After the dollar

by John Quiggin on May 11, 2008

It’s unclear whether we are bound for a Post-American World in the near future, but it seems pretty clear that we are bound for a world in which the US dollar is no longer the unique ‘reserve currency’. The combination of chronically large trade and budget deficits and willingness of the US monetary authorities to tolerate sustained inflation means that decisions by national central banks to hold US dollar reserves are now driven by a desire to preserve the existing order rather than by calculations of risk and return. In the long run this can’t be sustained.

If the US dollar can no longer satisfy the requirements of a reserve currency, what are the alternatives? I can see two possibilities.

The first is the euro. At current exchange rates, which seem likely to persist for some time, the eurozone is the world’s largest economy. And the euro share of reserves has been growing. Still, neither of these, in isolation, would be enough to allow the euro to achieve the kind of dominance that characterized the dollar in the early postwar period (or, before that, the pound sterling). In each case, these currencies combined economic hegemony with imperial power.

The eurozone may be the worlds largest economy, but the EU is not an economic hegemon. Europe is a postmodern kind of empire, so the possible rise of the euro would not follow the flag as om the past. What’s more likely is the euro equivalent of dollarization, with the eurozone potentially expanding beyond the EU, along with a growing penumbra of currencies pegged to the euro or targeting a euro exchange rate. This would in turn encourage countries outside the euro area to hold euros as foreign exchange reserves. All of this would be of a piece with the differentiated expansion that has characterized European institutions of all kinds.

The second possibility is a world without a reserve currency. If the decline of the US dollar continues, we might see gradual diversification into euros and pounds, renewed holding of the yen as Japan recovers and, with the relaxation of exchange controls, increased holdings of rupee and yuan. In principle, given modern computing resources, there should be no problem in quoting prices in six different currencies simultaneously, or in one or more baskets of currencies. Different choices might emerge in different markets.

Update Much the same thoughts from Peter Goodman in the NYT

{ 34 comments }

1

brooksfoe 05.11.08 at 9:03 am

Wouldn’t this be good for the US too? Lower the current account deficit, decrease artificial asset price inflation forcing people to save more, etc.? Generally push the country towards more sustainable economic behavior?

2

Jonathan Dresner 05.11.08 at 9:05 am

There’s at least a third possibility: return to a gold/etc. pseudo-standard in which reserves are held in commodities more than in currency.

3

leinad 05.11.08 at 9:45 am

This is the moment of triumph for RON PAUL Liberty Dollars!

4

abb1 05.11.08 at 10:03 am

I understand that “gold/etc. pseudo-standard” is pretty much a description of the Bretton-Woods system where the dollar replaces gold, serves as the peg for all the other currencies. If John is right that the reserves are likely to diversify, the global economy is likely to become less and less unipolar, then the possibility of finding a decent ‘peg’ currency becomes even more remote.

A plain gold-standard system also seems highly unlikely, as it makes governmental interventions in individual economies virtually impossible, and no one wants to return to the old boom-bust economic model.

I’m curious if it’s clear and obvious now that the Euro as common European currency is going to survive. Anecdotally, I see that a lot – a whooooole lot – of people believing that the Euro is associated with higher prices and lower standard of living. Isn’t it possible that a populist Italian or Greek (or perhaps even French) government would switch back to the Lira, Drachma, etc.? One such incident could, I think, cause a chain reaction and kill the whole project. What then?

5

abb1 05.11.08 at 10:06 am

Sorry, formatting issues. Nothing was supposed to be strikethroughed.

6

Z 05.11.08 at 10:49 am

Anecdotally, I see that a lot – a whooooole lot – of people believing that the Euro is associated with higher prices and lower standard of living.

Same anecdotal evidence, and yet I am willing to bet a considerable sum that there will be no reversal. The eurozone is too integrated.

7

Naadir Jeewa 05.11.08 at 11:04 am

What does lower standard of living mean? I’d like to know what we’re missing out on. Obesity, more expensive health care, urban sprawl, SUVs?

8

B 05.11.08 at 11:12 am

If you think of standards of living in terms of stuff, then yeah, the US beats the eurozone. We have more 52 inch plasmas, mcmansions, and cheap things made in China. yipee….

9

Naadir Jeewa 05.11.08 at 11:15 am

On a more serious note:

It’s unlikely any EU country will revert back to a national currency any time soon. They know full well they’ll lose out on the benefits of pooled sovereignty. Italy outside the Eurozone market is what, exactly?

