Calls for international financial cooperation are picking up. This will no doubt occupy much of the discussion at this weekend’s summit of Group of 20 leaders. U.S. officials would be wise to recognize the legitimate basis for grievances by their foreign counterparts. But they should also recognize that those grievances stem in part from advantages to the United States in global finance for more than a half century.
The U.S. dollar is the world’s reserve currency. At least two-thirds of foreign official reserves are held in dollar-denominated assets. Right now, foreign official institutions hold $4.25 trillion worth of the $13.25 trillion of U.S. government securities that are outstanding.
Foreigners prize the depth and liquidity of the U.S. government securities market, our adherence to the rule of law and contracts, and the fact that government officials have mostly followed the tracks laid down by Alexander Hamilton in abhorring default on our debt.
Those large official holders of U.S government securities, however, are trapped in those positions by dint of their size. They recognize that stopping purchases — or even redirecting a portion away from the United States — could roil markets and inflict large capital losses on themselves. Thus, they stand as willing buyers of U.S. government securities even as times get tough.
This role as a reserve currency and continued purchases by foreign official institutions explains a seeming paradox of the ongoing crisis. The United States is the epicenter of global market distress, but investors flood into the market for U.S. government securities. It would not seem to be a natural impulse to rush into a burning building at the first sign of smoke, but the financial market equivalent is happening. This reflects the funding advantage conferred upon us by being a reserve currency.
There are other advantages to the United States from its reserve-currency status. As a consequence, much of global finance is conducted in dollars. Many issuers abroad choose to borrow in dollars, even though this might create a mismatch on their balance sheets between the currency denominations of their assets and liabilities. They believe that those balance-sheet problems are outweighed by the advantages of accessing a wider world of investors.
If it happens abroad, then it also happens at home. Borrowing costs for our government and private sector are lower as a result of the universality of the dollar.
This dominance of the dollar poses problems for foreign officials. In particular, as the global financial market conflagration picked up heat, many Europeans banks needed liquidity, but not the sort that their home countries could provide. Those large financial institutions needed dollars to plug holes in their balance sheets. Officials at finance ministries and central banks were in the position of having resources in the wrong currency — their own — to address these strains.
Ultimately, officials had to turn to the Federal Reserve, which set up swap lines with the European Central Bank, the Bank of England and the Swiss National Bank, among others. The swap lines, which have grown to be open-ended, allow the central banks of Europe to trade their own currencies for the dominant one of global finance — the U.S. dollar.
Thus, foreign officials have an enthusiasm for change. A new international financial arrangement that lessened the status of the dollar would return more influence to European officials over their local markets. It might also serve as a firebreak that slowed the speed of financial crisis.
But it would also make U.S. dollar assets less attractive by limiting their universal acceptance and potentially creating plausible competitor vehicles. This would tend to raise borrowing costs for our public and private sectors, and lessen the dollar’s centrality as a safe haven.
U.S. officials in the outgoing and incoming administrations should recognize this tension. It is well and good to be cooperative participants in the move toward better global governance. But voters might view it as a poor trade-off if that global initiative required delimiting the dollar’s status and raising domestic funding costs.
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Carmen M. Reinhart is professor of economics at the University of Maryland. She is working on a book, “This Time is Different: Eight Centuries of Financial Folly.” Vincent R. Reinhart worked for the Federal Reserve’s Divisions of Monetary Affairs and International Finance and was secretary and economist of the Federal Open Market Committee.
