Twenty Dollars in my Pocket...

Barry Eichengreen: ExorbitantPrivilege- The Rise and Fall of the Dollar and the Future of the InternationalMonetary System 

First non-fiction book finished during my summer holidays. Great read.

Eichengreen offers a comprehensive account of how the USD came to be the world reserve currency, i.e. the currency in which the largest share of the world's trade is being done and, relatedly, which makes up the biggest chunk of central banks' reserves.

A first chapter covers the time period from the USD's creation in the 18th century up to the great depression that began in 1929. In the second half of the 19th century, the British pound had increasingly become the world's reserve currency. Trade acceptances- papers showing that an exporter would receive payment for goods that he had already shipped and which banks would buy from the exporter- were mainly denominated in pounds. The reasons behind this were a well-developed, liquid market for trade acceptances in the UK, a central bank which would buy securities if British banks needed cash, and a stable currency tied to gold. The market-making efforts of the newly created US Federal Reserve Bank and the shock of World War I to European economies then lead to an increasing role of USD-denominated trade acceptances in 1920s. However, the great depression’s severe effects on trade and foreign borrowing brought this first rise to prominence of the USD to a halt.

Chapter 3 describes the USD’s rise to dominance after World War II under the Bretton Woods System. Major driving factors were the US's international economic dominance, the need for USD to finance European and Asian reconstruction, as well as the US’s financial stability and its open financial markets. At the same time, there was also a lack of alternatives to the USD. Gold supplies were limited and two rather unsavory regimes, the Soviet Union and South Africa, were the main producers. Due to political or economic instability, the Franc and the UK sterling also failed to offer a credible alternative. 
However, by the end of the 1950s, a new imbalance arose in the international monetary system: The USD shortage from the immediate after war period had transformed into a situation where foreign-held USD exceeded US gold holdings, all while the US maintained its commitment to exchange USD into gold at a fixed value. This in turn gave rise to the so-called Triffin Dilemma: The US could either reduce the USD supply, which would threaten world trade and economic growth; or it could continue to provide an unlimited supply of USD, ultimately resulting in a run of foreign investors on US gold reserves. After years of negotiations, the Nixon administration gave up on the USD’s peg to gold, resulting in a system of flexible exchange rates. It still took some years for the USD’s share of the world’s reserve currencies to fall, mostly as a result over inflationary policies under the Carter administration. However, this fall reflected the devaluation of dollar assets rather than central banks actually selling USDs. The USD was weakened, but remained the world’s dominant reserve currency.

Chapter 4 traces the evolution of European monetary arrangements. The establishment of the common market very much depended on exchange rate stability between participating states. Until the late 1960s, this stability was mostly provided by pegging European currencies against the USD, which stabilized European currencies against each other. The influx of capital in the 1970s as a result of the USD's weakness began to threaten this equilibrium. In regular intervals, the question arose whether Germany would let its currency appreciate against other European currencies, or other countries such as France would devalue their currencies. There were several attempts to create a more stable exchange rate regime within Europe, based on more or less narrow exchange rate bands. Because the German Central bank refused any kind of intervention obligations or pooling of reserves, these systems were, however, prone to chronic crisis and instability, especially in the late 1970s and again in 1990. It took German reunification and a bargain of France supporting it in exchange for monetary union to bring about the Euro (1).

Chapter 5 delivers a concise and at the same time comprehensive run-down of the factors which drove the 2008 financial crisis. Eichengreen essentially identifies three clusters of explantory variables:   

• On the private sector side, banks were taking inordinate risks. At the core of the crisis were complex financial products such as collateralized debt obligations- essentially ways of repackaging often highly risky mortgage-based securities while simultaneously hiding the enormous default risk many of those mortgages carried. The growth of the wholesale money market on which banks could borrow also encouraged them to increasingly leverage themselves. Banks were increasingly confident that more complex mathematical models allowed them to monitor and control the risks in their portfolios. Finally, competition, both due to globalization and deregulation, led commercial and investment banks to take on substantial risks to make profits.
• On the governmental side, regulators largely viewed derivatives markets as efficient mechanisms to manage risks. Risk-taking by banks was also encouraged as the US Fed had created the impression that it would not allow asset prizes to collapse. The Fed also kept its interest rates low after the 2001 economic crisis, which further encouraged risk-taking by financial investors. Finally, there was general confidence in the Fed having mastered the business cycle and having reduced the volatility of financial markets.
• Internationally, foreign government purchases of US treasury and agency securities also contributed to low interest rates, resulting in even more risk-taking by banks.

