Monday, January 31, 2005

Is the US dollar still an international public good?

(Has it really been a week since my last post? Try to improve on that . . . )

The international currency we see today, with the US dollar acting as the primary reserve currency for the world and the most important currency for internationally traded commodities, is not an unprecedented one. Lawrence Broz, an economist and historian, has written about another international monetary regime, one that existed in the 18th, 19th and early 20th centuries during the era of the gold standard. Broz argues:
From the perspective of international political economy, such a regime is something of an international public good. When a sufficient number of governments commit credibly to a set of international monetary rules, the result is that goods, services, and capital can flow across borders relatively unimpeded by currency concerns, creating joint-welfare gains and promoting technical efficiency.
The international monetary regime that Broz analyzes had three key players: England, France and Germany. England had a strong commitment to the gold standard, ensuring that the sterling always had a fixed value. This worked wonders for European trade, since European countries could trade with a newly industrialized England with the assurance that the sterling that they received for their raw materials would hold its value and would buy them a healthy basket of English industrial goods.

In order for England to maintain their gold standard without wildly fluctuating interest rates, which would've been a burden for the European economy, and would've resulted in similarly fluctuating rates in France, the Bank of England needed a lender of last resort. Essentially, the Bank of England needed the Bank of France to lend them gold when their reserves were drained in order to prevent crazy interest rate increases. And France built up huge gold reserves in order to act as a lender of last resort. According to Broz, by 1908, the Bank of France had "well over three times the reserves held by the Bank of England."

Does this sound familiar to anyone else? After reading a ton about the Chinese-American currency situation, I definitely noticed some paralels. In the current international currency regime, which is really a dollar hegemony, Chinese lending preserves the system. Without China buying American treasuries—lending to the United States—the dollar would be unable to preserve its current value.

Understanding the current situation as an international currency regime also gives shape to what might come after the end of the dollar's reign. What we might be experiencing now is the end of the dollar regime and the rise of another. Perhaps the Euro will take the place of the dollar, or perhaps we will operate without a clear regime until there is an obvious replacement. If the latter happens, we can expect huge economic costs for the world, due to the increase in transaction costs. Until a new system forms, the international economy will be fundamentally unstable. But, as Broz says:
From a perspective of comparative politics, however, a smoothly functioning monetary regime is far from a natural state of affairs. Adherence to a common set of monetary rules and conventions requires a certain degree of macroeconomic-policy cooperation among member governments, despite potentially vast differences in the domestic constraints confronting policy makers. The overriding political obstacle in the way of establishing and maintaining a multilateral commitment to a common set of exchange-rate rules is that national politicians face heterogeneous domestic electorates and organized constitutencies, not homogeneous global ones. According to this view, the paradox is not the difficulty of designing a stable international monetary regime in a world of opportunistic but like-minded national governments, but that such systems, composed of an extremely diverse group of nation-states, have ever existed, let alone operated relatively smoothly for extended periods of time.
So the rise of a new regime is certainly not a foregone conclusion.

Here are some pertinent questions that I don't feel up to answering right now:
  1. As there are now three huge economic powers—the United States, China, and the European Union—is a stable currency regime possible? Can China afford to be the lender of last resort to the EU as it was to the US, and for how long? Will it decide to establish a free-floating currency that could make a claim for the leader in the regime in its own right?
  2. What are the domestic political barriers in China, the US and the EU that are killing the current regime and might lead to the rise of the next one?
  3. What are the interim costs of a regime-less world economy? What does it look like? Will we go back to gold in the interim? Will we go back to gold for the long-run?
I think I've talked myself out for now, but I'm really interested in answering some of those questions, especially the second one, so I'll try to post again in the next couple of days.


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