Exorbitant Privilege

Trump’s Trade Wars Will Hurt Dollar’s Exorbitant Privilege

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Dear Reader, we would suggest that before you start reading this column, you read the column published yesterday. In yesterday’s column we saw how the tariffs unleashed by the US President Donald Trump will hurt America, instead of making it great again. Reading this column, before you read today’s column, will give you a complete perspective on the issue. This is the second in a series of three columns on the issue. The third column will appear on Thursday.

The American dollar is at the heart of the global financial system as it has evolved. The reasons for this are historical.

By 1944, it was clear that the Allied forces are going to win the Second World War. In July 1944, they gathered at the Mount Washington Hotel, Bretton Woods, New Hampshire in the US, to design a new financial system for the world. Europe had been totally destroyed during the course of the war and even countries like Britain and France were in a bad shape despite being on the winning side. European countries were in no position to negotiate. And so, the American dollar was placed at the heart of the financial system that evolved at Bretton Woods.

The US was ready to convert dollars into gold at the rate of $35 for one ounce (31.1 grams) of gold. This came to be known as the Bretton Woods Agreement. It made the
American dollar the premier international currency of choice, as it was the only currency that could be converted into gold.

This ensured that over a period of time countries moved to carrying out their international trade primarily in American dollars. It also ensured that countries held their foreign exchange reserves in dollars because dollar was the only currency which could be converted into gold.

This structure that emerged gave the American dollar an exorbitant privilege. While the rest of the world had to earn these dollars by exporting stuff, the United States could simply print them and buy all the stuff that it needed. This has been one of the primary reasons why United States, over the decades, has turned into a big buyer of things. All the American buying drives global demand.

Given that the dollar became the international trading and reserve currency, the oil cartel OPEC (Organization of the Petroleum Exporting Countries), also sold the oil that it produced, in dollars. This was one more reason for the world to buy and sell stuff in dollars. Every country did not produce the total oil it consumed, and in order to import enough oil to fulfil its consumption needs, it needed dollars. The only way to earn these dollars was to price its exports in dollars.

In fact, the Saudi Arabia led OPEC continuing to price oil in dollars, is one of the major reasons why dollar continues to be the major reserve as well as trading currency of the world. Even the Americans recognise this fact.

As Nassim Nicholas Taleb writes in his new book Skin in the Game—Hidden Asymmetries in Daily Life: “It is clear since the attack on the World Trade Center (in which most of the attackers were Saudi citizens) that someone in that nonpartying kingdom had a hand—somehow—in the matter. But no bureaucrat, fearful of oil disruptions, made the right decision—instead, the absurd invasion of Iraq was endorsed because it appeared to be simpler.”

So, dollar due to various reasons is the international currency in which people and countries want to deal with. As George Gilder writes in The Scandal of Money—Why Wall Street Recovers But the Economy Never Does: “Today it [i.e. the dollar] handles more than 60 percent of world trade, denominates more than half the market capitalization of world stocks, and partakes in 87 percent of global currency trades.”

Given this, over the years, countries have accumulated huge dollar reserves. A significant chunk of these reserves have been earned by exporting stuff to the United States.  The United States is the biggest economy in the world. It accounts for nearly one-fourth of the world’s GDP. By virtue of this, it is also the world’s biggest market, where China, Japan and countries from South- East Asia sell their goods and earn dollars in the process.

It is also the world’s biggest consumer of oil and consumes nearly a fourth of the global oil production. This meant that oil-rich states such as Saudi Arabia could sell oil to it and thus earn dollars in the process.

The dollars earned by other countries haven’t stayed in the vaults of their central banks. They have been invested in American treasury securities and other debt securities. Treasury securities are basically financial securities issued by the American government to finance its fiscal deficit, which is the difference between what a government earns and what it spends. Take a look at Figure 1. It basically plots the foreign investment in American treasuries over the last 40 years.

Figure 1:

Source: Board of Governors of the Federal Reserve System (US)

 

The foreigners currently own more than $6 trillion of American government treasury securities. This along with the easy money policy initiated by the Federal Reserve of the United States, in the aftermath of the financial crisis that broke out in September 2008, has ensured that the interest that the US government pays on these securities has been around 2% per year, over the last five years.

The interest paid on the US treasury securities sets the benchmark for other loans in the American financial system (or for that matter any other financial system) because lending to the government is deemed to be the safest form of lending. Over and above this, the foreigners have invested close to $3.3 trillion in other American debt securities.

This inflow of dollars into the United States has kept interest rates low. These low interest rates have kept the American consumption story going to some extent. As the American stand-up comedian George Calrin once said: “Consumption is the new national pastime. People spending money they don’t have on things they don’t need, money they don’t have so they can max out their credit cards… And they didn’t like it when they got it home anyway.”

Donald Trump’s tariff policy will attack at the heart of this model. Countries earn dollars by exporting stuff to the United States and other parts of the world. These dollars then find their way back to the United States where they are invested in treasury and other debt securities, and help maintain low interest rates.

