The Dollar and Its Rivals

I was in graduate school, studying American foreign policy when I stumbled on Riccardo Parboni's "The Dollar and Its Rivals."  This thin volume showed how the foreign exchange market was the arena in which capitalist rivalries were expressed. More than any single book, it set me on a more than 30-year path.

The dramatic world of foreign exchange that Parboni depicted changed in a significant way in the mid-1990s. Led by the shift in the US, and the appointment of Robert Rubin to replace Lloyd Bentsen at Treasury, the foreign exchange market was de-weaponized. That is the real meaning of the strong dollar policy.  It was a signal to the world that the US would no longer seek trade or financial advantage (reduce debt burden) by depreciating or threatening to depreciate the dollar.  This marked the end of the brief period in which the major industrialized countries tried to direct the currency market. It took several years but letting markets determine exchange rates was endorsed by the G7 and G20. 

Around the launch of the Fed's asset purchase plan, there was a surge in discussions spurred by Brazil's finance minister that this was a currency war. Many observers confused manipulation of interest rates and the manipulation of currencies and often seemingly on libertarian grounds, seeing it as the state's encroachment in the market. However, the significance of the difference is on practical, not ideological grounds.   

Seeking trade advantage through depreciating one's currency is a zero-sum exercise. The depreciating country ostensibly takes part of the aggregate demand from another country.  It puts the others in a position to consider depreciating their own currency, leading to a downward spiral (see 1920s). Easing monetary policy using orthodox or unorthodox policies stimulates domestic demand and could spur other countries to cut interest rates and increase their own demand. Manipulating monetary variables can be a non-zero sum game. 

Yes, there are intellectual fads, and references to currency wars faded. There is a new game afoot.  The weaponization of the dollar is not about price but about access. It did not begin in 2016 but has steadily increased since 9/11. The US is using access to what had heretofore been a public good (utility), namely the use of the US financial system and dollar funding to punish others. 

The US threatened to use its financial power against the UK in the Suez Crisis in 1956. One result was that the Soviet Union took its dollars out of the US and deposited them in British clearing banks. In so doing the Communists gave birth to the eurodollar market, the offshore market for dollars that was not beholden to the US interest rate cap and other regulations. The increasing willingness of the US to deny access to the dollar market is spurring more talk of alternatives.  

Europe is expected to announce tomorrow a new initiative to boost the use of the euro. The immediate spur is the US decision to pull out of the agreement with Iran and re-apply sanctions. It has granted a six-month exemption for limited oil sales, but the financial embargo includes cutting Iran off from the Belgian-based SWIFT system.  

When the US first announced this, European officials tut-tutted and threatened to launch its own payment system. The Zero Hedges of the world jumped up and down declaring once again the demise of the dollar. It turns out that no country wants to host the special purpose vehicle that was supposed to offer a workaround to the US financial embargo.  The launch of the Asian Infrastructure Investment Bank, a parallel Chinese-sponsored development bank, was also celebrated as a sign of the demise of the US and the role of the dollar until it was learned that subscriptions and loans were in US dollars. 

Russia, worried about US sanctions, appears to have reduced its dollar reserve from $96 bln in March to about $14 bln in May. US Treasury figures suggest it has remained in the $14-$15 bln area for the last several months. It might have shifted its holdings to the Chinese yuan, as some have suggested. The yuan did see a jump in reserve holdings.  However, Russia may have just transferred part of the dollar reserves out of the US banking system entirely and therefore might not be detected by the Treasury methodology.  Russia reportedly is close to issuing euro-denominated bonds for the first time in five years.  

When Paraboni wrote his book, it was common to believe that there was a natural monopoly on the numeraire, the vehicle, invoicing and reserve currency. After a period of bouncing from one alternative to another (euro, yuan, SDR, Bitcoin--yes it was not that long ago that analysts at money center banks were recommending central banks hold Bitcoins in reserves), the new intellectual fad is to consider a multi-currency reserve regime. Ironically, this is very much what exists today. Given some limited fluctuation, the dollar's share of global reserves is a little more than 60%, and the euro is around 20% (the whole is roughly the same size as the sum of its parts-legacy currencies). A handful of other currencies jockey for the remaining 20% or so and that includes sterling, yen, Canadian dollar, Australian dollar, and Chinese yuan.  

We all use the QWERTY keyboard, though superior ones and better ergonomic designs exist. Few people have learned Esperanto. The dollar might not be loved, but it is widely used and missed when taken away.  It is not a tyranny, as Business Week claimed a couple months ago.  Central banks, businesses, and investors can make other choices but chose the dollar. The dollar's role as the numeraire is backed by the US Treasury market. There cannot be a compelling alternative to the dollar until there is a compelling alternative to the US Treasury market.  Europe may fiddle around the edges, but it is not anywhere close to a bond market that can rival the US. Russia and China are even further behind.