Book Review of Exorbitant Privilege: The Rise and Fall of the US Dollar and the Future of the International Monetary System by Barry Eichengreen

This Book Review of the Exorbitant Privilege: The Rise and Fall of the US Dollar and the Future of the International Monetary System by Barry Eichengreen is brought to you from José Fernando Bolaños from the Titans of Investing.

Genre: Economics
Author: Barry Eichengreen
Title: Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Buy the Book)

Summary

During the Great Depression, the United Kingdom elected to preserve its financial system rather than protect the value of the pound and thereby relinquished its role as the home of the global reserve currency. In its place arose America and the U.S. Dollar which has reigned relatively unchallenged until this day.

However, within the next few decades, the U.S. Dollar’s solitary role as the world’s reserve currency seems increasingly likely to erode. One of the following may take its place: the Euro, the Renminbi, Special Drawing Rights (SDRs), gold, or some other combination of one or more of those currencies (with the U.S. Dollar.) As that change evolves, the relative power of the U.S. will be reduced; and some of the luxuries associated with sole control of the world’s reserve currency will be lost.

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When the U.S. ended the gold standard in the early 1970’s, the U.S. dollar was, obviously, no longer “as good as gold.” So what was it “as good as?” Global currencies would now generally float freely, based on relative financial and economic conditions as determined by the global marketplace and the actions of individual central banks.

As a result, the value of the world’s global reserve currency would now be based on the world’s confidence in the commitment and ability of the U.S. government and its people to manage their affairs effectively. The reason for the emerging reduction in the omnipotence of the U.S. Dollar is simple. The long-term financial condition of America is precarious. Unfortunately, America is far from alone.

While the financial condition of the U.S. is no longer ideal, its qualifications as a reserve currency remain vastly superior to its principle competition – for now. The characteristics of a legitimate reserve currency include the following: deep and properly functioning financial markets, a stable and effective government, excellent liquidity, military strength, rule of law, agricultural and energy independence, prudent regulation, the ability to both import and export effectively, a moral and ethical culture, and the confidence and respect of its trading partners. At present, while the status of America has waned in some areas, its collective qualifications far outpace its nearest competitors.

What could eventually compete with the U.S. Dollar for the role of global reserve currency?

The Euro is currently backed by an imperfect union that is solely monetary and not fiscal. Moreover, individual participants remain sovereign nations rather that a set of collective states. That collection of nations includes both fully developed and less developed economies, and widely diverse cultures.

While the Euro was established, at least partially, to provide some increased independence from the U.S., the European Union is currently in significant disarray. Its future is too uncertain, at present, to be considered seriously as the primary reserve currency.

The Renminbi remains too illiquid and is currently mostly pegged to the American currency. China also has much to do on many of the fronts that characterize a reserve currency (efficient and open financial markets, adequate rule of law and regulation, military strength, etc.) What China does appear to have, however, is a rapidly growing economy (now the second largest in the world), vast financial reserves, and a very positive balance of payments position.

Assuming these figures are accurate and that they persist, China’s ascent towards the U.S. may be rapid, and many of their issues could be resolved over the next decade or two. Today China owns, via the investment of its currency reserves, more than half of the U.S. Treasury bonds held outside of the U.S. This both links the two countries tightly and provides leverage over the U.S. as they are now a significant U.S. creditor.

Chinese officials have already stated their concerns regarding U.S. financial conditions, and have begun to somewhat diversify their currency holdings beyond the U.S. Dollar. They have also expressed their potential support for the expansion of SDRs by the year 2020, and stated their desire to develop a naval capability that rivals that of the U.S. by around 2035.

Prelude

Following World War II (WWII), the US dollar has been ubiquitous in bank accounts around the globe. The figures speak for themselves. Three quarters of all $100 dollar bills circulate outside the United States. If you add the value of those bills with the rest of U.S paper currency continuously trading hands overseas, it adds up to a stunning $500 billion.

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Even more impressive is the sum of U.S dollars held by foreign central banks: $5 trillion. Accounting for 85% of the world’s foreign exchange transactions and 60% of foreign central banks’ foreign currency reserves; the overpowering presence of the dollar is indisputable.