The big fear is that the EU post-imperial empire will define itself along ethnic lines. Sarkozy seems intent on not letting Turkey into EU within the next 20 years, but the EU remains Turkey’s largest trading zone. Eurozone really needs to expand across North Africa and the Caucasus.

10

abb1 05.11.08 at 11:16 am

2005:

Experts agree it would be economic suicide. A prominent politician compared the prospect to a horror film.

But that has done little to deter Italy’s populist Northern League Party, a member of Premier Silvio Berlusconi’s coalition, from its proposal to bring back the lira, Italy’s oft-ridiculed former currency.

2008:

Lega Nord ran in the election in coalition with PdL and the Movement for Autonomy, gaining a stunning 8.3% of the national vote. This result (a gain of 4.2% in two years) allowed the election of 60 deputies (+37) and 26 senators (+13).

11

jim 05.11.08 at 12:25 pm

It takes a very long time for reserves to switch between currencies. As I recall, “The Sterling Balances Problem” dragged on for something like twenty years before they were down to negligible proportions. The Dollar Balances Problem would drag on for even longer. And it’s unclear that central banks are ever going to be willing to precipitate it, particularly since there’s no obvious successor (as the dollar was to sterling). I don’t see why you think the situation unsustainable.

12

Tom West 05.11.08 at 1:52 pm

What does lower standard of living mean? I’d like to know what we’re missing out on. Obesity, more expensive health care, urban sprawl, SUVs?

Look, no matter what you think of how people spend their money, you cannot deny that the drive towards a higher standard of living (be it instinctual or even desirable) is what guides most people’s political or economic decisions.

Unless you want to throttle back democracy, you cannot expect governments to ignore that drive for anything anything less than catastrophic consequences. Well, you can, but then you must expect them to be replaced by another government willing to follow the drive towards higher standards of living.

Unless you understand that it is the process of trying to increase our wealth that drives us, not the destination, you have no hope of influencing human behaviour. (After all, do you really believe humans (as a whole) will decide (or even *can* decide) that we have “enough” wealth?)

13

Purple State 05.11.08 at 2:04 pm

I vote for diversification. It seems wise not to be tied too tightly to a single currency or a single nation’s economy. It would be interesting to see how this would affect the market for commodities (like oil) now bought and sold in dollars. One would have an incentive to buy oil with a currency that one suspects will decline in value and sell oil for a currency that one suspects will increase in value (or that one is under-invested in). Ths would create interesting arbitrage opportunities and might result in the prices for oil varying by currency but not exactly in the same way as the current exchange rates for the currencies would suggest. For instance, if I wanted to sell oil but had too many dollars on hand and/or were worried the dollar might decline in value, I might provide a discount to a buyer with Euros but charge a premium to a buyer with dollars. So if the exchange rate were 1.50 dollars to 1.00 euro, but I wanted euros, I might offer a unit of oil worth 1.00 euro for 1.55 dollars (or 0.95 euros) to encourage buyers to buy in euros and not dollars. This would then effect the currency market, tending to drive the value of the dollar down.

14

praisegod barebones 05.11.08 at 2:35 pm

Well, 8.3 percent of the vote may be stunning for the Lega Nord, but it doesn’t strike me as anything like a whole sale rejection of the Euro.

It’s what – 1 in 12 of the population? 1 in 24 if you leave out those who were voting for them before.

More importantly: currency changes tend to give retailers an opportunity to put up prices. Changing back gives them another opportunity.

My anecdotal evidence is that a fair number of the grumblers (at least in France, which is the place in Eurozone where I knwo most people) understand this fairly well. It doesn’t seem to be rocket science….

15

Naadir Jeewa 05.11.08 at 3:56 pm

“In principle, given modern computing resources, there should be no problem in quoting prices in six different currencies simultaneously.” This seems crucial.

Perhaps an economic sociologist could weigh in.

16

abb1 05.11.08 at 4:14 pm

I mentioned the Lega Nord just to demonstrate that the anti-Euro sentiment does spill into politics. And these are the good times now. Imagine a serious recession or some economic calamity and how it could escalate. I’m not saying it’s very likely, but I believe it’s a possibility.

17

noen 05.11.08 at 5:33 pm

“Wouldn’t this be good for the US too?”

No, it would be very very bad for the US. Especially if the switch over occurred relatively quickly. For a long time the US has been running a magic checkbook. A dollar is a promissory note after all. With our handy magic checkbook we have been able to spend, spend, spend and somehow those checks go out but they never seem to return to be cashed.

