Is Dollar Dominance Good for the U.S.?

Thoughts on the U.S.'s so-called exorbitant privilege.

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You might have noticed that people are talking about tariffs and trade deficits. As it relates to these topics, a number of people in the Trump administration have lamented the cost that the dollar-based trading system imposes on the United States. A number of commentators have scoffed at this claim. In doing so, they frequently refer to the “exorbitant privilege” that the U.S. receives as the issuer of the global reserve currency. This term was coined in the 1960s by a French Finance Minister who pointed out the significants benefits that the U.S. received from such a system in which the dollar is dominant.

What is a bit frustrating about these arguments is that, for some, merely saying the words “exorbitant privilege” is seen as a sufficient response to claims that the system also has costs. For them, it is laughable to think about the costs of a system that also provides such significant benefits.

Nonetheless, the claims made about the costs of the system pose important questions that one should attempt to answer. Economics is fundamentally about tradeoffs. This implies that most institutional arrangements will have both costs and benefits. A natural question to ask is what the costs are and whether the benefits always exceed the costs. Is this true in all states of the world? Are there conditions under which the costs could exceed the benefits?

I see this as especially important because the arguments being made about the costs of the system are not particularly new. The primary difference between the arguments being made now and the arguments made in the past is that the arguments made in the past were often hypothetical. They were claims like “given X, eventually Y.” But the longer one goes without observing Y, the less people take that hypothetical seriously. However, I would argue that some of these hypothetical arguments are not necessarily hypotheticals any longer.

Furthermore, regardless of what you think about the administration or the people making these claims, it is important to consider the underlying economic arguments and recognize that other economists have thought about these issues and written about them as well. Thus, we might want to detach personalities from claims and ask: “What does economics have to say?"

Why Trade Deficits Are Different for the U.S.

Let’s start our discussion with the costs and benefits of trade associated with the dollar’s reserve currency status.

When you are taught a typical model of international trade with flexible exchange rates, discussion of the balance of trade goes something like this. If a country runs persistent trade deficits, its currency will begin to depreciate. The depreciation of the currency makes foreign goods more expensive. This tends to reduce imports and push the country toward balanced trade. The basic point here is that a typical textbook argument is that flexible exchange rates adjust to the balance of trade and these adjustments tend to reduce the trade deficit and push the country towards balanced trade.

By contrast, the U.S. runs persistent trade deficits that do not self-correct. In fact, many times, the dollar appreciates while the U.S. is running trade deficits. How can we explain this phenomenon?

The reason that the U.S. is different is that the dollar is the primary currency used in global trade. Suppose you are in Germany and you need to buy oil from Saudi Arabia. This oil is invoiced in dollars. However, everyone around you is using euros. How do you get dollars? Well, you might say that you go to the bank and exchange euros for dollars, but that doesn’t really answer the question. Where did the bank get the dollars? The short answer is that other countries have to be net importers of dollars and therefore net exporters to the U.S.

What this implies is that the U.S. must run persistent trade deficits with the rest of the world in order to provide the world with dollars.

What are the benefits and the costs?

One benefit of the system is that the U.S. never has to worry about its balance of payments. Since trade is invoiced in dollars, the U.S. doesn’t ever have to worry about having a shortage of dollars. This isn’t true of other countries. When they see dwindling dollar reserves, they might have to resort to buying dollars on the open market or take out dollar-denominated loans. This can result in significant economic costs for those countries that the U.S. never has to worry about.

People also like to frame the benefit of this situation as follows. The dollar’s global status gives the U.S. the ability to supply the rest of the world with cheap pieces of paper in exchange for valuable goods and services. When framed in that way, it certainly seems like the U.S. is getting a great deal.

However, this does not mean that this scenario is without costs. Consider the following example. Suppose that instead of dollars, the U.S. was shipping the rest of the world Ford Mustangs. Now, imagine that Ford’s production of Mustangs is too low to meet demand. What would happen? The simple answer is that the world price of Mustangs would rise to meet global demand.

