Have my apologies, loyal readers and devoted followers, for the sparse blogging as of late. Out and about, some relaxing here, some other projects there.
Anyways, the latest econ read was Barry Eichengreen’s Exorbitant Privilege. Three stars. Monetary economics is among the hardest for slice of the field for laypeople to understand. If you’re intermediate — you’ve taken, and learned from, a macro course and kept up with the Financial Times a bit since — you’ll find this book moderately challenging. If you’re advanced, it’s all old news. If you’re a novice, I’ll try to help (which might make this blog post a bit tiresome for the others).
The basic question the book seeks to answer is: “Will the U.S. dollar maintain its ‘exorbitant privilege’ as the international reserve currency?” And the way the book answers the question is: “Here’s the history of the international monetary system. Oh, and here’s a chapter of analysis, too.”
What is the ‘exorbitant privilege’ that the U.S. dollar and consequently the U.S. economy enjoy? Well, first, here’s what it looks like:
The dollar remains far and away the most important currency for invoicing and settling international transactions, including even imports and exports that do not touch US shores. South Korea and Thailand set the prices of more than 80 percent of their trade in dollars despite the fact that only 20 percent of their exports go to American buyers. Fully 70 percent of Australia’s exports are invoiced in dollars despite the fact that fewer than 6 percent are destined for the United States. The principal commodity exchanges quote prices in dollars. Oil is priced in dollars. The dollar is used in 85 percent of all foreign exchange transactions worldwide. It accounts for nearly half of the global stock of international debt securities. It is the form in which central banks hold more than 60 percent of their foreign currency reserves.
That last one, in bold, is the most well-known — it is what we mean when we say that the U.S. dollar is the ‘international reserve currency.’ Why do central banks around the world — the equivalents to the Federal Reserve, such as the E.C.B., the Bank of Japan, and the Bank of England — hold U.S. dollars? They do it partly in order to stabilize their exchange rates — and they do that in order to prevent, e.g., a domestic industry that primarily exports to Sweden facing devastation by a depreciation of the krona with respect to the domestic currency (which would make the domestic product more expensive to Swedes). But why do they mostly reserve dollars to stabilize their exchange rates? The answer is sort of recursive and in that sense quintessentially economic — they use dollars because all the other central banks are using dollars to stabilize their exchange rates, so by stabilizing its own currency relative to the dollar, each individual central bank can simultaneously stabilize its currency with respect to all the others, using just one metric and one kind of intervention. By buying dollars on the foreign-exchange market, foreign central banks can depreciate their own currency, and build the foreign reserves necessary to, at other times, sell dollars in order to appreciate their own currency. E.g.: When the Japanese yen was appreciating too quickly, in a way that hurt the competitiveness of its exports to the U.S. and elsewhere, the Bank of Japan would buy up U.S. dollars and dollar-denominated assets. After the bubble burst, the Japanese yen faced devastating depreciation, as foreign investors fled from Japanese assets — and the Bank of Japan was equipped with dollar reserves that it could use to appreciate and stabilize the exchange rate in the event of a panic. (Am I belaboring these explanations? Apologies — mixed readership, I assume.)
But anyways: Another reason each central bank holds dollars is that it functions as a ‘lender of last resort.’ When everybody freaks out in a financial panic, the central bank, with its access to the public fisc., is supposed to be there to lend to banks and (sometimes) companies facing temporary liquidity problems, to help them meet their obligations without going under. And since (as above) most international business is conducted in dollars, a typical foreign business and the banks it deals with have liabilities in (1) their own domestic currency and (2) dollars. So, if the central bank is to be able to lend to help its banks help each other and their other businesses meet those liabilities in a liquidity crisis, it needs to have its own currency (which is trivial) and U.S. dollars — and not really any others. And, beyond that, foreign multinationals, as a matter of prudence, want to hold a lot of dollars because they mostly do their international trade in dollars.
