Wednesday, 6 April 2011

Exorbitant privilege - Why the US dollar will no longer be the global currency

By Neil McCulloch

Barry Eichengreen is a soft spoken man. But as one of the world’s leading authorities on the international monetary system, it is worth straining to hear what he has to say. The week before last I listened to him present at the London School of Economics (LSE) the key ideas behind his new book - Exorbitant Privilege: the Rise and Fall of the Dollar.

As the title suggests, he has some controversial ideas. His bottom line was two clear messages:
  1. In 10 years time, the US dollar will no longer dominate as the world’s global currency – the position will be shared between three currencies, the US$, the Euro, and the Renminbi (the Chinese currency).
  2. This is a good thing.
The US$ is now by far the most dominant global currency – 85% of all foreign exchange transactions in the world involve the US$ and 61% of reserves are held in dollars. The idea that, in as short a period as 10 years, this ‘Exorbitant Privilege’ might be eroded is therefore quite shocking. Eichengreen argues that this will happen for three reasons.
  • First, the political stalemate in the USA has made effective measures to tackle the US’s huge structural deficit almost impossible. As a result investors are already getting nervous that the value of the dollar will fall and are beginning to put their money elsewhere.
  • Second, Eichengreen has a surprisingly upbeat view for the Euro. He believes that exit from the Euro would be a catastrophe for Greece, Ireland, Portugal or any other currently troubled economy. They therefore have no choice but to stay.
  • Third, the Chinese are committed to making the Renminbi an international currency by 2020. Of course this will involve huge reforms – commercialisation of the banking sector; removing links with State Owned Enterprises, flexible exchange rates and so forth. But Eichengreen argues that this can be done just as the US$ took over from the £ Sterling in the 10 years from 1914 to 1924.
So what does all this mean? Eichengreen argues that a tri-polar world could be a good thing. It would bring market discipline to the fiscal and monetary policies of the three blocs, particularly the US, discouraging the inflation of enormous bubbles such as the one that precipitated the most recent financial crisis.

But there are risks. The part that I found least convincing was his confidence in the future of the Euro. As the Economist has been repeatedly arguing, the periphery of Europe is broke. The right solution to this is to recognise it and allow an orderly and substantial reduction of these sovereign debts. But the politics of Europe makes this difficult. It seems just as likely that further political turmoil from the heavy costs of adjustment being experienced by these countries might result in the exit of at least one from the Euro. This would create huge uncertainty and undoubtedly weaken the position of the Euro as a global currency.

Interestingly, Eichengreen takes a different view. His most serious concern is with the US. If the political stasis in the US prevents it from addressing its yawning structural deficit, there could be a flight from the dollar and a much more rapid shift to other currencies. Will the markets wait for an orderly transition to a tri-polar world? As Eichengreen puts it 'we have 10 years to get this right, but history shows that financial crises happen roughly once every three years!'.

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