eichengreen on boltho

This is a brisk and invigorating account of a century of international monetary developments by one of America’s foremost economic historians. As would be expected, Exorbitant Privilege is extremely well informed, cogently argued and broadly persuasive. Events and policies, such as the Suez war, the ems breakdown or the current financial crisis—together with sharp criticism of the excessive deregulation favoured by both Alan Greenspan and Larry Summers—are splendidly documented. Conflicting views of what might happen in future are clearly put forward and analysed. Unexpectedly, perhaps, the book also displays fairly frequent touches of humour. In other words, it is both erudite and readable.

The main story begins in 1913, the year in which the us Federal Reserve system was created. At the time, America was already the world’s largest economy and largest exporter. Yet the dollar was hardly used in international exchanges. Semi-obscure currencies such as the Belgian franc or Italian lira were apparently more important. By 1924, just over a decade later, the dollar had dethroned sterling as the world’s main reserve currency and unit of account. Thus, already during the Weimar hyperinflation, prices in shops across German cities were only decided upon late each morning once a phone call from Berlin had provided the day’s exchange rate between the Reichsmark and the dollar. In part, the currency’s rise reflected America’s growing importance as a world power. But it was also strongly aided by the conscious efforts the newly founded Federal Reserve made to help its internationalization. After World War Two, of course, the dollar’s dominant role in international exchanges was institutionalized in the Bretton Woods agreement, enshrining what, at the time of the Vietnam War, de Gaulle’s finance minister Giscard d’Estaing would dub America’s ‘exorbitant privilege’. In some respects this would increase when Nixon abandoned convertibility with gold in the 1970s.

Yet in recent years, voices have increasingly been heard challenging this dominant role. Today, ‘in the wake of the most serious financial crisis in eighty years, a crisis born and bred in the United States’, Eichengreen writes:

There is again widespread criticism of America’s exorbitant privilege. Other countries question whether the United States should have been permitted to run current-account deficits approaching 6 per cent of gdp in the run-up to the crisis. Emerging markets complain that as their economies expanded, and their central banks felt compelled to augment their dollar reserves, they were obliged to provide cheap finance for the us external deficit, like it or not. With cheap foreign finance keeping us interest rates low and enabling American households to live beyond their means, poor households in the developing world ended up subsidizing rich ones in the United States. The cheap finance that other countries provided the us in order to obtain the dollars needed . . . underwrote the practices that culminated in the crisis.

More than this, some have argued that, ‘as a result of the financial mismanagement that spawned the crisis and growing dissatisfaction with the operation of the international monetary system’, the dollar’s singular status is now in doubt:

The us government has not been a worthy steward of an international currency, its critics complain. It looked the other way while the private sector produced the mother of all financial crises. It ran enormous budget deficits and incurred a gigantic debt . . . The dollar is at risk of losing its exorbitant privilege to the euro, the renminbi, or the book-keeping claims issued by the imf known as Special Drawing Rights.

The usual counter-argument has been that incumbent status should protect the dollar for many years or even decades to come. Interestingly, however, one lesson that Eichengreen draws from the inter-war experience is that reserve-currency status can quickly change hands if a new dominant power arrives on the scene. In the early years of its existence, it was thought that the euro might dispute the dollar’s hegemonic role. That never quite happened, and attention has now turned to the rise of China. The country is already a larger exporter than the United States, holds massive foreign reserves (mainly, of course, in the form of dollars), and its gdp, converted at current exchange rates, could match America’s by the middle of the next decade; in purchasing power parity terms, it should be larger well before. China is also beginning to flex its muscle in the international monetary arena. First came suggestions by Chinese officials in March 2009 that Special Drawing Rights should play a larger role. Then came lectures from the official state-run news agency, Xinhua, when Standard & Poor lowered America’s sovereign debt rating in August 2011: Washington was urged to cut its ‘gigantic military expenditure and bloated social welfare costs’—the latter, a nice ‘socialist’ touch. Might China wish gradually to raise the importance of its currency in international exchanges? Recent moves by the country’s monetary authorities suggest that this could well be the case; Eichengreen reports a Shanghai banking official mooting the possibility of a convertible renminbi by as early as 2020. Even if the ccp were to harbour doubts, an America enfeebled by continuing balance of payments and budget deficits, as well as by mounting external and domestic debt, could see importance slipping from the dollar. After all, sterling lost its international role in part because of the gradual weakening of the British economy. The dollar could follow a similar fate.