The reasons behind the dollar’s prominent global role were clear in the years following WWII.

Back then, the United States’ economic output accounted for more than half of that of the world’s Great Powers. America was the world’s largest importer and main source of credit, and as a result it was logical to conduct all international financial business in dollars. Today, however, the tables seem to have turned. US exports, once half of the world’s economic output, have decreased to a meager 13%.

Foreigners often criticize the United States for its exploitation of the dollar’s global dominance. Yet, as long as foreign banks value the convenience of dollar securities they will be willing to pay more to obtain them. This translates to a lower cost of debt and a higher return on the country’s foreign investments. Therefore, America is able to run an external deficit, importing more than it exports year after year, without ever becoming more indebted to the rest of the world.

The dollar’s dominance allows American households to live beyond their means because cheap foreign finance keeps U.S interest rates lower than they should be. Often referred to by many as America’s “exorbitant privilege,” this asymmetric financial system has allowed America to dominate the world stage, even as it bluntly steered the world towards one of the worst financial crises in history.

Eloquently said, Eichengreen illustrates the realities of the global financial environment: “The United States lit the fire, but foreigners were forced by the perverse structure of the system to provide the fuel”.

As a result of the financial mismanagement that led the world into a tailspin, the almighty dollar is losing its footing. In search for a replacement of the once king dollar, Barry Eichengreen walks us through a detailed economical and historical narrative of the dollar and its counterparts.

Analyzing the current global dynamic, he singles out the euro, the renminbi, and IMF Special Drawing Rights (SDRs) to be next in line in becoming the world’s main reserve currency. This brief exposes the reader to Mr. Eichengreen’s most important points. Following the same logic that he used; it depicts several possible scenarios for the future of the world’s currency markets and concludes by stating that the dollar’s role as reserve currency is not quite over yet.

Enter the Dollar

Dating back to the 18th century, the dollar was created by the forefathers of the United States and was the glue that bound together the thirteen original colonies. Since then, the dollar’s rise to power has been slow and tumultuous at times.

The greenback played no major international role when it was introduced. It did not even play a role in financing America’s own import and export trade. Britain had a well-developed banking system that, fueled by a stable pound, serviced the debt and credit of the British Empire and the rest of the world.

The role “trade acceptances” played in the international import and export markets forced U.S importers and exporters to rely on London’s banking system for trade credit. This factor alone was one of the main reasons why the dollar was not recognized as a reserve currency by the world’s major powers: Britain, France, and Germany. British banks lent with less risk and lower interest rates than their U.S counterparts because the dollar faced many obstacles.

First, current regulations in the United States did not allow US banks to branch overseas. Second, before the passage of the Federal Reserve Act in 1913, national banks were prohibited from dealing in trade credit. Third, London remained by far the most liquid market for trade acceptances. It can be said that London possessed a “first-mover advantage” being home to the world’s incumbent international currency, thus attracting governments and central banks to hold their reserves there, feeding a perpetual cycle of enhanced liquidity.

The United States faced several issues in trying to enter the international currency markets.

The country’s financial markets were volatile because the United States had no central bank to stabilize its them. As a result, the US faced fourteen financial crises before World War I (WWI). After enduring one of the worst financial crises in 1907, U.S financiers realized the need for a permanent mechanism for managing monetary problems.

Characters like Nelson Aldrich, leader of the newly established National Monetary Commission, as well as the German-born financier, Paul Warburg, among others, helped draft the Aldrich Plan which slowly made its way through congress and morphed into the Federal Reserve Act. It created a central bank responsible for regulating the supply of credit and preventing any market seizures.

Slowly, the dollar gained the confidence it deserved. It is indisputable that WWI established the United States as the factory and grainery of the world, and also transformed the country from a debtor to a creditor nation. An unstable British sterling coupled with an aggressive expansion of US banks around the globe allowed New York to challenge the once untouchable London.

