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: So the principle theme of the book—there seems to be a certain discomfort with the standing of the dollar. Maybe you could just explain why that is.
Eswar S Prasad: So the global financial crisis had its origins in the United States. The US has built up a huge amount of public debts since the financial crisis and the Federal Reserve has been pumping a lot of dollars into the global financial system. So all of this logically should lead to a decline in the dollar’s value as well as its prominence.
But that hasn’t happened, in fact quite the reverse. And the reason is simple; it comes down to the supply and demand for safety. The world after the financial crisis sees a lot of financial turmoil and what the world wants when there is turmoil is safe financial assets. That is, assets that are expected to hold at least their principle value and that are liquid, that is, relatively easy to trade.
The demand for safe assets has gone up because the emerging markets want to protect themselves from capital flow volatility. They’re now becoming much more open to capital flows, so are exposed to more capital flow volatility. Second, private investors want more safety in times of turmoil. Financial institutions are being asked to hold more safe financial assets so the demand has surged.
But at the same time the supply, partly due to the financial crisis, has shrunk quite significantly. The eurozone is not what we though it was, there are parts of the eurozone that are strong, other parts that are weak. If you take the safe part of the eurozone, the core eurozone economies, those account for only around 40 per cent of government debt issued by the entire eurozone. Japan and Switzerland, traditionally safe haven economies, don’t want money coming into their economies because that would drive up the value of their currencies and make their exports less competitive, so they’ve become net demanders of safe assets rather than suppliers. Private sector securities are not considered safe anymore. They have a surge of demand, a shrinking of supply and who’s left? The US. So it’s a very discomforting situation because the US in a sense perpetrated a lot of these difficulties in global financial markets and the world is sort of rewarding it by pouring even more money into the US.
JE: But the US, the dollar, still offers security doesn’t it? So from that point of view investors are getting what they’re paying for.
EP: They’re getting very low returns on their US government securities because interest rates in the US are very low. But in addition, behind the dollar strength in times of financial turmoil is this uncomfortable trend that the value of the dollar is falling against the other major currencies. Not against some of the advanced economy currencies, but against emerging market currencies.
So take China for example, the value of the dollar is falling against the renminbi and the value of the dollar is likely to fall in the future which is not such a bad thing because the US is still running a very large trade deficit. Plus it needs to pay off all the obligations it has been building up.
So the world is willing to pay an enormous price for safety, they’re willing to accept very low rates of return in US government securities and a decline in the domestic currency value of their US treasury security holdings.
JE: There has to be a global reserve currency. There can be no return to the gold standard. So it seems what you’re describing is in many ways an unsatisfactory situation where the dollar has the prominent role. But what’s the alternative?
EP: That’s a good point. In international finance ultimately everything is relative and this is not really a story about American exceptionalism. But basically what it shows is that the US economy and the set of institutions that the US has put together backing up its currency, are much stronger than any competitors in the rest of the world.
But the US has managed to do something that few other economies have been able to do. Not only does it have economic size, it is still the largest economy in the world, it has very deep liquid financial markets which means it is very easy to trade in those markets and there are a lot of securities that foreign investors can hold. But in addition, foreign investors have a lot of confidence in the US because it has strong institutions. It has an open and transparent democratic government, and one might argue that Washington is stuck in political gridlock right now, but it does have a self-correcting tendency over time. And more importantly there is this institutional system of checks and balances among the legislative branch, the judicial branch and the executive branch.
JE: Maybe too many checks and balances.
EP: Maybe! Second there is the sense that the US’s public institutions, especially the Central Bank, that the world trusts. And third, a legal system that gives investors, both domestic and foreign, the sense that they are going to be treated fairly according to the letter of the law. And all of this put together, inspires a lot of confidence among foreign investors, that they wont get snookered.
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: So the principle theme of the book—there seems to be a certain discomfort with the standing of the dollar. Maybe you could just explain why that is.
Eswar S Prasad: So the global financial crisis had its origins in the United States. The US has built up a huge amount of public debts since the financial crisis and the Federal Reserve has been pumping a lot of dollars into the global financial system. So all of this logically should lead to a decline in the dollar’s value as well as its prominence.
But that hasn’t happened, in fact quite the reverse. And the reason is simple; it comes down to the supply and demand for safety. The world after the financial crisis sees a lot of financial turmoil and what the world wants when there is turmoil is safe financial assets. That is, assets that are expected to hold at least their principle value and that are liquid, that is, relatively easy to trade.
The demand for safe assets has gone up because the emerging markets want to protect themselves from capital flow volatility. They’re now becoming much more open to capital flows, so are exposed to more capital flow volatility. Second, private investors want more safety in times of turmoil. Financial institutions are being asked to hold more safe financial assets so the demand has surged.
But at the same time the supply, partly due to the financial crisis, has shrunk quite significantly. The eurozone is not what we though it was, there are parts of the eurozone that are strong, other parts that are weak. If you take the safe part of the eurozone, the core eurozone economies, those account for only around 40 per cent of government debt issued by the entire eurozone. Japan and Switzerland, traditionally safe haven economies, don’t want money coming into their economies because that would drive up the value of their currencies and make their exports less competitive, so they’ve become net demanders of safe assets rather than suppliers. Private sector securities are not considered safe anymore. They have a surge of demand, a shrinking of supply and who’s left? The US. So it’s a very discomforting situation because the US in a sense perpetrated a lot of these difficulties in global financial markets and the world is sort of rewarding it by pouring even more money into the US.
JE: But the US, the dollar, still offers security doesn’t it? So from that point of view investors are getting what they’re paying for.
EP: They’re getting very low returns on their US government securities because interest rates in the US are very low. But in addition, behind the dollar strength in times of financial turmoil is this uncomfortable trend that the value of the dollar is falling against the other major currencies. Not against some of the advanced economy currencies, but against emerging market currencies.
So take China for example, the value of the dollar is falling against the renminbi and the value of the dollar is likely to fall in the future which is not such a bad thing because the US is still running a very large trade deficit. Plus it needs to pay off all the obligations it has been building up.
So the world is willing to pay an enormous price for safety, they’re willing to accept very low rates of return in US government securities and a decline in the domestic currency value of their US treasury security holdings.
JE: There has to be a global reserve currency. There can be no return to the gold standard. So it seems what you’re describing is in many ways an unsatisfactory situation where the dollar has the prominent role. But what’s the alternative?
EP: That’s a good point. In international finance ultimately everything is relative and this is not really a story about American exceptionalism. But basically what it shows is that the US economy and the set of institutions that the US has put together backing up its currency, are much stronger than any competitors in the rest of the world.
But the US has managed to do something that few other economies have been able to do. Not only does it have economic size, it is still the largest economy in the world, it has very deep liquid financial markets which means it is very easy to trade in those markets and there are a lot of securities that foreign investors can hold. But in addition, foreign investors have a lot of confidence in the US because it has strong institutions. It has an open and transparent democratic government, and one might argue that Washington is stuck in political gridlock right now, but it does have a self-correcting tendency over time. And more importantly there is this institutional system of checks and balances among the legislative branch, the judicial branch and the executive branch.
JE: Maybe too many checks and balances.
EP: Maybe! Second there is the sense that the US’s public institutions, especially the Central Bank, that the world trusts. And third, a legal system that gives investors, both domestic and foreign, the sense that they are going to be treated fairly according to the letter of the law. And all of this put together, inspires a lot of confidence among foreign investors, that they wont get snookered.
