The World Reserve: Its Beautiful When You’re On Top… Even When It’s Ugly

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We might not realize it, but the US has it good. Anything we need we can get, we are the world’s reserve currency, so when times get rough – we are even more flush.

There are three prevailing theories in economics regarding how to improve a weak economy. The first, is the theory that government spending can boost the economy by increasing aggregate demand.

Four factors make up our Gross Domestic Product (GDP), consumer spending, investment, government spending, and net exports. (CIGX). When faced with declining consumer spending (C), such as in a recession where people just don’t have money or don’t want to buy anything, the government (G) can spend more to offset this dip. When people start to see that things are still good, or they get some $ from, they spend more and C goes back to its long-run equilibrium.

The second theory suggests that this raises price levels but doesn’t do much to the economy, we aren’t pushing producers to make more stuff. Proponents suggest that instead of boosting aggregate demand, we should aim towards increasing supply, by means of interest rate manipulation, bond purchases, and the likes.

The third, is simply – do nothing, these are normal business cycles and they are best left alone. No sense in trying to shorten them, the economy always self-corrects to the optimal long-run equilibrium.

Here you have Keynes (1st) vs. Hayek (3rd) (note this is a fun but long video “rap”- you might want to continue reading):

In all three cases, the US is tremendously at an advantage given its status as central bank to the world’s reserve currency.

(PLUG: I’ve covered the debt stuff a lot – please feel free to catch up,

Do We Really NEED To Be Concerned About The Debt?,”

I Like To Think Our Debt Is $4 Trillion,”

7 Reasons Why The Government Should Spend More Money”  )

Case 1: Government spending

Being the reserve currency, when the world economy crashes (we can look at the current Eurozone crisis and the “world recession”), everyone RUNS back to the dollar. This means that when other governments are having to increase there interest rates to attract investors (because now there is more risk), the United States lowers it. Yes, it becomes cheaper to borrow.

Looking into recessions since 1985 – 4 periods qualify as being “global” where economic growth has been 3% or less globally. These are: 1990-1993, 1998, 2001-2002, 2008-2009. Here is a graph of 10-year and 3-month treasury rates from 1970.

You will notice that following each of these recessions we see strong declines in our 3-month treasury yields, followed by a dip in 10-year rates. So yes, recessions on a global scale actually reduce our yields. (Note there is some lag, which is expected due to informational delay.)

Case 2: Monetary expansion measures

Since we are the central bank of this reserve currency, we can directly control our interest rates, and the supply of dollars through bond purchases. Also, there are residual effects that we feel when we do. When we lower our interest rates, or move to increase the supply of money, a few things happen. First, our debt becomes cheaper to finance via inflation. Second, because our currency is devalued, our exports become more competitive and we push out competition. Third, other countries who peg their currency on the dollar see this boost (of course in a world recession that might be good, but can cause overheating if it is just domestic).

Case 3: Doing nothing

Well, we can always do nothing if we wanted. When we do nothing, our current new debt obligations become cheaper to service.

 

Being the reserve  currency also gives our firms the unique advantage of not having to worry too much about converting imports into dollars from other currencies. Yes, domestic firms do it – but it is much more common for foreign companies. This means that our production prices usually are less susceptible to currency fluctuation – a huge advantage in a turbulent world.

Now that you know some of the benefits that the US has being the world reserve currency, let’s make sure not to lose it. We do have competition (Euro and Yuan), but now there isn’t much threat – unless we are reckless!

The argument over the debt ceiling, consistent “monetary easing” measures and any threats toward currency manipulation or default should be eyed carefully.

Stay tuned more to come!

One comment on “The World Reserve: Its Beautiful When You’re On Top… Even When It’s Ugly

  1. Reply Robin Jan 30,2013 %I:%M %p

    Hmmm……

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