Wednesday, September 24, 2008
Don't assume the euro will displace the dollar
A combination of negative real interest rates and an exploding budget deficit as the US government takes on the "bad" assets of the banking system looks awful for the dollar. If the worst has yet to happen, it is because the crisis-driven homing instinct of Americans has led to substantial repatriation of overseas investments. There is nonetheless a groundswell of comment about the viability of a reserve currency attached to a broken financial system, a persistent current account deficit and a fiscal nightmare. With the euro taking a growing chunk of official reserves, and panic in the air, is dollar hegemony at an end? In the extreme circumstances now prevailing, nothing can be ruled out. But if sterling's history is any guide, it is risky to forecast the instant demise of a reserve currency. For while the US outgrew the UK economy from the 1870s, it took two world wars, a botched return to the gold standard and a subsequent devaluation, before the dollar definitively replaced sterling in 1945. There are good reasons for the protracted lag, not least the incumbency advantage stemming from network effects. Because everyone now uses the dollar it offers a degree of liquidity and acceptability that others cannot match until such time as the US makes so great a hash of policy that these benefits are outweighed by costs. Maybe the latest financial crisis will do the trick, but I doubt it. The first reason, forcefully advanced by Adam Posen, of the Peterson Institute for International Economics, is that the dollar's status is not purely about economics. For many countries security considerations are paramount. It seems inconceivable that Japan, Korea, Taiwan or Saudi Arabia would wish to junk the dollar given their current security relationships with the US. How far China sees its huge dollar reserves as a potential foreign policy weapon is unclear. What is clear is that the economic cost of using the weapon would be high and with reserves piling up at an annual rate of $500bn it is becoming ever higher. Charles Dumas, of Lombard Street Research, estimates that China makes 1-2 per cent on its (largely) dollar reserves. It then loses up to 10 per cent on the exchange rate and suffers a Chinese inflation rate of 6 per cent for a total real return in yuan of about minus 15 per cent. That is a loss of $270bn a year, or a stunning 7-8 per cent of gross domestic product. How long this can continue is moot. Yet interdependence on this scale means that selling dollar reserves would be an economic catastrophe. Diversifying new flows would make more sense and would not finish the dollar. To return to the analogy with sterling, the euro is not the only candidate to displace the dollar. Those who like to extrapolate China's current growth rate could argue that the shift of power to Asia will ultimately turn the yuan into a reserve currency. In the very long term there may be something in this, but I am suspicious of mechanistic extrapolations. And, would an undemocratic developing country command sufficient confidence for its currency to achieve such status? The euro is another matter. Inside and outside Europe it has been a notable success and it has taken a growing share of foreign exchange reserves at the dollar's expense. Yet those who expect the euro to dethrone the dollar before long are taking much about the integrity of monetary union for granted. This is because the pressures of adjustment to internal divergence as the euro soars will be exceptionally difficult to handle. The north-south divide in the eurozone in terms of relative unit labour costs requires a huge effort by the south, and Italy in particular, to address a serious loss of competitiveness. Countries such as Spain are also struggling with cyclical problems arising from the divergence in real interest rates in Europe. Before assuming the euro will topple the dollar, you have to be utterly confident that these problems will be well managed. I am not.