by Sara Eisen
If ever there was an important time to hear from preeminent scholars and critical voices on these difficult, but approachable, issues, it is now. I have selected a unique and diverse group of authorities to contribute their thoughts. They include economists; researchers who have spent years studying capital flows, reserves, and exchange rates; and an individual who has made a fortune actually trading currencies. Also featured are a central banker and officials of the IMF. These are strong opinion leaders and individuals who have led the debates on specific issues facing the currency market; some of them have driven public policy, and some are actively playing that role.
The world finds itself once again on the brink of major financial systemic change, the direction of which is not yet eminently clear, but which will most certainly affect almost all of us in our lifetimes. Here you can gain perspective on the leading questions that will dominate the next decade or less from experts elucidating the feasibility of various options that are under current or future consideration by world leaders. You may even become inspired to watch the world stage more actively and listen as these issues are deliberated and events unfold in the near future. That is my intent.
INTRODUCTION
BRETTON WOODS AND THE EMERGENCE OF THE U.S. DOLLAR RESERVE SYSTEM
In order to understand the current international monetary system, its challenges, and the questions about its longevity, it is important to understand how today’s framework came into being. Currencies as we know them today are fiat, which means that they are paper money, and that the paper possesses no more value than the denomination printed on it. Before a collective multinational decision made money fiat in the 1970s, paper money had been backed by gold. This international financial order, the gold exchange standard, had been established in 1944 in a pact known as the Bretton Woods Agreement, named for the scenic New Hampshire town that hosted an illustrious delegation of world leaders in July of 1944, before the end of World War II. They devised an international monetary system to provide stability to their economies for a postwar world. The Bretton Woods Agreement determined that the U.S. dollar would have value beyond that which was printed on paper, in the form of gold. A fixed amount of gold would therefore be deposited or set aside to represent the value of the U.S. dollars that were printed, and all other currencies in the world would then be pegged, or become valued, relative to the U.S. dollar. This marked the beginning of the dollar’s preeminent role in the international world order, a role that had previously been played by the British pound. Bretton Woods also laid the foundation for the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, now known as the World Bank. The IMF was created to monitor and stabilize exchange rates and lend currencies to nations with trade gaps, whereas the focus of the World Bank is lending to and aiding countries that are in need.
Historically, this was not the first period characterized by a gold standard; however, it is the most recent. By the 1960s, the United States was experiencing difficulty in maintaining its status as the issuer of the world’s reserve currency, as it was unable to provide sufficient gold to countries that were demanding it in exchange for their U.S. dollars. Moreover, world leaders recognized that as economies underwent fluctuations in growth, more flexibility in the monetary system was needed. In 1971, President Richard Nixon broke the link between gold and the dollar, marking the end of the Bretton Woods concordance and the beginning of the modern-day fiat currency system, in which the value of the dollar would be backed by nothing physical—like gold—but only by the promise of the U.S. government. It also meant that currencies would float freely, meaning that their value would be allowed to fluctuate against the value of the dollar based on the market. Thus the international reserve currency system, built around the U.S. dollar and confidence in the U.S. government, was born.
The Foreign Exchange Market
When currencies became free-floating in the 1970s, a door opened into a new international trading dimension known as the foreign exchange market. This market enables traders of all types and from all countries to exchange and invest in currencies in a forum outside of government control. The foreign exchange market is the largest and most liquid of all world markets. For that reason alone, if you didn’t know anything about it before, it’s time to learn.
A few fast facts about this unique market: it is the only market that is open for trading 24 hours every day except weekends, and to illustrate its liquidity, the volume of trading on an average daily basis was $3.98 trillion in 2010, an increase of about 20 percent over the preceding three-year period. Its emergence as the largest exchange market in so short a period has to do with the growth in high-frequency trading and the electronic revolution. This is a market with no central exchange; it is known as an over-the-counter market because traders deal directly with one another in large financial centers.
The major players who trade foreign exchange, or forex, are banks (commercial banks, investment banks, and central banks), corporations, hedge funds, and individuals. There are several reasons to trade. Banks can trade simply to make a profit. Corporations like McDonald’s, which receive a large portion of their sales from outside the United States in foreign currencies, can trade to hedge their overseas exposure, so that they’re not as vulnerable to daily fluctuations in currencies that can affect their bottom lines.
Currencies and Central Banks
Another key player in the foreign exchange market is the central banks of the world.
Central banks are responsible for the creation of currency in almost every country in the world. In the United States, this all-important regulator of monetary policy, the Federal Reserve Bank, commonly referred to as the Fed, is prominently newsworthy on a weekly, if not a daily, basis. Monetary policy is distinguished from fiscal policy, which is the domain of the president and Congress and is formulated through changes in taxes and government spending. The Fed’s directors, appointed by the president and approved by the Senate, strive to maintain high employment, stable prices, and stable interest rates. The Fed exerts its authority primarily via monetary policy, such as lowering interest rates in order to promote economic growth and supplement employment opportunities. The rationale for this policy is easy to understand; if the economy needs stimulation, lowering interest rates should encourage business growth, thus easing unemployment.