In time, America was able to develop a stable trade acceptance market and with that the dollar finally assumed a meaningful international role. Not only was the dollar financing more than half of U.S imports and exports, but also Europe’s postwar reconstruction.

However, as inexperienced U.S banking institutions rushed to provide funds for reconstruction and development, more and more dubious loans were extended to the wrong parties. Very much like in the 2008 financial crisis, the majority of these loans lapsed into default, contributing to the Great Depression.

The Great Depression was devastating in many ways.

It destabilized banking systems forcing central banks to choose between stabilizing the financial system or stabilizing the currency, often times a lose/lose situation. The British sterling was the first to fall victim to this great destabilizing power. By providing banks with emergency assistance, the Bank of England signaled to investors that they were choosing to stabilize the financial system, and so the value of the sterling plunged.

Conversely, the Fed fought hard to defend the dollar, choosing to stabilize the currency as opposed to the financial system. The results were clear. Nearly 2,000 banks went under in the six months after August 1931. Although both Britain and the United States suffered great losses in the early 1930’s, the losses were overwhelmingly American.

Albeit the dollar lost its up-and-coming prominence temporarily, it was clear by this time that a changing of the guard was taking place, and the dollar had now overtaken the sterling as the leading international currency. World War II (WWII) would serve to clarify this soon enough.

Reserve Currencies No More

The dollar reigned supreme following WWII. Nearly two decades after becoming the world’s leading reserve currency, the dollar was the dominant currency in which prices were quoted, trade was invoiced, and transactions were settled worldwide. In the years following WWII the dollar was literally considered to be as good as gold seeing as the United States guaranteed gold at a fixed price of $35 an ounce.

America was now the only country who had both open financial markets and financial stability; something Germany, France, and Great Britain lacked. America’s “exorbitant privilege” as described by French finance Minister Valéry Giscard d’Estaing, was in full force as America was able to purchase goods and companies using resources conjured out of thin air through its massive balance-of-payments deficit.

Although the dollar was the dominant force behind world trade for nearly a quarter of a century following WWII, it was not alone in the world stage. The pound, for historical reasons, if nothing else, continued to be the dollar’s principal rival.

As Britain and its allies ran down their dollar reserves to procure war-time supplies from the United States they forced central banks and governments to increase their accumulated sterling balances, exceeding dollar balances by a factor of two to one. This created an illusory impression that the pound was still the leading reserve currency. The truth was that most of these reserves were being held by members of the commonwealth.

Britain was imposing strict controls, limiting the exchange of pounds for goods and more useful currencies.

Without these controls, it was a widely known fact that the value of the pound would drop substantially. This was later confirmed when the United States forced Britain to remove these controls in exchange for loans to finance reconstruction. As expected, when Britain removed the controls, more than $1 billion of Britain’s total $2.5 billion was converted from sterling into dollars. And so the idea that a convertible pound sterling might play a leading international role came to an end.

The Franc found itself in a similar situation. Although formerly known as an important reserve currency, the political and financial chaos that continuously tormented France in conjunction with the growing budget deficit that came with financing the cost of the War of Algeria in 1958 forced the French central bank to repeatedly devalue the Franc.

Germany had no balance-of-payments problems whatsoever.

The problem in Germany was more psychological than anything else. With memories of the extreme hyperinflations that occurred in Germany in the 1920’s fresh in everyone’s mind, the Bundesbank reacted to the slightest whiff of inflation in almost Pavlovian fashion.

As a result, Germany maintained stringent restrictions on purchases of money market instruments by nonresidents, all in an effort to control the attraction of foreign capital when imposing higher interest rates to curb inflation. With these restrictions went any potential attraction foreigners had to do financial business using the Deutsche Mark.

In the years after WWII, Japan resembled today’s China. Growing three times as fast as the US, it became the world’s second largest economy by the 1970’s. Yet the yen did not enjoy a place in the world’s financial markets. Like China today, Japan’s growth was fueled solely by exports. Because of this, Japan had no desire for the yen to play a significant role in international transactions.