Now, let’s consider the same scenario with dollars. The rest of the world has a flow demand for dollars. The U.S. supplies that flow demand by running trade deficits with the rest of the world. Imagine that U.S. trade deficits are not large enough to meet global demand. What would happen? The simple answer is that the world price of the dollar would rise to meet global demand. Or, in other words, the dollar would appreciate relative to all other currencies.

Again, many see this as a benefit to the U.S. As the dollar gets stronger, foreign goods get cheaper. As a result, U.S. consumers can afford more stuff and thus start sending more dollars to other countries to help meet the demand.

There are potential costs as well. As the dollar appreciates, this not only makes consumer goods cheaper, but it also makes foreign labor and land and other inputs cheaper as well. Moderate movements in the relative strength of the dollar are likely to affect consumption patterns. However, larger changes in the relative strength of the dollar can affect patterns of production.

The reason that patterns of production require larger changes is that moving production from one geographic location to another requires paying a substantial fixed cost. Large fixed costs in the face of uncertainty entails what is referred to as an optimal stopping problem. In other words, decision-makers have the option, but not the obligation to move their business or factory to another geographic location. However, because of the large fixed costs and uncertainty surrounding the relative strength of the dollar, they will wait until the relative strength of the dollar is sufficiently high before moving. Of course, the same scenario operates in reverse when it comes to re-shoring. People will wait until the dollar is sufficiently weak before returning. This means that there is an intermediate range of the dollar’s value for which people simply stay where they are.

What those vocal about this in the Trump administration are essentially arguing is that because of the dollar’s role in the global economy, insufficiently large trade deficits tend to cause the relative strength of the dollar to rise to the threshold that causes offshoring. However, since the dollar never sufficiently weakens, re-shoring rarely occurs. Thus, over time, this leads to more and more production moving overseas.

Critics of the administration largely respond, “so what?” This is just market dynamics at work. Why should we care about this? It frees up resources to be allocated to alternative uses.

People in the administration counter that this is significant both in terms of human and economic costs. The human cost is that offshoring can devastate the communities where this production previously took place. Yes, there are benefits that are dispersed across all consumers, but there are costs that are concentrated in these communities. They also argue that some of these costs are hard to quantify. These are costs related to the dignity of work and the breakdown of societal bonds.

An additional economic cost is that, to the extent that this production is in things like manufacturing, this can weaken the industrial base of the United States. Such weakness can be quite costly during times of war or other national emergencies.

Furthermore, the position of the administration seems to be that trade should reflect genuine differences in comparative advantage. However, the shifts in the pattern of production I’ve just described have little to do with comparative advantage or natural cost advantages and much more to do with fluctuations in the relative strength of the dollar.

Why the National Debt is Different for the U.S.

Not only is the dollar the global reserve currency, but the U.S. Treasury security is the global reserve asset. In other words, as those dollars flow abroad, foreign banks and financial institutions don’t simply sit on a pile of dollars. They store these dollar balances over time by purchasing U.S. Treasury securities. This is what I prefer to call the Treasury Standard.

This state of affairs also provides benefits to the U.S. Since these holders of dollars need to hold dollars and since they would prefer to earn a rate of return, they become passive (i.e., price-insensitive) buyers. Having a large passive demand for its debt means that the U.S. government can accumulate more debt without the same consequences for borrowing costs that other countries would in a similar financial position. This is another aspect of the way in which the system provides the U.S. with an “exorbitant privilege.”

At the same time, a large passive demand for debt can come with costs as well. For example, there is now a sizable literature in economics on so-called safe asset shortages. Some blame the low interest rates of the early 2000s as the result of a global savings glut. As the rest of the world was growing, their demand for U.S. Treasury securities was growing as well. Since there were not enough Treasury securities to meet this demand, the excess demand pushed the prices of those securities higher and yields lower. A number of people have argued that it was these low yields that led to significant misallocation of resources through access to cheaper credit, which ultimately led to the 2007-8 financial crisis.

