Eswar S Prasad is a professor at Cornell University and a Senior Fellow at the Brookings Institution. His latest book, The Dollar Trap, published by Princeton University Press, explores the global monetary system, and the dominant role played in it by the dollar.
Prasad explains that the dollar cannot for now escape its role as the global reserve currency, “due to weaknesses in the rest of the world and deep problems in the structure of the global monetary system.” There are substantial consequences of this, for the US, other western nations and the developing world.
He spoke to the Prospector about this and other subjects, the full results of which will be published here over the coming days.
Jay Elwes: On the subject of quantitative easing—the Fed has engineered a very extraordinary situation with its asset purchase programme. But there are now politicians in the United States, like Rand Paul, who think that the Fed is debasing the currency and that the Federal Reserve should be abolished. That is a minority view but still one that is being voiced by a senior and very prominent US politician. What effect has quantitative easing had on the standing of the dollar and how easy do you think it will be to unwind QE?
Eswar Prasad: In a normal world, what the Fed did and what the US government has done with its issuance of massive amounts of public debt should definitely have driven down the dollar’s value and its prominence. But what we’ve seen is that at times of crisis, the world looks for dollars. The dollar still remains very important, and if anything, the Fed’s actions have entrenched the dollar’s role.
Why is this? In the US, as in many other economies, the problem was that monetary policy is being relied upon to do the work of all the other policies that are not pulling in the right direction. Fiscal policy should be supporting the recovery—it’s not, its being pulled back. There are structural reforms the US needs to undertake to help long-term productivity. Those are not being undertaken. So monetary policy is the only tool that’s working.
Now monetary policy has spill-overs. Last year when the Fed had engineered quantitative easing and even before that, that was leading to a flow of capital to emerging markets. The notion of the Fed pulling back on those operations has led to capital flowing out. So, the Fed is creating more turmoil in international financial markets creating more capital flow volatility and the paradox is that to protect themselves from this volatility, what are emerging markets doing? And what are they likely to continue to be doing? Building up reserves. And when they build up a lot of reserves, where can they go? Back to the US dollar.
So it’s a remarkable paradox again that actions by the US that create financial turmoil also pull more countries into the grip of the dollar. So when there is financial turmoil, anywhere in the world, in emerging markets in the eurozone, or—and this is the paradox—in the US itself, money comes to the US in search of protection.
So can the Fed pull back its quantitative easing operations? My sense is that the Fed can pull this off, but expectations and financial markets are very difficult to predict and they could come unhinged. But the difficulty here again in thinking about a scenario where you have panic in these markets leading to a plunge in the dollar, is that if you have panic in US government bond markets you’ll have panic in all US financial markets. If you have panic in all US financial markets that will very quickly infect world financial markets and when there is turmoil everywhere what do people want? Safety. And where do you go for safety? Back to the US dollar.
JE: That’s a very satisfying equilibrium state you’ve just described, one that cannot necessarily be relied upon here in the UK, where we also have a asset purchase programme—of £375bn. How do you see the British QE experiment? How does it compare with the US?
EP: In the UK again, I think that there are other policies that could have helped. In the UK, in particular, I don’t think it has been monetary policy that has been carrying the same burden itself. Other policies have been somewhat more supportive.
But it is true that in the UK as well there is some degree of leakage. But again, given the size of the UK financial markets, I think the spill-over effects have not been that large, unlike in the case of the US where the sheer absolute scale of the problem has been much greater. The UK economy does in some ways seem to have repaired itself, and the economy is registering good growth considering. So I think that even if one does not attribute this to the quantitative easing policies of The Bank of England, I think it had at least some positive effects.
Now whether the risks are going to manifest themselves as the BoE tries to pull back is still an open question because what is certainly true in the UK and the US, and many other advanced economies, is that even though the effects on the real economy might not be obvious, the effects on financial markets have certainly been very clear and if the pull back of quantitative easing in the UK and the US and so on, leads to financial markets being deflated and that in turn affects aggregate demand then we could end up in a situation where, so to speak, the artificial propping up of financial markets will end up badly which in turn will affect aggregate demand. My sense is that the BoE can manage this fairly well, although, it doesn’t have as much room for manoeuvre as the US because the US still remains very special in many ways.
