A new book examines the world’s love-hate relationship with the dollar - Mar 08, 2014
“LUMPY, unpredictable, potentially large”: that was how Tim Geithner, then
head of the New York Federal Reserve, described the need for dollars in
emerging economies in the dark days of October 2008, according to transcripts
of a Fed meeting released last month. To help smooth out those lumps, the Fed
offered to “swap” currencies with four favoured central banks, as far off as
South Korea and Singapore. They could exchange their own money for dollars at
the prevailing exchange rate (on condition that they later swap them back again
at the same rate). Why did the Fed decide to reach so far beyond its shores? It
worried that stress in a financially connected emerging economy could
eventually hurt America. But Mr Geithner also hinted at another motive. “The
privilege of being the reserve currency of the world comes with some burdens,”
That privilege is the subject of a new book, “The Dollar Trap”, by Eswar
Prasad of Cornell University, who shares the world’s ambivalence towards the
currency. The 2008 financial crisis might have been expected to erode the
dollar’s global prominence. Instead, he argues, it cemented it. America’s
fragility was, paradoxically, a source of strength for its currency.
In this section
The once and future currency
In the last four months of 2008 America attracted net capital inflows of
half a trillion dollars. The dollar was a haven in tumultuous times, even when
the tumult originated in America itself. The crisis also “shattered
conventional views” about the adequate level of foreign-exchange reserves,
prompting emerging economies with large dollar hoards to hoard even more.
Finally, America’s slump forced the Fed to ease monetary policy dramatically.
In response, central banks in emerging economies bought dollars to stop their
own currencies rising too fast.
Could Fed swap lines serve as a less costly alternative to rampant reserve
accumulation? If central banks could obtain dollars from the Fed whenever the
need arose, they would not need to husband their own supplies. The demand is
there: India, Indonesia, the Dominican Republic and Peru have all made
inquiries. The swap lines are good business: the Fed keeps the interest from
the foreign central bank’s loans to banks, even though the other central bank
bears the credit risk. The Fed earned 6.84% from South Korea’s first swap, for
example. But it is not a business the Fed wants to be in. As one official said,
“We’re not advertising.”
Swap lines would help emerging economies endure the dollar’s reign. But
will that reign endure? Mr Prasad thinks so. The dollar’s position is
“suboptimal but stable and self-reinforcing,” he writes. Much as Mr Prasad
finds America’s privileges distasteful, his book points to the country’s
qualifications for the job.
America is not only the world’s biggest economy, but also among the most
sophisticated. Size and sophistication do not always go together. In the 1900s
the pound was the global reserve currency and Britain’s financial system had
the widest reach. But America was the bigger economy. In the 2020s China will
probably be the world’s biggest economy, but not the most advanced.
America’s sophistication is reflected in the depth of its financial
markets. It is unusually good at creating tradeable claims on the profits and
revenues that its economy generates. In a more primitive system, these spoils
would mostly accrue to the state or tycoons; in America, they back a vast range
of financial assets.
Mr Prasad draws the obvious contrast with China and its currency, the yuan,
a “widely hyped” alternative to the dollar. China’s GDP is now over half the
size of America’s. But its debt markets are one-eighth as big, and foreigners
are permitted to own only a tiny fraction of them. China’s low
central-government debt should be a source of strength for its currency. But it
also limits the volume of financial instruments on offer.
America has a big external balance-sheet, if not an obviously strong one.
Its foreign liabilities exceed its overseas assets. But this worrying fact
conceals a saving grace: its foreign assets are unusually adventurous and
lucrative. Its liabilities, on the other hand, are largely liquid, safe and
low-yielding. America therefore earns more on its foreign assets than it pays
on its foreign liabilities.
Alongside its economic maturity, America also has a greying population.
This ageing is a source of economic weakness. But, Mr Prasad argues, it may be
another reason for the dollar’s global appeal. America’s pensioners hold a big
chunk of the government debt that is not held by foreigners. A formidable
political constituency, they will not allow the government to inflate away the
value of these claims. Thus America’s powerful pensioners serve to protect the
interests of its generous foreign creditors.
America’s sophistication has one final implication: the dollar has no long-term
tendency to strengthen. That again contrasts with its principal long-run rival.
China is still a catch-up economy. As it narrows the productivity gap with
America, its exchange rate, adjusted for inflation, will tend to rise. The yuan
has appreciated by about 35% against the dollar since mid-2005.
A self-deprecating currency
The dollar’s depreciation over that period is, of course, bad for anyone
holding American assets. But the dollar is not merely a store of value. It has
also become a popular “funding” currency. Banks and multinational firms borrow
in dollars, even as they accumulate assets in other denominations. Since no one
wants to borrow in a currency that only goes up, this is not a role that
China’s currency could easily play. Moreover, because of its role as a funding
currency, the dollar tends to strengthen in times of crisis. That explains why
emerging economies feel a “lumpy”, “unpredictable” need for dollars. America’s
currency may not hold its value against others. But in times of stress, the
appeal of a dollar asset is that it always holds its value against a dollar
debt. The dollar is a global hegemon partly because it is also a global hedge.
Mar 08, 2014