Over the nearly two decades since, U.S. politicians have largely used low interest rates as a justification for more spending and borrowing. After all, if the rest of the world is willing to lend at sufficiently low interest rates, don’t most spending projects have positive net present value? The issue with that strategy is that if the U.S. responds to demand for its debt by increasing the supply of its debt, this potentially leads to an unsustainable debt trajectory.

This creates the following tradeoff. Suppose that the U.S. economy grows at 2.5 percent per year while the rest of the world grows at 4 percent per year. A standard assumption in monetary economics is that the demand for money is unit elastic. This would imply that the demand for U.S. Treasury securities is rising at 4 percent per year. If the U.S. federal government doesn’t accumulate enough debt to meet this demand, this would cause interest rates to decline. Such artificially low interest rates might lead to a significant misallocation of capital. On the other hand, if the federal government responds to lowering borrowing rates by borrowing enough to meet demand, then the debt-to-GDP ratio will be rising over time and thus putting the federal government debt on an unsustainable path.

The Triffin Dilemma and the Stability of the System

This discussion of the costs and the benefits of the system is not new. Robert Triffin famously articulated the so-called Triffin Dilemma about what happens when a country supplies the reserve currency of the world.

We can state this idea as it relates to what we have discussed above. The basic idea is that a country that provides the global reserve currency and the global reserve asset will have to run persistent twin deficits (a trade deficit and a federal government budget deficit) to provide the rest of the world with the assets it needs. However, those long, persistent twin deficits might undermine the very faith in those assets. The state therefore might want to limit these deficits to prevent that decline in faith. However, as we have discussed above, doing so would create other frictions in the economy and trade. Hence, the dilemma.

Despite this idea being around for some time, it was seen as a possible eventuality, and therefore a hypothetical. Furthermore, there are a number of questions that economists would like answered. Is this just reasoning from an accounting identity? Can we write down a model that produces this result? Under what conditions is this type of system really unsustainable?

Luckily, there is a really great paper on this very topic. Emmanuel Farhi and Matteo Maggiori have a model of the international monetary system in which something like the Triffin Dilemma emerges as a result. Thus, it might be important to think about their work and what lessons that one can draw from it.

In their baseline model, there are two economic agents: the global hegemon and the rest of the world. The rest of the world needs a way to store its wealth from one period to the next. However, there is only one asset and it is risky. In good states, the risky asset gives investors their money back plus a high return. In bad states, not only doesn’t the risky asset pay a return, but investors actually lose some of their initial investment. In steps the global hegemon.

The global hegemon can issue debt that will always be paid back (in nominal terms). Since this security is always repaid (in nominal terms), it provides a “safe” asset for the rest of the world to purchase. This can help the rest of the world diversify away from the risky asset. A standard result in portfolio theory is that there is an optimal share of one’s portfolio to put in the risky asset that depends on the expected excess return on the risky asset (the expected return on the risky asset less the return on the safe asset), its variance, and the degree to which the investor is risk averse.

From the perspective of the global hegemon, the issuance of debt can be used to finance current consumption or to purchase some of the risky asset. To the extent to which the hegemon purchases the risky asset, the hegemon acts something like an intermediary to the rest of the world (as people like Charles Kindleberger described in the 1960s). In fact, the expected excess return on the hegemon’s portfolio generates a profit that allows the global hegemon to consume more later. Farhi and Maggiori refer to this profit as the hegemon’s exorbitant privilege. In a world in which anyone could issue debt like the hegemon to be used as reserves, this would lead to a scenario in which there are complete markets. In a complete market, the expected return on every asset is just the real interest rate. Thus, the global hegemon is only able to earn this profit from being the bank to the rest of the world because it is uniquely trusted to issue this “safe” debt.

