June 15, 2009
The Dollar as a Reserve Currency: Apres le Deluge
Time to review trends in reserves, against the backdrop of financial crisis, recession, and dollar gyrations. (I'll try to be original, but Brad Setser has been more diligent than I in covering these issues over the past few months.   )
A few observations:
- Known dollar reserves as a share of world reserves appear to be falling.
- Total dollar reserves have likely not declined as precipitously.
- Even with the decline in the dollar share, it is probably not as low as it was during the early 1990's.
- The dollar share is (mechanically) linked to the dollar's value.
- Known dollar reserves at end-2008 are less than predicted by a historical correlation.
- But this differential is infinitesimal compared to the "unallocated" share of total reserves.
Consider first the IMF statistics on known dollar, euro (and euro legacy), and pound reserves.
Figure 1: US dollar (blue), euro (red), sum of Deutsche mark, French franc, Dutch guilder, ECU (purple), and British pound (brown) shares of total reserves. NBER defined recession dates shaded gray. Source: IMF, COFER, March 31, 2009, NBER and author's calculations.
Figure 2: US dollar (blue), US dollar plus 60% of unallocated reserves (green), and IMF-estimated shares of total reserves (chartreuse triangles). NBER defined recession dates shaded gray. Source: IMF, COFER, March 31, 2009, and Chinn-Frankel (2007), NBER and author's calculations.
The triangles denote IMF-estimated holdings of US dollars. Before the COFER database was publicized, the IMF estimated aggregate currency holdings, guessing the portfolio of central banks that did not report the currency composition of their holdings. These figures were reported in the Annual Reports. Notice that the 2004 estimate pretty closely matches the guess that I make, namely that 60% of unallocated holdings are in US dollars. There is, of course, no guarantee that this proportion still holds.
Figure 3: US dollar (blue, right scale), US dollar plus 60% of unallocated reserves (green, right scale), and nominal value of US dollar against major currencies (red, left scale). NBER defined recession dates shaded gray. Source: IMF, COFER, March 31, 2009, Federal Reserve via FREDII, NBER and author's calculations.
Why has the dollar's share declined? Some proportion is likely due to the decline in the value of the dollar, since the calculation of the value of reserves is made using exchange rates. Of course, a decline in the share is not required, since central banks could be optimizing by keeping the currency shares constant.
Each one percent decline in the dollar's value is associated with a 0.91 percent decrease in the dollar value of US dollar reserves in the period up to 2008Q2. Based upon this historical correlation, the share of US dollars in total holdings should have been about 2.7 percentage points. Of course, this is small compared to the 37.2 percentage points of total reserves that are unknown in terms of currency composition.
That all being said, we want to be wary of what is coming down the pike. Brad Setser has a good review of possible triggers of a dollar currency crisis, that covers similar ground that I have:   .
Update 22 June 2009: Helmut Reisen has some thoughts on reserve currencies at VoxEU.
Posted by Menzie Chinn at June 15, 2009 04:20 PMdigg this | reddit
Excellent post. I do agree with your observations.
Thanks also for the link to Brad Steser's paper. Brad makes the following observation:
The impact of any one large actor’s dollar sales hinges on the reaction of other players in the market. If China’s central bank sold $100 billion of treasuries and bought $100 billion of German bunds, private investors necessarily would need to sell $100 billion of German bunds and buy $100 billion of treasuries. The critical issue is the price at which that trade takes place. If private investors increased their purchases of U.S. bonds as soon as China’s sales drove down the price by a small margin, the market impact would be modest; the sell-off would be orderly. Conversely, if private investors proved reluctant to increase holdings of treasuries, sales by a major central bank could be quite disruptive; market equilibrium would be restored only after a substantial fall in the dollar or a large rise in Treasury yields.3 In the worst scenario, significant private investors might perceive central bank sales as the trigger for a sustained bear market in treasuries, in which case they would join in the selling, requiring the dollar and treasuries to fall even farther before buyers were enticed into the market. A dollar and bond market sell-off that triggered other market moves — say, a rise in oil prices and a rise in risk spreads—would be even more disruptive."
