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“Exorbitant Privilege:” The Future of the US Dollar

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Michael Crittenden and Barry Eichengreen had a fascinating debate over the future of the US dollar in last week’s edition of the Wall Street JournalCrittenden avers that the dollar, despite talk to the contrary, will remain the global reserve currency because nothing presents itself as a legitimate alternative to the dollar at this point.  However, the US will experience diminishing returns for the status of the dollar.  On the contrary, Eichengreen posits that the US dollar will lose its global reserve status due to long-term deficits and competition from China’s renminbi and the Euro.

Publicly questioning the global reserve status of the US dollar has become a trendy way to check US power for many political leaders.  Crittenden notes, “French President Nicolas Sarkozy is expected to make the issue a priority for France’s presidency of the Group of 20 meetings this year, and even U.S. officials have acknowledged that a rethink of the dollar-centric world is inevitable.”  Sarkozy is not the first French president to question the US dollar’s global role.  Charles de Gaulle famously referred to the US dollar’s favored status as “exorbitant privilege,” threatening to exchange France’s entire dollar reserves for gold bullion on multiple occasions.

Three possibilities present themselves in this debate over the future of the US dollar: a single currency overtakes the US dollar as the global reserve currency; multiple countries vie for influence in a multi-polar system where currencies dominate by region; and, a supranational or global currency.  Let us examine these possibilities in order.

The first scenario is the most parsimonious, and hence the most plausible.  Yet, it suffers not from a theoretical lacuna but an empirical one: what is the viable alternative to the US dollar? Which countries are positioned to challenge the US dollar’s cherished reserve status? Only two possibilities present themselves as counterweights to the US dollar: China and the Eurozone.

The ostensible strength and viability of the Euro was far different in 2009, than, say, in 2011.  The passing of just a little time can make a world of difference.  Europe is engulfed in a maelstrom of economic problems from rapid inflation (i.e., United Kingdom) to a full-blown sovereign debt crisis.  Greece and Ireland accepted bailout money; bailouts of Spain, Portugal, Belgium, and Italy are in the offing, according to some economists.  All Eurozone central banks are cross-parties to one another; they hold vast amounts of one another’s sovereign debt.  The future of the Euro may depend on the appetite for bailouts by democratic publics and the bailout capabilities of Germany and France, specifically.

It is perhaps not surprising that the Euro is experiencing a precipitous decline.  After all, the Eurozone never satisfied Nobel Laureate Robert Mundell’s conditions for an “Optimum Currency Area (OCA).”  Mundell argues that monetary union is the last stage of economic integration.  For instance, Optimum Currency Areas have similar business cycles; similar openness with capital mobility and price/wage flexibility across the region; similar labor mobility across the region; and a risk sharing system that cooperates and coordinates policy in response to adverse effects in the aforementioned categories.  Needless to say, Europe fell well short of Mundell’s stringent criteria for monetary union.

Those who argue in favor of the Chinese Yuan have a large burden of proof.  Beijing has so far stymied repeated US-efforts at monetary reform.  China is adept at resisting international pressure to allow the value of its currency to rise.  Crittenden also notes that it has a very underdeveloped financial system (most of it is state-owned).  Indeed, it is hard to imagine the Chinese currency playing any role as the world reserve currency until it undertakes drastic monetary reform—namely, allowing a floating exchange rate no longer pegged to the US dollar.

The second scenario, a multi-polar world dominated by regional currencies, is hard to imagine because rapidly developing nations like China, India, and Brazil would doubtless play a large role in any multi-polar monetary regime.  Yet, these nations are clearly not ready to lend their currencies to reserve status, because each uses monetary policy as an integral part of its own domestic growth policies, and none has proven the long-term stability of their currency system (and hence garnered the trust of investors).  The Euro’s troubles no longer make it attractive either.  It is also dubious whether multi-polar monetary regimes would increase efficiency.  Therefore, absent a world shock in the confidence of the US dollar—not a scenario that is totally out of the realm of possibility—regional currency formations will likely fail to gain traction.

The third scenario, a supranational or global currency is nearly impossible.  Many experts reject the idea of a supranational or global currency.  It is also dubious whether financial markets would trust such a scenario, judging by their lukewarm reaction to the International Monetary Fund’s Special Drawing Rights, which could serve as a proxy for a global currency.  What is more, setting international monetary policy in a quick or unified manner would necessitate a global governance structure on a scale hitherto unprecedented (the United Nations system would not even come close).  The amount of cooperation and coordination for such an endeavor is merely insurmountable at this time.  The Eurozone’s struggle in devising timely policy responses and coordination in the sovereign debt crisis serves as a case-in-point—and this is only a microcosm of the problems a structure of global financial governance would engender.

