Thursday, April 3, 2008

So There is Hope for the Dollar

Barry Eichengreen tells us why we should not get too worked up over the figure below, which shows the current and projected share of international reserves for the Euro and the Dollar, and its implication that the Euro may surpass the dollar as the main reserve currency in ten years.

Writing in the Financial Times, Eichengreen says the following:

Judging from commentary by international economists, one would think that the dollar was on its deathbed. America’s financial crisis and the dollar’s depreciation are bringing us to a tipping point where the greenback will lose its international currency mantle to the euro. A few more losses on dollar investments, it is said, and central banks will learn to hold their reserves in euros. Other investors will follow. America’s “exorbitant privilege” will be no more.

To paraphrase Mark Twain, these reports of the dollar’s death are greatly exaggerated. They are based on a model of the demand for international reserves that does not apply to our 21st-century world.

The chief idea of this model is that international currency status is a source of network effects. Just as it pays to use the same computer software as other people in your network, it pays to use the same international currency as other official and private market participants.

Central banks thus find it attractive to hold dollars because other central banks hold dollars. With everyone doing likewise, the market in dollars is deep and liquid. Because trade is denominated in dollars, central banks find them convenient to smooth the balance of payments. This network externality is the source of the exorbitant privilege that the dollar has enjoyed for half a century.


[The network externality] logic is fundamentally flawed... The advantages to an individual central bank of holding its reserves in the same currency as other central banks range from slim to none. The real reason the dollar so dominated reserve holdings after the second world war was that only the US had liquid financial markets. Only the US market was free of capital controls. The dollar dominated foreign exchange reserves simply because there were no alternatives.


The dollar lost its role as a reserve currency in the 1930s, albeit temporarily, because of disastrous mismanagement of the US economy. Equally disastrous mismanagement today would certainly cause the dollar to disappear from the international scene, leaving the euro as the only international currency standing. That said, no matter how difficult the current situation and how contentious the US policy response to the crisis could prove to be, we are still very far from that point.
So there is hope for the dollar. I wonder what happens, though, when China and the rest of Asia grow into their income and unleash the full force of domestic demand. At that point, Asia no longer needs American consumers and therefore, no longer needs to prop up the dollar. If this potential Asian abandonment of the dollar were quickly followed by a similar move in the dollar-linked Gulf countries, would these developments be enough to undermine the dollar's reserve status? Even then, as Eichengreen indicates, the dollar would be still be an attractive currency because of the strong financial institutions in and economic power of the United States. (Yes, I am assuming the current financial crisis will ultimately make the U.S. financial system stronger.) Any thoughts?

1 comment:

  1. There is hope for the U.S. to remain a first world economic power iff. the trade imbalance is corrected and taxes are raised to pay for adequate instructure (schools,healthcare, factories). Presently, we we buy so much and sell so little that the exploding trade imbalance is recycled through Tokyo and Beijing to pay for the exploding budget deficit. If the U.S. continues its misplaced belief in free trade, as advocated by the extremists of the Chicago School of Economics, and fails to impose trade taxes for the purpose of rebuliding lost manufacturing capacity, then there is no hope whatsoever. Jane Jacobs got it right, Milton Friedman and his comrades got it totally wrong. See my forthcoming article in Int. Rev. Fin. An. "Nonstationarity of Efficient Finance Markets: FX Market Evolution from Stability to Instability".