Exorbitant Privilege: The Rise and Fall of the Dollar [Hardcover]

Charles Feinstein and Michael Bordo might come close, but nobody has a deeper understanding of 20th century finance than Barry Eichengreen. Unlike his peers, who tend to compile loosely connected essays on parts of the story, Eichengreen briskly tells the complete story of banking, currency and finance since its early days. This has two distinct benefits. First, the narrative's pace prohibits him from dwelling on early forms of currency, which bog down a lot of books like this, and no description of the recent financial crisis is more concise. Second, by limiting word count on anachronistic or (by now) clichéd history, he has space to include valuable insight on, for example, the Fed's early days or the significance of 1950s decolonization, all of which helps to illuminate a century of international exchange rate evolution. It reaches no valuable conclusion about the dollar, so the choice of title feels a bit rushed, but it will whet your appetite to keep looking. Money, like language, is a means of exchange. Incumbency, or usage, matters. Perhaps an expert in linguistics is what we need to take this further.

The U.S. benefits from an "exorbitant privilege" by having the dollar as the world's dominant currency.

The first benefit is convenience. Since dollars are so widely accepted, American individuals and firms need not go through the cost and inconvenience of changing their dollars into foreign currency. Secondly, the Fed can print dollars costlessly; whereas, foreign central banks have to expend real resources to gain dollar reserves -- allowing the U.S. to consume more than it produces.

Since the recent financial crisis more people have been questioning the dollar's role as the world's reserve currency. However, this is by no means the first time such questions have been asked. Similar questions were asked in the 1970s during the collapse of the Bretton Woods agreement, but the dollar's dominance continued unabated.

The dollar wasn't always the world's reserve currency: before that it was the pound. It took a very long time from the U.S. overtaking the U.K. economically -- roughly the period between the two world wars -- for the dollar to eventually overtake the pound. This is because the incumbent currency has clear advantages -- benefits such as more liquid markets and a greater coordination amongst third-parties -- that the rival currency has to overtake sufficiently to give enough people incentive to switch. This means that talk of the dollar's death is very much premature.

Eichengreen looks at the merits at two of the dollar's most prominent rivals: the euro and the renminbi. The euro is currently suffering, and although it covers a large economic area, it suffers doubly from not being under the control of a single government. The euro will have to digest these issues before it could become the world's premier currency. The renminbi has its own problems: the Chinese govenment's policies of strict capital controls and a cheap currency to boost exports aren't concordant with the requirements for the world's reserve currency.

Another floated alternative is for a new world reserve currency, along the lines of Keynes's "bancor" or an expansion of the IMF's program of Special Drawing Rights. These proposals, however, suffer from their own intractabilities.

Eichengreen's conclusion: don't write off the dollar yet, unless the U.S. presses the self-destruct button.

The author provides an interesting discussion about the rise and the fall of the U.S. dollar in an historical context. The dollar became a power bill only after WWII even though United Sates was the largest economy around 1880. When Europe and Japan was in ruins after WWII, the U.S. dollar gained global attention and became the currency of the world's banks; the kind of cash accepted worldwide. It is an economic consequence of a widespread international use of the U.S. dollar that confers on its issuer the geopolitical and strategic leverage, namely its strong financial position and leadership in foreign policy decisions. Because it pays less on its debts, it is better able to finance foreign operations and exert strategic influence. It does not depend on other people's money. Instead, it has leverage over other countries that depend on its currency. In the 19th century, when Britain colonized half the world, the sterling pound dominated international financial markets, with the post-World War II period, when sterling lost its dominance and the United States, not Britain, called the foreign-policy shots. But what made sense then makes less sense now, when both China and Germany export more than the United States. Today the U.S. share of global exports is only 13 percent. The United States is the source of less than 20 percent of foreign direct investment down from nearly 85 percent between 1945 and 1980. These two changes are both manifestations of the same fact: the United States is less dominant economically than 50 years ago. This fact reflects the progress of other economies, first Europe, then Japan, and then China and India.

But today, in the wake of the most serious financial crisis in 80 years, a crisis is born and bred in the United States, there is again widespread criticism of America's exorbitant privilege, other countries question whether the United States dollar should have been permitted to run current account deficits approaching 6 percentage of GDP in the run-up to the crisis. Emerging markets complain that as their economies expanded and their central banks felt compelled to augment their dollar reserves, they were obliged to provide cheap finance for the U.S. external deficit. With cheap foreign finance keeping U.S. interest rates low and enabling American households to live beyond their means, poor households in the developing world ended up subsidizing rich ones in the United States. The cheap finance that other countries provided the U.S. in order to obtain the dollars needed to back an expanding volume of international transactions underwrote the practices that culminated in the crisis. The United Sates lit the fire, but foreigners were forced to provide the fuel. If this was not injustice enough, there is the fact that America's international financial position was actually strengthened by the crisis. In the course of 2007 the dollar weakened by about eight percent on the foreign exchange market. But since American debts are denominated in American currency, there was no impact on their dollar value, In contrast, American foreign investments, whether in bonds or factories, became more valuable as the dollar fell, and the interest and dividends were more when converted back into dollars. Then in 2008, in the worst of financial crisis in 80 years, the U.S. govern¬ment was able to borrow vast sums at low interest rates because foreigners fig¬ured that the dollar was the safest currency to be in at a time of great turmoil. But in the spring of 2010, when financial volatility spiked, investors fled into the most liquid market, that for U.S, treasury bonds, pushing down the cost of borrowing for the U.S. government and along with it, the mortgage interest rates available to American households: this is what exorbitant privi¬lege is all about.

The author points out that it is not the exchange rate or the net foreign investment that plays a role in dollar's strength, but it is the general health of the U.S. economy that matters. Whether the dollar rises or falls will matter much less for U.S. strategic influence than whether U.S. economic growth averages 2 or 4 percent per annum over the next decade. Hence the likely scenario for a dollar crash is one in which brought about by poor American economy. Consequently the fate of the dollar is in American hands and not those of Chinese.