How Global Currencies Work: Past, Present, and Future

HOW GLOBAL CURRENCIES WORK

How Global

Currencies

Work

Past, Present,

and Future

Barry Eichengreen

Arnaud Mehl

Livia Chiţu

PRINCETON UNIVERSITY PRESS

PRINCETON AND OXFORD

Copyright © 2018 by Princeton University Press

Published by Princeton University Press,

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ISBN 978-0-691-17700-7

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10 9 8 7 6 5 4 3 2 1

CONTENTS

List of Tables vii   

List of Figures ix   

Acknowledgments xiii   

1   Introduction   1

2   The Origins of Foreign Balances   16

3   From Jekyll Island to Genoa   30

4   Reserve Currencies in the 1920s and 1930s   42

5   The Role of Currencies in Financing International Trade   58

6   Evidence from International Bond Markets   84

7   Reserve Currency Competition in the Second Half of the Twentieth Century   116

8   The Retreat of Sterling   145

9   The Rise and Fall of the Yen   158

10   The Euro as Second in Command   170

11   Prospects for the Renminbi   181

12   Conclusion   195

Notes   201

References   227

Index   245

TABLES

FIGURES

ACKNOWLEDGMENTS

Many persons have contributed to this manuscript over its long gestation. By far the most important contributor, as will be evident from the material that follows, is Marc Flandreau. Marc was a coauthor of the journal articles that were forerunners to Chapters 4 and 5. His comments led us to fundamentally rethink the organization and content of Chapter 2. His contribution to this project cannot be overstated. It would not exist without his input. Marc’s imprint on the final product will be clear to even the most casual reader.

We are grateful in addition to many friends and colleagues who commented on earlier drafts and on portions of the final manuscript. Attempting to list them risks offending by omission, since so many people have offered constructive feedback in seminars and over meals and coffee, spread over a period of years. Still, we would be remiss if we did not acknowledge the helpful comments of the following: Olivier Accominotti, Leszek Balcerowicz, Agnès Bénassy-Quéré, Matthieu Bussière, Menzie Chinn, Charles Engel, Kristin Forbes, Jeffrey Frankel, Jeffry Frieden, Norbert Gaillard, Pierre-Olivier Gourinchas, Pierre-Cyrille Hautcœur, John James, Robert Keohane, Philip Lane, Matteo Maggiori, Christopher Meissner, Ugo Panizza, Richard Portes, Angela Redish, Hélène Rey, and Thomas Willett.

Comments were also provided by seminar and conference participants at the following institutions: the American Economic Association annual meetings; the Asian Development Bank; Australian National University; the Bank for International Settlements; Clapes at the Catholic University of Santiago; Claremont McKenna College; the European Central Bank; the Fundación Areces (Madrid); Harvard University; Norges Bank; Stanford University; Tsinghua University; the University of Southern California; the University of Cambridge; and the University of California at Berkeley, Los Angeles, and Riverside. We are also indebted to the two anonymous referees of Princeton University Press and to our editors, Joe Jackson and Peter Dougherty.

A contribution of this project is new data, some from the archives of central banks and other institutions, others drawn from obscure and well-known published sources. In assembling these data, we relied on the hard work and goodwill of graduate student researchers, librarians, archivists, friends, and officials in a large number of different countries. (In some cases, the individuals in question qualify under more than one of the aforementioned five headings.) We can’t count the number of times we were told that the information you’re looking for no longer exists or we have those balance sheets from the 1920s that you’re asking about, but you can’t see them, only for the material to miraculously appear following intervention from the highest level (where, in monetary history, intervention from the highest level means a phone call from the central bank governor). For assistance with collecting data we are grateful to Olivier Accominotti, Leif Alendal, Walter Antonowicz, Gopalan Balachandran, Elizabeta Blejan, David Merchan Cardénas, Mauricio Cardenas, Pedro Carvalho, Filippo Cesrano, Vittorio Corbo, Jose DeGregorio, Oyvind Eitrheim, Rui Pedro Esteves, Peter Federer, Patrick Halbeisen, Mirako Hatase, Thomas Holub, Vappu Ikonen, Lars Jonung, Hans Kryger Larsen, Hassan Malik, Bernhard Mussak, Pilar Noguès Marco, Carry van Renslaar, Riad Rezzik, David Schindlower, Virgil Stoenescu, Trevin Stratton, and Pierre Turgeon. We are grateful for careful copyediting by Cyd Westmoreland.

