John Mauldin: The Damage to the US Brand

John Mauldin  |
There is no doubt that the image – what I will refer to in this letter as the "brand" – of the United States has been damaged in the past month. But what are the actual costs? And what does it matter to the average citizen? Can the US recover its tarnished image and go on about business as usual? Is the recent dysfunction in Washington DC now behind us, or is it destined to become part of a bleaker landscape? In this week's letter we try to answer those questions and more, as I step firmly into politically incorrect territory and offer a little advice to my junior senator from Texas. If nothing else, we will look at the problems we face in a different light.

An Exorbitant Privilege

The term exorbitant privilege refers to the alleged benefit the United States receives due to the US dollar's being the international reserve currency. The term was coined in the 1960s by Valéry Giscard d'Estaing (not Charles de Gaulle, as many think), then the French Minister of Finance, later President of France, and an early and major proponent of a United States of Europe. This was prior to the gold window's being shut by Nixon. Giscard saw the Bretton Woods monetary system not simply as a way to balance international payments but as something that was giving the United States a significant advantage in the world. He was right.

Under Bretton Woods, the US would never face a balance of payments crisis, because it purchased imports in its own currency. That exorbitant privilege could not redound to a country whose currency had only a regional reserve currency role, but in the postwar era the US dollar reigned supreme around the world.

Academically, the exorbitant privilege literature analyzes two empiric puzzles, the position and the income puzzle. The position puzzle consists of the difference between the (negative) U.S. net international investment position (NIIP) and the accumulated U.S. current account deficits, the former being much smaller than the latter. The income puzzle consists of the fact that despite a deeply negative NIIP, the U.S. income balance is positive, i.e. despite having much more liabilities than assets, earned income is higher than interest expenses. (Wikipedia)

What that means in practical terms is that the United States can purchase more with its currency than it produces and sells. In theory those accounts should balance. But the world's reserve currency, for all intent and purposes, becomes a product. The world needs dollars in order to conduct its trade. Today, if someone in Peru wants to buy something from Thailand, they first convert their local currency into US dollars and then purchase the product with those dollars. Those dollars eventually wind up at the Central Bank of Thailand, which includes them in its reserve balance. When someone in Thailand wants to purchase an imported product, their bank accesses those dollars, which may go anywhere in the world that will take the US dollar, which is to say pretty much anywhere.

Other currencies can also function as reserve currencies if there is sufficient trade between countries. The euro, the Canadian dollar, the Aussie dollar, and the yen are examples; but the US dollar is the 800-pound gorilla.

There have been other global reserve currencies. The British pound sterling served as a global currency prior to the ascendance of the dollar. In most ways, we in the US act as if our dollar will always be the world's reserve currency. History suggests, however, that reserve currencies come and go. The US dollar will remain the dominant reserve currency only as long as we respect the responsibility that comes with our exorbitant privilege.

That privilege allows US citizens to purchase goods and services at prices somewhat lower than those people in the rest of the world must pay. We can produce electronic fiat dollars, and the rest of the world accepts them because they need them to in order to trade with each other. And they do so because they trust the dollar more than they do any other currency that is readily available. You can take those dollars and come to the United States and purchase all manner of goods, including real estate and stocks. Just this week a Chinese company spent $600 million to buy a building in New York City. Such transactions happen all the time.

And there is one other item those dollars are used to pay for: US Treasury bonds. We buy oil and all manner of goods with our electronic dollars, and those dollars typically end up on the reserve balance sheets of other central banks, which buy our government bonds. It's hard to quantify the exact amount, but these transactions significantly lower the cost of borrowing for the US government. On a $16 trillion debt, every basis point (1/10 of 1%) means a saving of $16 billion annually. So 5 basis points would be $80 billion a year. There are credible estimates that the savings are well in excess of $100 billion a year. Thus, as the debt grows, the savings also grow! That also means the total debt compounds at a lower rate.

Just as an aside, $80-$100 billion a year will buy a lot of healthcare. Hold that thought as we continue to look at currency trading and reserve currency status.

A Friction-Free World?

