THE YUAN AS A WORLD RESERVE CURRENCY: Much ado about very little.

Money doesn't mind if we say it's evil. It's a fiction, an addiction and a tacit conspiracy. ~ Martin Amis 

What do the Roman denari, Venetian ducato, Dutch guilder and US dollar have in common?

At one point in time they have each been a “world (or reserve) currency.” The denari was the world currency for more than 4 centuries during the Roman Empire’s prime, as was the Venetian ducato during much of the Renaissance. The Dutch guilder emerged as a de facto world currency in the 18th century due to unprecedented domination of trade by the Dutch East India Company during a previous age of globalization. After WWII, the US dollar assumed prominence – and continues to lead – in the world of international trade, finance, securities and foreign exchange reserves. The dollar has been the world’s most important reserve currency for over 50 years. That almost seems like forever, until you remember the span of the denari; they don’t make ‘em like they used to. The final reserve currency now is the euro, born on Jan 1, 1999. It is used in the world’s largest economic assembly of nations and has become a key reserve currency as well. In a large sense, these reserve currencies make international trade and finance happen.

The dollar and euro together account for 84.3% of the world’s foreign exchange reserves. These reserves, which total $11.6 trillion, are funds that nations’ central banks hold as assets to manage the value of their currencies. The dollar accounted for nearly 90% of the $5.3 trillion a day in foreign-exchange transactions last year.

Earlier this month, the International Monetary Fund (IMF) said it will be adding the Chinese yuan (also called the renminbi) to its special drawing rights (SDR) basket of reserve currencies, which already contains the dollar, euro, British pound, and Japanese yen. Adding the yuan will acknowledge China’s impressive growth and economic standing; its nominal GDP is the second-largest in the world.[1]

Nevertheless, the yuan is not a world reserve currency in any substantive way. To be considered for IMF reserve currency status, a currency must be freely useable in foreign commerce. The yuan is used in less than 1% of world’s foreign exchange trades and international debt securities (e.g., bonds). To date, the Chinese have seemingly created more island territory in the South China Sea than international bond sales. Thus, the IMFs SDR decision probably has more to do with geopolitics than economics. It also assuages the Chinese and other emerging nations’ interests at the IMF because the US Congress has yet to pass (after 5 years) legislation needed to change the fund’s governance structure giving these nations more authority.

If it wants it to become a genuine reserve currency, the Chinese government will have to make some very knotty decisions regarding availability and stability of the yuan. Fundamentally the government will have to relax its total control over Chinese domestic financial markets and the yuan – something that it has shown no interest in doing so far.

One needed modification will be to increase its availability outside China and begin issuing yuan-denominated bonds and ETFs for international purchase. This year only 0.6% of international debt securities outstanding were denominated in yuan (virtually all in Asia), compared with 43% in dollars and 39% in euros. The Chinese took a small step last week by opening an exchange in Germany to trade yuan-denominated financial instruments. Nevertheless, few financiers are booking flights to Frankfurt.

In addition, international investors won’t be that interested in buying yuan bonds or ETFs unless they believe the yuan will be relatively stable and orderly. Recent events regarding the yuan have increased transnational concerns about its steadiness. Stability was not enhanced when in mid-August the People’s Bank of China (PBoC, its central bank) devalued the yuan by over 3% without any warnings. The PBoC remains cloaked in opacity regarding its possible monetary plans. Perhaps Zhou Xiaochuan, the head of the PBoC, could benefit from Janet Yellen providing him with a few pointers about more transparent monetary policy. Furthermore, these changes may lead to a significant reduction in China’s current-account (trade) surplus because international demand for yuan bonds will increase the value of its currency. That’s hardly what the Chinese would look forward to, given its success in creating substantial export-led growth for its economy.

The yuan’s future as a reserve currency will take a marathon’s worth of changes on the part of the Chinese government. With changed policies and time, they may make it to yuan world. The Chinese are out of the starting blocks but at a trifling pace.  

---

[1] China’s GDP growth has indeed been impressive; however, the Chinese per capita GDP is US$12,900 (ranked 113^st in the world) and nearly $32,000 less than the US GDP/capita. 

THE FALLACY OF FREE HIGHER EDUCATION

Cauliflower is nothing but cabbage with a college education. ~ Mark Twain

Forget college football, we are now entering the peak of college applications season, when high-school seniors decide where they want to spend the next several years of their lives. The ever-rising cost of going to college is a prominent factor for many applicants. In May, Sen. Bernie Sanders introduced legislation to make 4-year public colleges and universities tuition free. He said, “We live in a highly competitive global economy. If our economy is to be strong, we need the best educated work force in the world. That will not happen if every year hundreds of thousands of bright young people cannot afford to go to college and if millions more leave school deeply in debt.”

His plan, reputed to cost $750 billion (B), would replace what public colleges and universities now charge in tuition and fees. It would also overhaul student loan programs to reduce their cost in part by eliminating any accrued federal profits on the loans. After Sen. Sanders’ noteworthy announcement, Hillary Clinton produced her own plan to reduce the cost of going to college by providing $350B in federal money to states over 10 years, so undergraduates would pay tuition at public colleges “without needing loans.” If Sen. Sanders’ or Hillary’s plans somehow become law (a very unlikely prospect with Republican majorities in Congress), far lower (“free”) college costs will dramatically increase the demand for higher education.

Both plans embrace the idea that a college degree is the new high school diploma. Although a growing number of people believe this, I think it’s exaggerated and not self-evident. Holders of BAs still receive a sizeable 60% premium in wages over high-school diploma holders. Sanders’ and Clinton’s proposals would essentially expand the long-established norm of free K-12 public education and offer free K-16 public education. To say that’s a big change in government educational policy is a PhD-level understatement. From a market perspective, the concept of lowering a service’s price a lot (a college education) in the face of notably escalating demand poses many challenges.

