There's been a lot of discussion lately of the dollar losing its role as the main reserve currency, based on various pronouncements on the topic by Chinese officials seemingly unhappy with the current situation (either the low return on their investments, mostly US Treasuries, or the slow devaluation of the dollar against other currencies or assets) - including, most notably, a proposal by the boss of China's Central bank to create a new world currency. This has led to fretting about shifts in global influence or even a new "Beijing Consensus" to replace the Washington one, and of course to more or less gleeful comments about the end of the American Empire.
I'd like to argue that a lot of this is very premature, but end with a serious question: why is the euro usually not taken seriously?
wikipedia's definition of a reserve currency provides an interesting start, as much for what it underlines as for what it omits:
A reserve currency (or anchor currency) is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.
That definition flags the two most fundamental characteristics of a reserve currency:
- it is a way for countries to store value that can be used internationally (that's what foreign exchange reserves are: money that can be used outside the country, to trade or to service debt)
- it is used internationally to price various traded goods, which means that it will be needed, even if for a split second (if payment is made in another currency, the ability to convert it into dollars, ie a rate of exchange and the requisite potential liquidity, needs to be available), to make purchases of such goods.
What the definition carefully avoids is to say if there is any causality relationship between the two items above. It also ignores a simple, if profound, item: a reserve currency is a reserve currency because it is a reserve currency.
In fact, all of these are linked to the same fact, which also goes to the heart of what money is, at the most basic level: money is worth something because others accept to take it in exchange for something that they provide to you - ie others recognize its value. And the more people recognize its value, the more it actually has.
It thus seems intuitive that money should be based on something with obvious intrinsic value for everybody (and food or energy, as regularly proposed on ET by ChrisCook seem like obvious places to start), but that is clearly not enough: money needs to be practical to transport, easy to store, difficult to counterfeit and available in sufficient, if not excessive, quantities. All of which are difficult qualities to find in goods that tend to be consumed up relatively rapidly and locally, like most foods and (until the discovery of oil) energy sources.
Thus, for a long time, gold has played this role, because it is relatively rare (thus its value), but available almost everywhere (it is found in its natural state in streams all over the world), very dense (ie it occupies a small volume for a given weight, which is convenient to transport and hard to fake), chemically inert (ie it does not degrade and thus does not 'leak' value) but easy to work on as a metal.
But gold's most important quality is a more subtle one: it is universally accepted, despite being (or because it is) a conventional form of money. What this means is that gold is not valued for its intrinsic qualities (you can't eat it, and its jewellery uses are intimately linked to its nature as a way to display wealth) but for the fact that it can be counted upon to be tradeable anywhere for other goods at good value. That value is artificial (it derives from people accepting it), but once established, just like other conventions, it is self-reinforcing and self-perpetuating: people value gold because they know that people value gold.
Currencies (paper money) are, similarly, a form of conventional money. It can be argued that they are a step further removed from any "real" quality, being based on the full faith and credit of the entity (usually, but not necessarily, a public body) which creates it, but while the intrinsic quality of that entity (whether its creditworthiness or its ability to impose its will by force) was initially required to establish the currency, the currency will survive if it seen to function as a currency - ie if it provides enough of the core functions of a currency (store of value, instrument of trade, a way to estinguish debt) and/or is perceived to fill that role, even if the entity behind it gets weaker.
Which brings us to foreign currencies. The first need was to trade with other countries that used different currencies. Quite naturally, one would accept another currency in payment only if one intended to buy goods that are sold in that currency (in its country of origin or elsewhere), now or later, at an acceptable price. When currencies were based on gold, the issue was not so much the acceptability of the currency, but the possibility that it might lose value against gold (devaluation, by way of the printing press, or by fiat decision) or that it might be confiscated or refused, ie political risks. With currencies no longer based on gold, the acceptability of any foreign currency for payment against goods (or to service debt) becomes an additional political risk. And each political risk can always be split into two questions: 1) can they deliver?, and 2) will they do it? The first question goes to "objective" factors, such as the availability of goods, the breadth of the markets using that currency, or the strength of public finances; the second to more subjective items (who decides, on what criteria? what happens if they don't? can they get away with it?)
