The U.S. Can’t Afford To Lose Its Reserve Currency Status

The loss of its exorbitant privilege would be disastrous

The U.S. is currently the world’s reserve currency. This means that other countries demand a lot of U.S. dollars because:

1. Commodities like crude oil are priced in dollars so commodity imports must be paid for using dollars.
2. Many other countries issue debt in dollars. By borrowing in dollars, these countries can pay a lower interest rate on their debt because investors don’t need to worry about currency risk.
3. Foreign central banks hold a lot of dollars and U.S. Treasuries (the large and liquid Treasury market further increases the attractiveness of the U.S. dollar to other countries) in their foreign exchange reserves to act as a stabilizer for their own currencies (and allow them to prop up their currencies in the case of a currency crisis).
4. A lot of international trade is conducted in dollars — so countries need dollars to buy and sell goods from each other.

This extra and large demand for U.S. dollars drives up its value relative to other currencies. This creates some big benefits for the U.S.

Foremost, it allows the U.S. to borrow at low rates. When foreign countries hold a lot of dollars, they tend to invest those dollars in U.S. Treasuries. Thus, reserve status brings with it a massively increased demand for U.S. Treasury Bonds. On the margin, this pushes bond prices up and interest rates down, allowing the U.S. to finance large debt burdens without worrying about interest expenses getting out of control.

And that’s pretty critical these days — the U.S. has a large trade deficit (3.3% of GDP) and an even larger budget deficit (7.4%), yet it pays just 1.74% yield on 10 year Treasury Bonds. Without this seemingly endless appetite for U.S. government debt from the rest of the world, we would be forced to reduce our debt levels, likely through slowdown-inducing austerity.

A hypothetical

Here’s how that might play out if some exogenous shock caused the world to start questioning the U.S. dollar’s reserve currency status. First, it’s important to recall that minus a complete disaster, it would take years if not longer for ingrained habits within financial markets to adjust.

But even some deterioration would be a bad thing. It would mean less demand for dollars, which translates to less demand for U.S. Treasury bonds. Interest rates in the U.S., especially at the long end would rise. For our government, that means interest expenses go up as a percentage of GDP (a bad thing given that federal debt is more than 120% of GDP) — this would impede the government’s ability to spend as the vast majority of tax revenues suddenly gets devoted to paying interest on the debt. And if some portion of foreign investors and central banks decide to stop revolving their U.S. debt holdings, that could even bring into question the ability of the U.S. to repay without resorting to printing money, putting further upward pressure on interest rates and downward pressure on the dollar. Dollar volatility would accelerate the move away from the dollar into some more stable alternative. But hey, at least we would suddenly export more.

Domestically, higher interest rates, capital flight (to diversify out of the U.S. dollar) and lower government spending would put pressure on stock (and real estate) prices as well as the economy. Losing reserve status would also impact the U.S.’ already limited ability to fight off any resulting recessions with monetary policy as the Federal Reserve would need to choose between raising rates to defend the weakening dollar or lowering rates to defend the weakening economy.

This is not the base case. For now, the U.S. maintains its status as the economic and financial center of the world. But if we take for granted and repeatedly abuse our exorbitant privilege, that privilege will inevitably be lost.

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