Financial support for portions of this research was provided by the National Science Foundation, the France-Berkeley Fund, and the Committee on Research and Clausen Center for International Business and Policy, both of the University of California at Berkeley.

Finally, we acknowledge with thanks the permission of the following, where needed, to reproduce previously published material. Note that all the material included in this book has been substantially reformatted and revised compared to these prior publications.

Chapter 2. Marc Flandreau and Clemens Jobst (2009), The Empirics of International Currencies: Network Externalities, History and Persistence, Economic Journal 119, pp. 643–664.

Chapter 4. Barry Eichengreen and Marc Flandreau (2009), The Rise and Fall of the Dollar (Or When Did the Dollar Replace Sterling as the Leading International Currency?), European Review of Economic History 13, pp. 377–411.

Chapter 5. Barry Eichengreen and Marc Flandreau (2012), The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency 1914–39, Open Economies Review 23, pp. 57–87.

Chapter 6. Livia Chiţu, Barry Eichengreen, and Arnaud Mehl (2014), When Did the Dollar Overtake Sterling as the Leading International Currency? Evidence from the Bond Markets, Journal of Development Economics 111, pp. 225–245.

Chapter 7. Barry Eichengreen, Livia Chiţu, and Arnaud Mehl (2016), Stability or Upheaval? The Currency Composition of International Reserves in the Long Run, IMF Economic Review 64, pp. 354–380.

Chapter 10. Portions from Arnaud Mehl (2015), L’euro sur la scène internationale après la crise financière et celle de la dette, Revue d’économie financière 119(3), pp. 55–68.

Chapter 11. Portions from Barry Eichengreen (2013), Number One Country, Number One Currency? World Economy 36, pp. 363–374.

The views expressed in this book are those of the authors and do not necessarily reflect those of the European Central Bank or the Eurosystem. They should not be reported as such.

HOW GLOBAL CURRENCIES WORK

1

Introduction

In both scholarly narratives and popular histories, the dynamics of the global economy are portrayed in terms of the rise and fall of great powers.¹ The economic historian Angus Maddison, in his influential synthesis, characterized the dynamics of global growth in terms of the gap between the technological leader and its followers. The identity of the lead country may change, but technical progress in the leader always defines the limits of the possible. The task for other countries is not to expand that frontier but to follow the leader and close the technology gap.² Charles Kindleberger emphasized stability as well as growth, but like Maddison, he described global dynamics in terms of the changing identity but unchanging importance of the lead economy. In Kindleberger’s analysis, only the leading power had the capacity to stabilize the international system. It was therefore in periods of transition, when economic leadership passed from one country to another, that risks to stability were greatest.³

More concretely, these stories are told in terms of British hegemony in the nineteenth century, when Great Britain as the first industrial nation defined the technological frontier, and the country helped stabilize the global system by lending countercyclically—exporting capital when other economies suffered downturns—and by maintaining an open market for the goods of distressed foreign producers. They are told in terms of American hegemony in the twentieth century, when the power of the United States was effectively institutionalized in what is sometimes referred to as the Bretton Woods–GATT System.⁴ Extrapolating into the future, they will be told in terms of Chinese hegemony in the twenty-first.

Monetary historians view the same history through the lens of currencies. The nineteenth-century international economy—the era of the international gold standard, also sometimes called the first age of financial globalization—was dominated by the pound sterling. The Bank of England, its issuer, was conductor of the international orchestra.⁵ Britain’s status as leading foreign lender and home to the world’s deepest financial markets gave its central bank unmatched influence over the operation of the international monetary and financial system. Britain’s colonial trade, with India in particular, cushioned its balance of payments and eased adjustment in international financial markets.

