Saturday, August 13, 2011

S&P and Exorbitant Privilege

. Saturday, August 13, 2011

Layna Mosley, one of my professors here at UNC, has a guest-post at the Monkey Cage on the sovereign debt downgrade. I'm not going to excerpt much as it's worth reading in full, but I want to highlight a few things. First:

[O]n the basis of just its fiscal statistics, the U.S. would have been under pressure to accept an IMF program long ago. Of course, there are many differences between the US and the typical IMF borrower; the broader point is that the US can’t necessarily expect its “special” status vis-à-vis markets to persist indefinitely.

I think the "many differences" part is really key here, as Layna gets to a bit further down:

In the U.S. case, the fact remains that Treasury securities are a favored “flight to safety” instrument for investors worldwide. When risk acceptance and global liquidity is high, investors look for high-risk, high-return assets – equity offerings in emerging or frontier markets, for instance. But when risk aversion is high, investors seek out safe havens. Treasury bonds have long been such a haven, both for domestic and foreign investors. Many holders of U.S. government securities are official entities (such as foreign central banks), while others are private investors.

What other options do these safety-seeking investors have? There’s the Swiss franc. And there’s gold. Both have experienced surges in prices that come from the search for safe investments. But where else might investors go? Certainly not into euro-denominated instruments, given the continuing crisis in the euro-zone. And probably not into renminbi-denominated instruments; for all of the speculation that the dollar’s “exorbitant privilege” is reaching its end, don’t expect it just yet.

The US is different from other countries that might go on to a IMF program in a lot of ways, but most importantly because it can create the most important store of value in the world, and it can do so whenever it pleases. Ireland, for example, cannot. Neither can Greece or Thailand or Malaysia or even Japan. Gold is limited by quantity, which is why prices are through the roof. Swiss francs are limited by the small size of the Swiss economy and its lack of centrality in the global economic system. The dollar is not only the most-used and most-traded currency in the world, it is also embedded in the global economy in ways that other currencies are not.

The graph above was constructed with BIS data. (Just ignore the isolates like "OtherEMS" and "FRF", which aren't actually in the currency system anymore; I was too lazy to take them out before making the graph.) Node size represents the % of total global currency exchange in a country's currency, and tie thickness represents the (bilateral) size of currency exchange between two currencies. The US is obviously the most central node and is also the largest by far; Swiss francs ("CHF") are much smaller and only has ties to Europe and the US. For the rest of the world shifting out of dollars into the Swiss franc isn't even really an option. For that matter, neither is the euro or yen. Only the US dollar has a truly global reach.

Network externalities can be very powerful. If everyone in the world is using dollars as a medium of exchange, it makes sense for you to use dollars as a medium of exchange. And if you use dollars, then your trading partners and counterparty investors benefit from using dollars. This effect reinforces itself as it spreads through the international economic system. Self-reinforcing patterns are path-dependent in complex networks; it usually takes the destruction of the entire system to reverse them.

And since the US is the only country that can create dollars, it has a very important capability that countries on IMF programs do not: the ability to service its debts with paper, with a strong presumption that it will not be punished for doing so as long as network dynamics remain self-reinforcing. So far the lesson from the S&P downgrade is that those externalities are not only still in effect, but are intensifying.

In other words, the US's peers are not Greece and Ireland, or the countries involved in the 1990s Asian flu. The US's peers are not even France and Germany, which are large industrial countries but do not control the printing press. Nor even Japan, which is sustaining a debt/GDP of nearly 200%. The US has no peers, and this shows up in the bond market data (to be discussed in a future post).

Several times in her post Layna explicitly or implicitly references Barry Eichengreen, who has written a lot on capital, debt, and currency. In a recent column, Eichengreen argues two things. First, that the argument of his recent book Exorbitant Privilege is essentially wrong: the global currency system will not move to a USD/euro condominium in the near term, because "a pox has been cast on both their houses". Second, that there are no other viable alternatives in the form of national currencies -- he explicitly mentions the Swiss franc, Canadian dollar, Chinese RMB, and Australian dollar as being insufficient, despite being the main contenders -- and international baskets like the IMF's SDRs suffer from a lack of liquidity and over-exposure to the USD and euro. So he suggests moving to global GDP-indexed bonds. But this ignores politics. If Europe can't even issue Euro-bonds, and if SDRs are unattractive for a number of reasons, why should we think that a global effort will be more successful?

So I agree with Layna: the era of "exorbitant privilege" is not only not over, but this crisis has seemingly reinforced it. You don't hear much talk about "decoupling" these days.


Emmanuel said...

This post is confusing. You use foreign exchange data to try and explain capital market movements.

The dollar isn't the Treasury market. Moreover, using FX data to explain continued demand for greenbacks is a really bad idea since, the last I checked, the dollar was plumbing all-time lows on indices maintained by the Fed.

It isn't just Swiss francs and Japanese yen that folks want but pretty much anything else other than dollars.

If this ain't the case, then I'm a true believer in "strong dollar" policy.

S&P and Exorbitant Privilege
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