Export-led growth required a hypercompetitive exchange rate that was only attainable if Japanese financial markets remained in an airtight compartment sealed off from the rest of the world. Allowing foreign demand for yen would most likely have put upward pressure on the exchange rate, making Japan’s exports more expensive to the rest of the world. In the 1980’s Japan sought to transform Tokyo into a financial center and cultivate an international role for the yen.

The consequences were disastrous, resulting in a massive real estate boom and bust whose after-shocks are still being felt today. Let that be a warning for Chinese policymakers, who are seeking to transform Shanghai into an international financial center and the renminbi into an international currency.

The Dollar Based System

After it became clear to everyone involved that the new international monetary system was undoubtedly dollar based, the issue became limiting the ability of the United States to manipulate the system to its advantage.

Britain led the way, suggesting a system devised by economist Maynard Keynes in which a global central bank would attempt to prevent countries from running large balance-of-payments deficits. The Keynes Plan was combined with an American led plan, devised by Harry Dexter White, which ultimately evolved into the IMF.

In the years following WWII the United States played a crucial role on the world stage.

Not only was America playing a pivotal role in the creation of the Bretton Woods Agreement; it also financed Europe and Japan’s massive capital needs through the Marshall and Dodge Plans. The Bretton Woods agreement put the United States in a peculiar position. By guaranteeing gold purchases at $35 an ounce, the United States found itself committed to provide two reserve assets at a fixed price, gold and dollars, but the supply of one was elastic and the other was not.

The fact that the stock of foreign-held dollars was larger than U.S gold holdings is referred to as the Triffin Dilemma; if the United States refused to provide dollars to other countries, trade would stagnate and growth would be stifled. But if the United States did provide an unlimited supply of dollars, lubricating growth and trade, confidence in its commitment to convert them into gold would be eroded.

Today, just like in the late 1940’s, China and India find themselves in an analogous situation in which their rapidly growing economies allow them to accumulate more dollars than they know what to do with. Then as now they worry whether these dollars will hold their value and in the case of a disorderly scramble out of dollars, they worry about the destabilization of financial markets.

The gold standard system was unsustainable and in 1967 the IMF was authorized to issue bookkeeping claims called Special Drawing Rights (SDRs) to supplement gold and dollar reserves.

The next few years led to the demise of the Bretton Woods agreement and the switch from a gold backed dollar to flexible and floating exchange rates in 1973. The last quarter of the 20th century witnessed an overstrong dollar continuously on the verge of collapsing in value, a disgruntled OPEC threatening to price oil in another unit, and even consideration of the idea of creating a “Substitution Account” at the IMF in which dollar reserves could be exchanged for SDRs in an orderly fashion.

It is important to recall now that the idea of a Substitution Account through which countries like China might exchange their dollars for SDRs is again in the air today. Regardless of all the talk, the dollar remained the dominant reserve currency; however, for the first time in seven decades, a serious rival was slowly coming into play.

Enter the Euro

The days where the world has had no alternative to the dollar were long gone by 1999. With the euro, Europe and the rest of the world found a new currency to hold as a reserve. Originally a political project, Europe established the euro to insulate euro zone members from the instability of the dollar.

Pushed by erratic U.S policies, France and Germany led the effort towards monetary cooperation; starting in the 1970s with the establishment of the European Monetary System and evolving into the crisis-ridden euro zone that we have come to know today. The monetary union, launched in 1999, included some of Europe’s strongest economies, such as France and Germany, but also some less stable countries such as Italy, Portugal, and Spain.

The Maastricht Treaty clearly established strict criteria for inflation, budget deficits, and debt of euro zone members.

However, Italy, Portugal, and Spain slipped through the cracks because of the danger that they would regularly depreciate their currencies and steal a competitive advantage on German and French exporters. The fact that they would run deficits and press the European Central Bank (ECB) for a more accommodating monetary policy was briefly considered but ultimately dismissed as a secondary problem.

This saddled the euro area with a set of heavily indebted members. Their deep structural problems would eventually come back to haunt the union while standing in the way of the euro and a more prominent international role. The fact that Britain refused to adopt the euro was a deep blow on the new currency’s quest to rival the dollar. However, since its inception, the euro has grown from being an intriguing alternative to the dollar to a prominent reserve currency.

