Free Money?

The dollar as an international reserve currency allows the United States to pile up huge budget and trade deficits as export-surplus countries accumulate dollars for their foreign exchange reserves.

If you have a money printing machine and others are willing to accept whatever amount of money you care to print and recycle the money you spend on their goods back to you in return for IOUs, you would have a currency system that resembles our current international monetary system.

The US in fact owns such a money printer. Many countries are willing to sell goods to the US on credit in exchange for dollar-denominated IOUs. Creditor countries are willing to do that because the US dollar is a reserve currency.

A reserve currency is an internationally accepted currency and the prices of many commodities such as oil are quoted in dollars. When things are quoted in dollars, there is no currency exchange risk involved for the US. If the US dollar exchange value falls vs other currencies, the prices of goods quoted in dollars remain unchanged. Loans extended to the US are re-payable in dollars which the US can print at will. In fact, almost all US foreign liabilities are denominated in dollars, whereas around 70% of its foreign assets are in foreign currencies (Economist. 9/24/2010).

With such a money printer, the US has been piling up budget deficits and trade deficits to fund consumption. These deficits became surplus savings of foreign countries whose central banks have increased their dollar reserves by some $2 trillion since 2000, three-quarters of them in Asia (Economist. 9/24/2010). Foreign central banks were estimated to have bought at least 50% of all US bonds in 2003 – 2004.

Foreign central banks are willing to hold so much dollar reserves because they wanted to keep their currencies from rising against the dollar. Artificially depressed exchange rates helped Asian countries, particularly China, to keep their export factories humming.

If the US dollar was not a reserve currency, foreign central banks would not want to hold it in increasing amount. Persistent US trade deficits would depreciate the dollar value and appreciate the value of trade-surplus foreign currencies. Such a decline of the dollar value should have reduced the US trade deficits over time. But such an adjustment never came to pass because of US dollar's reserve currency status.

There is of course no free money in the real world. As the US dollars were recycled back to the US financial system to fund credit expansion, prices of financial assets such as stocks, corporate bonds, government bonds, and US agency debt soared. Such asset price bubbles ultimately led to the housing boom and bust which ushered in the Great Recession beginning 2007. If China stopped buying US bonds, US interest rates could easily jump 2 percentage points leaving US economic recovery dead in the water.

On the other hand, the surplus dollars also led to asset price bubbles in Asian countries as their central banks buy up the surplus dollars with their local currencies. And sitting on a lot of US Treasury bonds is a sure way to suffer huge capital loss. In particular, China’s dollar reserves might lose in value amounting to more than 20% of its GDP if the yuan eventually appreciates against the dollar.