Fitch’s recent downgrade of U.S. public debt, dropping it one notch below “AAA,” is good reason to examine the relationship between U.S. debt and the dollar’s future as a reserve currency. The greenback is just the latest in a series of preferred currencies that have been used for foreign exchange reserves and to denominate other assets. But reserve currencies, unlike diamonds, aren’t necessarily forever, and that affects their issuers’ capacity to manage their public debt.
The British pound was the world’s reserve currency in the 19th and early 20th centuries, with a typical exchange rate a century ago of around US$5, vs. US$1.25 per pound today. The pound faded after 1945 because of Britain’s massive war debts, the erosion of the British empire and the Allies’ choice of the greenback to underpin the fixed exchange rate system negotiated at Bretton Woods, New Hampshire, in July 1944. Even though that system collapsed in the 1970s, the dollar remains the predominant global currency, accounting for a modest majority of global foreign exchange holdings.
Operating a reserve currency has two big advantages to the home country: a relatively strong exchange rate (making imports cheaper and suppressing inflation), and the ability to issue lots of public debt denominated in your own currency at favorable interest rates, which means you don’t face foreign exchange risk on it. Investors like reserve currency assets because they perceive overall risk as low, believing strong economies can always find the resources to pay their debts — although just printing money and inflating them away is also an option, albeit a misguided one.
Among many Americans, 80 years of the dollar being the world’s reserve currency seems to have nurtured a belief that the world has an unlimited demand for U.S. debt so their government can issue unlimited amounts of it. There is even a school of economic thinking — “Modern Monetary Theory” — that essentially argues that for a reserve-currency country like the U.S., fiscal deficits and rising public debt simply don’t matter, since they can always be financed with bond issues.
Given this mindset, which seems especially common in Washington, D.C., it’s no surprise that public debt as a share of U.S. GDP has tripled over the past 25 years to around 120 per cent of GDP, much higher than in a typical AAA-rated jurisdiction. Bill Clinton was the last president to balance the books. Neither Republicans nor Democrats are today seized with the need to balance the budget, leading instead to priorities like cutting taxes for Republicans or spending more for Democrats. It is therefore hard to reconcile what investors want to believe about the low risk of holding U.S. dollar assets and the evident unwillingness of both Congress and the four presidents since Clinton to control the public debt. In this absence of leadership, imagine how hard it would be, should the dollar lose its lustre, either to increase taxes or make major spending cuts or both in order to make good on foreign debt service obligations.
The Fitch decision to downgrade U.S. public debt a notch has perturbed many conventional economists and financial markets, but it’s hardly surprising. In addition to lack of fiscal discipline in the face of high and rising public debt, Fitch emphasized an “erosion of governance” reflected in the unwillingness to find compromises and build political consensus on big policy issues. Political polarization is clearly not cost-free.
What does all this mean for Canada? The loonie is a minor reserve currency with few of the advantages of a major reserve currency. In IMF data it’s included in the “other” category, which itself represents just three per cent of overall international reserves. A one-step U.S. debt downgrade will have only mild if any lasting effects on Canadian bond and equity markets. But it’s a warning for us, too. Canada’s deep economic and financial integration with the U.S. always means we are on the front lines if there is turbulence State-side. And the Fitch downgrade should remind governments across Canada that effective fiscal management is the best way to maintain or even improve their credit rating and keep the future cost of public debt as low as possible.
This is hardly the end of the greenback as the predominant reserve currency. Nothing else is ready to take its place, not the euro and certainly not the renminbi. But a credit downgrade is notice to investors that American public debt may not be the low-risk asset it once was.
Glen Hodgson is a fellow-in-residence at the C.D. Howe Institute.