So we’re slowly getting the picture of ‘exorbitant privilege’ — every other country in the world has to hold a lot of dollars and worry about its exchange rates with respect to the dollar, but the U.S. doesn’t have to requite these monetary affections and anxieties. There are a lot of reasons why this is a pretty sweet deal for the U.S. Just think about the most basic one: If another country’s central bank (or its private companies) wants more U.S. dollars to hold and we in the U.S. don’t want as much of their domestic currency, then they will trade real goods for our dollars — which are printed by the Treasury by fiat for a negligible cost. In a very real sense, the dollars that are simply held abroad — including, which Eichengreen didn’t mention, those held by international criminals, who trust the full faith and credit of the U.S. government beyond any other — represent the value of goods and services that we in the U.S. got basically for free from other countries. This is what economists call seignorage. There are other benefits, too: Our companies don’t need to expend as much intellectual effort or derivatives-brokerage fees on hedging the risks of currency movements, because they (1) raise money, (2) do international transactions, and (3) report to their shareholders all in the same currency. Next (and this gets a bit arcane) this demand for dollars also drives up the demand for highly liquid, dollar-denominated assets, such as U.S. Treasuries and mortgage-backed securities. This means that U.S. borrowers — including the federal government, state governments, government agencies, corporations issuing bonds, and individuals seeking mortgages — enjoy artificially lower interest rates on their loans (as we’ll see later, this had a pretty salient downside, as well). That is, we in the U.S. get to borrow extra cheap, because international investors want our assets not just on the basis of our ability to repay principal and interest, but because they use our assets for transactions with each other — if you imagine the supply and demand curves for loans in the U.S., the reserve value of dollars amounts to just a boost in supply.
Finally, in the now extinct Bretton Woods system of fixed exchange rates, the dollar had a different ‘exorbitant privilege’ (one which led to the coinage of that phrase in the first place): Because the dollar was used for international transactions, the U.S. could buy other countries’ exports in dollars. This meant that the U.S. as a whole could consistently run a large trade deficit with another country without depleting its reserves of that country’s currency. Other countries couldn’t do that. Suppose that Bretton Woods set the dollar-franc exchange rate at 1 to 1; suppose also that France constantly bought a lot more from the U.S. than vice versa. In that case, France would slowly run out of dollars, which would lead speculators to suspect that France’s central bank would no longer be able to maintain the 1 to 1 exchange rate — they would engage in a ‘speculative attack’ against the Franc by simply selling off their francs in exchange for the dollar (at the 1 to 1 rate that the Bank of France was obligated to honor) in anticipation of an eventual forced depreciation of the franc. To defend the franc and honor its fixed-exchange-rate commitment, the Bank of France would have to keep selling off its dollars to these speculators — if the speculators won in this game of chicken, the Bank of France would eventually run out of dollars and be forced to stop honoring its commitment to exchange 1 franc for 1 dollar, which would effectively amount to a depreciation of the franc. To avoid this, in advance, the French government would have to make onerous efforts, accompanied by all kinds of economic distortions and inefficiencies, to prevent itself from running chronic trade deficits with the U.S. (All this is no longer a problem, in the exact same form, with our current system of a floating exchange rate between the dollar and the euro.) The U.S. never had to think about any of that, because it purchased its imports in dollars. Exorbitant privilege.
So the bottom line is: The U.S. dollar is the international currency, and that brings us all kinds of awesome/unfair benefits.
So why do the other countries put up with their decided lack of exorbitant privilege? And how did we get here? The short answer is: World War I, and then World War II. WWI, happening soon after the establishment of the Federal Reserve, made the U.S. into a major international lender — got our assets circulating abroad, etc., which helped New York begin to compete with London as the financial capital of the world and the dollar to compete with the pound as the international reserve currency. After World War II, the U.S. emerged as a single economy producing more than 50% of global GDP. It was an oasis stability compared to Europe, and Asia was still too poor (its political instability aside) to be a player. And, essentially, lots of countries wanted to curry American favor. So there were really no alternatives to the dollar as an international currency — not sterling because Britain was too sick, and not the Deutsche Mark because West Germany was too eager to win American favor given the looming threat of Soviet troops to its east.
