Picture Credit: Dominik Meissner
The Trump administration seems to have accidentally stumbled upon a means to weaponize America’s “exorbitant privilege.” The term, coined by Valéry Giscard d'Estaing, the French minister of finance in the 1960s and later, French president, expresses the benefits garnered by the United States from being the issuer of the international reserve currency.
In times of global economic turbulence, exorbitant privilege means that safe-haven flows benefit U.S. financial conditions, especially the “risk-free” U.S. treasury market. If such flows are combined with glacial increases in short-term interest rates by the Federal Reserve and substantial fiscal expansion by the U.S. government, global turmoil can actually allow the U.S. to economically outperform the rest of the world.
Larry Kudlow, President Trump’s economic advisor, recently boasted that “trillions of dollars of capital from all over the world is coming into the United States because our economy, our investors, our workforce are crushing it right now. We are crushing it.” For sure, external flows into the United States are due to better economic prospects here and the expectation of higher short-term interest rates. But they are also due to increasing economic turmoil abroad. And this time, the turmoil is in part due to economic measures implemented by the White House.
The role of the US dollar in the global economy has created a paradoxical arrangement: whenever risks in the global economy rise, capital flows to the United States, and the USD appreciates. This is even the case when economic turmoil emanates from the United States itself.
When the U.S. housing bubble popped, the American financial system almost froze up after the collapse of Lehman Brothers in September 2008. But in this extreme risk-off environment, global fund flows still favored the United States, allowing the Federal Reserve to rapidly lower interest rates and pump money into the economy without the risk of a rapid outflow of funds and consequent currency crisis.
As many developing economies are aware, this is an exorbitant privilege. Economic crises generally trigger a retreat by both domestic and foreign investors as they seek safe havens to park their assets. In the extreme, such “sudden stops” can precipitate a currency crisis. But since the USD is the world’s dominant reserve currency, when things go wrong, everyone flees into the safety of U.S. assets, and especially U.S. treasury securities, which are traded in the most liquid market on the globe and seen as the least risky asset class.
This is perhaps the greatest benefit of the exorbitant privilege. Naturally, there are also drawbacks, such as a higher-valued currency than would otherwise be the case. This causes a loss of export competitiveness and large current account deficits. However, the advantages are generally recognized to outweigh the drawbacks.
Most importantly, the United States benefits from greater macro-economic stability, since the risk of a currency crisis does not exist – the United States owes all its debts in its own currency, so all it needs to do is print more dollars. This can help smooth out the boom-bust cycles of capitalism. When things go wrong anywhere in the world, everyone flees to the USD, giving the Federal Reserve greater leeway to stimulate the economy.
All of the economic crises that created safe-haven flows to the USD after 1980 have been at best accidents, at worst due to the folly of market participants and policy-makers. For instance, many hold that the Federal Reserve was insufficiently cautious and failed to pro-actively forestall the housing bubble. Nevertheless, no one accuses the Fed of maliciously creating the housing bubble to gain more power. At the end of the day, U.S. policy-makers have never deliberately engineered economic havoc for the purpose of creating safe-haven flows that lower U.S. interest rates, especially long-term rates.
We might be entering a new era. It is highly unlikely that the Trump administration thought this through and deliberately created the economic turbulence that is now strengthening U.S. economic prospects. Moreover, a series of factors have coalesced to make this possible, but the fact remains: the U.S. seems to be “winning” the trade skirmish with China and certainly has the upper hand vis-à-vis Turkey.
In the case of Turkey, its economy was already in dire straits with a yawning current account deficit and political interference inducing a loss of trust in the efficacy of the Turkish central bank. For economic observers, Turkey was well on its way to economic trouble, representing a textbook case of an emerging-market crisis.
Nevertheless, the Trump administration’s imposition of economic sanctions on Turkey for political reasons is pushing the Turkish economy over the edge. This is economic coercion par excellence. And the fear of contagion to other emerging markets is creating safe-haven flows into the USD.
This time, the transition mechanism of these flows into the U.S. economy is especially strong, since the federal government is engaging in considerable economic stimulus via tax cuts and a big spending bill. The upshot is lower U.S. long-term rates (the Federal Reserve is raising short-term rates, albeit very slowly), allowing the government to borrow at relatively low rates and making the economic stimulus more affordable. This, naturally, creates greater confidence in U.S. economic prospects, engendering a virtuous feedback loop.
China also has its own dynamics, but again the initiation of a trade skirmish by the Trump administration seems to be hurting Chinese economic prospects more than its rival’s. Larry Kudlow went as far as to argue that the Chinese economy “looks terrible.” Although an overstatement, Chinese stock markets are in bear market territory while the Chinese yuan has devalued by almost 10% vis-à-vis the USD since April 2018.
The downturn in Chinese markets is in part due to Beijing’s debt deleveraging campaign and greater oversight of how Chinese local governments finance infrastructure projects. However, the economic sanctions by the White House are clearly intended to inflict pain on China. At this crucial point in time, they are heightening economic uncertainty, leading to safe-haven flows that favor the United States.
In this context, Li Xiao, the Dean of Jilin University’s School of Economics, notes that China’s economic ascent was “essentially a status rise within the dollar system.” While China has benefited from the USD system and become one of its main supporters and risk bearers, it is structurally locked in a subordinate position.
Like most developing economies, China depends on the USD in global trade and finance, while a large part of its national savings are in USD. Although Beijing has a political advantage – the Chinese political economy is likely to be able to absorb more economic pain – China is nonetheless wedged into an inferior role. The more the Trump administration ups the ante, the more Beijing must fear capital outflows and financial instability.
It is almost as if the Trump administration has found a way to “Make America Great Again” by creating economic havoc abroad. Yet, there is a big irony: the weaponization of its exorbitant privilege runs directly counter to Trump’s single-minded focus on lowering the U.S. trade deficit.
Perhaps the last thing Trump wants is a massive USD rally spurred by a crumbling world economy. The United States would then start to run even larger trade deficits, becoming the global economy’s consumer of last resort, a natural stabilizer role built into the exorbitant privilege. But this means a massive trade deficit and loss of global competitiveness for American industry.
Trump’s liberal use of economic sanctions and tariffs is creating multiple unintended consequences. More ominously, abusing the exorbitant privilege in this manner could spell long-term disaster for the USD’s role as the principal international reserve currency. For now, there are no viable alternatives. But a reserve currency issuer that creates economic havoc, seemingly on purpose, to strengthen its own economic conditions may soon find that global confidence in its role as steward of the international economy evaporating.