A Keynesian Theory of Hegemonic Currencies – Or Why the World Pays Dollar Tribute

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By Thomas Palley

Sev­er­al years ago (June 2006) I wrote an arti­cle advanc­ing a new the­o­ry of why the dol­lar is the world’s dom­i­nant cur­ren­cy and why it is like­ly to remain so. The arti­cle was pub­lished in the midst of the last boom and sank like a stone. But now debate about the cause of the dollar’s hege­mo­ny has been revived in an inter­est­ing paper by Fields and Ver­nen­go titled “Hege­mon­ic cur­ren­cies dur­ing the cri­sis: The dol­lar ver­sus the euro in a Cartelist per­spec­tive” (also here). Their paper pro­vides an oppor­tu­ni­ty to revive dis­cus­sion, so I am post­ing the arti­cle again. Here it is (sub­ject to a cou­ple of word edits):

The U.S. dol­lar is much in the news these days and there is a sense that the world econ­o­my may have 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 pre­miere 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.

Many for­eign pol­i­cy­mak­ers com­plain about the U.S.’s spe­cial advan­tage, which allows it 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 Unit­ed States. 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 low­er­ing inter­est rates, there­by increas­ing house­hold wealth and low­er­ing the cost of bor­row­ing mon­ey. Addi­tion­al­ly, the U.S. gov­ern­ment gets seignor­age (a free loan) from the hun­dreds of mil­lions in dol­lar bills held off­shore. Print­ing a one hun­dred dol­lar bill is almost cost­less to the U.S. gov­ern­ment, but for­eign­ers must give over one hun­dred dol­lars of resources to get the bill. That’s a tidy prof­it for U.S. tax­pay­ers.

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 inter­na­tion­al­ly com­pet­i­tive because an over-val­ued dol­lar makes U.S. exports more expen­sive and imports cheap­er. Reserve cur­ren­cy sta­tus there­fore pro­motes trade deficits and de-indus­tri­al­iza­tion.

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. Addi­tion­al­ly, the fact that many gov­ern­ments over-issue their own mon­ey and cre­ate high infla­tion, encour­ages for­eign cit­i­zens to pro­tect them­selves by hold­ing dol­lars instead of domes­tic cur­ren­cy.

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 is how they help 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 will 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 unrec­og­nized the­o­ry that can be labeled the “buy­er of last resort” or Key­ne­sian 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, be it due to poor income dis­tri­b­u­tion or bad domes­tic eco­nom­ic poli­cies. This forces them to rely on the Amer­i­can con­sumer.

The log­ic of this third the­o­ry is eas­i­ly illus­trat­ed. Over the last decade, while Europe and Japan stag­nat­ed, the U.S. grew 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.

East Asian coun­tries (espe­cial­ly Chi­na) have been par­tic­u­lar­ly will­ing to run trade sur­plus­es with the U.S. because this has fuelled export-led growth. These coun­tries rely on exports to keep their fac­to­ries oper­at­ing. Export suc­cess then attracts for­eign direct invest­ment that advances devel­op­ment. Under-val­ued exchange rates are vital for this strat­e­gy as it keeps exports com­pet­i­tive. Coun­tries have there­fore chan­neled their trade sur­plus­es into dol­lars, keep­ing the dol­lar over-val­ued and enabling them to sell in the U.S. mar­ket. This explains both the con­tin­u­ing strong demand for dol­lars despite the U.S. trade deficit, and the dollar’s dom­i­nance in offi­cial for­eign exchange hold­ings.

Iron­i­cal­ly, America’s dis­pen­sa­tion from trade deficit dis­ci­pline stems from oth­er coun­tries’ fail­ure to devel­op an equiv­a­lent of the Amer­i­can con­sumer. Coun­tries want to indus­tri­al­ize with full employ­ment, but they lack ade­quate inter­nal demand. Con­se­quent­ly, they must rely on the U.S. mar­ket. It is also why Ger­many sup­plies BMWs and Mer­cedes-Ben­zes in return for paper dol­lar IOUs.

Con­ven­tion­al the­o­ry says the dol­lar will only lose its dom­i­nance when coun­tries become sat­u­rat­ed with dol­lar hold­ings. At that stage they will cease buy­ing and may even sell dol­lars, caus­ing a fall of the dol­lar. 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 Key­ne­sian the­o­ry of hege­mon­ic cur­ren­cies sug­gests a dif­fer­ent take. One rea­son the dol­lar could top­ple is if coun­tries final­ly man­age to devel­op their own con­sump­tion mar­kets. Euroland is most capa­ble of doing this, but for the moment it is 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 they are blocked by China’s total­i­tar­i­an polit­i­cal sys­tem that fears unions.

An alter­na­tive source of col­lapse is if Amer­i­can con­sumers reduce spend­ing because they feel over-extend­ed, 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 U.S. eco­nom­ic prospects.

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.

How­ev­er, none are well served by this co-depen­dence. Oth­er coun­tries are resent­ful of the U.S.’s spe­cial sit­u­a­tion that exempts it from trade deficit dis­ci­pline. Side-by-side, U.S. long-term eco­nom­ic prospects are under­mined by the ero­sion of the man­u­fac­tur­ing sec­tor, while U.S. work­ers face wage and job pres­sures from imports that are advan­taged by the dollar’s over-val­u­a­tion. More­over, all are vul­ner­a­ble to a sud­den stop of the sys­tem result­ing from finan­cial over-exten­sion of the U.S. con­sumer.

This sug­gests that the rest of the world needs to devel­op an alter­na­tive to the U.S. con­sumer. That will require rais­ing wages in devel­op­ing economies, and encour­ag­ing con­sump­tion in Europe and Japan. Such mea­sures would sta­bi­lize the glob­al econ­o­my by pro­vid­ing a sec­ond engine of growth, and it would also cor­rect the large glob­al finan­cial imbal­ances that have devel­oped as a result of over-reliance on the U.S. con­sumer.

This arti­cle was orig­i­nal­ly pub­lished by Yale Glob­al Online as “Why Dol­lar Hege­mo­ny is Unhealthy.” Per­mis­sion to re-pub­lish and use can be obtained by e‑mailing Yale Glob­al at globalization@yale.edu.

Copy­right Thomas I. Pal­ley

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.