A guest review of Exorbitant
Privilege: the rise and fall of the dollar, by Barry Eichengreen

Philip Thornton, Clarity Economics

From a
standing start in 1914, the US dollar overtook sterling as an international
currency within the space of less than a decade. When sterling finally fell off
its pedestal as the world’s reserve currency in the wake of the Suez crisis, it
was America that gave it the final shove.

Could
history be about to repeat itself? The dollar is going through a crisis of
confidence, weighed down by historically high deficits. Since its entry into
WTO in 2001, China has leapt to become the world’s second-largest economy. Meanwhile
the Chinese authorities have publicly raised the idea of alternatives to the
dollar and taken preliminary steps towards making the renminbi a more
international currency.

Anything is
possible and, as Barry Eichengreen points out, if history is any guide then a
collapse of the dollar would develop not gradually but abruptly. History
plays a significant role in this short but detailed and fast-moving analysis of
the rise of the greenback as an international currency. Readers eager for
Eichengreen’s forecast of how the tensions between China and the US over
currencies will pan out need to wait 150 pages for that action to begin.

Their
patience is rewarded, as Exorbitant Privilege is almost five books in
one. A history of the dawn of the dollar provides a long historical context;
the post-war battle of supremacy takes us to Bretton Woods; then the creation
of the euro; the 2008/09 financial crisis; and finally the denouement of the
dollar. Eichengreen,
a professor of economics and political science at the University of California,
Berkeley, mixes those two disciplines effortlessly to show how it is long term
shifts in economic and political power that determine the fate of currencies. Thus it
took a quarter of a century and a devastating world war before sterling’s
demise as a global reserve currency was clear. Incumbency gives currencies
significant advantages, as the author frequently points out.

The dollar
has had a remarkable run as sole reserve currency over the last half century.
This enabled the US to run deficits “without tears” as French economist Jacques
Rueff put it, by printing money and requiring its trading partners to buy its
currency in order to transact.

This is
what Valery Giscard d’Estaing, then France’s finance minister, bitterly
described as the dollar’s “exorbitant privilege”, the elegant phrase that gives
the book its title.

But despite
the sub-title of the book, Eichengreen does not believe that history will
repeat itself in the way that sterling really did experience a rise and fall. The author
carefully points out the weakness in what he described as ”sensationalist”
reporting of the dollar’s imminent decline. The first is that unlike the 1950s
when the US held relatively few pounds, the Chinese hold some $2 trillion in
their reserves. A decision
to engineer a crash in the dollar would leave Beijing nursing staggering paper
losses on its holdings. Secondly China’s export-driven economy depends on US
consumers continuing to “buy Chinese”. Massive dollar depreciation would send
import prices sky high and trigger painful retrenchment among Chinese
companies. Third,
other countries – users of the euro in particular – would suffer too as their
currencies appreciated and would be more than willing to work with the Federal
Reserve to stabilise the dollar. Finally
China would have to allow the renminbi to fluctuate within the liquid and open
financial markets that Beijing has to date resisted while it seeks to engineer
high levels of export-driven economic growth to fund its infrastructure needs.

For
Eichengreen, the threat to the dollar comes not from the Chinese but from
America itself, and particular “eye popping” US deficits. He blames the
ballooning of the deficit during the good times of the Bush era, the cost of
tackling the financial crisis and the ticking time-bomb as the baby boomers
reach retirement. He pins his
hopes on a bipartisan initiative by Congress to rebalance the nation’s finances
but is not optimistic, a view supported by the recent failure of the National
Commission on Fiscal responsibility to strike a deal. The best
outcome would be a gentle decline in the dollar combined with tough action to
reduce the fiscal deficit while investing in infrastructure to help deliver a more
balanced economic recovery based on high-skilled industrial activity.

The point
is that whatever action is taken – Eichengreen suggests tax reform, caps on
bankers’ bonuses and investment – the dollar’s fate still rests with America,
something he sees as “good news”.

While the
Sino-American aspect of the book will grab headlines in the US, European
readers should not skip over the sections on the euro. In fact the
book is as much about the euro and the dollar. The dollar’s turmoils could have
opened the way for the single currency but political compromises towards
national sovereignty that prevented fiscal union and a genuine eurobond market
hampered the euro’s emergence as a truly global currency. As Eichengreen
puts it, the euro is a “currency with no state” while the renminbi is a
“currency with too much state”. The lack of rivals means that reports of the
dollar’s demise as an international currency appear to be greatly exaggerated.

Here's a new book for aid practitioners and policy makers  – the pdf version is available for free download. Impact Evaluation in Practice is by Paul Gertler, an affiliate of the Abdul Latif Jameel Poverty Action Lab, J-PAL, and co-authors Sebastian Martinez, Patrick Premand, Laura Rawlings and Christel Vermeersch.

It's published by the World Bank, and “presents a non-technical overview of how to design and use impact evaluation to build more effective programs to alleviate poverty and improve people’s lives. The goal is to further the ability of policymakers and practitioners to use impact evaluations to help make policy decisions based on evidence of what works the most effectively.”

The book comes with training videos and power points. Sounds a terrific resource for people in the aid business. Effectiveness is a key aid issue – see Owen Barder's recent blog post on this point. As he says: “Most people don’t need to be convinced that development is
desirable; they need to be convinced that aid works.”