Eichengreen puts all these arguments forward but, ultimately, is not convinced by them. Neither the Chinese renminbi (a still inconvertible currency with too much state) nor the euro (a currency with not enough state and, one would now add, a distinctly uncertain future ahead of it) represent viable alternatives. The concessions made to win political backing for European monetary union in the run-up to Maastricht—an independent Central Bank, but no fiscal or political integration—have limited the euro’s ability to rival the dollar, Eichengreen argues; while the ‘fateful decision’ to go for a larger union ‘saddled the euro area with a set of heavily indebted members with deep structural problems’. Exorbitant Privilege concludes that despite its current difficulties ‘the continent will move gradually, if in spurts, towards deeper integration, as it always has.’ But ‘because institutional reform will be slow’, the euro’s rise as an international currency will be laggardly as well.

There are, no doubt, threats to America’s (not quite) hegemonic position and the dollar could crash should foreign investors, and primarily China, suddenly lose faith in the currency. But this would be in no one’s interest. China is the first to realize that a dollar collapse would leave it doubly poorer; its massive us Treasury Bond holdings would be worth a good deal less in domestic currency, and its export competitiveness would suffer a huge blow. A greater danger comes from America’s very large budget deficits and public debt. These are unlikely to come down soon and could eventually put upward pressure on domestic interest rates or lead to higher inflation. Growth would then slow down, but even this would be unlikely to trigger a sudden flight from the dollar, given the lack of sufficiently attractive alternatives that match the deep and liquid capital markets that America provides. Instead, Eichengreen foresees a world of multiple international currencies, with the euro and the renminbi, for instance, playing more significant roles at the regional level—not unlike the 19th-century experience when sterling’s predominance was tempered by the presence of the franc and the mark.

The dollar’s hegemonic role as the world’s principal reserve and transactions currency is thus broadly expected to continue—and with it, its exercise of ‘exorbitant privilege’. But in what precisely does this privilege consist? At the simplest level, there is a convenience gain to Americans from being able to use their own currency in international trade. No need to convert into exotic monies, no need to pay for cover on forward exchange markets. In addition, there is, of course, the time-honoured privilege of ‘seignorage’—the printing of intrinsically useless banknotes in exchange for real resources. At the simplest level, this is shown by the fact that dollar bills to the tune of perhaps some $500 billion have been accumulated abroad. To obtain this money foreigners have provided the us with real goods and services. The us in exchange has given them bits of paper. The annual gain to the us of this continuing foreign demand for, overwhelmingly, $100 banknotes, often used in the underground economy, has been estimated at some 0.1 per cent of America’s gdp. This is nice to have, but hardly seems overwhelming. As Eichengreen puts it, seignorage ‘is about number 23’ on the list of factors determining the place of the United States in the world.

More important has been the accumulation of dollar reserves by other countries. It is this that angered Giscard d’Estaing: America could run large trade deficits because Europe and Japan willingly held the dollars they received for their exports, instead of exchanging them for real resources produced in the us. In practice, he argued, it was Europe and Japan that were paying for the war in Vietnam. And over the last decade or two, something similar has been happening vis-à-vis East Asia, and especially China. The large trade surpluses of that country have been overwhelmingly converted into us Treasury bonds and the ensuing massive capital inflows have facilitated the borrowing excesses by Americans that contributed to the recent financial crisis.

It is indeed true that, since the dollar is the international currency, other countries feel the need to hold it. Unlike the accumulation of dollar banknotes, this is not quite an unrequited gift to America because those surplus dollars are invested on America’s capital markets, where they earn interest, but the us still gains. Demand for us assets, primarily Treasury bonds, is higher than it otherwise would have been, thereby lowering the interest rate that America has to pay for its borrowing: estimates suggest reductions of up to 1 percentage point in the level of long-term rates in the course of the last decade. This could be equivalent to an annual benefit of, again, 0.1 per cent of gdp. And not only does America pay less for borrowing (in its own currency) than other countries, it also earns more on its investment abroad than foreigners do in the us. In part this stems from America having taken on the role of a world banker, borrowing short and lending long, but it is also aided by the dollar’s reserve-currency status. Lastly, that status also enhances the us position in the world allowing it to influence and push other countries in directions they might otherwise not have chosen. All this is, surely, profoundly wrong. The richest country on earth—and the imperialist power to boot—has so far been able to exploit with impunity everyone else, and will, in all likelihood, continue to do so in future. To those that have, shall be given! In a just world such privileges should obviously not exist.