In sum, the US dollar is likely to remain the world reserve currency, at least in the short and medium term.  The US may experience diminishing returns from such status, but the three scenarios highlighted above are all highly doubtful.  To be sure, the US faces many deep and mounting problems, from the world’s largest trade imbalance with China to structurally unsustainable amounts of government debt.  However, despite the US-origins of the recent financial crisis, central banks and investors fled to the dollar during precipitous portions of the crisis.  Indeed, “The dollar’s supremacy during such a disruptive period demonstrates its resiliency,” Crittenden argues.  Thus, despite murmurings and political pushes to the contrary, de Gaulle’s “exorbitant privilege” will remain in the hands of Americans for some time to come.


2 Responses

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  1. Ryan’s piece is excellent goes but leaves out a number of factors.

    The first and most important is that for 40 years the world has been on a dollar standard, meaning nations had to acquire huge quantities of dollars in reserve to back up their own currencies. A side effect of this arrangement has been the hollowing out of the US manufacturing base as other nations had to sell to America to get dollars, buying little in return, but otherwise the system worked well as long as the dollar was stable as it was from early Reagan until late Clinton.

    The reason the world is squawking now is because the US has pursued a weak dollar policy since 2001, attempting to beggar its neighbors with a cheaper exchange rate. As a result, gold in dollars has risen from $250 to more than $1400, signaling a major devaluation. This, in turn, has led other nations to lower their currencies, creating significant commodity inflation across the globe and even food-based revolts. The 1970s saw similar revolts for similar reasons.

    Any how, the falling dollar has not only destabilized world prices and trade relations — who will make a ten-year trade investment between Europe and the US under such conditions? — it has devalued national reserves. A ten percent fall in the dollar costs China $300 billion. This is why leaders from China, South Korea, France, Russia, Brazil and even World Bank President Robert Zoellick (a closet supply-sider, I think) have all complained about the dollar, and why there’s talk of replacing it. The US, in its mad dash to lower the dollar, is screwing — and screwing up –the world, big time. It can’t act like this forever without provoking a revolt or system-wide breakdown.

    Another point: Mundell designed and implemented the euro, and defends it vigorously to this day. I don’t think he would agree that Europe was insufficiently integrated to be a common currency area. He is pushing for Asia to go under a common currency next, which is surely even less harmonized. As he sees it, so what? Why not make the world a common currency zone? Discretionary national monetary policy is a license for Keynesian mischief and creates unnecessary barriers to trade.

    Moreover, Mundell has been a big advisor to China on its dollar peg. Earlier this decade China did let the yuan rise by 30 percent against the dollar. Did this impact the trade deficit? Not obviously: it rose even faster during this period. However, once the dollar’s fall/volatility became apparent, China repegged, lest it be swamped. Without dollar stability, asking China to float its currency is a tall order.

    Anyhow, this exchange rate chess is bad economics. In the 1970s the US tried to lower the dollar’s exchange rate to boost exports. The result? Devaluation and inflation, offsetting the exchange rate advantage. Meanwhile, huge sums of national wealth were destroyed or redistributed.

    Currency is a veil. You can’t change the fundamental terms of trade by altering its value.

    Sean R

    March 15, 2011 at 10:44 pm

  2. Thanks for this response, Sean. Indeed, I think part of the strength of the argument that the world will remain on a dollar standard, at least for the near future, is the issue of profound path dependency. What would countries do with their vast amounts of dollar reserves if the world abandoned the dollar? This is a key question.

    I think it is great that you mentioned the hollowing out of the manufacturing sector and the rise in gold prices over the last 10 years. I’m really surprised more investors have not been flocking to gold with the “Bernanke-copter” constantly hovering and dropping free cash (it’s no wonder the Fed discontinued printing M3 in March 2006–sheer embarrassment over its rise, although total money supply is easily calculated using MZM, as well as M2). There seems to be a calculated media bias against those advocating a return to gold, either for investments or as the base of a monetary system (“gold bugs” such as yourself). Financial programs bring analysts advocating gold onto their shows merely to be punching bags, as it were, for less heterodox economists (mostly Keynesians).

    “Discretionary national monetary policy is a license for Keynesian mischief and creates unnecessary barriers to trade.” Very true. “Asymmetric monetary policy” is one of the most dangerous trends of the past 30 years, with Fed Chairman often operating (purportedly) under supply-side or monetarist ideologies while tipping their hat to Keynesian “demand management” and slashing rates any time there is even a hint or rumor of recession.

    On Mundell: I think one of the great ironies of his advocating for the Euro is how loosely (in my opinion) the Eurozone fit his rigid criteria for monetary union. I think these chickens are coming home to roost now. Moreover, if Asia, or the world, were to adopt a unified currency, how will this be governed? I wonder what he thinks about the Gulf Cooperative Council’s (GCC) murmurings that they will also experiment with a unified currency zone? Does Mundell argue that Asia has the necessary institutions to stabilize a system should something in the European vein happen? What about the world? This is seriously dubious. My point about world currency was the lack of a requisite monetary structure/global financial governance system needed to police free-riders, prevent sovereign debt crises, stabilize currencies, inter alia.


    March 17, 2011 at 6:41 pm

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