We know the credit crisis is a clear and present threat to the global economy. But its most important long term legacy may not be economic, but geopolitical.
I was reminded of that possibility when reading a recent trenchant analysis by Professors Menzie Chinn at the University of Wisconsin and Jeffrey Frankel of Harvard. They ran a simulation showing that the euro would replace the dollar as the world’s largest reserve currency within the next 10 or 15 years. Their analysis is not based on this crisis. But this crisis could easily accelerate the trends they have identified.
Don’t dismiss this research as some anti-dollar propaganda. Professors Chinn and Frankel actually started with the opposite notion – that the euro would not overtake the dollar for a long time. After all, the world doesn’t change reserve currencies very often.
Sterling held pole position until the second world war, but lost it because of the UK’s imperial overreach. The US economy had already overtaken that of the UK in the 1870s. One of the factors that delayed the dollar’s rise was lack of a sophisticated financial sector, which did not develop until the establishment of the Federal Reserve System in 1913. Global reserve currency status is due to many factors such as the size of the economy, the country’s share in international trade and the depth of the financial markets. Inertia is another. If yours is a global reserve currency today, it is likely to be one tomorrow too. But this works only up to a point – a tipping point.
Professors Chinn and Frankel state two underlying reasons for the decline in the international role of the US dollar. The first is persistent current account deficits combined with a long-term decline in the dollar’s exchange rate – and perhaps imperial overreach, too. The second is the emergence of a genuine alternative to the dollar. Neither the yen nor the D-Mark never had a realistic chance of replacing the dollar. But the euro is a real alternative. The eurozone economy is almost as large as that of the US, and realistically may surpass it as it continues to enlarge. London is the eurozone’s de facto financial center, despite the fact that the UK itself has not adopted the euro. Also, the eurozone bond markets are now almost as deep and liquid as their US counterparts. As of this past week, arguably more so – even if that differential is a fleeting phenomenon.
The projected speed at which the dollar will lose its predominant position as a global reserve currency obviously depends on prevailing assumptions. The work of Professors Chinn and Frankel shows that this could happen shockingly fast. Some of those trends are accelerating right now. The (previously) reckless monetary policy of the Federal Reserve has accelerated the dollar’s decline and caused a rise in inflationary expectations. It could be reasonable to expect US inflation to pick up significantly once the present recession ends. Future inflation will weigh heavily on the global role of the US dollar.
An immediate consequence of high inflation is that many developing countries will find it harder to maintain their dollar pegs. They may be reluctant to drop them now but there will come a point when the rise in inflationary pressures becomes unbearable. If and when they drop their pegs, they will almost certainly rebalance their reserve portfolios as well.
Another factor that pushes in the same direction is the weakening of the US financial sector in general. This has been a crisis of Anglo Saxon transaction based capitalism. Not so long ago, it was considered to be vastly superior to the eurozone’s “old fashioned” relationship finance. I have some doubt that, in a few years’ time, people will continue to assess the relative strengths of the Anglo Saxon and continental European financial systems in quite the same way. I would also expect the eurozone economy to withstand the economic shocks of the credit crisis in relatively better shape.
Inertia means that the euro will not overtake the dollar any time soon. At present the euro only accounts for a little over a quarter of world reserves according to a survey conducted by the International Monetary Fund, against the dollar’s share of two-thirds. But to keep the euro down forever, you would need to rely on some rather far-fetched conspiracy theories. One such theory says that foreign central banks collude to hang on to dollars to protect the value of their holdings. It just doesn’t work that way. The network externalities that have favored the dollar in the past could just as easily favor the euro in the future.
The potential geopolitical implications of such a projected shift are immense. For a start, the US will lose its exorbitant privilege – the ability to achieve permanently higher returns on foreign assets than the returns paid to foreign investors who take positions in the US. The dollar will suddenly cease to be “our currency, and your problem”. Influence in international financial institutions will wane. Losing the dollar as the world’s leading international currency not only leads to a loss of political power. It constitutes loss of aggregate power. That in turn profoundly changes the dynamics of global actors on the international relations stage.
There is little politicians can do to prevent such a seismic shift. I suspect the US political establishment is not yet aware of what is going to hit it. Then again, the same can be said of European political leaders, who have not given any hint yet that they are ready to deal with the responsibilities that come with running the world’s leading currency. There however, is a train of thought for another day, and another article.