Sterling, it is said, had no consequential rivals as an international and reserve currency in this period. London had no equals as an international financial center. The Bank of England had more influence over capital flows, exchange rates, and related financial matters than did any other central bank.

Paralleling these narratives of British economic and financial dominance in the nineteenth century, analogous stories are told about the twentieth-century international economy, or at least the international economy of the second half of the century. Once the torch of leadership was passed, international monetary and financial relations were dominated by the United States and the U.S. dollar. The dollar was the only freely available and widely accepted national currency in the Bretton Woods international monetary system, under which the greenback was pegged to gold while other currencies were effectively pegged to the dollar. Only the United States possessed deep and liquid financial markets on which its currency could be freely bought and sold and used by traders around the world, together with the economic, financial, and military strength to guarantee that its markets would remain open to other countries.

Moreover, what was true in the third quarter of the twentieth century—the heyday of Bretton Woods—was still true in the fourth, even though the Bretton Woods par value system was no more. Through the end of the twentieth century and longer, the dollar remained the dominant international and reserve currency. International monetary economists like Milton Gilbert and Ronald McKinnon referred to the monetary arrangements of the third and fourth quarters of the twentieth century, revealingly, not as the Bretton Woods and post–Bretton Woods periods but as the era of the gold-dollar system and the dollar standard, respectively.⁶

The dominance of the dollar gave the Federal Reserve System singular leverage over global financial conditions. That leverage evidently persists to this day, as reflected in the close attention paid to the impact of Fed policy on international financial conditions and the complaints of policy makers about the implications for their countries of U.S. monetary easing and tightening.⁷

Looking to the future, the same stories of political, economic, and monetary dominance are now told in terms of Chinese hegemony. The twenty-first century global economy, it is suggested, will be organized around the Chinese renminbi and regulated by the People’s Bank of China. China’s immensely large population all but guarantees that the country will overtake the United States as the single largest economy, just as the U.S. overtook Britain in the late nineteenth century.⁸ The renminbi will then overtake the dollar as the dominant international currency, for the same reasons that the dollar overtook sterling. Or so it is said by those who foresee this as the Chinese century, much as its predecessor was the American century.⁹

The Traditional View

This traditional view, that economic dominance and monetary dominance go together, flows from models with strong network externalities, so that first-mover advantage matters, and when those externalities are sufficiently powerful that the result is winner takes all.¹⁰ In these models, it pays when transacting across borders to use the same currency used by others transacting across borders. Network returns are strongly increasing, in other words. Expressing the price of one’s exports in the same currency as other exporters enables customers to easily compare prices and facilitates the efforts of entrants to break into international markets. Since intermediate inputs, when sourced from abroad, will similarly be priced and invoiced in the dominant international currency, a firm will prefer to express the prices of its exports in that same currency, thus preventing its costs from fluctuating relative to its revenues when the exchange rate changes.

Likewise, denominating one’s debt securities in the same currency as other issuers enables investors to readily compare returns and makes it easier for new issuers to secure loans on international capital markets. Borrowing costs will be lowest in the deepest and most liquid financial market, which possesses its depth and liquidity because it is the market to which importers and exporters turn for trade finance. The country with the deepest and most liquid financial market will similarly be attractive as a place for investors from other countries to hold their foreign balances, since investors value the ability to buy and sell without moving prices. Thus, not only private investors seeking to diversify their portfolios but also central banks and governments, when deciding on the composition of their foreign reserves, will be drawn to the currency of the country with the deepest and most liquid financial markets—in other words, the same currency to which other investors are drawn.

For all these reasons, a single national unit will tend to dominate as the international unit of account, means of payment, and store of value. When those network increasing returns are sufficiently strong, international currency status will resemble a natural monopoly. There will be room in the world for only one true international currency. In the past this was sterling. Now it is the U.S. dollar. In the future it will be the renminbi.

