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The 2021 Globie: “Three Days at Camp David” and “The Global Currency Power of the US Dollar”

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Fall is the time of the year to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The prize is strictly honorific and does not come with a check. But the award gives me a chance to draw attention to a recent book—or books—that are particularly insightful about globalization. Previous winners are listed at the bottom of the column.

This year there are two winners, Jeff Garten for Three Days at Camp David and Anthony Elson for The Global Currency Power of the US Dollar. Each book deals with the financial hegemony of the U.S. dollar in the global financial system. Together they provide a fascinating account of how the dollar came to hold—and hold onto—this role.

Garten looks at the decision by President Richard Nixon in the summer of 1971 to end the link between the dollar and gold, a central foundation of the Bretton Woods system. Foreign central pegged their exchange rates to the dollar, which was convertible to gold by the U.S. government for $35 an ounce. This arrangement reflected the U.S. position at the end of World War II as the predominant economic power, able to use its influence at Bretton Woods to ensure a dollar-dominated system.

But the imbalance between the U.S. and the rest of the world shifted during the 1950s, particularly as Germany and Japan emerged as economic powers with growing trade surpluses. U.S. government spending resulted in growing foreign holdings of dollars. Yale Professor Robert Triffin pointed out that the ability of the U.S. to exchange its gold for dollars was deteriorating, and this incipient crisis became known as the “Triffin dilemma.” By 1971 this situation was no longer sustainable. Foreign central banks held about $40 billion in dollars while U.S. gold holdings had fallen to $10 billion. Speculators were taking positions on the response of the U.S. and other central banks in a global chicken game.

Garten describes the main players in the decision to end the link with the dollar. Nixon had appointed John Connolly as Treasury Secretary mainly because of Connolly’s political skills.  Connolly in turn depended on the expertise in international finance of Paul Volcker, then under secretary of the Treasury for international monetary affairs. George Schulz was known for his organizational expertise and served as the director of the Office of Management and Budget. Arthur Burns, Chair of the Federal Reserve, sought to serve Nixon while maintaining some semblance of institutional autonomy. Other participants in the decision included Paul McCracken of the Council of Economic Advisors and Peter Peterson of the White House Council on International Economic Policy.

These men (yes, all men) had different perspectives on the best way to handle the crisis. Volcker and Burns shared an appreciation of the existing framework, and wanted to consult with their counterparts in other countries on reforming the system. Schulz, influenced by his background at the University of Chicago, looked forward to a day when flexible exchange rates would replace pegged rates. Connolly, on the other hand, had no ideological agenda. He sought to promote American interests and Nixon’s re-election, and saw the two as entirely compatible.

Nixon, Garten makes clear, was concerned about the impact of the situation on his 1972 election campaign, and his response must be understood in that context. Nixon consulted with these advisors at Camp David on the weekend of August 13 – 15 on how best to meet the dollar crisis. After a broad discussion, the decision to end the link of the dollar with gold sales was made. The rest of the weekend was spent on deciding on how to present the issue to the American public and U.S. allies.

Nixon spoke that Sunday night, making the case on the need to achieve economic prosperity in the aftermath of the Vietnam war. Other measures he presented included a tax credit for investment, a freeze on wages and prices and the establishment of a Cost of Living Council to enact measures to control inflation, and a 10% temporary tariff on imports. He justified the latter on the “unfair edge” that competitors had gained while the U.S. promoted their post-World War II recovery.

The U.S. subsequently negotiated with the other leading advanced economies on establishing new fixed rates, but the effort was unsuccessful. By March 1973, almost all of the Western European economies and Japan had embraced flexible exchange rates. The Jamaica Accords of 1978 marked the official of the Bretton Woods exchange rate system. Central banks could continue to peg their currencies against the dollar, but there was no obligation on the U.S. to support the “non-system.”

Anthony Elson brings the story forward in time to explain the continuing dominant position of the dollar. It is doubtful that anyone in 1971 or 1978 would have predicted a key role for the dollar in the post-Bretton Woods era, and Elson shows that the dollar’s continued dominance reflects several factors. First, the dollar continues to be used for invoicing international trade, even for non-U.S. trade flows. The dollar is used for this purpose in order to minimize transaction costs, as well as its record of macro stability. Second, the continued dominance of financial markets in the U.S. draws foreign investors looking for safe and liquid markets. This in turn has encouraged the growth of dollar-based financing outside the U.S. Third, the dollar continues to the most commonly-used currency for the foreign exchange reserves of central banks. U.S. Treasury bonds are seen as a global “safe asset.”

All this, Elson points out, bring benefits for U.S. traders and investors, who can use the dollar to purchase foreign goods and assets. In addition, the government can finance a continuing current account deficit through its provision of U.S. Treasury bonds. The foreign demand  for these securities also lowers the cost of financing the fiscal deficits. On the political side, the government has learned how to use access to the dollar-based international clearing system as a tool of foreign policy, effectively “weaponzing the dollar.”