If the euro were to become a global reserve then all those dollars will start finding their way home. The party will be officially over. You’ll notice that it was shortly after Iraq switched it’s bourse from dollars to euros that we attacked and that Iran has also dumped the dollar.

18

Michael 05.11.08 at 6:29 pm

There is a basic tension in the eurozone between nations that are primarily interested in growth even if the cost is inflation (France, Italy, Spain) and those that are interested in controlling inflation at the price of growth (Netherlands, Switzerland, Germany). Those tensions are growing, not weakening and they will continue to grow as economic growth becomes more tenuous. The Euro may survive, but if it survives on the terms of the former group it is unlikely to become a reserve currency.

19

Ginger Yellow 05.12.08 at 9:37 am

Surely the basket approach is inevitable and sensible. It’s going to be much more stable in the long run than single-currency reserves, and means central banks can, if they want, dump a collapsing currency without hurting themselves too badly.

20

stuart 05.12.08 at 10:11 am

For a long time the US has been running a magic checkbook. A dollar is a promissory note after all.

Isn’t there of the order of $400b of US currency held abroad (about half of the ~$800b total, i.e. M0), which if it was funded at current US treasury interest rates would cost about $10b a year to service. While this is a noticeable amount, it is hardly a magic checkbook.

The more important thing seems to be that there are lots of US treasury notes ($2.4T at the beginning of the year) being held by foreign organisations (banks and governments mostly) while the US dollar slid in value so consistently against most currencies. Essentially the US government has sold debt while the price was high, and will probably be repaying it while the price is low, which is a good deal for the US.

Of course the reason most governments didn’t sell is that they need US dollar denominated reserves to prove their solvency to their local trading partners, etc. If another currency (or several, preferably) became generally acceptable as a reserve currency (as the Euro is starting to) then reserves could react against devaluations like this, basically various reserve currencies could compete against each other, with the more stable (or appreciating) ones being preferred.

21

paul 05.12.08 at 12:24 pm

#18, Switzerland? Eurozone?
It doesn’t really affect the point you are making, though.

22

Ginger Yellow 05.12.08 at 12:26 pm

Isn’t there of the order of $400b of US currency held abroad (about half of the ~$800b total, i.e. M0), which if it was funded at current US treasury interest rates would cost about $10b a year to service. While this is a noticeable amount, it is hardly a magic checkbook.

Huh? Why are you only counting cash? US dollar bonds, particularly ones with ahistorically low long term interest rates, are the magic checkbook.

23

Tracy W 05.12.08 at 1:23 pm

For a long time the US has been running a magic checkbook. A dollar is a promissory note after all. With our handy magic checkbook we have been able to spend, spend, spend and somehow those checks go out but they never seem to return to be cashed.

A dollar note is a promissory note for what, precisely?

One big value is that if you owe the US government taxes, it will accept US dollars to pay off the debt. Another big one is that US courts are generally satifised by payment of legal settlements in dollars. And of course if you have a contract in USD, that needs US dollars to settle. But there’s no general obligation on the US government or US citizens to charge the same amount in US dollars, if the US dollar is less valuable, they can raise their prices, or taxes. This has happened in inflationary periods in the past. Inflation isn’t good, but the most direct costs are borne by savers, for example those foreign banks.

So how will these dollars find their way home?

24

Great Zamfir 05.12.08 at 1:56 pm

The way I’ve understood this, the dollar as reserve currency allows the US to depreciate the dollar with less punishment in its interest rates than for example Italy, or alternatively to pay less interest if the dollar is not depreciating.

And the reason foreigner borrowers accept this, is that a lot of their own contracts and obligations are written in dollars, so in the short run they are less sensitive to dollar depreciation than to other coins.

But why this would work for long-term lending is not clear to me. This would have more to do with a confidence that the dollar will not collapse entirely, wouldn’t it?

25

James Wimberley 05.12.08 at 2:02 pm

I live in Spain. There is zero enthusiasm for going back to Franco’s peseta. SFIK not even ETA wants its own currency.

The autonomy of the European Central Bank and its anti-inflationary priority, both set in stone, guarantee that Eurozone politicians like Sarkozy will make populist anti-ECB noises at frequent intervals, without any risk that they might lead to anything.

Paradoxically, though the Brussels Commission resent the ECB over which they have no control, it represents the purest achievement of Monnet’s supranationalism: the real delegation of precisely defined executive functions to unaccountable European technocrats. And it works.