The Dollar’s Demise

Nothing could threaten the reputation of the dollar more than the full-blown financial crisis that the United States experienced in 2008-2009. A currency’s stability is indispensable for exporters, importers, and investors, and the 2008 crisis did a remarkably good job in destroying the dollar’s stability.

There are those that claimed that after the crisis, the dollar’s international prominence was over. The idea that financial instruments issued by U.S institutions were as reliable as treasury bonds was shown to be false. In addition, fears that the Fed would use inflation to mitigate debt led many to lose faith in the dollar.

Yet, there were still many who believed all this dollar gloom and doom was overdone. If the dollar was able to come out of the crisis stronger than the euro and a host of other currencies, then surely it could survive anything. Defenders insisted that the dollar’s power was evident, as once again, the dollar acted as the ultimate safe haven for frightened investors around the world.

Eichengreen claims that “at the root of the crisis lay financial irregularities unchecked by adequate regulation”.

The outsourcing of the origination of mortgage contracts by banks, coupled with mortgage– backed securities (MBS) and collaterized debt obligations (CDOs), served to promote irresponsible behavior where brokers, originators, and even banks had no fiduciary responsibility to their so-called clients. The argument by investment banks that CDOs and MBS served to more efficiently separate out and shift risk to those with the right risk-bearing ability was later proven to be nothing but a smokescreen. In reality, risks were disguised and later shifted to unsuspecting, risk-averse clients.

Although investment banks were the main perpetrators of the issues stated above, Eichengreen is skeptical of rating agencies as well. Although Standard and Poor’s and Moody’s have denied that they were subject to conflict of interest, it is worth noting that these agencies would advise originators how to structure their CDOs so that they could win a AAA rating. Something that would benefit all parties involved.

The presence of credit default swaps, excessive bank leverage, and no regulation paved the way to one of the worst financial crises in history. The worldwide trend of minimizing capital and using high levels of leverage in commercial banks only added wood to the fire. Loose bank credit and documentation standards allowed brokers to move down the credit-quality spectrum in search of borrowers.

As Eichengreen describes it, this originate-and distribute model along with the perverse incentives it created was like an elaborate dance in which not all participants were fully in touch with their partners.

The lack of regulation in the complex securities market was due in large part to a political group that served under Clinton’s administration. The “President’s Working Group”, composed by Larry Summers, Robert Rubin, and former Federal Reserve chairman, Alan Greenspan claim that derivatives serve the important task of re-distributing risk. In doing so, they vehemently declared war on Brooksley Born, former head of the Commodity Futures and Trading Commission, who attempted to introduce regulation for the derivative markets.

The presence of elegant mathematical models, such as the Black-Scholes model, also played a major role in the stirrings of the crisis.

By providing investors with a false sense of security through quantifiable measurements of risk through the Value at Risk (VaR) model and other complex mathematical formulae, banks became confident of their ability to shoulder risk.

Not only did these models provide false confidence for institutions to take on more risk, but they also encouraged regulators to let them. In the wake of the crisis, investors forgot some valuable lessons. The fact that models are littered with simplifying assumptions and that periods of rapid financial innovation are often seedbeds for crisis never crossed the minds of investors or regulators alike.

Eichengreen’s list of contributors to the financial crisis is expansive. Increased competition among commercial and investment banks due to the introduction of the Glass-Steagall Act prompted investment bankers to move into riskier activities with more and more leverage. Flawed regulation by the Fed also played a part, encouraging banks to take on more risk as they incorrectly believed America had a healthy and stable economy.

As the dollar’s reputation hit an all-time low after the crisis many people wondered what would happen to its international role. Mass migration to other currencies was entirely plausible as many worried an indebted U.S. government would resort to inflation to work down the debt burden.

Many wondered why the dollar should continue to be the world’s reserve currency when it no longer accounted for a majority of the world’s industrial production. As the world economy becomes more multipolar, its monetary system should similarly become more multipolar.