The largest central banks operating in the world today are the Fed, which has existed since 1913; the European Central Bank, which has authority over the European Monetary Union, established in 1998; and the People’s Bank of China, which has evolved into a more modern-looking central bank since 1989, when China developed a more capitalist-style export economy.
Central banks are also active players in the foreign exchange market. When currency fluctuations that are inconsistent with a nation’s economic fundamentals are seen in the market, central banks can influence the value of their nations’ currencies by intervening and buying or selling currencies. In fundamental terms, the rationale for such manipulation is that a central bank can raise or lower the value of its currency by buying or selling foreign currency in exchange for its own. Generally speaking, it is in the interest of governments to maintain a weak home currency. A weak, or less expensive, home currency boosts exports and economic growth, whereas a currency that is overly strong, or valuable, with respect to other currencies could hurt investment by raising the costs of the country’s goods. Although this causal relationship is typically reliable, the economic repercussions of a strong or weak currency remain a subject of debate.
Central banks have also intervened in the foreign exchange market to manage currencies within political and economic alliances. In September of 1985, the G-5 finance ministers, representing the five leading economies of the day (the United States, the United Kingdom, Japan, Germany, and France), met at the Plaza Hotel in New York City and established the Plaza Accord, in which they agreed to collectively manipulate their currencies through foreign exchange trans
actions in order to devalue the U.S. dollar against the Japanese yen and the German deutsche mark. The goal was to restore the United States’ competitive edge, as it had become the world’s biggest debtor nation because of the amount of goods it imported, mostly produced in Japan, relative to the amount it exported. Many other measures were taken by the two governments because of this disparity, and U.S.-Japan relations were chilly for more than a decade as a result of this trade imbalance; however, the currency intervention was effective, with the yen doubling in value against the dollar in less than two years following the accord. Of course, this led to other problems, as Japan’s economy then embarked on a downward slide.
The International Reserve System Today
The U.S. dollar has remained the world’s reserve currency. In the most basic sense, this means that most major international transactions that involve the buying and selling of goods and services utilize U.S. dollars. When India sells goods to Brazil, for example, the Brazilian real gets converted to dollars to make the transaction. Historically, this came about because there were more U.S. dollars flooding the world than any other currency. On a related note, the U.S. dollar has also remained the world’s safe haven currency. In times of economic stress, foreign governments buy U.S. Treasuries, as they feel that their money is safe if they invest it in U.S. government bonds, with the promise of yields, or interest paid on their investment over time; this phenomenon has persisted even when the rates for Treasuries have sunk to all-time lows in the summer of 2012.
An acute example of the safe haven appeal of the dollar was manifested in 2008, after the fall of Lehman Brothers, followed by the Great Recession. Currency traders unloaded holdings of foreign currencies around the globe and fled into what was perceived as the safety of the U.S. dollar. History has proven that the dominance of the dollar (being involved in fully 85 percent of the world’s currency transactions), along with the depth and enormous liquidity of the U.S. Treasuries market, have made it the safest place to invest during times of panic and stress, even when the source of the economic unrest is attributable to events occurring in the United States. But the depth and severity of the financial crisis of 2008, compounded by a changing power dynamic in developed vs. emerging economies, are raising fundamental questions about how investors, central banks, and governments view the dollar—its value, its role, and its predominance.
CHAPTER 1
THE DOLLAR WILL REMAIN ON FIRST
GARY SHILLING
“I just don’t see at this point there is a major shift away from the dollar.”
—Ben Bernanke, Federal Reserve Chairman, March 2011
“Who’s on first, What’s on second, I Don’t Know is on third,” and so it goes in Abbott and Costello’s marvelous routine that deliberately confuses baseball players’ names with questions. In the game of global reserve currencies in future decades, we need to ask, Who’s on first, Is Anyone on second, and Who Cares What’s on third? By its nature, the currency roster always requires a batting order, since no currency operates independently in the international ballpark. The dollar doesn’t stand alone, but against the euro, the yen, and even gold.
Reserve Currency Advantages
Of course, being the primary global reserve currency, the position enjoyed by the dollar since World War II, has tremendous advantages and creates a huge demand for greenbacks. Most of the world’s trade is carried out in dollars, including trade and capital transactions that have no involvement with the United States. When Brazil sells iron ore to China, the transaction is probably in U.S. dollars. When Indians make a direct investment in Thailand, dollars are the likely medium of exchange.
Demand for bucks is supplied by foreign exchange reserves, which are mostly in dollars. Recently, foreigners’ willingness, even zeal, to hold greenbacks has allowed and perhaps encouraged America to run chronic trade and current account deficits (Figure 1-1) because foreigners are happy to recycle the surplus dollars that result back into Treasuries and other U.S. investments.