However, recall that the debt is only safe in nominal terms. In the future, in the “bad” state of the world, the hegemon’s portfolio performs poorly. The hegemon could choose to pass this cost on to those holding its debt in reserve by devaluing its currency. Yes, you get paid the currency you were promised, but the purchasing power of said currency is lower. In other words, the rest of world has to deal with the potential for moral hazard. The hegemon issues debt, promises to pay it back, but once something bad happens, it might decide to devalue its currency as a way of partially defaulting on the debt.

This basic setup allows us to think about critical issues. The main issue is as follows. In the model, the hegemon issues a particular amount of debt. After issuing this debt, the demand for that debt determines the interest rate on the debt. The interest rate on the debt is determined by the beliefs of the rest of the world about the likelihood that the hegemon will keep its promise not to devalue its currency.

What is particularly useful about the model is that debt crises typically happen when people believe that the debtor won’t pay back the debt. Thus, this isn’t something that happens gradually over time in response to fundamentals, but rather happens suddenly based on beliefs. In this model, the rest of the world forms beliefs about whether or not the hegemon will devalue based upon the level of debt that it issues. This is important because Farhi and Maggiori derive three different ranges of debt based on its magnitude. If debt is sufficiently low, the rest of the world will never expect the hegemon to devalue. Furthermore, if debt is sufficiently high, the rest of the world expects the hegemon to devalue with absolute certainty. Finally, there is an intermediate “instability" range of debt in which, under some conditions the hegemon has an incentive to devalue and other times does not. No one knows for certain. Thus, in this intermediate range, the rest of the world must simply assign some probability to its beliefs about devaluation.

Given that this is how the rest of the world forms its beliefs, the hegemon’s choice of the amount of debt to issue must take into account those beliefs. For example, the hegemon will never issue levels of debt in the range in which devaluation is assigned a probability of one. Nonetheless, it is possible that the hegemon could issue an amount of debt that puts it in the “instability” range. It is therefore important to consider why the hegemon would ever make that choice and what the implications of that choice would be.

The model is one of strategic interaction. The hegemon chooses its amount of debt based on its expectations of the beliefs that the rest of the world will form. The rest of the world forms its beliefs about whether or not the hegemon will devalue based on the level of debt that the hegemon chooses. The beliefs might or might not be correct. However, these beliefs can affect whether the hegemon’s debt is “safe” or not. Furthermore, we assume that the problem is moral hazard. The hegemon always intends not to devalue. However, in bad times, it has a financial incentive to devalue and thus might renege on its promise.

We can then think about the hegemon as making a decision about how much debt to issue in order to maximize the net benefit of debt issuance. The trade-off that the hegemon faces is that issuing more debt increases its benefit from serving as the bank to the rest of the world (its exorbitant privilege). However, the more debt that it issues, the more likely the hegemon faces discontinuous increases in the rest of the world’s subjective probability that it will devalue. Since devaluation is costly in and of itself and since an expected devaluation would wipe out the hegemon’s exorbitant privilege, the hegemon must then choose the level of debt that optimally balances this trade.

Thus, the issue is how much debt is optimal for the hegemon. We can think about this in reference to what the hegemon would choose if it could perfectly commit to never devalue. Let’s call this the “full commitment” level of debt.

Whenever the full commitment level of debt is in the “safe” range, the rest of the world never expects that the hegemon will devalue. The hegemon gets to borrow cheaply and profit from this exorbitant privilege. The rest of the world gets to diversify its portfolio with safe, interest-earning reserves.

However, when the full commitment level of debt is above this safe range, the hegemon faces a Triffin Dilemma-style tradeoff. In the instability range, the hegemon could issue the full commitment level of debt or it could limit its debt to the maximum amount of debt that would leave its debt in the safe range. The hegemon will choose the one that provides the highest expected benefit, given the beliefs of the rest of the world. This highlights the difficult choice the hegemon faces. On the one hand, by limiting debt, the hegemon can prevent a run on its debt by the rest of the world. On the other hand, by doing so, the hegemon isn’t getting the benefits from its exorbitant privilege that it would like. The hegemon therefore has to choose between increasing its profits from exorbitant privilege and limiting the likelihood of a run on its debt. The hegemon will choose the one that maximizes its expected net benefit. But this implies that sometimes the hegemon will choose a level of debt that leads to a run and the loss of its hegemon status.