But why still? The U.S. is much less than 50% of global GDP now, and will almost certainly continue to sink lower. Europe is safe and stable and it now has the euro (whose birth Eichengreen details). The answer, largely, is that the dollar has remained the international currency by default. That is, (1) it has simply enjoyed the advantages of incumbency itself and (2) credible alternatives have not yet arisen. Saying that the dollar enjoys the advantages of incumbency is another way of saying that “everyone uses the dollar as international currency because everybody else uses the dollar as international currency.” Even if you personally believe that the dollar isn’t the ideal currency for international transactions, you’ll be forced to use it insofar your counterparties are using it — so everyone can get locked into using the dollar even when every individual would like a different system (classic “prisoner’s dilemma”). Regarding the lack of alternatives: The euro has partly displaced the dollar in international reserves in recent years, but (recent events would seem to suggest with good reason) not very much — partly due to the inherent instability in having a monetary union without a fiscal union and partly due to the fact that Europe for demographic reasons is likely on the decline in the long term. The IMF’s Special Drawing Rights (SDRs) seem theoretically sound, but just haven’t caught on in practice. China is (have you heard?) really big and rising fast — but markets regard it as inherently unstable as a largely poor non-democracy, and its financial assets don’t trade internationally very much, so the RMB seems unlikely to replace the dollar anytime soon.
So all this leads to the big question that all of this history and theory is here to answer: What next? Could anything change all this this? Yes: A U.S. fiscal crisis. As the U.S. debt increases, foreign investors may become increasingly nervous that the U.S. will attempt to ‘monetize the debt,’ inflating and depreciating the dollar in a way that reduces the real value of foreigners’ holdings of U.S. assets. This could lead to a sudden flight from U.S. assets, which would itself depreciate the U.S. dollar, which itself would fulfill those very fears. Such dollar instability would drive global investors to demand an alternative.
More generally, the system could shift just a little bit at a slower pace. Indeed, Eichengreen’s prediction is that the dollar will maintain its leadership while losing some of its dominance. The continuing decline of the U.S. as a share of global GDP, and the concordant rise of Asia and Brasil, will create a more multipolar global economy, which will invite a more multipolar global monetary system. Combine those with more sophisticated financial markets that could make currency exchanges more efficient, and we can expect central banks and businesses to work with more diversified currencies and things like Special Drawing Rights over the long term. Will the loss of its privilege have some negative effects on the U.S.? Yes. Will those effects be disastrous? No.
So that’s the summary. Here are a few questions and Interesting Things:
Something I didn’t get: Eichengreen seems to imply, insofar as I understand him, that the U.S.’s artificially appreciated currency is a kind of privilege. But, econ 101 says that, very plainly, an appreciated currency is a privilege for importers and burden for exporters. Surely, Americans who have suffered with declining export-oriented manufacturing industries don’t consider themselves privileged. I don’t see how an artificially appreciated currency can be called a privilege for the economy as a whole — it would seem, rather, to just trade off between one group and another.
This being a book written within the past 4 years, the author is compelled to give His Angle on the Financial Crisis. In brief: the recent financial crisis was largely driven by a burst in a real-estate and asset bubble that was, in turn, ballooned by exceptionally low interest rates in the U.S. And to a certain extent, the usual explanation for these low interest rates — the Asian ‘savings glut’ — doesn’t quite explain it in full. After all, with interest rates in the U.S. so low, why wouldn’t the capital from gluttonous Asian savings go elsewhere, where it could earn a higher return? And the answer is that, as per above, this gluttonous capital wasn’t seeking out returns — in a way that would have led to its more efficient allocation — but was just looking for American dollar-denominated assets per se. Without the dollar’s status, we in the U.S. might not have enjoyed the privileges of cheap capital through the early 2000s and the exorbitances of 2008.
Final sylistic judgment: A lot of the writing, especially the more arcane aspects of various failed attempts to establish monetary union in Europe before the final, successful effort is, frankly, boring to the nonexpert who isn’t deeply interested in the question. (This is not a criticism of Eichengreen’s work — just a warning to the non-academic intellectual taste-bud.) Throughout, though, Eichengreen is a surprisingly good prose stylist for a monetary economist. And he has a sense of irony that made me LOL a bit. He quotes a British traveler who, upon arriving in the U.S. and trying to make some purchases, discovered that sterling had sharply depreciated over the course of his long voyage across the Atlantic: “Bit of a hold up, what?”