By this reasoning, the dollar will need to share its international role. However, the facts do not follow the aforementioned logic. According to the IMF, official foreign reserve holdings have only marginally decreased from 66% in 2003 to 61% in 2010. Several reasons account for this gap between rhetoric and reality.

The fact that the United States still possesses the world’s largest economy, as well as the largest financial market, encourages many to continue using the dollar. More importantly, the dollar’s flaws are insignificant compared to the shortcomings of all other candidates for international currency status.

“So long as Europe lacks the political will to create an emergency financing mechanism and, more generally, to put in place the other policies needed to complete its monetary union, the euro’s economic attractions as an alternative to the dollar will remain limited.” – Barry Eichengreen

Alternatives

The Euro, as it has already been discussed, is the biggest rival to the dollar. With its strong economy and disciplined central bank, the euro zone is poised for success. Playing against it is its potential for growth. With several southern European countries struggling with fiscal consolidation and a demographically challenged population, experts argue Europe will have trouble fostering future growth. This worries euro proponents because a stagnant population usually translates into a stagnant economy – welcome to the new Japan.

The main problem with the euro is not slow growth; ultimately, the problem is that the euro is a currency without a state. The lack of a euro-area government means it is difficult to help governments with financial problems or force them to take steps that are good for the union but not their own national interest.

The inability of the European Commission to enforce the Stability and Growth Pact, which is intended to limit budget deficits, is a perfect example.

When Europe develops economic and financial problems, cooperation among several governments and ratification from a host of national parliaments is necessary before any action can be taken. This slow-moving political machine forces investors and central banks to be cautious when adopting the euro.

Fear that euro governments will not act quickly enough to prevent financial fallout keeps many from putting their eggs in the euro basket. The recent financial crisis in Greece can attest to how sluggish the ECB and the rest of the euro zone are when prompt action is required.

Historically, the world’s leading international currency has been issued by the leading international power. The leading power also has the strategic and military capacity to shape international relations and institutions to support its currency.

This is not the case with Europe, but it is slowly becoming the case with China. In 2010, China was estimated to control nearly half of all U.S treasuries in the hands of official foreign owners. With sixty-five percent of China’s $2.5 trillion of reserves in dollar-denominated assets, it is a widely known fact that if China attempts to sell U.S treasury securities in quantities sufficient to significantly alter the composition of its reserve portfolio, prices would tank.

Then, the dollar would depreciate significantly making U.S imports of Chinese goods more expensive, thus harming an export-oriented China. Because of these reasons, China will more than likely adjust its reserve portfolio gradually and inconspicuously, simultaneously assuring the dollar’s prominence for the time being.

China is currently looking for a solution to this problem.

The issues in holding a dollar-heavy reserve portfolio have been clear to Chinese officials for some time. Since 2009 China’s central bank argues that the IMF’s SDRs should eventually replace the dollar as the world’s reserve currency. It may have taken forty-five years, but here is proof that history repeats itself, as once again SDRs are being considered as a possible replacement to the dollar.

It is easy to see why SDRs are an appealing idea. They could address the need for balance-of-payments insurance, and in effect in effect eliminate the exorbitant privilege enjoyed by the United States.

Although SDRs appear to be a viable solution there is much work to be done. In order to be considered attractive by central banks, SDRs must be used to settle a significant fraction of trade. In order to do so, a deep and liquid market for SDRs must be created.

The banking industry would have to be completely changed; banks would be required to lend and borrow in SDRs, and governments and corporations would need to buy and sell SDR-denominated bonds. Banks reject this idea because it is currently impossible to hedge the risk of SDR-denominated deposits on forward markets.

The responsibility for creating a liquid market in SDR claims should naturally fall to those who would stand to benefit the most if SDRs gain reserve-currency status.

China should take the lead, issuing its own SDR denominated government bonds, providing investors with an interest-rate premium to make up for the additional risk that comes from the inherent lack of liquidity in the market. China should see this as an investment in a more stable international system.