If Trump and America shut out the American market to other countries, the countries exporting stuff to the US (Japan, China, South Korea, Taiwan, and a whole host of other countries), will not earn as many dollars as they currently are. And if they don’t earn enough dollars, the likelihood of them continuing to invest in American debt securities, is very low. This will mean that the interest rates in the United States will start to rise. This is something that the country which is currently going through an early stage of economic recovery, cannot really afford.

Further, the other countries might also start to try and price their exports in currencies other than the dollar, as well. China has been working towards this for quite a while. Trump’s decision to introduce tariffs might just be the final push that the country needs.
If countries start pricing their exports in non-dollar currencies, Trump’s plan to impose tariff will hurt the exorbitant privilege that the dollar has enjoyed over the years.

In fact, in the third and final column in this series, which will appear on Thursday, we will see why Trump’s plan of trying to increase American exports while shrinking its imports, is essentially contradictory in nature.

The column originally appeared on Equitymaster on March 13, 2018.

The extortionate privilege of the dollar

3D chrome Dollar symbolVivek Kaul

On May 31, 2014, the total outstanding debt of the United States government stood at $17.52 trillion. The debt outstanding has gone up by $7.5 trillion, since the start of the financial crisis in September 2008. On September 30, 2008, the total debt outstanding had stood at $10.02 trillion.
In a normal situation as a country or an institution borrows more, the interest that investors demand tends to go up, as with more borrowing the chance of a default goes up. And given this increase in risk, a higher rate of interest needs to be offered to the investors.
But what has happened in the United States is exactly the opposite.
In September 2008, the average rate of interest that the United States government paid on its outstanding debt was 4.18%. In May 2014, this had fallen to 2.42%.
When the financial crisis broke out money started flowing into the United States, instead of flowing out of it. This was ironical given that the United States was the epicentre of the crisis. A lot of this money was invested in treasury bonds. The United States government issues treasury bonds to finance its fiscal deficit.
As Eswar S Prasad writes in The Dollar Trap—How the US Dollar Tightened Its Grip on Global Finance “From September to December 2008, U.S. securities markets had net capital inflows (inflows minus outflows) of half a trillion dollars…This was more than three times the total net inflows into U.S. securities markets in the first eight months of the year. The inflows largely went into government debt securities issued by the U.S. Treasury[i.e. treasury bonds].”
This trend has more or less continued since then. Money has continued to flow into treasury bonds, despite the fact that the outstanding debt of the United States has gone up at an astonishing pace. Between September 2008 and May 2014, the outstanding debt of the United States government went up by 75%.
The huge demand for treasury bonds has ensured that the American government can get away by paying a lower rate of interest on the bonds than it had in the past. In fact, foreign countries have continued to invest massive amounts of money into treasury bonds, as can be seen from the table.
foreign debt US
Between 2010 and 2012, the foreign countries bought around 43% of the debt issued by the United States government. In 2009, this number was slightly lower at 38.1%.
How do we explain this? As Prasad writes “The reason for this strange outcome is that the crisis has increased the demand for safe financial assets even as the supply of such assets from the rest of the world has shrunk, leaving the U.S. as the main provider.”
Large parts of Europe are in a worse situation than the United States and bonds of only countries like Austria, Germany, France, Netherlands etc, remain worth buying. But these bonds markets do not have the same kind of liquidity (being able to sell or buy a bond quickly) that the American bond market has. The same stands true for Japanese government bonds as well. “The stock of Japanese bonds is massive, but the amount of those bonds that are actively traded is small,” writes Prasad.
Also, there are not enough private sector securities being issued. Estimates made by the International Monetary Fund suggest that issuance of private sector securities globally fell from $3 trillion in 2007 to less than $750 billion in 2012. What has also not helped is the fact that things have changed in the United States as well. Before the crisis hit, bonds issued by the government sponsored enterprises Fannie Mae and Freddie Mac were considered as quasi government bonds. But after the financial mess these companies ended up in, they are no longer regarded as “equivalent to U.S. government debt in terms of safety”.
This explains one part of the puzzle. The foreign investors always have the option of keeping the dollars in their own vaults and not investing them in the United States. But the fact that they are investing means that they have faith that the American government will repay the money it has borrowed.
This “childlike faith of investors” goes against what history tells us. Most governments which end up with too much debt end up defaulting on it. Most countries which took part in the First World War and Second World War resorted to the printing press to pay off their huge debts. Between 1913 and 1950, inflation in France was greater than 13 percent per year, which means prices rose by a factor of 100. Germany had a rate of inflation of 17 percent, leading to prices rising by a factor of 300. The United States and Great Britain had a rate of inflation of around 3 percent per year. While that doesn’t sound much, even that led to prices rising by a factor of three1.