The same thing is true if the full commitment level of debt is so high that default is certain. Of course, the hegemon will never choose a level of debt that they know the rest of the world isn’t willing to fund. However, they face a similar trade-off as what I just described. They could severely limit their debt to the level that would prevent a run. Alternatively, they could choose the maximum level of debt in the “instability” zone. In this case, the hegemon must restrict its debt issuance. Again, how severely it restricts its debt will depend on the expected net benefit of the two scenarios.

At this point, this might seem pretty complicated. But we can simplify things to some punchlines. The first lesson here is that the benefits of being the issuer of the global reserve asset are real. However, since the issuer of that reserve asset can never perfectly commit not to devalue the debt it issues as a reserve for the rest of the world, the amount of these global reserves floating around out there in the system is actually important.

When debt is low, no one worries about devaluation and the hegemon provides an important role in the world economy as banker to the rest of the world. However, when debt gets sufficiently large, the rest of the world can no longer trust that the hegemon will keep its promises. The rest fo the world will then form beliefs about the likelihood that the hegemon will keep its promise. Once the debt gets sufficiently high, this can lead to self-fulfilling beliefs that the system cannot continue because the rest of the world expects the hegemon to devalue in difficult economic times. The hegemon thus become subject to something like Triffin’s dilemma where it has to balance the incentives associated with being banker to the world against the possibility that its own actions in issuing debt could ultimately undermine the system by destroying the confidence of the rest of the world.

Lessons for the Current Environment

This provides certain lessons for the present reality. When U.S. government debt was sufficiently low, the current system (“The Treasury Standard”) worked quite well in the sense that it provided the U.S. benefits with little potential costs. Much of the commentary that I see today seems to presume that this is always and everywhere true of anyone in the U.S.’s position. However, the model suggests that at a sufficiently high level of debt, this state of affairs becomes unstable and susceptible to self-fulfilling prophecies of collapse. In other words, at low levels of debt, what we call exorbitant privilege is obviously a net positive. However, once debt becomes sufficiently high, the nature of this exorbitant privilege becomes somewhat tenuous as higher levels of debt increase the risk that the system will break down.

What makes this really difficult is how to translate lessons from these models and arguments to the real world. For example, it is hard to assess where we are in the the real world relative to the model. The thresholds for high levels of debt are not known in the real world. Furthermore, beliefs based on the magnitude of debt are not necessarily based on fundamentals. This means that at higher levels of debt, a belief by the rest of the world that the debt is unsustainable can be self-fulfilling. One might not want to risk ending up in such a scenario. But the lesson from the model is that limiting this risk can be costly.

Whatever you think of the Trump administration’s actions over the last several weeks, it seems clear from their rhetoric that they are concerned about the stability of the system given both the magnitude and the trajectory of U.S. government debt. The lesson of this post is that they could be wrong in their assessment, but that their argument is not obviously ridiculous. Furthermore, it is not crazy to say that a system that served the U.S. well in the past might not always continue to provide the same in the future. As with any system, there are benefits and costs. In the present system, the expected net benefits are discontinuous and sometimes negative. Something that has served the U.S. well for decades could unravel quickly. For that reason, it is important to think carefully about the topic and try to think about the relevant tradeoffs.

Politics can make this hard to do. It is always easier to root for your team (if you have one) and it is always harder to understand and appreciate the thought process of people you disagree with or even dislike. Similarly, people you like can make bad arguments. But economics can be your guide. Economics helps us to think about the relevant tradeoffs and assess the arguments being made. This isn’t to say that what I have written here is the final word on the topic. Nonetheless, I wanted to highlight economic arguments that I think have gotten short shrift in the current debate. The reader can decide how valuable they think these arguments are to our present circumstances.