The first sentence is powerful. The strongest argument for a floating currency is that it allows monetary authorities to better protect their own currency, but what is obvious from Brad's excellent analysis is that floating currencies actually cede control to other nations and places us in the awful position of having to include monetary policy in our calculations when making decisions concerning the physical security of our nation.
The floating currency regime has not given us more control over our currency, but just the opposite, by floating the dollar we have actually given away control of our currency to other nations. This situation was never believed possible by Richard Nixon and his advisors when they made the final break between the dollar and gold and it is still missed by most of our monetary "experts" today.
The events described by Brad in the excerpt above would be totally moot under a gold standard.
Some day we will return to a currency anchored in reality. My only hope is that the event that drives us there is not a total destruction of our existing currency.
Posted by: DickF at June 16, 2009 05:33 AM
Menzie this is why I fail to understand your eagerness to fault Bush but give Obama a pass when it comes to the budget deficit. At least that it appears that way to me. I fault both.
Posted by: GWG at June 16, 2009 06:21 AM
GWG, if the good Professor did that -- faulted Obama in writing -- he would no longer be invited to the better wine and cheese parties in Madison. He would probably have to move down to beer and bowling in Milwaukee.
Posted by: jg at June 16, 2009 10:58 AM
GWG: Once again -- Because when Bush ran the deficits, we were near full employment...
Posted by: Menzie Chinn at June 16, 2009 01:25 PM
"The floating currency regime has not given us more control over our currency, but just the opposite, by floating the dollar we have actually given away control of our currency to other nations. "
I don't understand how your conclusion follows from the post. The problem is not the US floating its currency, but China fixing theirs.
Linking the dollar to gold would cede control of monetary policy and money supply growth to gold mines in south africa.
Posted by: MikeR at June 16, 2009 01:41 PM
The events described by Brad in the excerpt above would be totally moot under a gold standard
LOL. "Gold Standard" internationalism is what it is. You would have less control than under the float. Setser's point isn't what you are thinking.
Posted by: Johnson at June 16, 2009 01:53 PM
Menzie, I'm not sure if we can, even conceptually, attribute the fall of dollars share to purely exchange rate valuations. Reserves must be valued in nominal terms, here in dollars, so yes when dollars value declines, the dollars share in the reserves will fall. If the central banks do nothing, we will see, as in COFER, that that dollars share falls. If they instead reoptimise their portfolios to keep their dollars share unchanged (shares being measured in dollars terms), we would never observe the decline in dollars share in the first place.
I have yet to find a convincing argument that what we see is not a genuine diversification.
Posted by: PhR at June 16, 2009 07:23 PM
You need to read Brad Setser's article again especially the paragraph I posted. He is not talking about Chinese currency. He is talking about shifting from US bonds to German bonds, and he is also talking about the nations of the world losing faith in the dollar, exactly what Menzie's post is about.
By saying that South African gold mines would control money under a gold standard tells me that you do not know anything about a gold standard. I would suggest you read Jastrow's "Golden Constant" to get an idea of just how foolish your statement is.
Posted by: DickF at June 17, 2009 07:54 AM
You are making a typical mistake, one that I believe MikeR is also making. A gold standard takes control away. The point is not to give monetary authorities more control but less. As you give more control of the currency to monetary authorities you also cede control to other countries. It is the unlimited controlt that is the problem. When everyone is in control no one is in control and the currency has no stability and loses power as a medium of exchange. As the stability of the currency becomes weaker and weaker so does confidence in the currency and no confidence is the death knell for a monetary system.
Posted by: DickF at June 17, 2009 07:59 AM
Are you a fan of Alexander Hamilton and/or Adam Smith?
Posted by: steve at June 17, 2009 08:38 AM
"You need to read Brad Setser's article again especially the paragraph I posted. He is not talking about Chinese currency. He is talking about shifting from US bonds to German bonds, and he is also talking about the nations of the world losing faith in the dollar, exactly what Menzie's post is about.