Let's return to our example of trade between Peru and Thailand. There is presumably little reason for a furniture manufacturer in Thailand to take Peruvian money (which is called the nuevo sol). Let's assume this piece of furniture sells for 32,300 Thai baht or about $1000. So the buyer in Peru takes 2,764 nuevo sols, buys 1,000 US dollars, sends them to Thailand, and voila! his teak table comes in on the next boat.

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Except that it isn't quite that simple, as anyone who has done a substantial foreign transaction knows. You have to go to your local bank, which probably goes to its correspondent intermediary bank, which in turn deals with a large international investment bank, which then sends the money on to an intermediary in Thailand and then to a local Thai bank. At every step along the way there is a "toll" charged. While much smaller than it was a few decades ago, those tolls – that "friction" – can add up to a sizable sum. Depending on whom you ask and what you count, the total amount of currency traded per day is as much as $4 trillion, and just a few "pips" taken out to grease the skids tally up to a rather tidy sum.

(For the curious, a "pip" stands for "percentage in point" and is the smallest increment of trade in foreign exchange [FX] currency trading. In the FX market, prices are quoted to the fourth decimal point. For example, if a bar of soap in the drugstore is priced at $1.20, in the FX market the same bar of soap would be quoted at 1.2000. The change in that fourth decimal point is called 1 pip and is equal to 1/100th of 1%.)

Currently, there are only about seven currencies that are traded in serious amounts, although theoretically every currency is trading in some manner. When I was traveling around Africa, I would often come across a street in a city where currencies were being traded. The rates were much better than you could get at the local bank. Going with an "official" rate often means suffering a real loss in local buying power, and thus the spreads on some currencies are much wider than on others. No one wants to get stuck with an Argentine peso for very long outside of Argentina, and even inside Argentina the locals exchange money into pesos only when they need local currency. When I was last there, using a credit card cost anywhere between 10-15% more (if a local establishment took credit cards at all), because the store would have to cash in at the official rate rather than the street rate.

And while the "friction," or transaction cost, of trading a euro for a dollar and vice versa is a much smaller percentage, it is there. And thus the need for dollars to grease the wheels. To trade goods between Peru and Thailand, intermediaries usually have to find dollars.

But the key word in that sentence is usually. This week, London and Hong Kong agreed to begin trading in Chinese renminbi. The "extra" friction once incurred in converting to the US dollar will disappear, and the cost of doing direct transactions will fall. This absolutely makes sense for the two countries, and over time it will make sense on an ever-larger scale. Currencies are increasingly becoming mere electronic blips. For young traders, sitting at an FX desk is just another computer game, but if they are good at it, they get paid real money. Killing pips can be more profitable than killing zombies ever was.

The dollar is the world's reserve currency because it is a no-brainer trade. You don't have to think about your risk. If you take a ruble, you need to think about your risk and maybe buy some insurance. You ask yourself if you can trust Putin with your money. Even today, if you begin to stockpile renminbi, what can you do with them? You need to find something to import from China. There is risk to that trade. Not as large a risk as in the past, but more than if you deal in dollars.

Unless we damage our brand. Unless we start making that 27-year-old trader sitting at an investment bank in London think for a fraction of a second before he hits the button. He is in the business of killing pips, and if you increase his cost, even by 1/1000, the difference shows up in his bonus.

You scoff? Then why did credit default swaps on the US Treasury market rise over the last month? If you are buying US Treasury bonds, you are by definition seeking to avoid risk. You want zero risk, and last week the world markets decided – while watching CNN, CNBC, Bloomberg, and Al Jazeera, and reading the running commentary in the Wall Street Journal and the Financial Times, on Reuters, and in gods-know-how-many blogs – that there was indeed some small risk, and so they wanted to be paid more for holding Treasuries.

The world looked at the US, and unlike in the dozens of debt-ceiling games of chicken our politicians have played in the past, this time the fight at the edge of the cliff made the rest of the world nervous. In the past, you "knew" that the adults were playing a serious game over budgets, but there was always the sure sense that they would do the right thing and not risk the brand.

You can call it media spin or whatever you like, but this time there was a real sense that the adults had left the room. I totally understand why it happened, but the reaction from around the world was akin to watching your parents fighting and not being sure what would happen. I mean, you get used to your parents quarreling from time to time, but when they threaten to shut down the marriage and blow up the house, you might start to worry.

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