And thus we get to today. The dollar's dominance was fully established in the years after World War 2, when the US economy dominated the planet - including in the sector of oil production... - and the US had a comfortable trade surplus, is other people wanted US goods more than Americans bought foreign goods. It was also a time, until 1971, when the dollar was still fully convertible to gold at a fixed rate. The dollar was, then, a credible and convenient substitute to gold - which established it then as the uncontested world reserve currency, a status which, as we've seen above, has value on its own, given its self-sustaining and self-reinforcing nature - people use dollars because people use dollars. The move away from gold took place at a time when the US was still the dominant economy, when a large portion of international trade and commodity pricing took place in dollars, and when most countries and their populations had become used to storing and using dollars because they were, in most cases, more stable than their own currencies.
It obviously helps to become a reserve currency to have a large domestic market where people use the currency without caring about its international role; it also helps that the currency is trusted at home. But it made more sense for Europeans, prior to the introduction of the euro, to have reserves in the currencies of their neighbors, simply because they traded with them a lot, and needed such currencies rather often; still, the same conventional mechanism occurred then, with the DM becoming the dominant currency within Europe, because it was the larger and the most stable (ie least inflation-prone) currency.
Today, we're in a very unusual situation, for several reasons:
- the first item is that a number of countries have accumulated absolutely huge dollar reserves because they have responded to the US debt binge through mercantilist policies which have compounded the problem: ie, rather than let their currencies revaluate against the dollar, to balance out trade, they've preferred to protect their exports by "sterilising" their dollar income, by way of purchase of US Treasuries (effectively, banknotes with very large facial value) by their central banks rather than US goods and services by their population. This was linked to the painful memories of the 1997 crisis (where lack of reserves caused currency collapse and economic mayhem when investors fled) or, in oil-exporting countries, to a choice to build up reserves for future generations as the recent oil-related windfall was so huge; whatever the cause, it means that there are many countries, including several that are not friendly with the US, which have large absolute amounts of reserves, a large chunk of which is in dollars, whose fate is closely watched by everybody (thus the attention paid to declarations by Central Bank officials and the like);
- underlying this is the fact that the US has accumulated massive trade deficits; a currency's strength (which helps its role as a reserve currency, as the Swiss case shows) is usually backed by trade surpluses, which mean that the country produces more goods that are desired by the outside than it needs to import. In the case of the US, they took advantage of their currency's privileged status to accumulate deficits without any apparent consequence. Ever larger IOUs were seen as a endlessly acceptable substitute to goods. The dollar did lose value against other currencies during the period, but that took place mostly against a small number of countries, namely the euro, sterling and other rich world currencies like the Canadian or Australian dollars (and, it can be argued, against gold and oil);
- the other unusual thing today is that there is a potential substitute currency available - at least one with as large an underlying economy and domestic user base, deep capital markets, sound regulatory frameworks, and a long, credible tradition of inflation fighting via its main predecessor the Deutsche Mark: the euro;
- of course, to top it up, we have the current financial crisis, which is massively reshuffling the deck and causing currency movements in the short term which may not be related to long term trends or to "normal" currency valuation. For instance, the brutal strengthening of the dollar in autumn 2008 was most likely caused by a movement to cash and perceived safety by US investors who needed to liquidate assets and took advantage of the weak dollar to sell relatively better valued (in dollars) foreign assets and use the cash to plug holes in their portfolios, and stuff the rest in ultra-safe Treasuries.
