Opinion: Early warning signs for Canada from U.S. debt downgrade
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
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