|Why the World Pays Dollar Tribute
Copyright Thomas I. Palley
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
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 lowers 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.
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” 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
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 buyer of last resort story 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
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.