Is it worth it to be the global reserve currency?

The dollar's status as the world's reserve currency is not necessarily the exorbitant privilege it's often described, especially not when facing growth-threatening fiscal deficits and sluggish industrial growth. When one looks at the dramatic need for growth in the US, the status as world reserve currency becomes much more expensive.

Recent news in China and the US underscores the difficulties of the current system, which even after an economic crisis is still structurally the same as before. In China, inflation is increasing (see for example China's recent fine of Unilever) while in the US, GDP growth has slowed to 1.8%. The difference between now and the last cycle is that US consumers have been sucked dry. The US consumer can no longer drive demand. The good news is that the middle class in China, India, Brazil, etc. is growing incredibly fast, driving increases in consumerism and urbanization. The bad news is that as long as the Dollar is the world reserve-currency it will be difficult to realize the full potential of this enormous opportunity. The valuation premium enjoyed by the Dollar due to its unique status is a constant downward drag on US exports as well as Chinese consumption.

But what is the cost of losing the reserve currency? To those with significant dollar-denominated fortunes, the costs are significant. The outflow of capital from US financial markets would significantly raise the cost of capital for US corporations, governments, municipalities, and consumers. It would effectively transfer wealth from the haves to the have-nots, as job growth would increase but the value of dollar-denominated portfolios would decrease. Though it is never a good idea to describe a policy decision as a wealth transfer, that is effectively what has happened in the US since China's entry into the WTO, and a reversal is necessary for the global economy to rebalance.

Ultimately, the "wealth transfer" angle to this policy makes it almost impossible to enact. This is not a new story. The role of Pound Sterling decreased throughout the 1900s as the British Empire declined. Much of British hegemony abroad was focused on the role of Sterling in trade and the great benefits enjoyed by the City as a result. The decline of the British Empire as well as the decline of Sterling were completely unplanned and unmanaged. The transition is simply impossible to manage. Britain, just like the the US now, fights to maintain this status for its currency, with force if necessary. Part of the problem is the disporportionate power of elites in these societies. These factions have the most to lose from a paradigm shift- it takes substantial political change to overcome the inertia of present policies.

Risk pull-back

Oil is down 7% today. Gas is down 6%. Silver is down almost 9%. Rates are about 3 bps lower. Stocks are down 50 bps.

Something is happening in commodities. There are certainly reasons to be bearish. Prices are extremely high. Inventories are generally above their long-term average. Demand is pulling back. Most recent economic news has disappointed- from NFPs to ISM to GDP growth. So a pull-back is justified, but the change in commodities is far more extreme than the de-risking that is occurring in rates and equities. Why is that?

Bill Gross' new investment outlook reiterates his short treasuries thesis, this time relying on evidence from a recent paper by Carmen Reinhart and M. Belen Sbrancia. This paper describes how governments delever by setting treasury yields below real interest rates. It's a fascinating study and a valuable perspective. The last time the US faced an indebtedness comparable to today was during World War II, when total debt exceeded 100% of GDP. It's often assumed that we overcame the massive fiscal debt through 2 decades of substantial growth. But Gross, Reinhart, and Sbrancia remind us that yields on government debt were below real interest rates post WWII, thus effectively deleveraging the balance sheet over time. I've mentioned before the role of the Fed in supporting the government bond market during and after WWI and WWII. Milton Friedman describes the conflict between the Treasury and Fed after WWII, as the Treasury effectively forced the Fed to keep yields low for almost a decade after the end of the war (see Monetary History of the United States).

If Gross is correct and we are living in a world of negative real interest rates for savers, what is the outlook for inflation? Today's move in commodities says a lot. When the government is effectively deleveraging by keeping government debt yields below real interest rates, economic growth becomes the difference between hyperinflation and something more normal. That leaves commodities as the asset class the most leveraged to economic growth. As Gross points out, holders of Treasuries will get burned as yields stay below real rates. But with weaker growth than expected, commodities will no longer capture the yield being stolen by the Fed.