But, there are also costs of being the dominant reserve currency. For example, this can lead to shifts in the valuation of the dollar that are due primarily to developments abroad that affect risk appetites and international capital flows. In such cases, the dollar’s valuation can be pushed to levels inconsistent with U.S. economic fundamentals. For the United States, I believe that the most important goal must be to keep our own house in order. If we do this, then I expect that the U.S. dollar will earn the right to remain the most important reserve currency in the world. The United States has a number of advantages in sustaining the dominant reserve currency status of the U.S. dollar. First, there is a first-mover advantage. As the leading reserve currency in the world, there is no strong incentive for countries to move to other currencies as long as the dollar continues to have the attributes I discussed earlier. The history of reserve currency usage is characterized by considerable inertia. The U.S. dollar emerged as the leading reserve currency quite a bit after it became the world’s largest economy. Typically, the loss of dominant reserve currency status requires either substantial economic decline or political instability that motivates foreign counterparties to shift to a new reserve currency. Second, the U.S. has the deepest and most liquid capital markets in the world. This is important in making U.S. Treasuries and agency mortgage-backed securities attractive holdings as part of countries’ foreign exchange reserve portfolios.
These attributes are a prerequisite for a vibrant international financial system and are supportive to global trade. A regime with many reserve currencies would imply a well-governed international economy. This should facilitate global investment, resulting in rising productivity growth and improving standards of living. In other words, I don’t see this as a zero-sum game. If other countries’ currencies emerge to gain stature as reserve currencies, it is not obvious to me that the United States loses. This is assuming, of course, that the emergence of alternatives is being driven by their progress, rather than by the U.S. doing a poorer job in satisfying the attributes that I discussed earlier. Having more countries achieve the stature of having a reserve currency may also be desirable for other reasons. First, with more reserve currencies available, portfolio diversification opportunities are enhanced. This is desirable because, all else equal, it would allow investors to move further out on the risk/return frontier. Second, more currencies are likely to be close substitutes, which could dampen currency volatility. With many viable reserve currencies available, no particular one would necessarily have to bear the bulk of any adjustment. The dollar’s dominant reserve currency status has sometimes been referred to as the United States’ “exorbitant privilege,” implying that the U.S. benefits extraordinarily from this privileged status. I’d argue that the situation is much more nuanced. Yes, this status does allow the U.S. to benefit from seigniorage. More than half of all U.S. currency outstanding is held abroad.