seeing a change in the way the world thinks about the role of the US dollar, and Pettis thinks this is because the 2007-08 crisis in Europe and the US, the start of Abenomics, and the extremely difficult adjustment that China faces have all focused attention on the nature and structure of savings imbalances and their effect on the global balance of payments. It is becoming increasingly obvious that Keynes was right. Several years ago, Pettis received an email from Kenneth Austin, a Treasury Department economist who had read one of Pettis’ articles. He himself was working on the same set of ideas and over the years they have had a running conversation about this topic.

Kenneth Austin – Systemic equilibrium in a Bretton Woods II-type international monetary system: the special roles of reserve issuers and reserve accumulators

Abstract: This article develops a model, based on balance-of-payment identities, of the new international monetary system (Bretton Woods II or BWII). It shows that if some countries engineer current account surpluses by exchange-rate manipulation and foreign-reserve accumulation, the burden of the corresponding current account deficits falls first on the reserve-issuing countries, unless those savings inflows are diverted elsewhere. The imbalances of the BWII period result from official, policy-driven reserve flows, rather than market-determined, private savings flows. The struggle to divert these unwanted financing flows is at the root of the “currency wars” within the system.

In August in a much-commented-upon article in the New York Times, Jared Bernstein explained one of the corollaries of Austin’s model, pointing out that

Americans alone do not determine their rates of savings and consumption. Think of an open, global economy as having one huge, aggregated amount of income that must all be consumed, saved or invested. That means individual countries must adjust to one another. If trade-surplus countries suppress their own consumption and use their excess savings to accumulate dollars, trade-deficit countries must absorb those excess savings to finance their excess consumption or investment.

Note that as long as the dollar is the reserve currency, America’s trade deficit can worsen even when we’re not directly in on the trade. Suppose South Korea runs a surplus with Brazil. By storing its surplus export revenues in Treasury bonds, South Korea nudges up the relative value of the dollar against our competitors’ currencies, and our trade deficit increases, even though the original transaction had nothing to do with the United States.

Michael Pettis explains how being the reserve currency suppresses savings rates

The inexorable balance of payments accounting mechanisms make Bernstein’s claim – that “Americans alone do not determine their rates of savings“ – both necessarily true and joltingly shocking to most economists. How many times, for example, have you heard economists insist that the US trade deficit was “caused” by the fact that Americans refuse to save, or, even more foolishly, that “no one held a gun to the American consumer’s head and forced him to buy that flat-screen TV”?

The fact is that if foreign central banks buy trillions of dollars of US government bonds, except in the very unlikely case that there just happen to be trillions of dollars of productive American investments whose backers were unable to proceed only because American financial markets were unable to provide capital at reasonable prices, then either the US savings rates had to drop because a speculative investment boom unleashed a debt-funded consumption boom (i.e. household consumption rose faster than household income) or the US savings rate had to drop because of a rise in American unemployment. There is no other plausible outcome possible. Americans cannot wholly, and sometimes even partly, determine the American savings rate.

This mistaken belief that American savings are wholly a function of American household preferences arises because most economists – and, it seems, policymakers – can only imagine American households as autonomous economic units, and are seemingly incapable of imaging them as units within a system in which there are certain inflexible constraints. The same is true about households elsewhere. Because flexible exchange rates prevent Europe from running massive surpluses, German capital exports to countries like Spain created the same constraints, meaning that Spanish households too faced the choice only of speculative investment booms, consumption booms, and unemployment.

The fact that both Spain and the US experienced first booms in consumption and speculative investment and then steep rises in unemployment is just a requirement of the arithmetic, and has nothing to do with local cultural vice finally succumbing to the cultural virtue of foreigners. Rather than try to understand how systems constrain choice, economists and bankers, most of them quite wealthy, preferred to lecture and wag their fingers at ineluctably stupid middle- and working-class households.

SOURCE – Michael Pettis blog, NY Times, Journal of Post Keynesian Economics

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