Economics

Replacing the dollar

March 27, 2014
Placeholder image!
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. This is the fifth and final part of that interview.

Jay Elwes: In your book you say the dollar’s reserve status brings potential instability, but that strikes me as a comment not necessarily specific to the dollar. If we were to fast forward twenty years and the renminbi was the unit of account, then presumably these instabilities would still arise. So it seems that these points about the dollar could equally be applied elsewhere.

Eswar Prasad: So if there was one dominant reserve currency, then the prospect of instability is somewhat greater because then the world does not exert enough discipline on that one currency. If you had say, the US dollar, the euro and the renminbi, as potential competitors roughly equally weighted then none of these economies individually would be able to run extravagant policies because then people would shift away to the other currencies. So my sense is that having a uni-polar system certainly doesn’t help, but one could also make the reverse argument.

If we were starting with a blank slate we probably wouldn’t develop a system where one currency is so dominant. But given where we are right now in terms of financial development and also financial market imperfections around the world, a bad mix of policies and so on, maybe it’s not such a bad thing to have one central bank that the world trusts, one currency that the world is willing to accept in essentially unlimited quantities—because if you think about the financial crisis the demand worldwide was for dollars and if you didn’t have one institution or one currency that the world trusted perhaps it could have been a lot worse.

JE: Is there still an appetite on the part of China for treasuries?

EP: China would desperately like to diversify away from treasuries but as many of the quotes from Chinese officials in my book indicate they have no other place to hide. When an economy is accumulating say half a trillion dollars worth of reserves every year, as happened in 2013, there aren’t markets that are big enough, deep enough, liquid enough to go to. So while the Chinese are trying at the margin to diversify, to find real assets, they’re trying to move into a little bit of gold and other currencies, the reality is there isn’t enough of those other assets or instruments out there. So ultimately they have to turn back to US dollars for the vast majority of their holdings. In that sense their currency policy, that is, not letting their currency depreciate and intervening heavily in foreign exchange markets ties them even more to the US dollar.

JE: Do you think China's urge to diversify out of treasuries is going to encourage them to invest more in other countries?

EP: They’ve been trying hard—the Chinese central bank like every other central bank cares about three things: safety, liquidity and yield. If you look at the first two criteria—safety and liquidity—there aren’t many places to go. So what they’ve done with part of their reserve portfolio is move it to the Sovereign Wealth Fund, the China Investment Cooperation which now has a market capitalisation of about $500bn compared to the foreign exchange reserves of about $3.8 trillion. Even with this $500bn they’ve had a great deal of difficulty finding high quality assets and a lot of that money in fact comes into the US into equities, into real estate, and even the Sovereign Wealth Fund itself holds some US Treasury securities because again, it is very difficult to find such a massive amount of investments that you can put any place.

JE: What about Bitcoin?

EP: Two sets of observations. First, things like gold and Bitcoin have a certain allure because of the limited supply and the sense is that if you only ever have 20m Bitcoins that are only ever going to be mined or a finite supply of gold, those should hold their value. But ultimately the market value of gold is well above its intrinsic value. Bitcoin also has value because ultimately people have faith in it. But the crisis has taught us that first of all it is not necessarily assets that are limited in supply that keep their value because the fiat currencies were expanded into essentially infinite quantities and those are what made them more valuable because at a time of crisis you could get more of these into the system. This is why I think that given the nature of financial markets right now going to something like gold or any other restricted supply currency would be foolhardy.

But Bitcoin does presage one very important stage of development, that is, I think a move to electronic currencies and away from paper money. So I don’t think we’re going to be carrying around paper money for much longer, we’re going to be transacting largely through economic mediums and that will also mean, going back to an observation I made earlier, that the unit of account and medium of exchange functions in traditional fiat currencies might be replaced by some extent by these electronic currencies.

Of course if you had an electronic dollar you could still have the dollar maintaining all three functions. But to have a currency, or any asset, that has a store of value function, you still need an institution backing it. So the dollar has behind it The Federal Reserve, which in turn behind it has the US government with its taxing powers. So that is what makes the dollar dominant in its role. So I think again whether Bitcoins survive or not, they do suggest there are going to be important changes in financial markets and money markets. But I don’t think we will get away from fiat currencies so that Bitcoin will replace a fiat currency particularly as a store of value.

JE: Were you ever worried during the worst of the crisis, back in September 2008, that the dollar could loose its reserve currency status?

EP: Absolutely, I think in the initial days of the crisis this was a very real possibility and I think that all logic would suggest that what happened after the financial crisis should have led to a decline of the dollar’s value and prominence. And this is where my book essentially got its starting point because I was planning to write a very different book on capital flows, which have been going from poor to rich countries, which is a bit of a paradox.

But as I started looking at these things through the lens of the financial crisis I realised there was a much more interesting story to be told. As I sifted through the data I could see that every time you had turmoil potential, even in the US like the Standard and Poor’s downgrade of US debt, I don’t think it has happened in any other country where a rating agency downgrades a country’s debt and bond yields fall, because it created scares in peoples minds and some said “where am I going to put my money? In the US dollar”.

And we had it happen again in October 2013, there was a small, very small, but distinct probability that the US may at least technically default on its debt. What happened to the US treasuries in the very short end they did actually rise, but they rose from 0.2 per cent to 0.8 per cent which is nothing, and where did that money from short term treasuries go? It went into longer-term treasuries. So the yield on the ten year bond actually fell by thirty basis points from early September to the middle of October 2013. So again this was treasury bonds of a country that looked like it might default and money came into the US, and this has been a repeated pattern.

So the financial crisis was a very important game changer again driving up the demand and eliminating a lot of the supply, and leaving the US in a really much more strong position.

JE: What would have replaced it?

EP: That’s the key issue, I ask this question in my book, if not the dollar then what? And we don’t have a persuasive answer to that question and I don’t think we will have a persuasive answer to that question any time soon. Yes the renmimbi is going to become more important, yes I think the renmimbi could even account for between 5-10per cent of foreign exchange reserves if they do everything I mentioned that they would have to do.

It could happen in the next 10 to 15 years but just like the euro in its initial stages after its inception it looked like it was on its way to world domination and it flatlined very quickly, and the financial crisis hurt it. So the dollar is certainly going to become somewhat weaker but it will still remain by far the most dominant currency.