By Barry Eichengreen
If the euro’s crisis has a silver lining, it is that it has diverted attention away from risks to the dollar. It was not that long ago that confident observers were all predicting that the dollar was about to lose its “exorbitant privilege” as the leading international currency. First there was financial crisis, born and bred in the United States. Then there was QE2, which seemed designed to drive down the dollar on foreign exchange markets. All this made the dollar’s loss of preeminence seem inevitable.
The tables have turned. Now it is Europe that has deep economic and financial problems. Now it is the European Central Bank that seems certain to have to ramp up its bond-buying program. Now it is the euro area where political gridlock prevents policy makers from resolving the problem.
In the U.S. meanwhile, we have the extension of the Bush tax cuts together with payroll tax reductions, which amount to a further extension of the expiring fiscal stimulus. This tax “compromise,” as it is known, has led economists to up their forecasts of U.S. growth in 2011 from 3 to 4%. In Europe, meanwhile, where fiscal austerity is all the rage, these kind of upward revisions are exceedingly unlikely.
All this means that the dollar will be stronger than expected, the euro weaker. China may have made political noises about purchasing Irish and Spanish bonds, but which currency – the euro or the dollar – do you think prudent central banks will find it more attractive to hold?
There are of course a variety of smaller economies whose currencies are likely to be attractive to foreign investors, both public and private, from the Canadian loonie and Australian dollar to the Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are too small for their currencies to ever play more than a modest role in international portfolios.
Brazilian and Indian markets are potentially larger. But these countries worry about what significant foreign purchases of their securities would mean for their export competitiveness. They worry about the implications of foreign capital inflows for inflation and asset bubbles. India therefore retains capital controls which limit the access of foreign investors to its markets, in turn limiting the attractiveness of its currency for international use. Brazil has tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have moved in the same direction.
China is in the same boat. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. This has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. It has not prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use.
So the dollar is here to stay, more likely than not, if only for want of an alternative.
The one thing that could jeopardize the dollar’s dominance would be significant economic mismanagement in the United States. And significant economic mismanagement is not something that can be ruled out. The Congress and Administration have shown no willingness to take the hard decisions needed to close the budget gap. The Republicans have made themselves the party of no new taxes and mythical spending cuts. The Democrats are unable to articulate an alternative. 2011 will see another $1 trillion deficit. It is hard to imagine that 2012, an election year, will be any different. And the situation only deteriorates after that as the baby boomers retire and health care and pension costs explode.
We know just how these kind of fiscal crises play out, Europe having graciously reminded us. Previously sanguine investors wake up one morning to the fact that holding dollars is risky. They fear that the U.S. government, unable to square the budgetary circle, will impose a withholding tax on treasury bond interest – on treasury bond interest to foreigners in particular. Bond spreads will shoot up. The dollar will tank with the rush out of the greenback.
The impact on the international system would not be pretty. The Canadian and Australian dollar exchange rates would shoot through the roof. A suddenly strong euro would nip Europe’s recovery in the bid and plunge its economy back into turmoil. Emerging markets like China, reluctant to see their exchange rates move, would see a sharp acceleration of inflation and respond with even more distortionary controls. If you were worried by talk of currency wars late last year, you ain’t seen nothin’ yet.
With exorbitant privilege comes exorbitant responsibility. Responsibility for preventing the international monetary and financial system from descending into chaos rests with the United States. How much time does it have? Currency crises generally occur right before or after elections. Can you say November 2012?
Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California Berkeley. He is the author of Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.