Can this system continue? The “new Triffin dilemma” has arisen as a result of the relative decline of the U.S. economy in terms of its share of world GDP at the same time as the demand for safe assets continues to grow. An increase in the issuance of U.S. securities to finance fiscal deficits coupled to the political posturing over the debt ceiling may threaten the confidence of foreign investors in the ability of the U.S. government to meet its obligations, much as the declining gold stock led to the 1971 crisis.

But what alternatives are there? The Eurozone and China have grown in size and importance and their currencies may serve as regional rivals for the dollar. But a multipolar reserve currency system may itself be unstable. The IMF’s Special Drawing Rights were designed to supplement the dollar, but their use has been limited, and it would take concerted intergovernmental action to encourage its use. Digital currencies may change how we view money, and central banks are actively investigating their use.

There is little history to provide a guide on the circumstances that lead to a change in the hegemonic currency. The dollar began to rival the British pound in usage in the 1920s as the U.S. economy rapidly grew. But the transition was finalized by the costs to Great Britain of fighting World War II. If a peaceful transition to a new reserve currency system is to take place, it will require more international cooperation than has been shown on other issues.

 

2020    Tim Lee, Jamie Lee and Kevin Coldiron, The Rise of Carry: the Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis

2019    Branko Milanovic, Capitalism Alone: the Future of the System That Rules the World

2018    Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World

2017   Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic,  Global Inequality

2015   Benjamin J. Cohen,  Currency Power: Understanding Monetary Rivalry

The Return of Global Imbalances?

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The global economic contraction following the pandemic has led to a massive fiscal response. Governments have acknowledged the need to increase spending in order to offset the declines in consumption and investment. The decreases in public savings can lead to rising current account deficits that offset the capital inflows needed to cover the gap between savings and investment. But will these measures generate a return to the global imbalances that preceded the global financial crisis?

The IMF’s External Sector Report for 2020, subtitled Global Imbalances and the COVID-19 Crisis, appeared in August (see a summary here). The analysis was based on data from 2019, when the global current account imbalance (the absolute sum of all surpluses and deficits) fell by 0.2 of a percentage point to 2.9% of global GDP. But the report’s authors also considered the impact of the pandemic on countries’ balance of payments.

The IMF’s analysis suggested that about 40% of the 2019 current account positions were excessive. Larger than warranted surpluses were registered by Germany and the Netherlands, while deficits were larger than warranted in Canada, the U.K. and the U.S. China’s external position was in line with its fundamentals and policies.

In the report the IMF anticipated that in 2020 the U.S. would report a current account deficit equal to 0.5% of world GDP. Canada and the U.K.’s deficits were each projected to be equal in value to about 0.1% of global output. China was expected to register a surplus of about 0.2% of world GDP, as were Germany and Japan. These forecasts come with a large degree of uncertainty, and the report’s authors acknowledge that global financial stress could lead to more capital flow reversals and larger imbalances.

More recent data show clearly that the U.S. and China are running the largest current account imbalances in absolute terms. Brad Setser of the Council on Foreign Relations points out that Chinese firms have benefitted from the demand for electronic goods as workers stay at home, as well as the need for personal protective equipment. Moreover, the Chinese government has supported its firms that export, with less direct support for households. The U.S. has provided more direct support to households.

The fiscal responses of the two countries to the pandemic also differ. The Economist estimates that the 2020 U.S. budget balance will show a deficit equal to 15.3% of its GDP, while China’s deficit is estimated at 5.6% of GDP. Part of the U.S. fiscal deficit will be offset by household savings, which increased last spring to over 30% of disposable income. The savings rate has slowly come down since then, while households attempt to plan their spending in a world of uncertainty. If the recovery in the U.S. stalls and there is no additional fiscal stimulus, then households will be forced to dip into their savings.

The IMF’s current account forecasts are consistent with the analysis of  Matthew Klein and Michael Pettis in their recent book, Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace.  The authors claim that these imbalances reflect domestic policies that privilege the more affluent members of a country. The trade wars that divide nations reflect divisions within these countries between asset owners and workers.

Klein and Pettis attribute China’s surpluses, for example, to government decisions in the 1990s to foster development through investments and exports while suppressing Chinese consumption in order to generate savings. The government has since acknowledged this imbalance and sought to rebalance domestic spending, in part by promoting consumption expenditures while curbing shadow banking. But whenever economic growth has slowed, the government has responded by encouraging new investment, including housing, and total credit to the private sector has grown to 216% of GDP.