For the SDR to become a global currency, the IMF would need to play the role of a global central bank and provider of liquidity. How SDRs will be allocated and how the IMF will be held accountable are both questions that need to be answered before we even begin to consider the idea
of a global currency. As of today, taking into consideration the fact that SDRs are not liquid or readily used in market transactions, it is difficult to imagine the SDR replacing national currencies in central bank reserves.

“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.” – Barry Eichengreen

China has another ace under its sleeve: establishing the renminbi as an international currency. If this were to happen, China would be freed of having to hold foreign currencies to smooth its balance of payments or aid domestic firms with cross-border obligations. Chinese officials have indicated that the renminbi could become an international currency by 2020; much has to be done before then.

In an effort to insulate the Chinese economy from capital flow volatility as well as manipulating capital markets, China imposes strict restrictions on who can convert their currency. In doing so, they limit their currency’s international use. For the renminbi to play a major role in the world’s currency markets China must put in place major financial reforms that will liberalize markets, making them more liquid and transparent in the process.

China must move away from its pegged exchange rate and current growth model, however, based on the government’s actions during the 2008 crisis, it is clear that China still considers sustaining exports by pegging their currency to the dollar as paramount to their future success.

Chinese policy makers appear serious about their claims to establish the renminbi as a dominant reserve currency. There are plans to transform Shanghai into an international financial center by 2020 and the government now allows private companies to issue renminbi-denominated bonds offshore.

Nevertheless, serious challenges will need to be faced in the next few years in order to achieve the stated goal. By 2020, China’s economy will only be half of that of the United States at market exchange rates, meaning that the renminbi will still have a smaller platform than the dollar from which to launch its international career.

Several other options are being considered as a replacement to the almighty greenback.

Gold has come and gone throughout history, yet there are still those who believe it remains the obvious solution to many of our woes. The fact remains that gold is inconvenient. Plain and simple, how many foreign companies are inclined to accept gold as they are a dollar-denominated check?

Inconvenient as it is, China and India have both been adding gold to their reserves. The problem for China is that it pushes down the value of the dollar as it sells it to purchase more gold. Real assets such as timber acreage, oil reserves, and refineries are also an option. Liquidity poses the biggest challenge to this strategy. Central banks and other investors who value liquidity cannot expect to sell their assets quickly enough in a time of crisis.

After considering all the options- the euro, SDRs, renminbis, even gold and real assets- the world finds itself without a clear heir to the dollar. They do however, leave us an alternative: a prospect of multiple international currencies that could share the role of reserve currency king.

The sheer size of the twenty- first century world economy means that there is room for more than one reserve currency. The dollar will remain first among equals. The euro, in time, will sort out its issues and the renminbi will continue to play an increasingly larger role as China’s markets mature and become more transparent.

In this not-so-distant future the dollar will compete against these newfound rivals. Experts expect it to fare well unless the dollar finds itself in an economic disaster of the first order. Although farfetched, there are several ways this could happen.

It is not difficult to imagine political conflict between the United States and China that would prompt China to flex its muscles and utilize its immense foreign reserves as a way to coax the United States into submission.

Foreign policy experts point out that a Sino-American conflict, although plausible, would be a race to the bottom for all parties involved. If China was to begin dumping its U.S government securities, the bond market would come spiraling down, interest rates would spike, and the dollar would crater.

In doing so, China would be inflicting significant financial damage on itself, since it would be pushing down the value of its dollar assets. The United States would not go down without a fight, a new wave of protectionist measures would hit China where it hurts the most; its export market. In short, China would hesitate to begin such a conflict with such large potential for damage not only on itself but on the entire world economy.

A sudden shift in market sentiment towards the dollar could most likely trigger a dollar crash.

America is its own worst enemy when it comes to this. Dangerous economic policies leading to an unsustainable budget deficit could spook investors, leading them to liquidate their positions while at the same time forcing the dollar to collapse. Three key aspects related to U.S budgetary policy will dictate the ultimate fate of the dollar.