These models imply, further, that the currency of the country that is the leading commercial and financial power is the natural candidate for this dominant status. As a large economy, it will have extensive international trade and financial links. It will have well-developed financial markets. Its residents being accustomed to transacting in their own currency, its national unit will have a relatively large installed base, in the language of network economics.¹¹ Exporters and investors in other countries will consequently be drawn to the currency in question for transactions with residents of the lead economy. The currency of the leading economic power will thus have an intrinsic advantage in the competition for international currency status. This plausibly explains how sterling emerged as a global currency in the nineteenth century and how the dollar assumed this position in the twentieth.¹²

Models with network effects can also be models in which persistence is strong. In the limit, there may be lock-in—once an arrangement is in place, it will persist indefinitely.¹³ Once market participants have settled on a technology—in this context, on a monetary and financial technology (call it an international currency)—they will have no incentive to contemplate alternatives. Transacting using a different technology or platform not also used by members of one’s network will be prohibitively costly. In the international monetary and financial sphere, currencies other than the dominant unit will not possess the same attractions for individuals, banks, firms, and governments engaged in cross-border transactions. The prices of goods and financial instruments invoiced in other currencies will not be as easily compared. Settlements will not be as predictable. Investments will not be as liquid. Other currencies will not possess the same transparency, predictability, and liquidity, precisely because they are not the currencies that dominate international transactions. And since individuals, banks, firms, and governments make decisions in a decentralized fashion, there will be no mechanism for coordinating a large-scale shift from one international monetary and financial standard to another.¹⁴

It follows that international currency status will display inertia. It will persist even after the conditions making for the emergence and dominance of a particular national unit no longer prevail to the same extent. That currency will remain locked in unless a significant shock causes agents to abandon established practice and coordinate a shift from one equilibrium (from the common use of one international currency) to another. This explains, it is said, why sterling remained the dominant international currency well into the twentieth century, long after Great Britain had been surpassed in economic size and financial power by the United States. It explains why the shock of World War II was required for sterling to finally be supplanted by the dollar. These conjectures have obvious implications for how long the dollar is likely to remain the dominant international currency and what kind of shocks may be required for it to be supplanted by the renminbi.

The New View

This traditional view of international currency status is based more on theory than evidence.¹⁵ At most, the theoretical models in question merely allude to historical facts as a way of providing motivation, rather than engaging seriously with the evidence. And even scholars who treat the evidence seriously are hampered by the limits of the available empirical base.

Consider the currency composition of foreign exchange reserves. We know something about this in 1899 and 1913, courtesy of the pioneering estimates of Peter Lindert.¹⁶ We then know something about it starting in the 1970s, courtesy of the IMF and its Currency Composition of Official Foreign Exchange Reserves (COFER) database.¹⁷ But we know little about the periods before or between.

These are thin empirical reeds on which to hang an encompassing narrative. Moreover, the traditional narrative is hard to square with even this limited evidentiary base. For the final decades of the twentieth century, the IMF’s data confirm that the dollar accounts for the single largest share of identified foreign exchange reserves, but that this share is only on the order of 60 percent. Other currencies also played consequential international roles, in would appear.

Neither do Lindert’s data support the assertion that international currency status is a natural monopoly. In fact they show other currencies in additional to sterling—the German mark and the French franc—also accounting for non-negligible shares of central bank reserves in 1899 and 1913.¹⁸ (See Figures 1.1 and 1.2.)

FIGURE 1.1. Shares of Currencies in Known Reserves, 1899 (percent).

Source: Lindert (1969).

Note: DEM, German mark; FRF, French franc; GBP, British pound.

FIGURE 1.2. Shares of Currencies in Known Reserves, 1913 (percent).

Source: Lindert (1969).

Note: DEM, German mark; FRF, French franc; GBP, British pound.

New evidence on the period between 1913 (when Lindert’s analysis ends) and the early 1970s (when the IMF’s picks up) is equally hard to reconcile with the traditional view. Sterling, rather than remaining the preeminent international currency after World War I, in fact already shared that status with the dollar in the 1920s, suggesting that multiple international currencies can coexist. The dollar’s rise was rapid, at odds with the presumption that persistence is strong. Beginning in 1913, the greenback went from being used hardly at all in the international monetary domain to being a coequal with the pound barely 10 years later.

All this leads us to challenge the conventional wisdom. We argue