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Book review: How Global Currencies Work

Authors Barry Eichengreen, Arnaud Mehl and Livia Chitu argue that the Euro and the Renminbi will gradually displace the US Dollar as the leading international currency, writes Ian McLennan

The authors conclude that the euro, in particular, will play a more consequential role in international reserves relative to the US dollar, while China’s renminbi will be slower to achieve acceptance.

One of the co-authors of this review of 150 years of international currencies, Barry Eichengreen, is arguably the world’s most eminent living economic historian, and has written extensively about the gold standard and the Great Depression.  His co-authors are senior economists from the European Central Bank, so cynics may not be surprised to find that the book is relatively upbeat about prospects for the euro, which has once again begun to increase its market share of international reserves since the ECB’s 2012 'do whatever it takes' policies stabilised the Eurozone.

Why does it matter which currency take the lead role internationally? The phrase exorbitant privilege was coined in the 1960s to describe the benefits that the USA enjoyed as a result of the Dollar’s international dominance post Word War 2. Benefits include the ability to raise debt from foreigners at low interest rates and the tendency for the dollar to be viewed as a safe haven in times of crisis, even when the crisis emanates from within the US itself, as it did in 2008. Capital flight is one worry that the Fed has rarely had to deal with. Furthermore, the authorities issuing and setting interest rates for the dominant currency play a crucial role in global economic management, particularly at times of crisis, as we saw with Federal Reserve actions in 2008-10 and 1998. Some historians have even blamed the severity of the Great Depression on the failure of authorities in the USA to recognise that they needed to assume the responsibilities of leading world money issuer from a Great Britain weakened by WWI.

The traditional view has been that there can be only one dominant international reserve currency at a time as a result of network effects and a natural monopoly position that is hard to assail. This view appears to be supported by the dominance of the pound sterling before WWI, a period when the Bank of England was described as the 'Conductor of the international financial Orchestra' by Keynes, and by the dominance of the US dollar in the seventy years since WW2.

However, the authors argue that this old view is not only usurped by developments in modern financial technology that make it easy to deal in multiple currencies, it does not even fit with the more rigorously analysed historic facts. Sterling’s international dominance in the gold standard era was rather less robust than many have believed, with evidence presented here that the Franc and the Deutschmark also played large roles in foreign reserves before WWI. In the 1920s/30s, sterling and the dollar shared reserve currency status more or less equally for much of the period. Thus the authors argue that the dominance of the dollar in the second half of the twentieth century has been an anomaly: they propound the view that multiple currencies have shared dominance in international trading and reserves in the past and will do so in the future.

Thus, if the euro and the renminbi have the right attributes, the path for them to take market share from the dollar is clear. But what attributes qualify a currency to be an international leader? The authors identify four: size of the home economy, stability of politics and economy, deep liquidity of financial markets and the security of the nation.

While the authors believe the Euro now has those attributes, they expect it to take another generation for the renminbi to fully develop them. An analogy is drawn with the experience of Japan, which had the second largest economy in the world in the 1970-90, yet the yen, burdened by capital controls, never reached the level of international respect that the euro has today. China, the rising economic power of our own age, has been liberalising capital controls but at a cautious pace; as recently as 2015, capital controls were tightened in response to short term economic concerns. Renminbi financial markets remain relatively illiquid, while the latest Party Congress further centralised political power, a development not likely to be conducive to trust in the currency. Even going back to the 18th century the world’s leading currency, the Dutch Guilder, was minted in a country which had a republican government, meaning that merchants and investors could have greater faith in the rule of law than in jurisdictions where princes still ruled by fiat.

This reviewer tends to think that the authors may be too optimistic about prospects for the euro, where the continued lack of political commitment to the full consequences of a common currency may cause further dislocation ahead. And given that the renminbi’s rise will be slowed back by relatively weaker liquidity and political accountability, the dollar’s demise may continue to be a very, very slow one.

Ian McLennan is a partner at Triple Point LLP, a specialist venture capital, private lending and social impact investment firm