The inflation ensured that the value of the outstanding debt fell to very low levels. John Mauldin, an investment manager, explained this technique in a column he wrote in early 2011. If the Federal Reserve of the United States, the American central bank, printed so much money that the monetary base would go up to 9 quadrillion (one followed by fifteen zeroes) US dollars. In comparison to this the debt of $13 trillion (as it was the point of time the column was written) would be small change or around 0.14 percent of the monetary base2.
In fact, one of the rare occasions in history when a country did not default on its debt either by simply stopping to repay it or through inflation, was when Great Britain repaid its debt in the 19th century. The country had borrowed a lot to finance its war with the American revolutionaries and then the many wars with France in the Napoleonic era. The public debt of Great Britain was close to 100 percent of the GDP in the early 1770s. It rose to 200 percent of the GDP by the 1810s. It would take a century of budget surpluses run by the government for the level of debt to come down to a more manageable level of 30 percent of GDP. Budget surplus is a situation where the revenues of a government are greater than its expenditure3.
The point being that countries more often than not default on their debt once it gets to unmanageable levels. But foreign investors in treasury bonds who now own around $5.95 trillion worth of treasury bonds, did not seem to believe so, at least during the period 2009-2012. Why was that the case? One reason stems from the fact nearly $4.97 trillion worth of treasury bonds are intra-governmental holdings. These are investments made by various arms of the government in treasury bonds. This primarily includes social security trust funds. Over and above this around $4.5 trillion worth of treasury bonds are held by pension funds, mutual funds, financial institutions, state and local governments and households.
Hence, any hint of a default by the U.S. government is not going to go well with these set of investors. Also, a significant portion of this money belongs to retired people and those close to retirement. As Prasad puts it “Domestic holders of Treasury debt are potent voting and lobbying blocs. Older voters tend to have a high propensity to vote. Moreover, many of them live in crucial swing states like Florida and have a disproportionate bearing on the outcomes of U.S. presidential elections. Insurance companies as well as state and local governments would be clearly unhappy about an erosion of the value of their holdings. These groups have a lot of clout in Washington.”
Nevertheless, the United States government may decide to default on the part of its outstanding debt owned by the foreigners. There are two reasons why it is unlikely to do this, the foreign investors felt.
The United States government puts out a lot of data regarding the ownership of its treasury bonds. “But that information is based on surveys and other reporting tools, rather on registration of ownership or other direct tracking of bonds’ final ownership. The lack of definitive information about ultimate ownership of Treasury securities makes it technically very difficult for the U.S. government to selectively default on the portion of debt owned by foreigners,” writes Prasad.
Over and above this, the U.S. government is not legally allowed to discriminate between investors.
This explains to a large extent why foreign investors kept investing money in treasury bonds. But that changed in 2013. In 2013, the foreign countries bought only 19.6% of the treasury bonds sold in comparison to 43% they had bought between 2010 and 2012.
So, have the foreign financiers of America’s budget deficit started to get worried. As Adam Smith wrote in The Wealth of Nations “When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment [i.e., payment in an inflated or depreciated monetary unit].”
Have foreign countries investing in treasury bonds come around to this conclusion? Or what happened in 2013, will be reversed in 2014? There are no easy answers to these questions.
For a country like China which holds treasury bonds worth $1.27 trillion it doesn’t make sense to wake up one day and start selling these bonds. This will lead to falling prices and will hurt China also with the value of its foreign exchange reserves going down. As James Rickards writes in The Death of Money “Chinese leaders realize that they have overinvested in U.S. -dollar-denominated assets[which includes the treasury bonds]l they also know they cannot divest those assets quickly.”
It is easy to see that the United States government has gone overboard when it comes to borrowing, but whether that will lead to foreign investors staying away from treasury bonds in the future, remains difficult to predict. As Prasad puts it “It is possible that we are on a sandpile that is just a few grains away from collapse. The dollar trap might one day end in a dollar crash. For all its logical allure, however, this scenario is not easy to lay out in a convincing way.”
Author Satyajit Das summarizes the situation well when he says “Former French Finance Minister Valery Giscard d’Estaing used the term “exorbitant privilege” to describe American advantages deriving from the role of the dollar as a reserve currency and its central role in global trade. That privilege now is “extortionate.”” This extortionate privilege comes from the fact that “if not the dollar, and if not U.S. treasury debt, then what?” As things stand now, there is really not alternative to the dollar. The collapse of the dollar would also mean the collapse of the international financial system as it stands today. As James Rickards writes in The Death of Money “If confidence in the dollar is lost, no other currency stands to take its place as the world’s reserve currency…If it fails, the entire system fails with it, since the dollar and the system are one and the same.”

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The article appeared originally in the July 2014 issue of the Wealth Insight magazine

1T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)

2 Mauldin, J. 2011. Inflation and Hyperinflation. March 10. Available at http://www.mauldineconomics.com/frontlinethoughts/inflation-and-hyperinflation, Downloaded on June 23, 2012

3T. Piketty, Capital in the Twenty-First Century(Cambridge, Massachusetts and London: The Belknap Press of Harvard University Press, 2014)