By saying that South African gold mines would control money under a gold standard tells me that you do not know anything about a gold standard. I would suggest you read Jastrow's "Golden Constant" to get an idea of just how foolish your statement is"
Dick, no it is you who are confused. Not only would South Africa tell you what to do, the laws of gold would ravage the economy and structurally destroy it as the long depression showed.
The "faith" of the dollar is a global problem, not a American problem. America adjusts. We don't need them and we know it. They take the loss the worst. That is where you are wrong Dick. Gold Standard internationalism should be fought at all costs.
"As you give more control of the currency to monetary authorities you also cede control to other countries"
Once again factually false, other countries have no more power than what is given. With the Gold Standard, you just don't lose your power, but fix it on gold which is a internationalization of America as it was in the 19th century. It is the big reason why gold had to be dropped in the first place.
Dick your living a ideological fantasy.
Posted by: Johnson at June 18, 2009 11:23 AM
I do not believe that I could ever convince you of the foolishness of a floating currency and the strength of a stable currency, but you could discover it for yourself. Be skeptical. Don't let them hype you.
Consider the price index in 1970 before the currency was floated and what it is today.
Also consider a very hypothetical case that you loaned someone $20,000 in 1970 for a 30 year mortgage balloon due in 2000. How much would the home we worth today? How much would your mortgage be worth today - purchasing power in 2000 dollars compared to 1970 purchasing power?
Perhaps my challenge will stimulate you into doing a little more study on your own. Pick up a copy of Nathan Lewis' Gold: The Once and Future Money http://www.amazon.com/Gold-Future-Money-Nathan-Lewis/dp/0470047666 and after reading it, then let's talk.
Posted by: DickF at June 18, 2009 01:27 PM
The slow decline of the dollar and gradual gain of the euro in reserves and world trade is a very important long-term issue. But it's hard to even bring up the topic without getting drowned out by a nonsensical argument between those who imagine it will happen overnight and those who insist there is "no alternative" to the dollar.
The fact is that Eurozone GDP is already about even with US GDP. As the Eurozone expands, as new members grow faster than old members, and as new members' real exchange rates adjust (nominal GDPs grow faster than their real GDPs), Eurozone GDP will be slowly but steadily pulling ahead for the foreseeable future. Traditions and technical factors such as the liquidity of the US Treasuries market will keep the pace of change very slow, but not stop it. I think the Euro will almost certainly eventually supplant the dollar as the main global currency, but it could take, say, 50 years.
This has important implications for the US, which has come to rely on the dollar's status as the dominant global currency and the related financial inflows to bridge a widening gap between US productivity and US living standards. The change is happening so slowly it's almost unnoticable, but I think it's one of the factors contributing to the current submissive US foreign policy, along with the global recession and Bush's stupendously mismanaged attempts to be assertive in Iraq, Afghanistan, Pakistan and Georgia. I don't see any will among Americans at this point to actually address the reasons for their reliance on financial inflows. The reality is, most Americans want their government to borrow more and spend more on "stimulus" cushioning.
The trend also has very important implications for the EU. I think both the left and right of Europe are still living in idylls. Most of the UK & European left likes to imagine that the world is not so dangerous - in a nutshell, that as long as we adequately placate Moscow, Tehran and Beijing, everything will be fine. Most of the UK & European right likes to imagine that they will always have the super-powerful US protector. Neither really wants a strong Europe or to take responsibility for the fate of the world themselves. It's obviously not tenable for the world's largest economy, Europe, to be seeking protection from its economically much smaller neighbor, Russia, from a decling superpower on the other side of the globe.
Posted by: Tom at June 19, 2009 06:29 AM
After reading Tom's post, I was reminded of the tremendous value or free ride the US gets from having the US$ as the international researve currency. People all over the world holding dollars that never circulate or using dollars for transactions oustside of our borders. This helps support the value of the dollar. If the dollar is viewed as unstable, people will be less likely to hold dollars. From this perspective, perhaps the US would have more to gain from linking the currency to gold than we have to lose from the loss of flexibility in terms monetary policy options.
