Estimating The Possible Drag To U.S. GDP From A Decline In USD Reserve Status

Includes: UDN, UUP
by: GlobOracle

There is much talk of the US Dollar's status as a global reserve currency and the implications of a change in that status. Many people associate this possibility with a vague sense of demise for the Untied States as a global economic and political hegemon.

By contrast, quantitative estimates of how much drag on US GDP the loss of the US Dollar's reserve status would create remain difficult to come by. A McKinsey Global Institute report from 2009 estimated the gain to US GDP from the Dollar's reserve status as "only" between .3% and .5%. In an article arguing that people over-hype the importance of reserve currencies in the modern financial architecture, Paul Krugman estimated the boon to annual GDP at .1%.

It is easy to look at a low number for a rate of growth and dismiss its importance. But due to the compounding of GDP gains from one year to another, even a small different in annual percentage growth GDP growth has big consequences for the long-run economic trajectory of a nation. Even according to the most conservative estimates of the role of the Dollar's reserve status in juicing US GDP growth, over time, US GDP today would be much lower than it is if the Dollar did not become the global reserve currency. Small difference in annual rates of change can in the long run have counter-intuitively large consequences.

Just how different would US GDP be today in a world where the Dollar did not become the international reserve? Assumptions for how much the US Dollar's reserve status contributes the growth rate of American GDP vary. The situation is hypothetical and no one can know the answer for sure. But some simple calculations can paint a picture of how much lower US GDP would be today according to varying assumptions for how much the Dollar's reserve status contributes to US GDP growth.

According to the IMF, by the end of 2012, US GDP was $15.68 trillion. The Bretton Woods exchange rate system ended and currencies began floating on one another in March of 1973. That puts about 38 years between the birth of the current Dollar-dominated monetary system and the end of 2012.

The chart below shows how different US GDP would be today according to different sets of assumptions. If you were to halve Paul Krugman's estimate and assume USD reserve status contributes only .05% per year to GDP growth, its absence in the 38-year period between the start of 1974 and the end of 2012 would result in 2012 US GDP coming in 1.88% less than it did in historic experience. This means that US GDP at the end of 2012 would have been $294.4 billion lower than what it was. Doubling that drag assumption to Krugman's .1%, the cost to 2012 GDP increased to $583.4 billion. According to McKinsey's lower estimate of .3%, the nominal cost becomes $1.68 trillion. According to McKinsey's upper estimate of .5%, the cost of the USD's losing of its reserve status between 1974 and 2012 would have been $2.71 trillion.

Assumed Benefit to Annual GDP Growth

Implied Decrease in 2012 US GDP

Cost to 2012 US GDP (Trillions USD)



















Click to enlarge

These do not seem like trivial differences in US output. To belittle .1% differences in long-run rates of growth as "small" is to fail to appreciate how large of a difference those small differences in rates of growth can have on the magnitude of a long-run level, like the level of economic output a country produces.

Paul Krugman and McKinsey consultants can perform the basic math that lead to these results. Why then do these experts seem to perpetually under-hype the significance of a possible decline in the US Dollar's reserve status? Perhaps the power of compounding rates proves elusive to many. Albert Einstein once declared compound interest to be "the most powerful force in the universe." Comprehending the greatest powers at work in the universe is not an easy task. But estimating US GDP under various assumptions about the USD's reserve status's impact on output growth rates helps us glimpse the grandeur of the power of even a small shift in growth rates on long-run output levels.

The purpose of this article is not to articulate a view on whether the US Dollar will persist in serving as the international reserve currency for the foreseeable future. The issue remains, if nothing else, fraught with fog and uncertainty about what trajectory it will take going forward. The purpose instead is to create an analytical sketch of the extent to which a shift in the Dollar's reserve status can potentially impact American GDP in the long run, based on a hypothetical history in which the Dollar did not become the reserve and conjectures from educated people about the relationship of US GDP to the USD's reserve status.

The results of this analysis depend on a set of perhaps simplified assumptions. But talk of the US Dollar's role as a reserve currency tends to be fraught with vagary and confusion. By providing a quantitative analysis with articulated assumptions, this article hopes to bring increased clarity to a topic unlikely to dissipate in importance anytime soon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.