According to Dept. of Education statistics, 81% of high-school age students now graduate with a diploma, 34% of young adults now have a BA, and 44% of young adults have either an Associates or BA degree. Interestingly, 81 years ago, in 1934, 34% of adults had a high-school diploma, the same percentage that now holds a college degree.

Both Sen. Sanders’ and Hillary’s ideas to remove the expense of tuition when going to a public college is a leftish shibboleth that will cost a ton of taxpayer money[1] and put the post-high-school education (PHISE) market in a precarious, unbalanced position. It will significantly increase the number of students demanding an Associate or BA degree without increasing PHISE capacity to actually educate them.

Beyond these consequences, tuition-free college isn’t likely help that many young adults because of subsequent greater “degree-inflated” job requirements imposed by employers and probably most important, insufficient incentives for colleges to produce graduates more effectively and efficiently.[2]

I doubt that highly-selective colleges will increase their educational capacity much, but other private and public colleges, 2-year and online colleges might expand to meet more demand. However, such expansion will only occur if additional public funding for more facilities and faculty is made available to public universities and community colleges – something that neither Sen. Sanders’ nor Hillary’s plans directly address. Increased funding also flies in the face of many states’ contracted fiscal support for their public universities and community colleges during the past decade. This is why low-overhead providers of online PHISE services (such as MOOCs) will see this policy change as a significant opportunity. The need for more bricks-and-mortar classrooms (and of course administrators) may be partially avoided via online means. Whether online college education is effective remains an open question.

At first blush a “tuition-free college education” sounds quite appealing; everyone likes “free” – especially if you’re a young adult or the parent of one contemplating college – but has as much veracity as a driverless car. This idea has some merit from a generationally-based subsidy perspective. More public subsidies for young adults might begin to balance the far more sizeable subsidies offered to old folks through Social Security and Medicare/Medicaid expenditures, but I’m not really sure it’s truly equitable. After all, a university education’s principal benefit goes to those who graduate with a degree that traditionally has been rewarded by getting a much better (higher-paying) job than young people who don’t have a BA. Such wage premiums might continue, although I have serious doubts as ever-more students enroll in (and hopefully graduate from) college.

The valuable collective, social benefit of having more college graduates accrues from having a better educated more knowledgeable and productive population. This social benefit explains why subsidies are available to college students via government-guaranteed and -subsidized student loans and education tax credits. These fiscal mechanisms reduce the cost of attending college and are among the few directly helping young people.

I’m all for having more young adults graduate from college. But the market for educated labor in the US, like every market, has two sides to it – supply and demand. If the supply of young adults with college degrees rises significantly, as Sen. Sanders hopes, their salary prospects may not. Unless employers’ demand for educated labor also increases a lot, the price of such labor (their wages) won’t increase, it could even decrease. Such reductions in the wage premium for college graduates won’t be greeted with enthusiasm. With a “free college tuition” policy in place, maintaining the college-educated workers’ wage premium will require increased macroeconomic growth to spur employers’ hiring of more such workers. And it probably will further degrade the wages of lower-skilled high-school graduates. Despite its virtues, designing and implementing policies to advance macroeconomic growth remains a quixotic quest for economists and politicians, especially when Republicans decrease publicly-funded research, infrastructure expenditures and investment incentives.

Also, a sustained, large increase in folks who have PHISE degrees is likely to reduce the marginal value of such degrees, as reflected in reduced expected wages, even with economic growth. The law of diminishing marginal returns applies to holders of 2- and 4-year college degrees with respect to salary prospects simply because having such a degree will become less distinguishing.

No one wants to consider this possibility – and certainly no politician will say it, especially during the unending election season. Because it’s contrary to our long-established, personal hopes that more education provides better economic prospects. Middle-class citizens’ “American Dream” is founded on this hope; they hold it as a keystone of their children’s brighter future.

This is the fallacy of espousing unsystematic policies that can change only one part (the supply) of the market for highly-educated people. Such policies will produce an imbalance for college-educated workers because policy-makers don’t consider about how employers (the demanders) of BA-holding people will react to the consequences of their policies.

Other nations have adopted policies which reduce the cost of higher education, usually involving significant public expenditures and subsidies. Of the 15 countries listed, the nation with the lowest 2010 college costs (tuition, books and fees) was Denmark – Bernie’s favorite? – with annual costs of only $530. I can’t even count that low. The US college costs were $24,700 (private) and $7,123 (public). As a percent of median household income Denmark’s college costs were 2.3%, the composite US cost was 51.3%. According to a recent OECD report, 15 of the 33 nations had higher college (tertiary-level) graduation rates than the US, including Denmark. How does Denmark achieve such low college costs and elevated graduation rates? In part by having its citizens pay higher income taxes – a 71% higher average income tax rate than the US.

Our nation has a long and pricey way to go if we want to significantly lower the expense of getting a college degree and increase our national college graduation rate. Lowering college expenses for students is only one part of a possible solution, which will only be effective and beneficial if college education policy is systematically implemented, covering both the supply and demand sides of the market.

---

[1] Actually a lot more than a ton. One billion George Washington $1 bills weigh about 1,100 tons. So Sen. Sanders’ free college plan would weigh 825,000 tons of Georges. That’s about the weight of 8 huge Nimitz-class aircraft carriers, the largest US Navy ship. And something that Sen. Saunders would no doubt be very happy to trade-in for more college students.  

[2] Effectiveness is doing the right thing; efficiency is doing a thing right (in economics, doing it with the least opportunity cost).