Sunday, October 5, 2014

The Exorbitant Privilege

"The Exorbitant Privilege" of reserve currency status, while a wonderful rhetorical trope, is more a hindrance than help to non-specialists understanding of the political role of a reserve currency. The layers of abstract function embedded in a cross border currency system compound confusion over counter intuitive complexity.

First obscurity comes from the dual nature of money as both asset and liability. Because we handle it as cash we intuitively understand certain analogue properties it appears to manifest relative to our exchange of other valuables. But this obscures the essential property that sets money apart from other valuable objects: it has no intrinsic value itself, really never has, and exists always and everywhere as both an asset and liability. What is the intrinsic value of gold, a form of cash frequently misunderstood as sin qua non money? It does not oxidize, holds its luster, is easily malleable, is fairly dense and conducts electricity. It's hard to say, but it appears aesthetic properties of weightiness, malleability  and shininess recommended it as a medium of exchange, but this function in no way encompasses what is interesting about money with regard to power, which is the essentially interesting thing about a reserve currency. While cash money has properties that can be aesthetically embodied in gold, it is the liability side of money at scale, money in quantities not easily handled in cash, that ultimately creates the "Exorbitant Privilege".

A dollar is a liability to the US Government and an asset to anyone who holds it. It entitles its bearer to a dollars worth of whatever goods and services she may choose to exchange it for within the dollar denominated economy. There is a lot in those two sentences that we need to be clear about before moving on. Every dollar that exists anywhere in the world, in whatever form it is held from cash to bonds to keystroke records in a banks IT system, exists as a result of having first been spent by the US Government (or having been recorded as a bank asset/depositor liability as a loan on a Govt. chartered bank's books). If it was not first spent by the US Government or logged as an asset by a Govt. chartered bank it is at very best counterfeit: being issued and spent by the US Government is the only legitimate way dollars can come into being. It is an IOU of the US Government with which that government purchases things it determines to purchase. Politically,
the decisions that guide government purchasing are decisions about the allocation of real resources within the dollar economy. By purchasing foreign made things a government can change the allocation of real resources in the world outside its borders in ways favorable to its interests. Convincing other nations institutions to denominate their trade with the US in dollars rather than their own currencies is the essential characteristic of being a reserve currency and expands the dollar denominated economy to where ever this is accepted extending the realm in which holders of dollars can express demand without transaction costs, the "privilege" side of our equation.

But why would other countries want to trade in dollars? I'll come back to that after spending a few words on the value to financial markets of a reserve currency. Depth of markets, liquidity of markets, trust in enforcement of contracts within these markets and adequate global distribution are the hallmark of those currencies that have historically served this function, from the Ducat to the Guilder to the Pound to the Dollar. These properties allow financial activities at international scale with minimal transaction costs while allowing the issuer command over real resources within all those economic systems willing to denominate their trade with its currency. Another plug for the "privilege". Ultimately the asset/liability value of a reserve currency is a network effect subject to a power law: the more trade is denominated with it the more trade will be denominated with it. But to arrive at this threshold it must first have crossed that of trust, that investors believe it will hold an adequate share of its value across the time horizon of the deals they pursue. Thus trust in enforcement of contracts contra the power interests of the sponsoring government is the essential multiplier that on top of liquidity and depth is required to catapult a currency into contention for reserve status. This leaves adequate global distribution. Historically in European history this has come to pass where the banking system of a state has sponsored a general prosperity adequate for that nation to import significant real resources in whatever form for numerous and remote trading partners who are eager to profit monetarily from the export of their production, whatever it may be.

And this is the history of European Mercantilism. As Keynes and Marx understood where Adam Smith did not, the essential motive of the capitalist is money wealth and where money has been associated with gold mercantilism has been the result. Since 1971 we have been living in a world of mercantilism without gold, a subject to which we'll return, but for the purpose of understanding how reserve currency status has migrated around the Atlantic economy from Venice to Genoa to Antwerp to Bruges to Amsterdam to  to New York over the last 500 years the mercantilism  of gold is the guiding glow. When a market center becomes dominant and capitalist activities come to be denominated in the money of that market, competing economies manufacture and sell what they can on the best terms they may. Mercantilist states manage their transactions to ensure they sell more into the dominant system than they purchase from it. This management of trade forces the reserve issuer to export currency, which when gold at the end of the day depletes the reserve issuer of this metal. So a play of politics, the suppression of demand for nationalist/capitalist interests, facilitated the successive transfers of market centers enumerated above. By the end of WWII a ridiculous preponderance of the worlds gold sat in vaults in the United States.