Posted by: MikeR at June 19, 2009 09:19 AM
Yes, Mike, I totally agree. There are many on the right who are afraid of a world currency but we had a world currency in the 1700s called the guinea and in the 1800s called the pound sterling; or better, we had a guinea gold standard, then a pound gold standard.
The most serious economic declines in world history have been connected with a loss of confidence in the dominant currency. If the day comes when the dollar is replaced as the world currency it will not be a simple transition. World economic decline will result, but if the people of the world determine that the dollar is simply too unstable to keep its place as the reserve currency the dollar will be replaced no matter the cost.
I do not agree with Tom that the euro will replace the dollar. Europe, especially Germany, has made some positive moves to improve their economies but China is the big dog. If China gets its economy at a fraction of Europe it will become much more important economically. But more importantly it appears that the Chinese may understand monetary policy better than any country in the world. Once they totally understand Mundell's calls for them to anchor the yuan to a basket of currencies with gold as an indicator their economy will and currency will lead the world.
I am not very encouraged by what is happening in the US. Not only are the monetary authorities making mistakes recognized by the classical economists, they are making mistakes that even Keynes condemned. The level of incompetence is near criminal.
Posted by: DickF at June 19, 2009 01:25 PM
If I were a holder of US debt I would want a "gold backed" or "fixed" currency soon.
If I were the US, I would want to inflate away my debts and THEN go for a "gold backed" or "fixed" currency.
This is the war of words being waged now by the BRICS and the US. That is why the Russians are asking for a review of the SDR to include Gold!!
Posted by: jack in mumbai at June 19, 2009 11:32 PM
The Chinese currency might theoretically someday become a major reserve and global trade currency. But even though there is clear potential for Chinese GDP to surpass the EU's and the US's GDPs given China's greater population and much higher recent growth rates, obviously China's growth rates will slow down as its wages rise. So it would still take many decades for Chinese GDP to catch up to EU GDP, even if all goes well for China. Then there is the fact that China forbids the use of the yuan as a reserve or global trade currency, and if and when the Chinese government stops doing that, the yuan would only then be able to start catching up, from scratch. So predicting the future importance of the yuan as a global reserve and trade currency seems to me like idle guessing.
Also, not all of us believe that the Chinese government is omniscient and infallible in its economic policies. Personally, I think they are making a big mistake with this year's sharp reversal towards greater state direction of the economy, which if it continues will lead to a crash and depression reminiscent of 1988-1995 in the former Soviet Union.
Posted by: Tom at June 20, 2009 07:27 AM
Tom, what is true for Eastern Europe is also true for China
Real growth may slow down but nominal growth will keep growing at this speed
Posted by: Charly at June 20, 2009 06:12 PM
But even though there is clear potential for Chinese GDP to surpass the EU's and the US's GDPs given China's greater population and much higher recent growth rates, obviously China's growth rates will slow down as its wages rise.
This is not at all obvious. The power of capitalism is that in free markets labor rates grow and the economy grows and finds better and more efficient uses of capital. Look at the countries of the world with the most severe declines in wage rates and you will be looking at centrally planned economies where governments create wedges to hinder free trade and free use of capital.
If China continues to liberalize their economy and by extension their society the power of the free market will make their economy dominate the world. It is only their central control and fear of a free people that is holding them back.
Posted by: DickF at June 22, 2009 05:14 AM
The second sentence should read:
The power of capitalism is that in free markets labor rates grow as the economy grows and finds better and more efficient uses of capital.
It is better uses of capital that create higher wage rates and growth. Wages do not stiffle growth restrictions on capital use do.
Posted by: DickF at June 22, 2009 07:00 AM
I suspect that what Tom meant was: "China's growth rate cannot continue to grow exponentially (like it now is) forever". That statement is trivial to prove.
Posted by: bellanson at June 22, 2009 05:01 PM
Thanks bellanson. I was actually more interested in the reasoning behind Tom's statement than the statement itself. Too many people no longer understand where higher wages come from, or they simple pass over it. There can be no higher wages without productivity increases and the most powerful way to generate increased productivity is the creative use of capital. This is why government wedges that hinder the use of capital are so destructive.
Posted by: DickF at June 23, 2009 05:28 AM