At the conclusion of World War II, there was a meeting among the Allies in Bretton Woods, New Hampshire. There, it was agreed that institutional arrangements would enhance the U.S. dollar for across-country payments (as opposed to gold or another currency, such as the British Pound).
The choice of the U.S. dollar was a logical one. The United States had both the largest share of global trade and the largest share of gold, which it pledged to redeem to foreigners in exchange for their accumulated U.S. dollars. Given the U.S. dollar’s share of global trade at that time, size alone made it the preferred currency because markets for all currencies versus the U.S. dollar were deep. As a result, markets for foreign currencies versus the dollar were more liquid and less volatile, which reduced exchange rate risk and transaction costs.
This was a great encouragement for global trade and for capital to flow to its highest and best use across the globe.
Without it, consider what would occur: If a Peruvian farmer purchased goods from an Outer Mongolia craftsman, the transaction would require a counter party in the very thin and volatile cross of their two currencies. Instead with a recognized and institutional enhanced U.S. dollar, the buyer traded his currency for the dollar, and the seller, in turn, earned dollars that were either held for future purchases in U.S. banks or more easily sold into their home currency with low transaction costs.
This U.S. dollar-based system, with some modification, has worked for 70 years but is now threatened.
And there will be winners and losers.
While a stable and liquid medium of exchange provides benefits to all traders, the U.S. has been the primary beneficiary when its currency is the accepted medium of exchange. This is because private parties and governments hold U.S. dollar balances in banks, and these transaction balances are quickly invested into U.S. dollar denominated financial assets by the banks or are held directly in U.S. investments by the foreign owners.
Hence, worldwide transaction balances and foreign savings were biased toward U.S. assets investments, which produced a wealth effect for U.S. assets. This produces not just elevated and more stable prices but also higher investment returns relative to those of other countries.
So U.S. dollar acceptance as a reserve currency did much the same as the current Fed’s Quantitative Easing in which financial purchasing power from outside U.S. private sources enhanced the value of all U.S.-denominated securities as well as non-financial wealth such as real estate.
Wealth effects have become the policy tool to promote spending and all good economic things that follow – such as income, employment, and government collection of tax receipts that reduce government deficits and the accumulation of U.S. debt that will need to be serviced in the future.
Moreover, the willingness of both private and government foreign sources to hold financial assets denominated in the U.S. dollar greatly enhances the ability of the U.S. to borrow in U.S. dollars cheaply from the rest of the world. Note that there were two parts to that statement: cheaply and in U.S. dollars. And both matter.
It has worked to the advantage of the U.S. First, U.S. government debt has been heavily financed by foreign governments, which hold 60 percent of U.S. government debt not owned by U.S. government entities.
Now, for a country such as the U.S. that has a burgeoning debt problem —which will become more strained as Baby Boomer entitlements challenge our collective futures over the next decades —the ability to place bonds, denominated in U.S. dollars, cheaply to foreigners means we can more easily fund our government deficits and do so at lower interest rates. Without Exorbitant Privilege — the benefit the United States has because our currency is the international reserve currency—our government would require its citizens to add U.S. dollar risk onto their tax bills as interest rates on U.S. government debt would otherwise reflect.
This is the basis for the rest of the world’s U.S. envy that goes by the name of “Exorbitant Privilege.”
In contrast, for countries that do not enjoy Exorbitant Privilege, their government debt is more expensive to carry and, when more questionable, can only be sold markets if the foreign government debt is denominated and owed in U.S. dollars. To appreciate the problem, take a trip to Argentina. They will be most eager for your dollars because markets doubting the value of their currency have forced them to sell their country’s debt, denominated in the U.S. dollar.
As such, each tax payer in Argentina has assumed home currency risk if U.S. dollars, relative to their currency, become more expensive. And they have, as a result of lagging exports and/or forceful capital outflows.
That is what happens when a country does not have Exorbitant Privilege.
When funding government debt becomes unaffordable, what follows is a government bond default and then no one lends to you anymore. In our case, it would be the end of Baby Boomer entitlements.
As we have moved far from the time of the Bretton Woods Agreement, the success of global trade has caused other countries of the world, both those who oppose us as well as those we consider to be friends, to covet the U.S.’s Exorbitant Privilege.
For example, this past week, the central banks of Switzerland and China have agreed to a currency swap designed to boost trade and investment between the two countries. Switzerland joins a parade of 20 countries hoping to become offshore hubs for trading the Chinese Renminbi. Also as a result of this agreement, the Swiss central bank can access and intends to hold China’s government debt as a portion of its foreign exchange reserve thus moving away from US Treasuries.
The infrastructure to not deal in U.S. dollars when purchasing Chinese goods is developing across the globe. Other countries taking action to either provide exchange facilities with central bank back-up liquidity facilities in Chinese currency include Germany, the UK, the European Central Bank, New Zealand, Australia, and the BRIC countries. It’s worth noting that Russia and China have agreed to settle Russian energy exports to China in the Renminbi.
What this means is one no longer needs to deal in U.S. dollars to conduct business with China, but it will morph into the Remnimbi becoming a reserve currency for all cross-country trading and with China extracting Exorbitant Privilege from the rest of the world.
So the pendulum is swinging and is not confined to Europe or the BRIC countries. Now even U.S. Fortune 500 companies such as Ford are using the Renmimbi as a reserve currency in trade with China.
In addition to the morphing of global transaction currencies away from the U.S. dollar and U.S. financial assets, there are other disturbing developments that provide self-inflected wounds to U.S. Exorbitant Privilege.
FATCA, or the Foreign Account Tax Compliance Act, has gone into effect this month. Aggressive U.S.-required reporting, withholding requirements, and fines are chasing U.S. citizens out of non-dollar holdings back to the U.S. and the U.S. dollar. But FATCA and its IRS enforcer are being equally aggressive with foreign holders of U.S. assets and financial accounts. In particular, U.S. Treasuries, which had been tax-free to foreigners, are now subject to a 30 percent interest income withholding and must comply with IRS reporting regulations. This will encourage foreign holders of U.S. financial assets to invest, instead, in other currencies.
To further disincentivize foreign holders of U.S. dollar balances in financial accounts, the U.S. and its allies has resorted to enacting sanctions as leverage over foreigner governments, both their leaders and their economic and political friends. For example, going after Putin personally andthe Russian Oligarchs has its costs. What government or foreign leaders or their supporters will be willing to hold U.S. assets with the arbitrary and capricious ability of IRS to withhold income or freeze or seize their personal assets?
The BRIC countries seemingly have had enough and are laying the ground work for a structure that would serve as an alternative to the U.S. dollar, the U.S.-dominated IMF and World Bank.
It’s true that there are natural economic forces that cause Exorbitant Privilege to gravitate to successful exporters, but U.S. policies are accelerating the shift to China and other ports. But FATCA and sanction policies amount to capital controls that accelerate the demise of U.S. Exorbitant Privilege. A key element of obtaining Exorbitant Privilege is the freedom of capital to leave a country, and without that, capital does not enter. And the freedom of capital outflows now is de facto on the wane.
There are clearly benefits that accrue to a country’s economy and financial markets and investment returns if the policies of a country afford it Exorbitant Privilege.We have had it for so long (about 90 years) that it’s been taken for granted, but the current administration is squandering that privilege. Exorbitant Privilege is not a God-given American gift, and with the simultaneous implementation of FATCA and sanctions as a foreign policy, the ice we are skating on just got thinner.
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