26

lemuel pitkin 05.12.08 at 2:31 pm

If the decline of the US dollar continues, we might see gradual diversification into euros and pounds, renewed holding of the yen as Japan recovers and, with the relaxation of exchange controls, increased holdings of rupee and yuan. In principle, given modern computing resources, there should be no problem in quoting prices in six different currencies simultaneously

In routine conditions, sure. But the whole point of reserves is for protection in the event of crises. And in a crisis, the value of such a mixed pool of reserves could fluctuate unpredictably.

This is (I had thought) why the conventional view is that in a world without a reserve currency, there would be pressure to back away from multilateral (free) trade and move back toward more bilateral arrangements.

27

Tertium Quid 05.12.08 at 5:25 pm

I lived through the 1970s when the Federal Reserve, beginning during Nixon’s presidency and on through Ford’s and into Carter’s, inflated the currency to tame short-term interest rates and hide the worst of spiking oil prices.

The doomsayers were all telling us to buy gold, silver, wheat, platinum, coal, and oil, and for most of a decade they were right. After October 1979, when Paul Volcker became Chairman of the Federal Reserve, they were wrong. The dollar recovered after its demise seemed real.

28

Bill McNeill 05.12.08 at 5:41 pm

Right hand one key too far to the left: “…would not follow the flag as om in the past.”

29

lemuel pitkin 05.12.08 at 6:10 pm

… or put it another way: This post invites the question, What purpose does a reserve currency serve, besides convenience in quoting prices?

30

John Quiggin 05.12.08 at 7:27 pm

There’s no really good explanation of the role of a reserve currency, AFAIK. It’s a fact that the global economic system has generally produced one, and hasn’t functioned very well in its absence, but I don’t think there is a generally agreed explanation. The point you make at #26 is about right, but obviously the value of $US reserves is already fluctuating (well, plummeting really). So maybe we will just have to without a reserve currency and its somewhat poorly specified benefits.

31

Tomas 05.12.08 at 8:49 pm

Well, as long as we’re making up stuff about fantasy futures, how about a reality check? Go the economic report of the president and look at the actual data on the dollar’s real effective exchange rate index (doesn’t matter which particular index). What one will observe is that the dollar is about back to where it was in 1995, just prior to its steep appreciation. As nobody was screaming “the sky is falling” then, I don’t see why a return to what one might think of as the appropriate exchange rate will generate a huge shift in reserve holdings today. Get a grip.

As for why one needs a reserve currency (#29), well, I am not sure how one can post this post without actually knowing the answer to that question John. The reserve currency provides a numeraire, it provides liquidity for international trade, and it serves as a store of value. Yes, you do kind of need these things if you are going to have a global economy.

The reason the euro isn’t capable of serving in that role is because it lacks sufficiently deep and liquid markets for super low-risk euro-denominated assets. That is, there is really no large supply of the euro equivalent to US treasuries. Until such a market develops, the dollar is the only game in town when it comes to reserve currency status.

32

shteve 05.12.08 at 10:15 pm

Here’s one view, that bond market reaction would make it impossible to quit the euro:

“Adopting the euro is effectively irreversible. Leaving would require lengthy preparations, which, given the anticipated devaluation, would trigger the mother of all financial crises. National households and firms would shift deposits to other euro-area banks producing a system-wide bank run. Investors, trying to escape, would create a bond-market crisis. Here is what the train wreck would look like.”

http://www.voxeu.org/index.php?q=node/729

33

John Quiggin 05.13.08 at 3:59 am

“The reserve currency provides a numeraire, it provides liquidity for international trade, and it serves as a store of value.”

As any book on money will tell you on the first page. But the problem is, which of these functions is crucial? The dollar does fine for liquidity, which you seem to think is the crucial thing, but not nearly so well on the other two criteria.

To restate your first para, I agree that the $US is not that far below its previous all-time low , though the weakening against the euro is more marked. But the post gives plenty of reasons why circumstances are worse now than then. In 1995, the US was clearly set to address its budget problems, for example.

34

John Quiggin 05.13.08 at 5:22 am

Shteve: To clarify, the point is that it would be impossible for a country that desired a softer monetary policy to leave the eurozone, since everyone would anticipate devaluation, and (although this part isn’t spelt out) it would not be feasible to impose capital controls to prevent the associated capital flight.

A country that planned to tighten monetary policy would face a more manageable task of dealing with speculative capital inflows.

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