The Exorbitant Burden The Impact of the U.S. Dollar’s Reserve and Global Currency Status on the U.S. Twin-Deficits This page intentionally left blank The Exorbitant Burden The Impact of the U.S. Dollar’s Reserve and Global Currency Status on the U.S. Twin-Deficits By Dr. Taranza T. Ganziro Independent Scholar, Centreville, VA, USA Dr. Robert G. Vambery Pace University, New York, NY, USA United Kingdom À North America À Japan India À Malaysia À China Emerald Group Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2016 Copyright r 2016 Emerald Group Publishing Limited Reprints and permissions service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. Any opinions expressed in the chapters are those of the authors. Whilst Emerald makes every effort to ensure the quality and accuracy of its content, Emerald makes no representation implied or otherwise, as to the chapters’ suitability and application and disclaims any warranties, express or implied, to their use. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-78560-641-0 (Print) ISSN: 978-1-78560-640-3 (Online) ISOQAR certified Management System, awarded to Emerald for adherence to Environmental standard ISO 14001:2004. Certificate Number 1985 ISO 14001 Contents Summary ix List of Equations xvii List of Boxes xix List of Charts xxi List of Graphs xxiii List of Figures xxv List of Tables xxvii List of Appendices xxix CHAPTER 1 Introduction 1 CHAPTER 2 Literature Review 9 2.1. Theory of Reserve Currency 9 2.1.1. Principle 9 2.1.2. Functions of the Leading Reserve Currency 11 2.1.2.1. Store of value 12 2.1.2.2. Medium of exchange 15 2.1.2.3. Unit of account 15 2.1.3. Reserves Currency Accumulation Motives 16 2.1.3.1. Mercantilist rule 17 2.1.3.2. Self-insurance precautionary rule 18 2.1.3.3. Collateral rule 19 2.1.4. Cost of Excessive Reserves Holdings 20 2.1.5. International Reserve Currency Status Criteria 23 2.1.5.1. Economic and geopolitical weight 23 2.1.5.2. Macroeconomic stability 23 2.1.5.3. Trade openness 23 2.1.5.4. Financial depth dynamics 24 2.1.5.5. Winning the inertial duel 25 2.1.6. The Implications of Achieving Reserve Currency Status 27 v vi CONTENTS 2.1.7. Empirical Evidence of the U.S. Dollar Reserve Currency Status 31 2.1.7.1. The U.S. dollar is the global leading anchor currency 31 2.1.7.2. The U.S. dollar is the major form of cash currency worldwide 32 2.1.7.3. The U.S. dollar is a transaction À Centric to global forex markets 33 2.1.7.4. The U.S. dollar is the currency of choice in the international trade invoicing and settlement 36 2.1.7.5. The U.S. dollar is a prominent currency in international debt market 36 2.1.7.6. The U.S. dollar is a key currency in banking cross-border lending and investment portfolio 37 2.1.7.7. The U.S. dollar dominates foreign reserves holdings 37 2.2. Reserve Currency Historical Background 39 2.2.1. Overview 39 2.2.2. Gold Standard: 1819À1914 41 2.2.3. The British Pound Standard: 1914À1945 43 2.2.4. Bretton Woods System 1946À1973 44 2.2.4.1. Overview 44 2.2.4.2. The dollar-gold exchange standard 46 2.2.4.3. The Bretton Woods system dilemma 49 2.2.4.4. Nixon shock 51 2.2.5. Fiduciary Dollar Standard (1973ÀPresent) 53 2.3. US Dollar Global Liquidity 55 2.3.1. Overview 55 2.3.2. Private Dollar Global Liquidity 56 2.3.2.1. Eurodollar liquidity 57 2.3.2.2. Dollar-derivatives global liquidity 61 2.3.2.3. The Repo markets and the dollar-liquidity 75 2.3.3. Official Dollar-Global Liquidity 79 2.3.3.1. The Fed and the dollar global liquidity 79 2.3.3.2. The anatomy of banking bailout 82 2.3.4. The Interaction between Private and Official Liquidity 91 CHAPTER 3 Theoretical Framework 93 3.1. Overview 93 3.2. Great Powers Have Great Currencies 94 3.2.1. Leading Country Theoretical Outline 94 Contents vii 3.2.2. United States’ Geopolitical Leadership 96 3.2.2.1. Military power 99 3.2.2.2. Economic power 103 3.2.2.3. Political power 110 3.2.2.4. Global cultural influence 111 3.2.2.5. Summarizing 113 3.3. The Paradox of the U.S. Dollar 121 3.3.1. Overview 121 3.3.2. Dual Global and Domestic Role Paradox 121 3.3.3. Paradox of Strong Dollar Policy 125 3.3.4. Triffin Paradox 125 3.3.5. Trilemma Hypotheses 127 3.3.5.1. Mundell-Flemming trilemma 