Figure 1-1 U.S. Current Account and Trade Balance
(Seasonally Adjusted Quarterly Data; $ in Billions)
Source: Bureau of Economic Analysis
Washington wizards figured out decades ago that if they’re running a big budget deficit, they should also run a huge current account deficit in order to get foreigners to pay for the federal red ink with dollars that are recycled into Treasuries. This game became more crucial as U.S. households slashed their saving rate for 25 years (Figure 1-2) and supplied less and less money to fund federal deficits and business investments, while hyping household borrowing (Figure 1-3).
Figure 1-2 U.S. Personal Saving Rate
(Seasonally Adjusted Annual Rate)
Source: Bureau of Economic Analysis
Figure 1-3 Debt and Debt Service Payments as a Percentage of Disposable Personal Income
Source: Federal Reserve
$1 Trillion-Plus Deficits
Contrary to Congressional Budget Office projections, federal deficits in the $1 trillion-plus range are likely to persist if my forecast of chronic slow economic growth and chronic high unemployment is valid, and the resulting pressure on Washington to create jobs only increases. A key reason for the low 2 percent annual real GDP growth I forecast is my expectation that U.S. consumers will continue to deleverage, paying off the debts that they owe on their homes, credit cards, and other loans and pushing their saving rate back into double digits and the ratio of debt to disposable (after-tax) income back to its 65 percent norm.
This will compress the trade and current account deficits and reduce the amount of foreign-earned dollars that are recycled into federal deficit financing (assuming that foreigners continue to buy U.S. exports, since every 1 percent shortfall in consumer spending reduces our imports—the rest of the world’s exports—by 2.8 percent). At the same time, however, more consumer saving will fund much more of the chronic high federal deficits. In the third quarter of 2011, disposable personal income was $11.6 trillion, so if the household saving rate were 10 percent, $1.16 trillion in consumer saving would be available to fund federal deficits and business investments.
Down Memory Lane
Let’s take a stroll down memory lane to see what factors elevated various currencies to primary global trading and reserve status in the past. Not surprisingly, these currencies were linked to strong and sizable economies. The silver drachma issued in Athens in the fifth century BC was probably the first currency that circulated widely outside its issuer’s borders, and it followed Alexander the Great (356–323 BC) as he conquered the then-known world from Egypt to Persia. Then, as Greece faded and Rome rose to global dominance, its gold aureus and silver denarius coins dominated, even though Athenian and Roman money circulated simultaneously for years.
But as the Roman Empire faded and the related inflation galloped, continually devalued Roman coins became less and less acceptable outside the empire. This and Rome’s being overrun by Goths, Vandals, and Huns paved the way for the Byzantine Empire’s gold solidus coin to become the standard for international trade in the sixth century.
In the seventh century, when the Arabs, flush with Muslim zeal, burst out of the Arabian Peninsula and charged across North Africa, the Arabian dinar partially replaced the solidus. The solidus was being debased to cover Byzantine deficits and was no longer solid, but it still circulated internationally into the eleventh century. Nevertheless, the Arabs also had government deficit problems and gradually devalued the dinar, starting at the end of the tenth century.
Florence and Venice
The merchants and bankers of Florence—the same guys who financed the Renaissance—began to flourish in the thirteenth century, and their currency, the fiorino, was used throughout the Mediterranean in commercial transactions. However, the Venetian ducato took over in the fifteenth century after Marco Polo (1253–1324) and others opened up the land route to China, and Venice became the western terminus of the Silk Road. Alas, the Portuguese then discovere
d the much easier water route to China around the southern tip of Africa, and Venice became the tourist trap it’s been ever since while the ducato atrophied in international trade.
Global trade by water was the new technology of the seventeenth and eighteenth centuries, with the Dutch as the financial and commercial leaders, so the guilder reigned as the international currency. And paper money began to replace coins, even though it was not backed by the Dutch government. Spain, of course, controlled much of the New World after 1492, but the real de a ocho, or Spanish dollar, never really made the cut, since most of Spain’s New World gold was dissipated in financing the Spanish Armada and other military disasters. In the nineteenth century, national central banks and treasuries began to hold gold as reserves, and bills and interest-bearing deposit claims that were gold substitutes also began to be held as reserves.
At the same time, the Industrial Revolution, which began in both England and New England in the late eighteenth century, made the United Kingdom the leading exporter of manufactured goods and services, and the biggest importer of food and industrial raw materials. As a result, sterling dominated as the international reserve and trading currency, and between the 1860s and the start of World War I in 1914, 60 percent of global trade was in pounds. With the advent of the telegraph and other communications advances, sterling was increasingly used in commercial transactions between non-U.K. residents. This role was also enhanced by London’s emergence as the global leader in shipping and insurance and the center for both organized commodity markets and growing British foreign investments, usually denominated in sterling.
