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Boston College Economists Link Exorbitant Privilege and the Dollarization of Global Trade to Help Explain US Predominance in the World Economy

Boston College Economists Link Exorbitant Privilege

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Kristine Crane
By: Kristine Crane
Posted: December 14, 2017

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In a Nutshell: You might look at the massive US trade deficit and think the country is in particularly bad shape. While America undoubtedly has debts to pay, our nation is actually in an advantageous position in the world economy thanks to two phenomena: exorbitant privilege, which allows the US to borrow at lower interest rates because the dollar is the international currency reserve, and dollarization, which refers to the disproportionate share of world trade dominated in dollars. Two Boston College researchers examined these trends in tandem, in a theoretical study that posits two economies — that of the US and EU — where the dominant role of the US is due to its role as the main medium of exchange. We recently spoke with one of the researchers, Ryan Chahrour, about the study’s findings and potential future implications.

When it comes to global trade, the United States is in an especially advantageous position over other nations, and it all comes back to our currency.

Anyone who’s visited a foreign country and found that vendors are happily accepting US dollars should know that this is an example of dollarization. These merchants view the US dollar as more stable than the domestic currency, but their acceptance of US currency is contributing to America’s dominant position in the world economy. Dollarization, or the disproportionate share of international trade in both goods and financial assets dominated by the US dollar, helps shield the US from international market disturbances.

The other contributing factor to US predominance is that the US dollar is the international reserve currency, which allows the US to borrow at especially low interest rates. This, in macroeconomic terms, is known as exorbitant privilege.

Boston College Seal

While many studies have researched exorbitant privilege and dollarization separately, one recent study developed a model to study both at the same time.

To better understand the connections, Boston College economists and researchers Ryan Chahrour and Rosen Valchev developed a theoretical worldview where only two countries exist, and “international trade happens in decentralized, bilateral markets with limited contract enforceability.” The model also places US assets in a dominant position as the primary medium of exchange

We recently spoke with Ryan, who told us the study was inspired by political discussions about trade in the past two years, especially around the time of the 2016 presidential election.

“I was really curious about how changing trade policy might affect exorbitant privilege, which seems like a major benefit for the United States,” he said. “It’s been around for a long time, but I wanted to know if our trade or other economic policies might affect it.

“Even though the US is a debtor to the rest of the world, we actually earn a positive income on our asset position. Data indicates this has been the case for 50 years. We are trying to connect this fact with the special role that dollar assets play in providing liquidity, particularly for international trade.”

Does Changing Trade Policy Affect Exorbitant Privilege?

Ryan and Rosen’s project began in 2016 and was based on quantitative theory.

“There was a lot of pencil-and-paper work, thinking about how to capture the choices of households and of trading firms. Then, we went to the computer and tried to simulate the model,” Ryan said. “We wanted to understand if we try to make the model look like the real world, in some dimensions, would it match the findings on exorbitant privilege?”

Collage of Portraits of Ryan Chahrour and Rosen Valchev

Researchers Ryan Chahrour, left, and Rosen Valchev

The empirical motivation for the researchers was America’s unique external position. As the world’s largest debtor country, the US has foreign liabilities exceeding foreign assets by more than $8 trillion, or 40% of the GDP. But its international investment income is positive, meaning it is making negative payments on its large net debt to the rest of the world.

The researchers write, “The US is the only country in the world that has been able to sustain both a negative net foreign assets position (NFA) and a positive net international investment income flow.”

The US dollar also dominates global trade. “The dollar invoices almost half of global trade, and the share of transactions in dollars is five times larger than total US trade as a share of world trade,” according to the researchers. “No other country comes anywhere close to the dominant position of the dollar in terms of intermediating third-party transactions.”

The researchers used a two-country model: labeled the US and the EU, with each country populated by standard productive firms, a representative household, government, and import-export firms.

‘The Model is Always Right, and We’re Wrong’

As with any research worth conducting, Ryan and Rosen encountered some surprises along the way.

“We envisioned a situation in which the US was the net debtor to the world and earned its premium,” Ryan said. “But there were other long-run situations that were sustainable — for example, when the US is the net creditor to the world and the dollar is still the medium of exchange. These were things we didn’t anticipate. When it surprises us, the model is always right, and we’re wrong.

“When economic policy changes, the model tells us that quick changes could potentially break the privilege, while a slow change wouldn’t do that. We’re not quite to the point where we want to use our model to say whether the current situation is likely to change in the near future.”

Chart of Possible Scenarios from the Boston College Researchers' Model

One main conclusion of the study was the tenuous nature of exorbitant privilege. The US has had this advantage since World War II, but other foreign currencies have been in this position before.

“A country issuing the dominant asset benefits from lower interest rates on its foreign asset position, corresponding to the liquidity premium earned by the assets it issues,” Ryan said. “Such a privilege can persist indefinitely, but it is not unconditional. Changes in the environment or policy may lead the dominant currency to lose its privilege, potentially falling into a long-lasting period of low wealth and low returns on its foreign asset position.”

A Goal to Raise Awareness Among the Public & Policymakers

Although the study by Boston College researchers was theoretical in nature, Ryan and Rosen want to publish it and spread the word about their findings and the study’s implications.

“I think we’re really interested in raising awareness of this topic,” Ryan said. “We would like the US to treat this privilege as something valuable and worth considering in policy choices and other future governmental choices.”

Ultimately, what the study reveals is that the world helps the US finance its spending. Lower interest rates mean the US borrows at lower costs, while also allowing for a big trade deficit, so the US can buy more while selling less to other countries.

However, it’s important to consider that the global economy is dynamic, so the US could lose its foothold on exorbitant privilege. As the researchers write, “The model delivers a unique mapping from economic conditions to the dominant currency. Nevertheless, the model delivers a dynamic multiplicity: In steady state, either currency can serve as the international medium of exchange. Currency regimes are stable, but sufficiently large shocks or policy changes can lead to transitions, with large welfare implications.”