In a sixth chapter, Eichengreen discusses why the USD remained the world’s reserve currency even after the financial crisis of 2008.

• A first reason is the USD’s incumbency advantage. Exporters want to invoice transactions in the same currency as other exporters do, as this limits price fluctuations in comparison to their competitors. This continues to cement the USD’s dominance in the foreign exchange market. Central banks also want to maintain reserves in the currency in which most foreign trade is being invoiced. Morever, more countries have their currency pegged to the USD than to any other currency; pegging to the USD also helps those countries maintain stable exchange rates to each other.
• Second, central banks also prefer to have liquidity in their reserve instruments: they prefer US treasury bonds which can be easily bought and sold without their price level being affected. The depth and liquidity of the markets for U.S. securities remains unmatched.
• Third, there continues to be a lack of alternatives to the USD as a reserve asset. The Euro, the closest competitor, continues to suffer from the absence of a Euro area government. The Renmimbi is not fully convertible. It is mostly of use for buying goods from China, but not for central banks that want to intervene in foreign exchange markets or countries that want to finance imports from other countries. Special Drawing Rights are currently not traded in private markets, which limits their usefulness for central banks wanting to intervene in foreign exchange markets (3). Finally, gold, timber etc. must also first be converted into currency to be used for interventions in financial markets or to finance imports.

In a final chapter, Eichengreen discusses possible scenarios that may lead to the demise of the USD as the world’s reserve currency. He first debunks a scenario in which China would attack the USD by dumping the enormous amount of U.S. securities it has accumulated onto the market. Under such a scenario, China would, first of all, have to accept that the largest share of its own reserve assets loses its value and, second, that the competitiveness of its exports is endangered by a significant appreciation of the Renmimbi (4). A more realistic scenario would see an investor run on the USD due to burgeoning budget deficits. Overall, however, Eichengreen assesses as most likely a future in which the USD will, due to the US’s relative economic decline, lose importance in comparison to the EUR and the renmimbi, but still remain the world’s dominant reserve currency.

Overall, a great, informative, and accessible book, well-suited both for the beach and an advanced undergrad or postgraduate class on political economy. Must read for anybody interested in an informed discussion of the future of the world’s financial order. The chapter on the financial crisis of 2008 seems one of the most accessible and comprehensive accounts I have read. And no, before some smartass brings this up again, SDRs won’t be replacing the USD any time soon, just like Esperanto won't be replacing English....

Eichengreen also does a great job in bringing economic history to life, by giving descriptions of the key players involved. Not sure whether I really needed to know that Helmut Kohl sent more than 2000 love letters to his first wife, but these kind of details add to the pleasure of reading the book.

Perhaps the best book on economic history and political economy I have read during the last years, with my other favorite, Thomas Oatley’s International Political Economy, being an academic textbook . I also found Reinhart and Rogoff book on financial crises over the last eight centuries fascinating, but it is a much, much drier read than Eichengreen offers.

Random movie reference:

The advantages and disadvantages of being the reserve currency... the trillion dollar note. 

(1): Eichengreen also reflects on the discussion in the 1990s on whether the Eurozone should be inclusive of Southern European states or whether it should be limited to Germany and its stability-minded neighbors. In the end, the inclusive solution was chosen due to the desire to include Luxemburg into the Euro. While itself fiscally healthy, Luxemburg was in a currency union with Belgium, whose debt profile was much closer to the average Southern European state than to Germany. Including Belgium meant there was no excuse to exclude the PIGS from the Euro.

(2): SDRs were first introduced in 1969. They are not a currency by themselves, but represent a claim to currency held by IMF members. SDR arebased on a basket of key international currencies determined by the IMF everyfive years.

(3): Setting up a market for private or government-issued SDR would also not be easy. Any first-moving seller would have to be compensate potential buyers for not being able to trade SDR denominated products in deep markets (given that these markets do not exist, yet).

(4): Daniel Drezner makes a related argument in a 2009 piece in International Security.