First is the deterioration in the fiscal position prior to the financial crisis. Tax cuts from 2001 and 2003 pushed the budget into a structural deficit, and now the interest that has to be paid will only worsen the deficit. Second, many worry that America will have trouble reversing the enormous deficits that came about because of the crisis.

The 2009 and 2010 deficits were larger than the national income of all but six other countries in the world, and whether America can reverse these is dubious at best. Third, the upcoming wave of baby boomers that will be retiring in the next few years will put even more pressure on the budget as they raise the already unsustainable health and pension costs America has to deal with.

Experts worry because many believe America’s growth potential has been permanently damaged by the crisis. This is especially worrisome when U.S debt is expected to rise from 40 percent to 75 percent of GDP by 2015. Considering that America’s tax revenues are only 19 percent of GDP, one can see why many would lose faith in the dollar. [U.S. debt is already 90% of GDP, and tax revenues have fallen to 14 percent.]

Eichengreen warns that these events will develop not gradually but abruptly.

The United States will find itself in a crisis similar to the one Europe experienced in 2010, but magnified. The only way to avert this gloom and doom future is through a combination of tax increases and expenditure cuts. Undeniably, restoring fiscal balance will require dealing with entitlements. Pension costs will have to be limited in some way or another and the government might need to find additional sources of revenue.

This will be especially hard with a GOP unconditionally opposed to all new taxes, and a Democratic president who campaigned on a promise not to raise taxes on the middle class. At the end of the day though, it is important to remember that although the dollar’s prospects may be bleak, they might not be as bleak as the prospects of other currencies. Europe and Japan both have heavier debt burdens than the U.S, so maybe the dollar has a fighting chance after all.

As the world’s investors and central banks transition from dollar-heavy portfolios to multipolar dollar, euro, and renminbi portfolios, the United States will have to adjust. The Fed will have to abandon its traditional focus on inflation and employment growth to include the exchange rate among its objectives.

America will have to tighten its belt. Gone will be the days when we could consume and invest a trillion dollars more than we produce each year simply because central banks and foreign investors have a “thing” for dollars that require the United States no real resources to supply. America’s exorbitant privilege will be no more. Trade deficits will have to be cut, and exports will have to increase.

But the news is not all bad. Many argue that a weaker dollar does not necessarily mean a threat to American living standards. On the contrary, a weaker dollar that is no longer propped up by foreign investors will allow American manufacturing to become more competitive. With a weaker dollar, the United States will produce more manufactured goods, meaning there will be more jobs available. In doing so, problems such as the income inequality trend that has been seen in the United States during the last decade will be reversed.

What many do not realize is that a weaker dollar does not only affect America’s pocketbook. A weaker dollar will make it more difficult for the United States to project strategic influence in pursuit of foreign policy goals. Essentially, devalued dollars are less capable of buying the cooperation of foreign governments.

But a devalued dollar is not the only culprit for a decrease in U.S strategic leverage. The fact is that U.S geopolitical might is just as dependent on a strong dollar as it is on the nation’s economic and fiscal health. With this, we have come full circle; the same fundamental factors that rendered the U.S dollar less dominant financially are the ones rendering the United States less dominant geopolitically.

At the end of the day though, the news is good. The dollar is losing its clout because the world is growing more multipolar. The only way the greenback will lose its power is if there is a crash, and the only way the dollar will crash is if we bring it upon ourselves.

The solution then, lies not in finding a new reserve currency, but in accepting that the world needs to prepare for a time in which several international currencies will rule the world’s financial markets. Gone will be the days in which everyone, no matter what language they speak, has a dollar in their back pocket. Perhaps in the near future, villains will carry briefcases full of yuan and Somali pirates will start asking for ransom money in SDRs.

HookedtoBooks.com would like to thank the Titans of Investing for allowing us to publish this content. Titans is a student organization founded by Britt Harris. Learn more about the organization and the man behind it by clicking either of these links.

Britt always taught us Titans that Wisdom is Cheap, and principal can find treasure troves of the good stuff in books. We hope only will also express their thanks to the Titans if the book review brought wisdom into their lives.

This post has been slightly edited to promote search engine accessibility.

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