THOMAS I. PALLEY
Palley runs the Economics for Democratic and Open Societies
Project, and is the former chief economist of the US-China Economic
& Security Review Commission. He is the author of Plenty
of Nothing: The Downsizing of the American Dream and
the Case for Structural Keynesianism.
US dollar is the world’s premiere currency, with approximately
two thirds of world official foreign-exchange holdings being
dollars. Moreover, many countries appear willing to run sustained
trade surpluses with the US, supplying everything from t-shirts
to Porsches in return for additional dollar holdings. This willingness
to exchange valuable resources for paper IOUs represents a form
of dollar tribute.
foreign policymakers complain about the special advantage for
the US, allowing the nation to run enormous trade deficits without
apparent market sanction. Whereas balance-of-payments considerations
constrain other countries to run tight economic policies, no
equivalent constraint appears to hold for the US. This advantage
is rooted in the dollar’s special role as the world’s
the US, one major benefit of the dollar’s reserve-currency
role is that it increases the demand for US financial assets.
This drives up prices of stocks and bonds and lowers interest
rates, thereby increasing household wealth and lowering the
cost of borrowing money. Additionally, the US government gets
seignorage, or an interest-free loan, from the hundreds of millions
in dollar bills held offshore. Printing a $100 bill is almost
costless to the US government, but foreigners must give more
than $100 of resources to get the bill. That’s a tidy
profit for US taxpayers.
foreign demand for US assets also appreciates the dollar, which
is a mixed blessing. On one hand, consumers benefit from lower
import prices. On the other, it makes US manufacturing less
competitive internationally because an overvalued dollar makes
US exports more expensive and imports cheaper. Reserve-currency
status therefore promotes trade deficits and de-industrialization.
conventional explanation of the dollar’s reserve-currency
status is a “medium of exchange” story. The US has
historically been the largest and richest currency area, with
the largest share of world output and trade. This has provided
incentives for other countries to hold and use dollars. Additionally,
the fact that many governments over-issue their own money and
create high inflation encourages foreign citizens to protect
themselves by holding dollars instead of domestic currency.
theory of reserve currencies, associated with the political
left, is based on US military power and the Pax Americana. The
argument is that US military power provides the security that
protects the global market system, and New York is the new Rome.
Countries, such as Saudi Arabia, hold reserves in dollars because
New York is a political safe haven and because that helps cover
the costs of enforcing the Pax Americana.
two theories are mutually reinforcing. Thus, to the extent that
the dollar is widely used and is also a safe haven, investors
tend to rush into dollars in times of uncertainty. Consequently,
central banks in other countries need to accumulate large dollar-reserve
holdings to protect against financial disruptions that result
from sudden exits by investors, as happened in East Asia in
is a third unrecognized theory that can be labeled the “buyer
of last resort” theory of reserve currencies. Put bluntly,
the tribute other countries pay the US through their trade surpluses
is the result of their failure to generate adequate consumption
spending in their own markets, be it due to poor income distribution
or bad domestic economic policies. This forces other countries
to rely on the American consumer.
logic of this third theory is easily illustrated. Over the last
decade, while Europe and Japan stagnate, the US has grown on
the back of robust consumer spending. This spending has sucked
in imports, helping growth in Europe, East Asia and Latin America,
and making the US the major engine of global growth.
Asian countries, especially China, have been particularly willing
to run trade surpluses with the US because this has fuelled
export-led growth. These countries rely on exports to keep their
factories operating. Export success then attracts foreign direct
investment that advances development. Undervalued exchange rates
are vital for this strategy as it keeps exports competitive.
Countries have therefore channeled their trade surpluses into
dollars, keeping the dollar overvalued and enabling them to
sell in the US market. This explains both the continuing strong
demand for dollars despite the US trade deficit and the dollar’s
dominance in official foreign-exchange holdings.
America’s dispensation from trade-deficit discipline stems
from other countries’ failure to develop an equivalent
of the American consumer. Countries want to industrialize with
full employment, but they lack adequate internal demand. Consequently,
they must rely on the US market. It is also why Germany supplies
BMWs and Mercedes-Benzes in return for paper dollar IOUs.
theory says the dollar will only lose its dominance when countries
become saturated with dollar holdings. At that stage they will
cease buying and may even sell dollars, causing the currency
to fall. The problem with this story is that countries have
no incentive to sell dollars, as this would kill the golden
goose of export-led growth.
buyer-of-last-resort story suggests a different take. One reason
the dollar could topple is if countries finally manage to develop
their own consumption markets. Countries in the Euro zone are
most capable of doing this, but for the moment they are gripped
by policymaking that is obsessed with inflation and afraid of
growth. China needs to improve its income distribution in a
way that links income distribution to productivity. Unions are
the natural way to do this, but are blocked by China’s
totalitarian political system that fears such organization.
alternative source of collapse is if American consumers reduce
spending because they feel overextended, the Fed raises interest
rates too high or American banks tighten lending standards.
In this event, the US economy would stall and the dollar could
fall owing to diminished economic prospects in the US.
three theories have merit, but in today’s economic environment
the buyer-of-last-resort theory is especially relevant. As long
as other countries fail to generate sufficient demand in their
own markets, they will be compelled to rely on the US market
and pay dollar tribute.
none are well served by this co-dependence. Other countries
resent the special situation that exempts the US from trade-deficit
discipline. Side by side, the long-term economic prospects of
the US are undermined by the erosion of the manufacturing sector,
while US workers face wage and job pressures from imports that
are advantaged by the dollar’s overvaluation. Moreover,
all are vulnerable to a sudden stop of the system resulting
from financial overextension of the US consumer.
suggests that the rest of the world needs to develop an alternative
to the US consumer. That will require raising wages in developing
economies, and encouraging consumption in Europe and Japan.
Such measures would stabilize the global economy by providing
a second engine of growth, and it would also correct the large
global financial imbalances that have developed as a result
of over-reliance on the US consumer.
with permission from
YaleGlobal Online, a publication of the
Yale Center for the Study of Globalization. Copyright ©
2006 Yale Center for the Study of Globalization.