Similarly, Germany’s current account surpluses reflect its policies designed to encourage growth after the decade of the 1990s, when the costs of reunification weighed down the economy. There was a conscious decision to encourage savings, a shift that benefited capital owners at the expense of labor. Until this year the government took pride in its balanced budgets, despite a need for infrastructure spending. The high personal savings rate reflects in part a high degree of income inequality, with most gains going to those households more likely to save them. There was also an emphasis on the country’s external position, and wage increases were limited in order to hold down costs.

The increases in foreign savings were matched by capital flows to the U.S. These reflected the U.S. position as the financial hegemon, with the most liquid financial markets. Moreover, the U.S. provided something of great value: safe assets. U.S. Treasury bonds have been the preferred asset of central banks and European savers, although before the 2008-09 financial crisis mortgage backed securities with AAA ratings were seen as acceptable substitutes. The financial sector within the U.S. benefitted from the increase in domestic and foreign financial activity. But the capital inflows appreciated the dollar, which undermined the export sector. In the years leading up to the global financial crisis the Federal Reserve kept interest rates low in order to boost spending. A weak recovery after that crisis caused the Federal Reserve to continue its low interest rate policy.

The pandemic has brought a return to past conditions. Whether or not the most recent increase in the Chinese trade surplus is a transitory phenomenon, its current account is on track to record a surplus for the year (although at a much lower level than before the global financial crisis). Similarly, while Germany’s budget balance is forecast to show a deficit of 7.2% of its GDP for the year, its current account is expected to register a surplus equal in value to almost 6% of its GDP.  The U.S. current account deficit, which peaked at 6% of GDP in 2005, was equal in value to 3.5% of GDP in the second quarter of this year.

Klein and Pettis write that past global imbalances reflected a complementarity of interests between American financiers and Chinese and German industrialists, and reinforced inequality.  To change these patterns requires policy reorientations within these countries that will allow more income to be transferred to households. They admit that this is a difficult task, but point out that a new system was devised by the Allied nations at Bretton Woods in 1944 in order to guarantee living standards. The upheaval produced by the pandemic is global in nature and has the potential to bring about another policy transformation. The one necessary element that will be contested by those who profit from current arrangements is the political will.

Mars Descending? U.S. Security Alliances and the International Status of the Dollar

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A decade after the global financial crisis, the dollar continues to maintain its status as the chief international currency. Possible alternatives such as the euro or renminbi lack the broad financial markets that the U.S. possesses, and in the case of China the financial openness that allows foreign investors to enter and exit at will. Any change in the dollar’s predominance, therefore, will likely occur in response to geopolitical factors.

Linda S. Goldberg and Robert Lerman of the Federal Reserve Bank of New York provide an update on the dollar’s various roles. The dollar remains the dominant reserve currency, with a 63% share of global foreign exchange reserves, and serves as the anchor currency for about 65% of those countries with fixed exchange rates. The dollar is also widely utilized for private international transactions. It is used for the invoicing of 40% of the imports of countries other than the U.S., and about half of all cross-border bank claims are denominated in dollars.

This wide use of the dollar gives the U.S. government the ability to fund an increasing debt burden at relatively low interest rates. Moreover, as pointed out by the New York Times, the Trump administration can enforce its sanctions on countries such as Iran and Venezuela because global banks cannot function without access to dollars. While European leaders resent this dependence, they have yet to evolve a financial system that could serve as a viable alternative.

The dollar’s continued predominance may also reflect other factors. Barry Eichengreen of UC-Berkeley and Arnaud J. Mehl and Livia Chitu of the European Central Bank have examined the effect of geopolitical factors—the “Mars hypothesis”—versus pecuniary factors—the “Mercury hypothesis”—in determining the currency composition of the international reserves of 19 countries during the period of 1890-1913. Official reserves during this time could be held in the form of British sterling, French francs, German marks, U.S. dollars and Dutch guilders.

The authors find evidence that both sets of factors played roles. For example, a military alliance between a reserve issuing country and one that held reserves would boost the share of the currency of the reserve issuer by almost 30% if there was a military alliance between these nations. They conjecture that the reserve issuer may have used security guarantees to obtain financing from the security-dependent nation, or to serve the role of financial center when the allied country needed to borrow internationally.

Eichengreen, Mehl and Chitu then use their parameter estimates to measure by how much the dollar share of the international reserves of nations that currently have security arrangements with the U.S. would fall if such arrangements no longer existed. South Korea, for example, currently holds 84% of its foreign reserves in dollars; this share would fall to 54% in the absence of its security alliance with the U.S. Similarly, the dollar component of German foreign exchange reserves would decline from 98% to 68%.

