Linda S. Goldberg, Mark Choi*, and Hunter L. Clark*
It isn’t surprising that the dollar is always in the news, given the prominence of the United States in the global economy and how often the dollar is used in transactions around the world (as discussed in a 2010 Current Issues article). But the dollar may not retain this dominance forever. In this post, we consider and catalog the implications for the United States of a potential lessening of the dollar’s primacy in international transactions. The circumstances surrounding such a possibility are important for the effects. As long as U.S. fundamentals remain strong, key consequences could be somewhat higher funding costs and somewhat lower seigniorage revenues (the excess returns to the government of creating money), some reduced U.S. spillovers to the rest of the world, and enhanced sensitivity of the domestic economy to foreign economic conditions.
Why the Context for the Dollar’s Potential Decline Matters
Whether the rise of other currencies would present more negative or positive consequences for the United States is linked to conditions within the country. If the United States maintains the strong economic fundamentals and institutional strengths that have supported the dollar’s international role, the consequences of a reduced dollar role would not be a large concern. Indeed, the emergence of plausible alternatives to the dollar would signal strength in other economies and financial systems, which are positive developments. However, if poor U.S. policy decisions undermine the nation’s economic fundamentals and institutional strengths, a reduced international role for the dollar could be one component of a broader decline.
The Specific Consequences of a Declining Dollar Status
Some have suggested that the large benefits extracted by the United States from the dollar’s privileged international status could be undermined should the currency’s role decline. We examine this claim by grouping the potential consequences of a change in the dollar’s relative international status into five “buckets.” These consequences are summarized in the table below and discussed in more detail.
|Possible Effects of a Reduced Role of the Dollar
|Seigniorage revenues to the United States||Small reduction||Seigniorage revenues are relatively low; dollar cash holdings outside the United States are not likely to change much.|
|U.S. funding costs||Increase from low levels||While the United States does not have an “exorbitant privilege” in funding, reduced demand for dollar reserves can raise U.S. funding costs. Higher funding costs on debt raise interest payments to external creditors. This tightens domestic spending constraints, and some domestic expenditure could be crowded out.|
|Dollar depreciates; imports become more expensive||Dollar depreciation arises from lower net demand for dollars.|
|U.S. insulation from foreign shocks||Reduced U.S. autonomy in policy||International trade invoicing patterns change and U.S. import prices and consumption become more exposed to foreign shocks and exchange rate movements.|
|U.S. global influence||Reduced influence||Some rebalancing of country powers in international negotiations and institutions may occur.|
Seigniorage revenues to the United States: Total potential seigniorage losses to the United States are estimated to be moderate. Seigniorage revenues on U.S. currency outstanding can be approximated by the difference between interest earned on securities acquired in exchange for bank notes and the cost of producing and distributing those notes. In a low-interest-rate environment, seigniorage revenues have an upper bound of around $2.5 billion per year if calculated at 25 basis points, or $20 billion if calculated at an interest rate of 2 percent. Some lost foreign circulation of dollars would reduce this revenue accordingly.
U.S. funding costs: The United States is sometimes argued to have an “exorbitant privilege” of facing lower funding costs due to the dollar’s central role in the international monetary system. While there remains a small advantage for the United States in official and bond financings, and the debate over the reason for this is ongoing, recent studies (such as the 2011 paper by Curcuru et al.) attribute the lower rates charged to the United States to risk premia and to differences in tax rates and the relative stability of investment returns across nationalities, rather than to the dollar’s international role per se.
It is possible, however, that funding costs could rise on U.S. government borrowing if other country assets emerge as stronger alternative investment vehicles to U.S. Treasuries. If reduced demand for U.S. official debt leads to increased funding costs in the United States, the fiscal burden of U.S. debt would rise and could increasingly crowd out domestic spending.
Another type of cost arises on transactions in financial markets. High volumes of activity in U.S. dollars keep the dollar market highly liquid and lower the effects on exchange rates of large sales or purchases of U.S. dollars. While transaction costs could potentially rise with dollar exchange rate volatility, other cost drivers are the number of dealers, quote frequency, and transaction size. Unless large volumes of international financial and international trade transactions shift away from dollar use, there is little reason to expect that U.S. dollar transaction costs will rise.
Dollar value:The dollar’s value is supported by its status as the primary global reserve currency. A loss of reserve demand for U.S. dollars could be associated with a depreciated U.S. dollar relative to whichever currency gets an enhanced role. A weaker dollar would make U.S. goods more competitive internationally, while also potentially raising the costs of commodity and intermediate inputs, among other imports. A weaker dollar may not be an issue for the U.S. debt burden since U.S. liabilities are expressed in dollar terms, despite the size of the external debt of the United States. However, the costs of carrying the debt could rise if further dollar depreciation is expected and compensation for that risk is required by investors.
U.S. insulation from foreign shocks: Many international trade transactions use U.S. dollars as the invoicing currency. Likewise, many international financial transactions, including debt contracts, are issued and payable in U.S. dollars. This numeration of contracts in dollar terms helps insulate U.S. real activity from foreign developments. Import prices into the United States move to a lesser degree with exchange rate fluctuations compared with what is observed in other countries. This lower exchange rate pass-through into domestic import prices also keeps U.S. inflation relatively more insulated from foreign developments (Goldberg and Campa 2010). That is, when the dollar exchange rate moves, more of the expenditure switching burden is felt by the country’s foreign trading partners (Goldberg and Tille 2006). Greater invoicing in other currencies could shift more of the burden back to the United States. On the financial side, the global predominance of the dollar has enabled U.S. entities to issue their debt in dollars, helping the U.S. government and private entities avoid large currency mismatch risks on their balance sheets.
In general, the increased use of other currencies in place of the dollar could lead to a directional rebalancing of international transmission of shocks and stimuli. In a potentially more multipolar and integrated global economy, foreign developments and possible feedback effects of domestic policies would have to be increasingly taken into account, even for a large economy such as the United States.
U.S. global influence: Less quantifiable, but nonetheless important, could be a loss of global prestige and policy influence for the United States resulting from a shift toward a multipolar currency world. One key channel of U.S. global influence in the modern economic system has been within institutions such as the International Monetary Fund and World Bank that undergird the current international economic and financial order. A second avenue by which U.S. influence may be impacted is through the growing use of other currencies in international negotiations and transactions. This could further strengthen the reach of other countries in ways that could differ from U.S. preferences and interests.
In general, if a decline in the dollar’s international primacy were to occur in the context of strong U.S. growth and institutional fundamentals, it would not be a significant threat to the country’s economic well-being. However, the changes we described could have more adverse effects if the dollar’s reduced role were to be associated with less auspicious U.S. policy and institutions. These changes could have the greatest impact on U.S. fiscal costs and the sensitivity of the U.S. economy to developments in foreign markets.
*Mark Choi is a senior economic analyst and Hunter L. Clark an officer in the Federal Reserve Bank of New York’s Emerging Markets and International Affairs Group.
The views expressed in this blog are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).