Yet, are such privileges truly exorbitant? America is rich and powerful not because of the international role of the dollar. Causation clearly goes in the opposite direction. America does exert undue political influence, but that stems from its status as the world’s largest economic and military power, not from the reserve-currency role of the dollar, which merely results from that status. Seignorage accrues to any issuer of currency—thus, the Eurozone is benefiting from demand abroad for its €500 banknotes, an even handier instrument for the underground economy than the ubiquitous $100 bill—and the gains in question seem hardly mind boggling. Turning to the ability of the United States to run current-account deficits, this is hardly unique to the country. What is unique is that it can finance these deficits by issuing debt in its own currency, rather than having either to deplete its reserves or to make efforts to balance its books, as any ‘normal’ country is forced to do. Thus it could also inflate away the real value of its debts to the rest of the world, an option that is not available to other borrowing countries. But is it likely that it will do so? Yes, possibly, if public debt were to go on rising to levels well above 100 per cent of gdp, as some observers fear; but so far, at least, there has been little evidence that it has tried. Perhaps ‘exorbitant’ is too strong a word to describe the gains to America of having the dollar as an international currency. Eichengreen, for one, is not perturbed by the (unlikely) loss of that status for his country.

Still, even if not exorbitant, the gains to America should never have occurred. Why should European countries have facilitated the financing of the war in Vietnam? Why should developing countries invest in us paper assets rather than in domestic infrastructure? Yet this raises the issue as to what alternative arrangements would have prevailed in the international monetary system had the dollar not played the role it did. In a socialist utopia, we would have had benign world government and benign monetary arrangements. In the real world, we would have needed something a bit more realistic. At Bretton Woods, Keynes had proposed a plan centred on a world currency and a world financial institution. The us vetoed it. Nobody will ever know whether, had such a set-up been implemented, the world would have been a better place. As it is, the world may not have been quite as bad a place as is perhaps often thought. Keynes had warned at Bretton Woods that the system which was ultimately adopted, against his recommendations, would impart a deflationary bias to the global economy since only deficit countries (read Europe) were put under an obligation to rectify payments imbalances, while surplus countries (read the us) were left to pursue whatever other aims they had. In the event, of course, almost the opposite happened. The deficit country turned out to be the United States which, thanks to the dollar’s role, was under little compulsion to adjust. Ironically, rather than the system exhibiting a deflationary bias, it was an inflationary one that progressively undermined it.

Be this as it may, one can hardly dispute the fact that in the near three decades from Bretton Woods to the 1970s oil shocks, growth in the developed world was exceptionally smooth and rapid. Arguably, the dollar’s role contributed to this. America followed relatively accommodating monetary policies, thereby providing the international liquidity which growing world trade required. A world without a hegemonic currency, such as the one that prevailed in the inter-war years, may not have worked as smoothly. Since the 1970s, developments in the oecd countries have been much less favourable, but domestic policies and institutions would seem to be more likely culprits for slow growth and high unemployment. Many countries in the developing world, on the other hand, have done extremely well, at least over the last two decades. Domestic policies, again, must take pride of place in these successes, but world trade went on growing rapidly, unimpeded, and possibly helped, by the dollar’s role. Would things have been very different if Keynes’s ‘Clearing Union’ and ‘bancor’ (or the sdr) had been in place instead of the dollar? It is highly unlikely that different international monetary arrangements would have avoided the oil shocks, Japan’s stagflation, or the high-tech bubble of 2000–01. The Latin American debt crisis of the 1980s and the East Asian crisis of the later 1990s might, conceivably, have been better managed by an impartial world financial institution and possibly too the recent Great Recession, even if these various events, and especially the last one, owed more to inconsiderate financial deregulation at home, than they did to the dollar’s role in the international monetary system.

In the eyes of this reviewer, that role was (and still is) ultimately benign for the world economy. The us may not have consciously wanted to play the role of a world bank, or lender of last resort. Indeed, when its interests conflicted with those of the rest of the world, it chose unilateral action, as in the ‘Nixon shock’ of 1971. Nonetheless, few if any realistic alternatives were (or are) available. The dollar provided a unit of account that was (and is) widely used; it provided a store of (imperfect) value that people around the globe clearly prized; indeed, it is still seen as the ultimate safe asset in periods of crisis, more so even than gold or Swiss francs, as events over the last few years have amply shown. Most importantly, it provided an efficient medium of exchange. As argued above, world trade expanded dramatically in the postwar period thanks partly to the dollar’s presence (as it had also done in the late 19th century, thanks partly to sterling’s role at the time in oiling the wheels of commerce). The system is not eternal, of course, and is under stress. But since neither fully flexible exchange rates, nor a genuine world currency issued by a supra-national authority are on the cards, it still seems a better system than any realistic alternative. Yes, the dollar enjoyed some privileges, but these seem hardly exorbitant and may well have been a price worth paying, given the ensuing benefits to the world economy. A Panglossian conclusion, no doubt, but then Dr Pangloss may not, after all, have been wrong on everything.