In previous eras, such calculations might be seen as interesting only for providing counterfactuals. But the Trump administration seems intent on cutting back on America’s foreign military commitments. The U.S. and Korea, for example, have not negotiated a renewal of the Special Measures Agreement to finance the placement of U.S. troops in Korea.  German Chancellor Angela Merkel has defended her country’s role in NATO in the face of criticism from President Trump that Germany must spend more on defense expenditures. The possibility of a pan-European army to serve as an alternative security guarantee is no longer seen as totally far-fetched.

The dollar may be safe from replacement on economic grounds. But the imminent shrinkage of the British financial sector due to the United Kingdom’s withdrawal from the European Union  shows that political decisions follow their own logic, sometimes without regard for the economic consequences. If the dollar lose some of its dominance, it may be because of self-inflicted wounds.

Crises and Coordination

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Policy coordination often receives the same type of response as St. Augustine gave chastity: “Lord, grant me chastity and continence, but not yet.” A new volume from the IMF, edited by Atish R. Ghosh and Mahvash S. Qureshi, includes the papers from a 2015 symposium devoted to this subject. Policymakers in an open economy who take each other’s actions into account should be able to reach higher levels of welfare than they would working in isolation.  But actually engaging in coordination turns out to be harder–and less common– than many may think.

Jeffrey Frankel of Harvard’s Kennedy School of Government uses game theory to illustrate the circumstances that hamper coordination. One factor may be a fundamental divergence in how different policymakers view a situation. Many analysts on this side of the Atlantic, for example, use the “locomotive game” to show that Germany should engage in expansionary fiscal policies that would raise output for all nations. But (most) German policymakers have different views of the external impact of deficit spending. In the case of the Eurozone, a deficit in one country increases the probability that it will need a bailout by the other members of the monetary union. Only rules such as those of the Stability and Growth Pact that limit deficit expenditures can eliminate the moral hazard that would otherwise lead to widespread defaults.

Charles Engel of the University of Wisconsin (working paper here) also examines the recent literature on central bank coordination. He points out that the identifying the source of shocks is necessary to assess the benefits of cooperation to address them, and suggests that financial sector shocks may be most relevant for modeling open-economy coordination. But widespread cooperation could undercut the ability of a central bank to credibly commit to a single target, such as an inflation target.

Policymakers in emerging markets who must deal with the consequences of policies in advanced economies have been particularly mindful of their spillover effects. Raghuram Rajan, for example, who is back at the University of Chicago after serving as head of India’s central bank, has urged the Federal Reserve and other central banks to take into account the impact that their policies have on other nations, particularly when unwinding their Quantitative Easing asset purchases. He pointed out: “Recipient countries are not being irrational when they protest both the initiation of unconventional policy as well as an exit whose pace is driven solely by conditions in the source country.”

If international cooperation is viewed as a bargaining game, what incentives do the advanced economies have for cooperative behavior in light of the asymmetries among nations? Engel points out that in such circumstances, “…the emerging markets may believe that they have too little say in this implicit agreement, which is to say that they may perceives themselves as having too little weight in the bargaining game.” Conversely, central banks in the upper-income countries may in ordinary circumstances see little need to extend the scope of their decision-making outside their borders.

This attitude changes, however, when a crisis occurs, as Frederic Mishkin of Columbia shows in his examination of the response of central bankers to the global financial crisis. The Federal Reserve established swap lines to provide dollars to foreign central banks in countries where domestic banks faced a withdrawal of the funding they had used to acquire dollar-denominated assets. In addition, six central banks—the Federal Reserve, the Bank of Canada, the Bank of England, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank—announced a coordinated reduction of their policy rates. Coordination becomes quite relevant in a world of sudden stops and capital flight.

The need for such activities could increase if there is a global financial cycle, as Hélène Rey of the London Business School has stated. She presents evidence of the impact of global volatility, as measured by VIX, on international asset prices and capital flows. An important determinant of such volatility is monetary policy in the center countries. Rey agrees with Rajan that: “Central bankers of systemically important countries should pay more attention to their collective policy stance and its implications for the rest of the world.”

Perhaps a better motivation for the need for joint action comes from Charles Kindleberger’s list of the responsibilities that a hegemonic power such as Great Britain played in the period before World War I. These included acting as a lender of last resort during a financial crisis; indeed, it was the lack of such an international lender in the 1930s that Kindleberger believed was an important contributory factor to the Great Depression. Since the end of World War II the U.S. has vacillated in this role while the international monetary system has moved from crisis to crisis. Meanwhile, offshore credits denominated in dollars have grown in size, and could conceivably constrain the Federal Reserve’s ability to undertake purely domestic measures.

A policy of “America First” that means “America Only First and Last” ignores the fragility of the international financial system. Just as there are no atheists in foxholes, no one doubts the merits of coordination when there is a disruption of global markets. But suffering another crisis would be an expensive reminder that the best time to minimize systemic risk is before a crisis erupts.