The Dollar's Reserve status
: or, 'The Insatiable Appetite of the American Consumer'
Why did the dollar acquire reserve status, and will it retain that status? It has become a popular discussion. The answer may be surprisingly simple. The economic dominance of the US coincided with a shift, from the 1950s onwards, towards satisfaction of domestic consumers. As the wartime production was re-oriented towards households and consumer demands of the American nuclear family increased in political importance. These demands led both to implicit support for trade deficits by American political elite and explicit acquisition of the dollar by foreign exporters satisfying American consumers. And things have not changed. The requirements for initial and continued dollar dominance, in order of importance, are:
‘Common demand’ for the currency driven by foreign exports to American consumers
Lack of an alternative pervasive consumption model anywhere except America.
Those arguing for a switch away from the dollar fail to acknowledge its potential rivals have not developed anything resembling the America economic model for self-satisfaction. Absent an economic calamity leading to the demise of the US consumer, or a massive reshaping of economic structure elsewhere the dollar’s reserve status will remain unchallenged.
The threadbare argument of ‘institutional dominance’
Before addressing the economic logic, let’s question some of oft-cited institutional reasons for dollar dominance. The unique institutional framework of the US is often given as underpinning ‘common demand’ for its currency. Yes, compared to the alternatives like China, America looks quite good, up to a point.
US politics has never been free of risk, even from word-processing
The political divisions in the US are evident daily and directly bear on the risks of the recurrent US Debt Ceiling problem. An inability to pay outstanding US debt is now an ever-present threat. There is a precedent. The US Treasury failed to pay maturing Treasury Bills in Spring 1979. The failure was blamed on the inability of Congress to raise the Debt Ceiling in a timely fashion and, incredibly, to a breakdown in word processing equipment. Debt Ceiling brinkmanship remains a constant in Congress. Sure, the US is unlikely to renege on an obligation. A delayed payment may as far as it would get. But credit absolutists diligently assert that lost virginity on payment dates could lead to acceleration, leading to catastrophic loss of standing. That risk is played out at every Debt Ceiling stand-off. Reserve managers routinely overlook such risks.
The Fed: no ‘careful custodian’
Few who would claim the Federal Reserve has been an especially careful custodian of the dollar in the last 70 years. American inflation consistently exceeded Japanese, German and Swiss inflation by some margin over that period. And the printing of money since 2008 has been extraordinary. Since Lehman Brothers went bankrupt, M2 money supply in the U.S. rose by 281%, a compound annual growth rate of approximately 10%. This may be an extraordinary period, it suggests careful stewardship takes a back seat to political expediency which has frequently led to currency failure, rather than currency dominance. The maintenance of reserve status despite such a relaxed custodial approach suggests other factors are important.
There is no doubt that investors would trust the American legal system more than, say, the Chinese legal system – at least until now. But the legal case is not watertight either. The legal system of the United Kingdom is, for contract law, virtually identical to that of the US and that did not save sterling from losing its reserve status.
Some point to ‘network externalities’ as an explanation and this may justify the dollars continued use as a reserve, but the network effect is a result, not a cause of reserve status. And network effects are frequently superseded. Just ask Microsoft.
‘It’s the (consumer) economy, stupid’
We are left, as usual, with “it’s the economy, stupid.” And not just the overall size of the American economy, but its composition. The single most convincing reason why the dollar is the reserve currency is because foreigners wanted a slice of the US consumer market, or to proxy American consumers elsewhere, and both American politicians and consumers gain from this arrangement.
You don’t have far to look to see how the process emerged. The Washington Consensus led to the ‘rules-based’ international trading system with the dollar at its heart. That Consensus emerged in large part because foreign countries (initially Latin America) realised that access the American market, required persuasive policy changes to be allowed in. The Washington Consensus emerged from Latin America, although it was formalised in Washington. Thereafter, expansion of international trade was accompanied by the permeation of the dollar through the financial world.
American political logic strongly supported expansion as a means of both crafting and satisfying voter demands. America did not need to encourage its status. America was handed the status. The country did not seek to make itself attractive, it simply was the only market worth selling to with the only political system that allowed its citizens to obtain a constant stream of new products.
No threat in sight
Resentment, geopolitical disturbance, and fashion will raise questions of the status of the dollar periodically. But America remains the ‘consumer of last resort’. Until that changes, the dollar will retain its ascendency. As the devil said to Homer Simpson ‘have all the doughnuts in the world’. The world keeps giving America all its doughnuts and in return the world will be paid in dollars.