127 3.3.5.2. Rodrik political trilemma 131 3.4. US Dollar and Global Imbalances 134 3.4.1. Supply-Side School 135 3.4.2. Demand-Side School 136 3.4.3. Rebalancing Act 139 3.5. Exorbitant Privilege 142 3.5.1. Overview 142 3.5.2. Exorbitant Privilege Benefits to United States 143 3.5.2.1. Convenience for U.S. citizens 143 3.5.2.2. Convenience for the U.S. government 144 3.5.2.3. Seigniorage 145 3.5.3. Exorbitant Benefits to the Rest of the World 147 3.5.4. Exorbitant Privilege under Scrutiny 147 3.6. Exorbitant Burden 149 3.6.1. Competitiveness Burden 149 3.6.2. Exorbitant Reserve Currency Curse 151 3.6.3. Political Burden 152 3.6.4. Monetary Policy Burden 152 3.6.5. Capital Flow Burden 152 3.6.6. Reserve Currency Status Maintenance Burden 153 3.6.7. The Twin Deficit Burden 154 3.6.7.1. Overview 154 3.6.7.2. Twin deficit identity 154 3.6.8. Debt Burden 160 3.7. Currency Wars 162 3.8. Is There a Viable Alternative to the US Dollar as the World Leading Reserve Currency? 165 3.8.1. Overview 165 3.8.2. Viable Alternatives 165 3.8.2.1. Special drawing rights (SDR) 166 3.8.2.2. EURO 169 3.8.2.3. Chinese Renminbi (RMB) 176 viii CONTENTS 3.8.3. Is There Any Other Currency Alternative? 188 3.8.4. Multipolar Reserve Currency System 188 3.8.5. Is the U.S. Dollar Trapped into the Global System? 191 3.8.6. Way Forward 192 CHAPTER 4 Methodology 195 4.1. Model Specification 195 4.1.1. Overview 195 4.1.2. Variables Specification 196 4.1.2.1. Dependent variable specification 196 4.1.2.2. Independent variables specification 198 4.1.3. Model-Equation Specification 203 4.1.4. Data 204 4.1.4.1. Data source 204 4.1.4.2. Data description 204 4.2. Quantitative Analysis 204 4.2.1. OLS Regression 204 4.2.2. Stationarity Tests 206 4.2.3. Cointegration Tests 207 4.2.3.1. Johansen maximum likelihood tests 208 4.2.3.2. Johansen ML results and analysis 208 4.2.4. Vector Error Correction Model 209 4.2.4.1. VECM regression 210 4.2.4.2. VECM diagnostic tests 212 4.2.5. Results Analysis 219 CHAPTER 5 Conclusion 223 Appendices 229 References 233 Index 247 Summary t is neither simple, nor inexpensive to be the home of a leading reserve and global currency at the epicenter of the world eco- Inomic system. The US dollar is the living history of this paradox and its dual role À as both a national and a global reserve currency À has set off a plethora of competitive analyses and debates in demonstrating that a global monetary system that is dollar-centric is inherently unstable because the dollar is first and foremost a domestic currency subjected to the monetary and fiscal policies and national interests of the United States. It has been often opined that the US policies À even if they are domestically sound À are not necessary concomitant with the global interests of the rest of the world which however remains inextricably under their influence. This is because À given the dominant status of the US dollar as an international reserve asset and global currency À the US policies naturally reverberate globally through the dominance of the US dollar over the global economy and inevitably generates significant externalities for the rest of the world; thus making the dollar-dominated global financial system vulnerable to US domestic monetary and fiscal policies. Dismayed by the vulnerability of global financial system to US policy through the US dollar dominance, the World Bank (2011) went on to argue that the Multipolarity in the world in terms of security and economic relations should be matched by a Multipolar Reserve Currency System simply because the transformation of glo- bal patterns of economic growth necessarily drive change in the international monetary system. To comply with such Multipolarity, the SDR (Special Drawing Rights) became in the view of many analysts, the natural alternative reserve currency because À being a basket of currencies À it is assumed that it can stabilize the global financial system preached by the World Bank and be able to impartially enforce discipline on both the deficit countries and surplus countries that respectively issue and relentlessly accumulate reserve currency-denominated assets that entertain the global financial imbalances.