At this point, there are a few safe predictions, and some large uncertainties. Amongst the certainties:
- There will be no yuan, or rouble, or petro as reserve currency for the foreseeable future. Each of these has major flaws that prevent it from playing such a role, but the main one in each case is that their home countries' governments will NOT be trusted to preserve the value of currencies or, more to the point, to not play with foreigners' holdings of their currency. Would you expect Russian authorities, or the Chinese communist party, or any oil monarchy, to never engage in confiscatory measures, or to not favor local companies against you in case of a major financial dispute? In other words, would you entrust the political leadership of these countries with full control over your wealth? Because that's what it means to have the yuan, or rouble, as a reserve currency: it means relying on the legal system and courts, and ultimately on the political system, of China or Russia. That the US under Bush somewhat abused the trust put in it (i) does not make the alternatives good and (ii) was not quite to the point that the currency was made politically unreliable. A reserve currency will only come from a country whose authorities are demonstrably able to enforce rules about money neutrally (and I'm willing to bet that if you somehow had a Saudi-China-Russia alliance to flex its collective industrial-energy muscles against the West, their leaders would still have their money in Switzerland rather than within each other's grasp...);
- The US Dollar will remain "a" major reserve currency for decades to come, if not the only one. While it is conceivable that the US Dollar will no longer be the dominant reserve currency (whether because the euro increases its share, or because the system breaks down and splits into many different smaller (presumably regional) sub-systems, or something else), it will remain an active reserve currency. The US economy's size ensures that it will remain a pole of the world economy of its own right, with a need for others to use the dollar to trade with it. Also, more importantly, the fact that most commodities and many internationally traded goods are priced in dollars today ensures, out of pure inertia, that the dollar will keep a disproportionate role in such trade. Just look at how a number of commodities are still traded in pounds in London, a century after the UK lost its dominant economic position. Today, with the much vaster financial markets on top of the physical markets for all commodities completely built on the dollar, it will be even harder to move away from that currency: it would require all market players to adapt new conventions, new market rule and instruments, and new mental frameworks (all at the same time) to keep on playing together. It's just like saying that all companies are going to move away from Windows Office because the new Open Office is better (and free!): it's just not going to happen, beause the value of everybody else using the same standard as you is so much more important than the cost of your little bit of the system. So, even imagining a massive movement of defiance towards the dollar, and barring catastrophic collapse (of the kind that would make reserve currencies irrelevant anyway) I cannot right now see anything more than a relative balancing away from the dollar (to, say, 40/45/15 instead of 65/25/10 for the share of dollar/euro/others).
That said, I'm not willing to bet yet (or: anymore) on such a slide happening any time soon. I believe it will, mostly because I still think that the main long term danger right now, after 12 trillion dollars of federal injections in the US financial system, is massive inflation rather than the deflation everybody "serious" worries about, and that will ultimately lead to a serious devaluation of the dollar against more virtuous currencies - namely, against the one that does have all the theoretical attributes to become an acceptable substitute to store value, the euro: a stable legal system, a large economy with no external imbalances, deep financial markets.
But my position is obviously not shared by the Chinese, nor by most (London or New-York-based) financial analysts, who all seem to think that the euro is about to break down, that the ECB is woefully behind the curve on the crisis, and who crow that the eurozone did not manage to escape the crisis any more than the Anglo-Saxon world (ie, why bother being virtuous when you're punished all the same - might as well have the fun when you can). Europe is divided and hapless and weak we're being told again and again and again... maybe to avoid the above suggested move towards the euro?
The Economist has this fun quote as a conclusion of its latest Charlemagne column:
Chinese officials are reportedly fascinated by European welfare and public-health systems, as well as by EU product regulation. Providing a model for red-tape or welfare reform may not be as much fun as jointly running a multipolar world. But with its pathetic record of handling partners such as China, Europe should welcome recognition of its relevance, however it is offered.
Despite its apparent topic, this is highly relevant to our discussion of currencies: what makes a currency credible to the rest of the world is not hard power, it's soft power. Soft power usually comes only on the heels of hard power, when used smartly, as the US demonstrated after WW2, and the correlation has maybe been made mistakenly between a safe currency and hard power, but hard power, most of the time, comes with no soft power spontaneously attached... The US blew a lot of soft power in the past decade and, like trust, it's faster to destroy than to build, so Obama's new direction will take time to have an effect there. Meanwhile, we're still having massive deficits, imbalances and stranded assets, which make the dollar look bad or worse.
But that does not mean that the other countries or blocs that look like they have some form of hard power (China with cash, Saudi Arabia with oil, etc...) have any credibility as substitutes. The euro may have a chance if Europe's soft power is taken seriously - which will happen only when its own politicians actually take it seriously themselves, rather than believing neocon theories about Mars and Venus...
Reserve currencies come from Venus.