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The Dollar’s Limited Reprieve

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Pacific Money

The Dollar’s Limited Reprieve

Failure to raise the debt ceiling would have been catastrophic for both the U.S. and global economy. Investors should take note.

Today House Republicans are expected to pass legislation lifting the ceiling on the federal government’s borrowing authority for three months.  Among other things, this grants a limited reprieve to the dollar’s “exorbitant privilege” – its role as the only true international and reserve currency and the principal source of global liquidity.

Consider what would have happened had House Republicans not agreed to raise the debt ceiling.  By the middle of next month the U.S. Treasury, denied authorization to borrow, would have lacked the resources to meet its spending obligations.  It would have had to choose who to pay and who to delay.  Presumably the Treasury would have chosen to give priority to paying the bondholders.  But whether doing so would have been legal is an open question.  Indeed, whether it would been workable, given the more than two million requests for payment received by Treasury each day, is dubious.  Imagine, moreover, the outcry from others, including conceivably pensioners and military enlistees, receiving IOUs.  In the face of this political noise, the rating agencies would have been all but certain to downgrade U.S. debt.

These events could have had devastating implications for the willingness of foreigners to hold dollars and accept them in payment for services rendered.  Even if the Treasury was initially able to prioritize payments to bondholders, questions would have been asked about how long this would remain the case.  Over time, the pushback from other stakeholders would have grown.  While the debt ceiling would have remained static, the bills would have continued to roll in.  The longer the deadlock lasted, the harder it would have become for Treasury to make ends meet.

The impact on the global financial system, while ultimately unfathomable, could have been catastrophic.  Commercial and central banks, which hold U.S. Treasury bonds as a reserve of safe and liquid assets, would have scrambled to find substitutes.  A few hedge funds might have offered to take those bonds off the banks’ hands at rock-bottom prices, just as they have been scooping up Greek government bonds.  But it seems likely that the market in U.S. treasuries would have cratered.  The scramble into Norwegian krone, Australian dollars and other substitutes would have driven up these currencies to painful heights.  Even worse, it would have driven up the euro, the worst thing imaginable for a European economy locked in recession.  Inevitably these large exchange rate and interest rate swings would have caught important institutional investors wrong-footed.

Of course, the dollar’s critics have cried wolf before.  In previous crises – even crises originating in the United States – investors have scrambled into dollars, not out of them, the dollar constituting the only true safe haven.  To the surprise of many observers, the dollar strengthened in August-September 2007 when the Subprime Crisis erupted.  It strengthened again following the bankruptcy of Lehman Brothers in September 2008. 

But this time would have been different, to coin a phrase.  Investors scrambled into dollars in response to the eruption of Subprime and again with Lehman’s failure because U.S. treasuries are liquid, and there is nothing that investors value more than liquidity in a crisis.   The U.S. treasury market is the single largest and most liquid financial market in the world.  And while subprime and Lehman placed a cloud over other asset classes, it did nothing to diminish the liquidity of U.S. treasury bonds.

A crisis caused by failure to raise the debt ceiling would have been different.  It would have been a dagger pointed directly at the heart of U.S. treasury market liquidity.  Unlike 2007-8, America’s safe-haven status and the dollar’s exorbitant privilege would have been at risk.

So we should be happy that this specter has been taken off the table.  The only problem of course being that it may be back as early as this spring, the promised debt-ceiling extension being for just three months.  And once President Obama’s reelection honeymoon is over, the Republicans may be less willing to compromise.

Central and commercial banks, in Asia and elsewhere, have been put on notice.   If the U.S. does, in fact, hit the debt ceiling in the spring, they will not be able to claim that this was a surprise.

But what they should do to prepare is less clear.  Central banks should diversify out of dollar reserves.  We see them buying gold as part of this effort.  But physical gold, while comforting, is not exactly liquid.  Buying, selling and even transporting gold bars is logistically challenging, as the German Bundesbank, currently repatriating gold from Paris, is learning to its chagrin. 

Central banks can also move into other subsidiary currencies like the krone.  But these are in very limited supply.  Subsidiary currencies account for barely 5 per cent of allocated central bank reserves according to the IMF.  Try to sell them in significant amounts and the price will collapse.  If central banks want to bet on the European Central Bank doing what it promises, they can hold euros.  If they want to bet against the Bank of Japan delivering on its commitment to inflate, they can hold yen.  None of these alternatives to the dollar, in other words, is particularly attractive. 

Firms and commercial banks, for their part, have been diversifying into riskier asset classes like corporate bonds and emerging market equities.  But if there is a debt ceiling crisis in the U.S. in May, this appetite for riskier assets may evaporate.  Banks and firms that had moved in this direction previously will take losses.

Ultimately, then, the world needs another source of safe and liquid assets.  China, in aspiring to internationalize the renminbi, seeks to become that source.  But everyone, including Chinese officials, understands that renminbi internationalization will take years to complete.  China will have to liberalize the capital account of the balance of payments in order to give foreign investors access to its financial markets.  This process is underway, but Chinese officials are undertaking it slowly – crossing the stream by feeling with stones.  With the country exposed to larger capital inflows and outflows, the exchange rate will have to be allowed to fluctuate more widely as a buffer.  China will have to deepen its financial markets and convince foreign investors that assets held there are safe and secure.  And deep and liquid financial markets with a reputation for safety are not built in a day. 

The problem being that the world economy may have not years but only months.

Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley and author of Exorbitant Privilege: The Rise and Fall of the Dollar (Oxford University Press).