Friday, November 18, 2011

Review: Exorbitant Privilege

. Friday, November 18, 2011

I read Barry Eichengreen's Exorbitant Privilege last night, whose subject is found in the subtitle "the Rise and Fall of the Dollar and the Future of the International Monetary System". From this, one might expect the bulk of the book to be a current discussion of the imminent fall of the dollar as the world's reserve currency, as well as predictions regarding what sort of system will replace it. This expectation is not well met.

As always, Eichengreen does best when he sticks to a narrative of economic history. There are two predominant strands here: chapters two and three, tracing the origins of the US as an international currency, from before the Revolutionary War until the collapse of the Bretton Woods system of fixed exchange rates in the 1970s; and chapter four, which recounts the series of economic and monetary integration regimes in Europe that culminated in the introduction of the European monetary union in 1999. Those two histories make up roughly the first two-thirds of this short book, the rest of which is dedicated to a discussion of the subprime crisis and other contemporary events.

The problem with the book is that there is no conceptual frame shaping Eichengreen's discussion. From the subtitle and many of the chapter titles (the euro's "Rivalry" with the dollar; the greenback's "Monopoly No More"; the specter of a "Dollar Crash") you might expect Eichengreen to be pessimistic about the future role of the dollar in the international monetary system. In the introduction Eichengreen sets the book up in this way, arguing on page 6 that "The conventional wisdom about the historical processes resulting in the current state of affairs – that incumbency is an overwhelming advantage in the competition for reserve currency status – is wrong". But the core of the book actually makes the opposite case: the role of the dollar as the pre-eminent global currency is likely to remain for the foreseeable future, both because of the attributes of the US as the world's largest economy, and because of the deficiencies of the only conceivable challengers.

Concerning the latter, Eichengreen spends the majority of the time on the EU. He also discusses Japan (no desire for the yen to be a reserve currency), China (no capability for the yuan to be without major reforms which would likely be destabilizing), other currencies like the Brazilian real and Indian rupee (not big enough, or global enough, economies or financial systems), and the IMF "special drawing rights" (SDRs, which among other criticisms are only used as accounting devices, and are not accepted by any private actors as a medium of exchange), but dismisses them in short order. He dedicates a long chapter to European postwar monetary history, some of which may be interesting to those approaching this subject for the first time, but all of which has been dealt with in more detail, and with more theoretical and empirical care, elsewhere.

Without making too much of a case, Eichengreen seems to suggest that the subprime crisis may be a catalyst for a shift in the global monetary architecture. His discussion of the crisis is not strong, either as a standalone discussion or as a means of linking it to the potential for a change in the global reserve currency. For example, near the beginning of this chapter he claims "At the root of the crisis lay financial irregularities unchecked by adequate regulation" (p. 98). At this point most observers acknowledge that this was the manifestation of the crisis, perhaps even the proximate cause, but not the root cause. Eichengreen seems to understand this a bit later on, when he discussions macroeconomic imbalances in the global system, the global savings glut, the US domestic political economy that led to low national savings and persistent budget deficits, loose Fed policy and the "Greenspan put", etc. All of these are deeper causes than the inability of banks or regulators to judge the extent of risk embedded in asset-backed securities, which, in this context, appear to be more leaf than root.

The end of Eichengreen's discussion of the crisis leads him to marvel that the strength of the dollar was reinforced as a result of the crisis, not weakened. This may also surprise a reader not already aware of this phenomenon, since all of the book until that point has set the stage for a rapid move away from the dollar following a crisis, similar in speed and precedent to the rise of the dollar in the immediate aftermath of World War I. The rest of the book is dedicated to a discussion of why that is unlikely to happen.

As a part of that explication Eichengreen reverses what he wrote earlier about the incumbency advantage. In the first chapter he wrote that arguing that the status quo is durable precisely because it is the status quo is "wrong". But later, on pages 124-126, he argues that the "advantage of incumbency" is "not to be dismissed". Then he hedges again, writing of China on p. 146:

That said, Chinese policymakers are serious about transforming Shanghai into an international financial center by 2020. Doing so will require deeper and more liquid markets. It will require liberalizing the access of foreign investors to those markets, which in turn imply other changes in the country's tried-and-true growth model. Liberalizing the access of foreign investors to China's financial markets will in turn require a more flexible exchange rate to accommodate a larger volume of capital inflows and outflows. While these are not changes that can occur overnight, it is worth recalling how the United States moved in less than 10 ears from a position where the dollar played no international role to one where it was the leading international currency. There is precedent, in other words, for the schedule that the Chinese authorities aspire to meet.
This should lead us to a comparison of the the world in the 2010s to that of the 1910s, and the relative positions of the US and China within those worlds. In the earlier period the largest economy (the US) was not the issuer of the global reserve currency as it is now. Despite that, it took at least one World War, and the subsequent collapse of the global economy during the interwar period, for the dollar to supplant the pound sterling. To reach undisputed dollar pre-eminence took another World War. The rapid shift in the dollar was therefore a consequence of the rapid shifts in the organization of global security and economic apparatus. As bad as the subprime crisis has been, it has not been anywhere near that scale.

Perhaps because Eichengreen does not have a clear conceptual framework with which to make sense of his history, his views about the future are wishy-washy: the "fall of the dollar" mentioned in the subtitle is not inevitable, nor even likely; then again, the rise of the dollar was rapid, and China's economic rise is rapid, so who knows?

A better approach, I think, would be to try to understand monetary dynamics in a network context. Eichengreen considers this briefly, in footnote 50 on page 151, only to dismiss it just as briefly. This is a shame. If he better understood network dynamics he might not write things like this, from page 8:
There may have been only one country with sufficiently deep financial markets in the second half of the twentieth century, but not because this exclusivity is an intrinsic feature of the global financial system.
But what if it is? What if the distribution of financial liquidity is power-law distributed? What if this introduces scale-free dynamics into the global financial network? This would imply that there is only room for one reserve currency at a time, and that currency is likely to remain in place until there is such a large shock that the network itself is destroyed, at which point a new network is constructed with a new currency at the center of it.

Such a shock occurred from 1914-1945. It has not occurred since, which is why the dollar's pre-eminence has survived less-major shocks like the collapse of Bretton Woods, the rise of emerging market economies, the monetary unification of Europe, the end of the Cold War, and the subprime crisis. Such a history might lead us to expect more stasis than change in the coming years, barring a systemic collapse on a level not seen since the interwar period.

Eichengreen does not spend much time in this short book on theoretical explanations for the nature of the global monetary system, instead choosing to trace several historical developments. This is fine, but it leaves us with more description than explanation, and so teaches us little about what to expect from the future.


Review: Exorbitant Privilege
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