The Cost of America’s Free Lunch

BRUSSELS – For decades, the world has complained that the dollar’s role as global reserve currency has given the United States, in a term usually attributed to Charles de Gaulle but actually coined by his finance minister, Valery Giscard d’Estaing, an “exorbitant privilege.” As long as exchange rates were fixed under the Bretton Woods system, the nature of that privilege was clear: the US was the only country that could freely determine its own monetary policy. All others had to adapt to the policy dictated by the US.

This changed with the advent of floating exchange rates in the early 1970’s, which allowed more stability-conscious countries, such as Germany, to decouple from a US monetary policy that they considered too inflationary. But, even under floating exchange rates, the US retained an advantage: given that the dollar remained the key global reserve currency, the US could finance large external deficits at very favorable rates.

Today, the US Treasury can still borrow unlimited amounts at rock-bottom interest rates. Indeed, the interest rate on inflation-protected bonds has now become -0.5%, even for a five-year maturity! The US government is thus essentially being paid in real terms to take investors’ money – a generous offer that it is accepting on a huge scale, in the hope that channeling these resources to American consumers will boost household spending and thus generate more jobs.

The US seems to have come as close as one can imagine to getting the proverbial “free lunch” – except that, as economists are fond of pointing out, there is no such thing. And that is true here as well: performing the role of reserve currency enables the US to borrow on the cheap, but at the cost of any significant influence over the exchange rate, which is determined by the rest of the world’s demand for dollar assets.