When Currency
Empires Fall
Professor Avinash
Persaud
12 October, 2004
(We warmly
welcome Professor Persaud as a contributor to 321gold :)
The United
States today, as Britain before, has benefited greatly from having
the world's reserve currency as its local currency. This has
allowed America to spend 22% more than its income over the past
five years. No other country could do that but having the reserve
currency means you can write checks and nobody cashes them.
But reserve currencies come and go. Over the past two and a half
thousand years there have been over a dozen reserve currencies
that no longer exist. Sterling lost its status in the first half
of the 20th century, the dollar will lose its status in the first
half of this century. The beginning of the end for the dollar
will be triggered by an inevitable decision by the Chinese to
switch from a dollar peg to a free float - sometime in the next
decade.
Losing reserve currency status will lead to a series of economic
and political crises in the United States. The world's new reserve
currency is an unlikely fellow. It is not the euro and today
it is not even convertible. You guess it.
One of the
nice things about being a currency forecaster is that expectations
of you are very low. Moderate success is greeted with great surprise.
But there are a few things which are more certain than others.
For example, at any one time, there tends to be a single dominant
currency in the financial world, not two or more, just one. Some
people believe that while the euro may not topple the dollar,
it will at least share the spoils of financial hegemony. History
suggests not. In the currency markets the spoils go to the victor,
alone, they are not shared. Either the euro succeeds internationally,
or it does not. (Which, least I anger my Europhile friends, does
not make it a failure, just not an international currency widely
accepted outside the euro-area. Many countries have credible,
stable, currencies that are not international currencies, such
as Canada, the UK, Japan and Sweden.)
The spoils of
reserve currency status
In the past, it was worth asking what the spoils were to being
an international or reserve currency. Some countries deliberately
tried to avoid their currency becoming internationalized, such
as post-war Germany. The Bundesbank felt that the more deutschemarks
were held outside of Germany, the less control they would have
over money supply and monetary conditions. European aspirations
for the euro to become the world's reserve currency are more
French than German.
Today, the spoils of reserve currency status are more clearly
visible than ever before. If your currency is a reserve currency,
you can pay for things by writing checks, which nobody cashes.
You can spend more than you earn to a far greater extent than
anyone else. This is exactly what the US has done in recent years.
In the last five years alone, US national expenditure has exceeded
national income by over 22% of GDP.
When that excess spending was due to investment in technology
in the late 1990s, it was not clear whether the US was exploiting
its status of having a reserve currency or just enjoying an investment
boom. But today that excess spending is on unproductive consumption:
tanks, bullets and pills. Few countries in the past have ever
been able to sustain a deficit on external accounts as large
as that in the United States today. And when other countries
have run sizeable deficits, they have had to pay significant
premiums to borrow the money, not as in the case of the US today,
receive a discount. These are some of the immediate advantages
of being a reserve currency.
International and reserve currency status also lends the host
country even greater influence than otherwise. One of the interesting
passages of dollar diplomacy in recent years in early 1998 when
Japan and Singapore were both generously putting up the cash
to support the east-Asian economies amid the Asian financial
crisis, the US Treasury was dictating the terms.
The network power
of computer operating systems and global currencies
There are good reasons why there is seldom more than one dominant
currency. Reserve currencies have the attributes of a natural
monopoly or in more modern parlance, a network. If it costs extra
to trade with some one who uses a different currency than you,
it makes sense for you to use the currency that most other people
use, this makes that currency yet bigger and cheaper to use.
There is a good analogy with computers. Windows is the dollar
of operating systems.
This networking power is why Central banks store dollars in their
reserves in a far greater proportion than the proportion of trade
with the US. While trade with the US represents around 30% of
all trade, central banks on average hold 70% of their reserves
in dollars. It is why most commodities, like oil, copper and
coffee are priced in dollars wherever they are found and whoever
they are sold to.
Something else we can be more certain of is that reserve currencies
come and go. They don't last forever. International currencies
in the past have included the Chinese Liang and Greek drachma,
coined in the fifth century B.C., the silver punch-marked coins
of fourth century India, the Roman denari, the Byzantine solidus
and Islamic dinar of the middle-ages, the Venetian ducato of
the Renaissance, the seventeenth century Dutch guilder and of
course, more recently, sterling and the dollar.
Size does matter
A necessary condition of a currency becoming a reserve currency
appears to be its breadth of use, and cost and ease of transaction,
not, as some might think, the ability to hold its value. Clearly
hyperinflation would not serve a reserve currency well, and there
are currencies that have become reserve currencies by virtue
of economic size, that have ended their reign through inflation.
Though cause and effect is not altogether clear in these cases,
this appears to have been the fate of the denari and the solidus
in the 12th century AD. But within the normal bands of inflation,
it is size as a trader that matters. In the long-term, the Swiss
franc and yen have been better stores of value than the dollar.
Since 1980, they have appreciated by more than 21% and 54% versus
the dollar respectively. Yet for much of this time, combined,
they have represented no more than 10% of central bank reserves.
In the 18th century Britain was the largest economy of the western
world, London was the center of international trade and finance,
the currency was convertible and so sterling became the world's
reserve currency. By the late 19th century, the US had become
the world's largest economy, a position solidified by Europe's
repeated attempt at self-annihilation from the 1880s to the 1940s.
By the 1960s, the dollar had usurped sterling and was the world's
new reserve currency with 60% of total central bank reserves
being held in dollars, twice the level of sterling reserves.
