Renouncing Privileges

Gillian Tett reported in the Financial Times on an idea circulating in Washington that financial flows into the US could be taxed to raise revenue and/or to depreciate the US dollar. A similar solution was mentioned in Stephen Miran’s influential essay which we discussed three weeks ago. This would raise the funding cost of the US government and would ultimately express a renunciation of the “exorbitant privilege” which for decades has allowed the US to pursue largely unconstrained fiscal policies thanks to the dollar status as the world’s dominant reserve currency.

There is a precedent in the modern history of the US when the White House voluntarily affected the US dollar status by surprise: the “Nixon shock” of August 1971, when the President suspended the convertibility to gold. While it was a political success for Richard Nixon in the short-term, it ended up exacerbating the US inflation problem. Equally, we do not think that renouncing the “exorbitant privilege” would serve the US economic interests in the long-run – the evidence that a dollar overvaluation has “hollowed out” US productive forces is scarce in our view – but these debates fuel a “mood music” in Washington which in any case is contributing to the ongoing correction of the USD.

There is no off-the-shelf solution to reshape the international monetary system should the dollar status erode. In 2010 the IMF worked on some ideas, but expanding the role of the Special Drawing Rights would not be straightforward. In any case, cooperative solutions would require a level of support for multilateralism which is – for now at least – missing in the US administration. The Euro area’s preference for current account surpluses has for long impaired the Euro’s capacity to play a major role in the international monetary system. The change of fiscal stance in Berlin may change this. Yet, a lot would need to be done on capital market union – including the emergence of a larger pool of jointly-issued safe assets – to bring the European currency closer to the requirements of a dominants reserve currency in terms of market depth and liquidity. Streamlining the EU’s decision-making process would also probably be necessary. Raising the euro status is however no longer unthinkable.