Prasad explains that the dollar cannot for now escape its role as the global reserve currency, “due to weaknesses in the rest of the world and deep problems in the structure of the global monetary system.” There are substantial consequences of this, for the US, other western nations and the developing world.
He spoke to the Prospector about this and other subjects, the full results of which will be published here over the coming days.
Jay Elwes: On the subject of quantitative easing—the Fed has engineered a very extraordinary situation with its asset purchase programme. But there are now politicians in the United States, like Rand Paul, who think that the Fed is debasing the currency and that the Federal Reserve should be abolished. That is a minority view but still one that is being voiced by a senior and very prominent US politician. What effect has quantitative easing had on the standing of the dollar and how easy do you think it will be to unwind QE?
Eswar Prasad: In a normal world, what the Fed did and what the US government has done with its issuance of massive amounts of public debt should definitely have driven down the dollar’s value and its prominence. But what we’ve seen is that at times of crisis, the world looks for dollars. The dollar still remains very important, and if anything, the Fed’s actions have entrenched the dollar’s role.
Why is this? In the US, as in many other economies, the problem was that monetary policy is being relied upon to do the work of all the other policies that are not pulling in the right direction. Fiscal policy should be supporting the recovery—it’s not, its being pulled back. There are structural reforms the US needs to undertake to help long-term productivity. Those are not being undertaken. So monetary policy is the only tool that’s working.
Now monetary policy has spill-overs. Last year when the Fed had engineered quantitative easing and even before that, that was leading to a flow of capital to emerging markets. The notion of the Fed pulling back on those operations has led to capital flowing out. So, the Fed is creating more turmoil in international financial markets creating more capital flow volatility and the paradox is that to protect themselves from this volatility, what are emerging markets doing? And what are they likely to continue to be doing? Building up reserves. And when they build up a lot of reserves, where can they go? Back to the US dollar.
So it’s a remarkable paradox again that actions by the US that create financial turmoil also pull more countries into the grip of the dollar. So when there is financial turmoil, anywhere in the world, in emerging markets in the eurozone, or—and this is the paradox—in the US itself, money comes to the US in search of protection.
So can the Fed pull back its quantitative easing operations? My sense is that the Fed can pull this off, but expectations and financial markets are very difficult to predict and they could come unhinged. But the difficulty here again in thinking about a scenario where you have panic in these markets leading to a plunge in the dollar, is that if you have panic in US government bond markets you’ll have panic in all US financial markets. If you have panic in all US financial markets that will very quickly infect world financial markets and when there is turmoil everywhere what do people want? Safety. And where do you go for safety? Back to the US dollar.
JE: That’s a very satisfying equilibrium state you’ve just described, one that cannot necessarily be relied upon here in the UK, where we also have a asset purchase programme—of £375bn. How do you see the British QE experiment? How does it compare with the US?
EP: In the UK again, I think that there are other policies that could have helped. In the UK, in particular, I don’t think it has been monetary policy that has been carrying the same burden itself. Other policies have been somewhat more supportive.
But it is true that in the UK as well there is some degree of leakage. But again, given the size of the UK financial markets, I think the spill-over effects have not been that large, unlike in the case of the US where the sheer absolute scale of the problem has been much greater. The UK economy does in some ways seem to have repaired itself, and the economy is registering good growth considering. So I think that even if one does not attribute this to the quantitative easing policies of The Bank of England, I think it had at least some positive effects.
Now whether the risks are going to manifest themselves as the BoE tries to pull back is still an open question because what is certainly true in the UK and the US, and many other advanced economies, is that even though the effects on the real economy might not be obvious, the effects on financial markets have certainly been very clear and if the pull back of quantitative easing in the UK and the US and so on, leads to financial markets being deflated and that in turn affects aggregate demand then we could end up in a situation where, so to speak, the artificial propping up of financial markets will end up badly which in turn will affect aggregate demand. My sense is that the BoE can manage this fairly well, although, it doesn’t have as much room for manoeuvre as the US because the US still remains very special in many ways.