The future is
not rosy for the dollar
But
time doesn't stop. By the mid-21st century, the US will no longer
be the world's largest economy. By then, China and India will
have overtaken the US, western Europe and Japan, on purchasing
power parity terms at least, which should represent where exchange
rates are likely to be in the long-run. Indeed optimistic measures
of sustainable growth in China and India suggest this will be
the case in twenty years time. Ladies and gentlemen, within my
life time, the dollar will start to lose its reserve currency
status, not to the euro, but to the renimbi.
The process is likely to be long and drawn out, rather like sterling's
slip, slide away. Although the UK had lost its position of the
world's largest economy in the late 19th century, by 1928, it
was still the world's major reserve currency with twice as many
central bank reserves being held in sterling than in dollars.
In part this slow process was a result of the authorities trying
to delay it. Gaining reserve currency status is heaven as you
write checks and no one cashes them. Losing reserve currency
status is hell as everyone starts to cash all the checks you
ever wrote back in time. Britain's economic history and politics
for the first three quarters of the last century was dominated
by the over hang of sterling balances and the pressure on sterling
and the economy as these were liquidated.
The principal way in which Britain tried to slow the process
was through the use of imperial power and influence. By the 1930s,
sterling's reserve currency status was largely a result of sterling
balances held by the British colonies. The majority of sterling
reserves were in fact held by Ireland, India, Pakistan and Australia,
not the major economies of the time, the US, France, Germany
or Japan. In the post-war period, the British authorities formalized
the sterling area within which there were few restrictions to
trade but strict rules controlling the movement of goods and
capital into and out of the bloc. One could argue that sterling
was no longer an international currency in the sense of third
parties voluntarily choosing to use it as a vehicle currency.
However, there is no reason to suppose that the US would not
follow a new imperialism by exerting similar pressure on countries
to stick to the dollar-bloc.
Hope for the euro?
There are three further implications of this thinking. First,
those Europeans who want the euro to become the major international
currency must consider an aggressive enlargement eastwards. A
European Union which by 2025 included the former Soviet-bloc,
Turkey and North Africa could rival the dollar and remnimbi.
Second, the loss of reserve currency status for the US will bring
economic and political crisis. If it was economically and politically
painful for the UK, even though its international reserve position
was not in heavy deficit, what will it be for the US which has
become the world's largest debtor. There will be an avalanche
of checks coming home to be paid when the dollar begins to lose
its status. Of course excessive debt in your own currency is
spelt, inflation. That is the most likely outcome. This links
to my reference earlier of not knowing the cause and effect of
the denari's demise, I suspect the loss of reserve currency status
itself leads to inflation as a country tries to inflate its way
out of the sudden demand by creditors to be paid back.
The renminbi's
path
Third, if the renminbi is to become a major reserve currency
it first has to leave the dollar-bloc. This will happen later
rather than sooner. One of the other certainties in foreign exchange,
what I call the Second Rule of Foreign Exchange, is that the
smaller, more open an economy is, the more the authorities manage
the exchange rate and similarly, the larger, moiré closed
an economy is, the less the authorities care about the exchange
rate.
Policy makers perceive a trade-off, at least over the course
of the political cycle between the economic flexibility afforded
by a floating exchange rate that can respond to new and varying
circumstances and the economic disruption that a volatile exchange
rate, sensitive to external factors, factors often beyond the
control of the country, can cause. This potential disruption
is greatest the more open an economy is to international trade,
small open economies opt for inflexible exchange rates. Large
closed economies prefer to keep the flexibility of a floating
rate.
A dollar peg today,
a float tomorrow
We think of China as a vast country with a growing economy, but
in many ways it has the characteristics of a small open economy
today with the market sectors of the economy being led, driven
and dependent on international trade. Although I am not altogether
comfortable about the meaning of some of the national statistics
in a command economy, for what they are worth, they suggest that
in terms of trade as a percent of GDP, China is far more open
than the United States or Euroland, countries which pursue exchange
rate flexibility and is more akin to France, Spain and Korea,
countries which choose exchange rate management. The current
arrangement therefore is likely to persist for a while longer.
That does not mean that there will not be a revaluation of the
renmimbi shortly, it could even happen around the end of this
year, but that the Chinese will revalue the renmimbi and stick
to a pegged system, though the limits may widen a little from
the current 1.0%. But a dollar peg is not China's destiny. It
may have an open economy today, but longer-term, China will be
a large economy, driven by domestic rather than the external
sector. Then it will prefer a more flexible exchange rate. The
decision to move from a peg to a float will mark the beginning
of the end of the dollar's reserve currency status.
Conclusion
To conclude the United States today, as Britain before, has benefited
greatly from having the world's reserve currency as its local
currency. This has allowed America to spend 22% more than its
income over the past five years. No other country could do that
but having the reserve currency means you can write cheques and
nobody cashes them.
But reserve currencies come and go. They are determined largely
by whoever is the biggest economic power of the day. Over the
past two and a half thousand years there have been over a dozen
reserve currencies that no longer exist. Sterling lost its status
in the first half of the 20th century, the dollar will lose its
status in the first half of this century. The beginning of the
end for the dollar will be triggered by an inevitable decision
by the Chinese to switch from a dollar peg to a free float -
sometime in the next decade.
Losing reserve currency status will lead to a series of economic
and political crises in the United States. The world's new reserve
currency is an unlikely fellow. It is not the euro and today
it is not even convertible.
Avinash
Persaud
7 October 2004
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