Eichengreen on the Dollar

At Project Syndicate, Barry Eichengreen sees some interesting similarities between today's debates over the dollar's global role and those of the 1960's, when the Bretton Woods system was nearing its collapse:

In 1964, it was the rapidly growing economies of Europe, still catching up to the US, that were howling about the Federal Reserve. As a result of a recklessly expansionary American policy, they argued, they were being flooded with imported finance. The US was “exporting inflation.”

American officials countered that the financial inflows reflected Europe’s underdeveloped capital markets. Europe’s inflation problem was a byproduct of its central banks’ reluctance to tighten policy more aggressively, and European countries’ hesitancy to let their currencies rise, reflecting their long-standing commitment to export-led growth.

The effort to replace the dollar with IMF "Special Drawing Rights" (SDRs) ultimately failed, and no agreement was reached on achieving greater flexibility within the context of the Bretton Woods system:

The other focus of negotiations in the 1960’s was an effort to enhance exchange-rate flexibility. Proposals to this effect – a response to the emergence of chronic surpluses in Germany and Italy, and chronic deficits in the US – attracted growing attention once the SDR negotiations sputtered to a close in 1968.

But, with other countries having enjoyed two decades of export-led growth as a result of pegging their currencies to the dollar, there was a reluctance to mess with success. While the IMF, in a high-profile report on exchange rates in mid-1970, endorsed the principle of greater flexibility, it offered no new ideas for getting countries to move in this direction and proposed no new sanctions against countries that resisted. International imbalances continued to mount until the system came crashing down in 1971-1973.

A crucial difference between then and today's informal "Bretton Woods II" system is that the dollar is no longer linked to gold, and, therefore the US no longer has to worry about a drain on its gold reserves.  President Nixon ended the original Bretton Woods system in August 1971 with the announcement that the US would no longer redeem dollars for gold at the request of foreign governments (US citizens had lost their ability to exchange dollars for gold in 1933).

This means the "system" doesn't come to an end when the US pulls the plug, but when the surplus countries decide to stop holding and accumulating dollars.  There are really two issues: (i) the composition of official reserves - i.e., what currency they are denominated in (ii) and the level of reserves - whether surplus countries continue to intervene sell their own currencies in exchange for reserves to prevent appreciation.

In terms of the composition of reserves, writing at Vox, the prolific Prof. Eichengreen explains that there is no plausible alternative to the dollar.  The euro isn't looking so great right now, of course, and, as for the others:

There are of course a variety of smaller economies whose currencies are likely to be attractive to foreign investors, both public and private, from the Canadian loonie and Australian dollar to the Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are too small for their currencies to ever play more than a modest role in international portfolios.

Brazilian and Indian markets are potentially larger. But these countries worry about what significant foreign purchases of their securities would mean for their export competitiveness. They worry about the implications of foreign capital inflows for inflation and asset bubbles. India therefore retains capital controls which limit the access of foreign investors to its markets, in turn limiting the attractiveness of its currency for international use. Brazil meanwhile has tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have moved in the same direction.

China is in the same boat. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. Yet this has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. Nor has it prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use.

So the dollar is here to stay, more likely than not, if only for want of an alternative.

Flawed as they are, Eichengreen notes, the alternatives will look more attractive if US policies severely undermine confidence in the dollar.  Not raising the debt ceiling, for example, would do the trick (and it appears the Republicans' business backers may be forcing some sense into them on this one).  As Eichengreen has it, a form of Spiderman's motto applies: "with exorbitant priviledge comes exorbitant responsibility."