Sunday, November 13, 2011

Book Review - Exorbitant Privilege: Barry Eichengreen

The USD / INR exchange rate crossed 50 recently (on the way up, just to be clear - though your macro economic intuition might be excused for imagining the opposite).  This line was last crossed in the last quarter of 2008, when I am told something really big happened in the global economy.  Certain siblings took a fall I hear ... it starts with an L, I am pretty sure of it.

Milestones like this make me curious.  So I got interested in the US Dollar, its story and its future.  There is a broadly prevalent sense of the decline of the US as a sole economic power in the world.  How does that impact the dollar, I wondered, as the world seems perversely intent on pumping more money into dollars while everything around was collapsing under the weight of problems centered in the home of the very same currency.

Barry Eichengreen is a professor of economics at Berkeley, and one of the bigger name experts on the international monetary system.  His columns also appear regularly in Mint, which is my introduction to him.  Exorbitant Privilege is his delightful book on the rise and fall of the US Dollar.  The book was published earlier this year, and has received some great reviews.
The dollar remains far and away the most important currency for invoicing and settling international transactions, including even imports and exports that do not touch US shores.  South Korea and Thailand set the prices of more than 80 percent of their trade in dollars despite the fact that only 20 percent of their exports go to American buyers.  Fully 70 percent of Australia's exports are invoiced in dollars despite the fact that fewer than 6 percent are destined for the United States.  The principal commodity exchanges quote prices in dollars.  Oil is priced in dollars.  The dollar is used in 85 percent of all foreign exchange transactions worldwide.  It accounts for nearly half of the global stock of international debt securities.  It is the form in which central banks hold ore than 60 percent of their foreign currency reserves.
In short, the dollar is a pretty big deal.  Actually, where foreign exchange matters are concerned, it is pretty much the only deal in town.

This gives the Americans some straight-forward benefits - no currency conversion costs for international transactions; no exchange rate risks in trade etc.  But there are also some other much more serious (and controversial) benefits of the dollar's international currency status, particularly in the form of a reserve currency - 
... real resources that other countries provide the United States in order to obtain our dollars.  It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries have to pony up $100 of actual goods and services in order to obtain one.
Or there is the 'artificially' lower interest rates in the US because of all the inflow of foreign reserves into US Government bonds and the like.
This has long been a sore point for foreigners, who see themselves as supporting American living standards and subsidizing American multinationals through the operation of this asymmetric financial system.  Charles de Gaulle made the issue a cause celebre in a series of presidential press conferences in the 1960s.  His finance minister, Valery Giscard d'Estaing, referred to it as America's "exorbitant privilege."
I quote this setup of the book so extensively because I for one found it simple and useful.  As a relative outsider to the world of international finance, I have only had a vague sense of the benefits the US derives from its reserve currency status.  Eichengreen does a great job of putting his financial journalist avatar to work as he lays out the argument in a very crisp and easily understandable 5 pages.  And I have to say, I found the 'exorbitant privilege' phrase delectable!

This is a very short book, taking a chapter each to explain the origin, the dominance, the emerging rivalry, the crisis, and the possible future outlook on the dollar.  The most interesting part of the dollar origin story in my mind was this little nugget:
Incumbency is thought to be a powerful advantage in international currency competition.  IT is blithely asserted that another quarter of a century, until after World War II, had to pass before the dollar displaced sterling as the dominant international unit.  But this supposed fact is not, in fact, a fact.  From a standing start in 1914, the dollar had already overtaken sterling by 1925.  This should be taken as a caution by those inclined to argue that incumbency gives the dollar formidable advantages today.
Food for thought, that. 

Eichengreen isn't one for playing to the galleries.  His views on what the future holds for the dollar can only be described as ... mainstream.  A tad boring I have to say.  No exciting, unorthodox views on what might be in store.  In broad brush-strokes, his take that the two credible rivals for the dollar are the Euro (in spite of Europe's current problems) and the Renminbi.  He discounts the currencies of UK, Switzerland and Canada for coming from countries that are presently too small on the international economic scene to be able to make any noticeable dent.  Japan, while a larger economy, still stands very little chance in Eichengreen's view, due to the many decades of governmental policy there to discourage internationalization of the Yen to retain export competitiveness.  He is not very bullish on non-currencies that can compete with the dollar, stuff he calls 'funny money' - like the IMF's Special Drawing Rights.

His short to medium term outlook on Renminbi:
Someday, perhaps, the renminbi will rival the dollar.  For the foreseeable future, however, it is hard to see how it could match the currency of what will remain a larger economy, the United States.  Regional reserve currency?  Yes.  Subsidiary reserve currency?  Yes.  But dominant reserve currency?  That is harder to imagine.
The thesis that emerges from Exorbitant Privilege is that we are moving to a world where the dollar will continue to be the dominant international currency, but will have to share the spotlight with two contenders - the Euro and the Renminbi.  The 'Exorbitant Privilege' might not remain any longer.  This will cost the US 1.5 - 2 % of their GDP in terms of additional interest expenses and international trade costs.  But things could get much worse (from the dollar's perspective) if the fiscal situation in the US doesn't get reigned in quickly.  And on this last one, he declares himself pessimistic.

If you are a sophisticated Foreign Exchange markets player, and are already aware of the nuances of international trade in some detail, you might not find anything new in Exorbitant Privilege.  If you are looking for polarizingly strong views of the sort that get page views and comments on politico-economic blogs, this is certainly NOT the book for you.  But if you are, like me, an outsider interested in a balanced view of this fascinating story of the birth, maturity and possible decline of the world's largest currency, and you want it all under 200 pages, I have a recommendation to make.

1 comment:

  1. I read sometime back on seeking alpha (Thanks to JS who introduced it to me!), about some study by McKinsey on how much of the "exorbitant privilege" that Eichengreen / Charles DeGaulle describes truly exists.

    They pointed out the issue that the country that prints the reserve currency (US) ends up having an implicitly stronger currency than other countries. Some of these countries can become cost competitive and net exporters (China). This would not hurt US if had nothing to import from them as the dollars never return (all that US did was print some paper). However, that is not the case. US has been a big time importer, maybe driven by being the reserve currency, and not only that, all these exporting countries end up depositing their profits back into US ending up increasing its debt. At some point this cycle is untenable unless US changes it ways or there is nothing else rising up to take the dollar's position. Another article on the same site mentioned that an important condition for this to happen is the occurrence of some global event (e.g. WWI, WWII). The financial crisis / EU is a possible candidate. It also noted that increase in Gold reserves by central banks across the world as a sign of reduction of faith in dollar.

    I am still trying to learn this stuff, but just wanted to mention these articles that seem relevant to this post.