by Joseph Joyce
The Continuing Dominance of the Dollar: A Review of Cohen’s “Currency Power”
Every year I choose a book that deals with an important aspect of globalization, and award it the Globalization Book of the Year, also known as the “Globie.” Unfortunately, there is no cash prize to go along with it, so recognition is the sole award. Previous winners can be found hereand here.
The winner of this year’s award is Currency Power: Understanding Monetary Rivalry by Benjamin J. Cohen of the University of California: Santa Barbara. The book deals with an issue that is widely-discussed but poorly-understood: the status of the dollar as what Cohen calls the “top currency.” The book’s appearance is quite timely, in view of the many warnings that China’s currency, the renminbi (RMB), is about to replace the dollar (see, for example, here).
Cohen proposes a pyramid taxonomy of currencies. On the top is the “top currency,” and in the modern era only the pound and dollar have achieved that status. The next level is occupied by “patrician currencies,” which are used for cross-border purposes but have not been universally adopted. This category includes the euro and yen, and most likely in the near future the RMB. Further down the pyramid are “elite currencies” with some international role such as the British pound and the Swiss franc, and then “plebeian currencies” that are used only for domestic purposes in their issuing countries. Below these are “permeated currencies” which face competition in their own country of issuance from foreign monies that are seen as more stable, “quasi-currencies” that have a legal status in their own country but little actual usage, and finally at the base of the pyramid are “pseudo-currencies” that exist in name only.
Cohen points out that not too long ago the euro was seen a competitor for the dollar as a “top currency.” The euro’s share of the publicly known currency composition of central banks’ foreign exchange reserves has fluctuated around 25% in the last decade, and its share of the international banking market is higher. But Cohen believes that the relative position of the euro may have peaked due to its inability to devise a way to deal with fiscal imbalances among members of the Eurozone.
Cohen compares the Eurozone’s institutional framework with that of the U.S., which adopted a common currency early in its history. The U.S. system includes fiscal transfers (“automatic stabilizers”) between the federal government and the states but no bailout of a state government in fiscal distress, accompanied by balanced budget restrictions in most states. The European Union’s (EU) Stability and Growth Pact put a limit on the budget deficits of its members and their debt, and was followed by the European Fiscal Compact that mandates balanced budget regulations in national laws. But resistance to the EU’s oversight of national budgets has been widespread. Moreover, the European Stability Mechanism, the EU’s instrument to assist members in financial crisis, is still a work in progress, as the lack of resolution of the Greek debt crisis demonstrates. While the size of the Eurozone ensures the wide usage of the euro and a role as a “patrician currency,” the inability of its member governments to decide on how to handle fiscal governance ensures that it will never rival the dollar.
China does not face the problem of unruly national governments, although the finances of local governments are shaky. The RMB has become more widely used in international commerce, not a surprising development in view of the rise of China as a global trading nation. The IMF is considering the inclusion of the RMB with dollars, euros, pounds and yen in the basket of currencies that comprise the IMF’s own unit of value, the Special Drawing Right. The Chinese government sees the upgrade in the status of the RMB as a confirmation of that country’s ascent in economic status.
But Cohen cautions against interpreting the increasing use of the RMB in trade as a precursor to the widespread adoption of the RMB as a global currency. He points out that there are private functions as well as official roles of an international currency, including its use for foreign exchange trading and financial investments. The RMB is not widely used for financial transactions, in part due to barriers to the foreign acquisition of Chinese securities, while the size of Chinese financial markets, while growing, is limited. Eswar Prasad and Lei Ye of Cornell reported in 2012 that “China still comes up short when it comes to the key dimensions of financial market development, and financial system weaknesses are likely to impede its steps to heighten the currency’s international role.”
Moreover, the government’s response this summer to the volatility in its stock markets was seen as heavy-handed. Cohen questions whether the Chinese government is willing to relinquish its control of the financial sector, despite its desire to promote the international use of the RMB. Capital flight would be a threat to stability and a sign of the government’s loss of legitimacy.
Cohen concludes his insightful analysis with a prediction that “Well into the foreseeable future, the greenback will remain supreme.” The U.S. currency continues to have widespread usage for many purposes. But any sort of triumphalism would be short-sighted. A recent working paper by Robert N McCauley, Patrick McGuire and Vladyslav Sushko of the Bank for International Settlements estimated the amount of dollar-denominated credit outside the U.S. at about $9 trillion. A rise in the cost of borrowing in dollars will be passed on to the foreign borrowers, which will further slow down their economies. The decision in September of the Federal Open Market Committee to delay raising interest rates reflected its concern about the global economy, which complicates its ability to use monetary policy for domestic goals. The U.S. can not ignore the feedback between the international roles of the dollar and its own economic welfare. Great responsibility comes with great power.
cross posted with Capital Ebbs and Flows