Harry Dexter White may have had a better idea than he's credited with in what he was up to in his negotiations with Keynes at Bretton Woods. It's possible he understood quite well what I'm now trying to explain and as such was eager to see the US assume the Exorbitant Privilege: he was after all a Soviet Agent. Keynes labored long and hard at Bretton Woods to establish a dedicated trade currency he called Bancor who's role in the international system would be to mediate the imbalances that mercantilism had historically exploited in the competition between European states. Keynes goal, in my opinion, was ultimately humanist: having written "The Economic Consequences of the Peace" in an attempt to circumvent the mercantile exploitation of Germany by the Allies at Versailles, he understood all to well by 1948 in Vermont the risks of currency imbalances. In any case, Keynes lost and from 48 to 71 world trade, such as it was excluding the Soviet Union, China and India, was run on the basis of a gold backed dollar.

By this point, after two world wars, the markets for US Treasury debt, for US commercial debt and stocks as well as the export market for US goods were all quite strong and deep. I addition to having forced savings on the US population to finance the war effort, the US had the good sense to fund its exports through the Marshall Plan in Europe and MacArthur's occupation of Japan. These along with the Roosevelt reforms of the US financial system along with the clarity of our Constitutional jurisprudence left the US meeting all the qualifying conditions for a global reserve currency. Because our GIs were well paid with enforced savings, at wars end there was pent up demand that transitioning US industry could not meet. Our foreign trading partners received direct grants and loans to invest in rebuilding both their cities and their industry and as they did so the exploited the American market to which they exported. And this is where the privilege begins to become exorbitant.

As the US fought the pointless war in Viet Nam while at the same time embarking on an ill conceived "War on Poverty" (that missed the essential poverty fighting tool of good paid jobs), DeGaul's France reverted to mercantilist form and by purchasing Treasury bills, recycled their export earnings back into the US economy. Rather than taking the dollars paid to French producers and purchasing with them American goods or services, by purchasing Treasury debt, the French kept the earnings from their export market from expressing themselves as increased and balancing demand by French workers for American or other dollar denominated goods. As US debt and its purchase by France increased in the Johnson and Nixon administrations, France began to deplete the US gold reserves that underpinned the Bretton Woods system. It was Valery Giscard d'Estaing who first objected to the US "Exorbitant Privilge" and who set up the mercantilist policies that ultimately led Nixon to withdraw from the Gold Standard in 1971.

While this ended the French (and other nations) run on US gold, it merely shifted the "exorbitant" payment from gold to labor. Because a dollar is both an asset and a liability, by purchasing it in the form of Treasury bills, our foreign mercantilist trading partners re-cycled their earnings back into financial instruments within the US system rather than purchasing goods and services provided by the real American economy. My entire life I've listened to a benighted rhetoric of the monetary benefits of this foreign mercantilism within the US blaming the American "consumer" for running up debt. The American "consumer" never made any such decision: the cost to America of reserve currency status is that our trading partners, by purchasing our government liabilities, can recycle their dollar earnings directly back into the US economy. France, Germany, Japan and now China have all exploited this property of the reserve currency to import jobs and export demand back to the United States. This demand expresses itself financially as a run up of the Federal Deficit, a reality essential to foreign nationals having access to dollars with which to participate in the dollar denominated economy, and in the debt of Americans who's debt has increased not as a function of their borrowing more, but as a function of ever increasing interest rates (not the low ones the Fed charges banks, the ever higher ones we see in our consumer credit, the ones that don't go down when the Fed eases).

You will notice no other nation in the world willing to compete with the US for the Exorbitant Privilege of being the issuer of the world reserve currency. This is why. The cost of issuing the reserve currency is the loss of jobs, industry and demand and the ability to regulate the allocation of real resources within the issuers borders. Because the world uses our money and has chosen, often for good reason and due to maltreatment by us, to hold the asset side of our currency, the liability has expressed itself here at home in chronic weak demand, hollowing out of industry, increasing disengagement from the formal economy (seen in the declining labor participation rate that accounts entirely for the "drop"in unemployment). Now that the money is untethered from gold, there remains no mechanical check on the abuse of the fiat money system by the financial elite now running the country. Likewise, as that elite has fully captured the benefits of the privilege, they have fully offloaded the costs on an American citizenry now robbed of effective engagement in a political system where a corrupted Supreme Court has defined money politically spent as Constitutionally protected speech. Thus money is the only interest represented by our nominal democracy and the true cost of the Exorbitant Privilege has been revealed.

While the residual wealth of the failed New Deal is drained from a pauperized middle class, a financial elite has re-tooled American Democracy to represent and support its interests. It is now globalizing this exploitation and deleterious affects evident here since the 80s have sequentially begun to express themselves in all of our WWII satrapies, in the 90s in Japan, for the last six years in Southern Europe and now in Europe's heart, France and Germany. China, without credible rule of law, can't denominate foreign trade in Yuan and suffers from an elite that identifies more with their Western elite compatriots than with the billion Chinese in China and so offers no alternative. The Exorbitant Privilege is the power inherent in money scaled to the needs of global power. To the extent that power is used for public good, it has the ability to make the world richer. To the extent it is used for personal gain, it has the power to destroy the very systems on which it depends for its continued existence. We are currently on this latter path and will remain there until some effective political force understands the ultimate nihilism of personal greed and organizes some opposition to it. We await and such power shows no sign of arising.

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