Today I had a delightful lunch with an old friend with whom I chatted about the Scottish Enlightenment, amongst other things, and in particular what big fans we both are of David Hume. Adam Smith owed a great intellectual debt to Hume, as Nicholas Phillipson's recent biography Adam Smith: An Enlightened Life (reviewed by me in the New Statesman) makes clear. Not all that many people realise that Hume did write about economics. When I got back to my desk I looked up his classic essay 'Of the Balance of Trade' from Essays Moral, Political and Literary of 1752. This is the essay that sets out the famous price-specie flow mechanism. Hume was the first to point out that capital and current accounts have to balance, ex post. He wrote:

“There still prevails, even in nations well acquainted with commerce, a strong jealousy with regard to the balance of trade, and a fear that all their gold and silver may be leaving them….. I should as soon dread that all our springs and rivers should be exhausted, as that money should abandon a kingdom where there are people and industry.”

He goes on to point out the equilibrating adjustments to monetary shocks that occur via the exchange rate and discusses the adverse effects of accumulating reserves and trying to prevent the addition to the money supply from affecting prices. He would be unimpressed with China's exchange rate policy, but equally unimpressed by concern about US sales of financial assets to foreigners. For as the essay concludes:

“A government has great reason to preserve with care its people and its manufactures. Its money, it may safely trust to the course of human affairs, without fear or jealousy. Of it it ever give attention to this latter circumstance, it ought only to be so far as it affects the former.”

I think one has to describe Hume as a monetarist with a Keynesian heart.

You might think I should really get a life, but I've spent part of this Sunday afternoon reading the December 2010 Financial Stability Report from the Bank of England. This is not the world's most exciting or raciest document but it's not just one for finance nerds either.

To give just one example as we head into bank bonus season, chart 5.9 on page 52 tells me that the four major UK banks received a subsidy amounting to £100bn in 2009 from access to cheap funds via the Bank of England. Chart 4.3 on page 38 tells me that their profits in that year were £40bn and 2010 profits are likely to be a little higher. The Bank's Special Liquidity Scheme, providing cheap funding, continues until January 2012. Looking at these two charts, I ask myself where the profits which are supposed to justify a return to bonuses actually come from?

I just devoured the UK paperback edition of The Big Short, which author Michael Lewis has been here publicising this past week. It's one of the popular classics of the Great Crash, managing to be both a page turner and a clear explanation of the financial instruments at the heart of the financial meltdown. (Having said that, every time I thought I'd understood the CDOs and CDSs, I forgot, and had to go back and remind myself. In the end Lewis's phrase 'pile of shit' seemed a perfectly adequate synonym.)

Lewis is a terrific story teller, and he recounts the origins and unfolding of the sub-prime crisis through interwoven stories about a handful of characters who were amongst the only investors to foresee the crash. Hence they shorted the financial derivatives on sub-prime mortgages – the infamous CDOs, sometimes using the CDSs which were bets on them. Intriguingly, all turn out to be in various ways misfits, loners or eccentrics. It took a distinctive character to stand against the crowd – Lewis successfully brings these people to life. As for the crowd, the Goldmans, Bear Stearns etc traders and bosses, they made the sub-prime derivatives complex to fool their clients and ended up fooling themselves. Once they kept some of them on their own books rather than shuffling all of it onto AIG and the like, disaster was only a matter of time.

Once the sub-prime market got going, after 2005, almost all the mortgages originated were bound to go belly up. In 2005 alone, half a trillion dollars worth of mortgages were extended to non-creditworthy borrowers; the figures got bigger in successive years. There was no way loans on this scale could be repaid by low income borrowers. Nevertheless, the Wall Street machine wanted the mortgages created because the margins from fees on the bonds and derivatives spun on top of them were so juicy.

But throughout the second half of the noughties, the rising incidence of default and fraud was clear in the statistics. Wall Street managed to ignore the implications because the ratings agencies meekly rated almost all the CDOs as triple-A, even those which were created out of the riskier tranches of previous CDOs. The eagerness of investment banks to screw their clients, and the inadequacy of the ratings agencies are two key elements in this story, along with the denseness of a few individuals who just did not understand the risk they were taking. (This includes the CEOs of the investment banks.)

Lewis is also very clear about the wider purpose of the sub-prime machine, to allow poor people to spend as if they were rich, and paper over the yawning inequality in the United States. In this he agrees with Raghuram Rajan's Fault Lines. While more than 2 million people lost their homes, the losers on Wall Street walked away with millions or tens of millions in payoffs. Equally, he points out forcefully that Goldman Sachs managed to transfer around $20bn directly from the taxpayer (bailing out AIG) to itself at the height of the crisis, and suffered hardly at all for its own greed and misjudgement. In this he echoes Matt Taibi's Griftopia (Taibi has a detailed account of the negotiations between Goldmans and the authorities at the time).

So The Big Short joins my list of gripping and accessible reads about the crisis – along with Whoops! by John Lanchester as well. The behaviour of the Wall Streeters defies belief in retrospect – as does their continuing insistence that they can go back now to business as normal. I think not.