At first glance, the modern history of the global economic system seems to support the long-held view that the leading world power’s currency—the British pound, the U.S. dollar, and perhaps someday the Chinese yuan—invariably dominates international trade and finance. In How Global Currencies Work, three noted economists provide a reassessment of this history and the theories behind the conventional wisdom. Read on to learn more about the two views of global currencies, changes in international monetary leadership, and more.
Your title refers to “two views” of global currencies. Can you explain?
We distinguish the “old view” and the “new view”—you can probably infer from the terminology to which view we personally incline. In the old view, one currency will tend dominate as the vehicle for cross-border transactions at any point in time. In the past it was the British pound; more recently it has been the U.S. dollar; and in the future it may be the Chinese renminbi, these being the currencies of the leading international economies of the nineteenth, twentieth, and twenty first centuries. The argument, grounded largely in theory, is that a single currency has tended to dominate, or will dominate, because it pays for investors and producers when engaging in cross-border transactions; specifically, it pays for them to do cross-border business in the same currency as their partners and competitors. This pattern reflects the convenience value of conformity—it reflects what economists refer to as “network externalities.” In this view, it pays to quote the prices of one’s exports in the same units in which they are quoted by other exporters; this makes it easy for customers to compare prices, enabling a newly competitive producer to break into international markets. It pays to denominate bonds marketed to foreign investors in the same currency as other international bonds, in this case to make it easier for investors to compare yields and maximize the demand for the bonds in question.
In what we call the new view, on the other hand, several national currencies can coexist—they can play consequential international roles at the same point in time. In the modern world, it is argued, network externalities are not all that strong. For one thing, interchangeability costs are low as a result of modern financial technology. The existence of deep and liquid markets allows investors and exporters to do business in a variety of different currencies and switch all but effortlessly between them—to sell one currency for another at negligible cost. The existence of hedging instruments allows those investors to insure themselves against financial risks—specifically, against the risk that prices will move in unexpected ways. Prices denominated in different currencies are easy to compare, since everyone now carries a currency converter in his or her pocket, in the form of a smartphone. These observations point to the conclusion, which is compelling in our view, that several national currencies can simultaneously serve as units of account, means of payment and stores of value for individuals, firms and governments engaged in cross-border transactions.
In our book we provide several kinds of evidence supporting the relevance of the new view, not just today but in the past as well. We suggest that the old view is an inaccurate characterization of not just the current state of affairs but, in fact, of the last century and more of international monetary history.
What exactly motivated you to write this book?
We were worried by the extent to which the old view, which pointed to a battle to the death for international monetary supremacy between the dollar and the renminbi, continues to dominate scholarly analysis and popular discourse. This misapprehension gives rise to concerns that we think are misplaced, and to policy recommendations that we think are misguided. Renminbi internationalization, the technical name for policies intended to foster use of China’s currency in cross-border transactions not just within China itself but among third countries as well, is not in fact an existential threat to the dollar’s international role. To the contrary, it is entirely consistent with continued international use of the greenback, or so our evidence suggests.
In addition, making a convincing case for the new view requires marshaling historical, institutional and statistical material and analyzing the better part of a century. We though this extensive body of evidence cried out for a book-length treatment.
To what revisions of received historical wisdom does your analysis point?
We use that historical, institutional and statistical analysis to show that the old view of single-currency dominance is inaccurate not just for today but also as a description of the situation in the first half of the twentieth century and even in the final decades of the nineteenth. In the 1920s and 1930s, the pound sterling and the dollar both in fact played consequential international roles. Under the pre-World War I gold standard, the same was true of sterling, the French franc and the German mark. Our reassessment of the historical record suggests that the coexistence of multiple international currencies, the state of affairs toward which we are currently moving, is not the exception but in fact the rule. There is nothing unprecedented or anomalous about it.
And, contrary to what is sometimes asserted, we show that there is no necessary association between international currency competition and financial instability. The classical gold standard was a prototypical multiple international and reserve currency system by our reading of the evidence. But, whatever its other defects, the gold standard system was a strikingly stable exchange-rate arrangement.
Finally, we show that, under certain circumstances at least, international monetary and financial leadership can be gained and lost quickly. This is contrary to the conventional wisdom that persistence and inertia are overwhelmingly strong in the monetary domain owing to the prevalence of network effects. It is contrary to the presumption that changes of the guard are relatively rare. It is similarly contrary to the presumption that, once an international currency, always an international currency.
So you argue, contrary to conventional wisdom, that changes in international monetary leadership can occur quickly under certain circumstances. But what circumstances exactly?
The rising currency has to confront and overcome economic and institutional challenges, while the incumbent has to find it hard to keep up. Consider the case of the U.S. dollar. As late as 1914 the dollar played essentially no international role despite the fact that the U.S. had long since become the single largest economy. This initial position reflected the fact that although the U.S. had many of the economic preconditions in place—not only was it was far and away the largest economy but it was also the the number-one exporter—it lacked the institutional prerequisites. Passage of the Federal Reserve Act in 1913 corrected this deficiency. The founding of the Fed created a lender and liquidity provider of last resort. And the Federal Reserve Act authorized U.S. banks to branch abroad, essentially for the first time. World War I, which disrupted London’s foreign financial relations, meanwhile created an opening, of which the U.S. took full advantage. Over the first post-Fed decade, the greenback quickly rose to international prominence. It came to be widely used internationally, fully matching the role of the incumbent international currency, the British pound sterling, already by the middle of the first post-World War I decade.
The shift to dollar dominance after World War II was equally swift. Again the stage was set by a combination of economic and institutional advances on the side of the rising power and difficulties for the incumbent. The U.S. emerged from World War II significantly strengthened economically, the UK significantly weakened. In terms of institutions, the U.S. responded to the unsettled monetary and financial circumstances of the immediate postwar period with the Marshall Plan and other initiatives extending the country’s international financial reach. The UK meanwhile, was forced to resort to capital controls and stringent financial regulation, which limited sterling’s appeal.
What are the implications of your analysis for the future of the international monetary and financial system?
The implications depend on the policies adopted, prospectively, by the governments and central banks that are the issuers of the potential international currencies. Here we have in mind not just the dollar and the renminbi but also the euro, the Euro Area being the third economy, along with the U.S. and China with the economic scale that is a prerequisite for being able to issue a true international currency. If all three issuers follow sound and stable policies, then there is no reason why their three currencies can’t share the international stage for the foreseeable future—in effect there’s no reason why they can’t share that stage indefinitely. The global economy will be better off with three sources of liquidity, compared to the current status quo where it is all but wholly dependent on one.
In contrast, if one or more of the issuers in question follows erratic policies, investors will flee its currency, since in a world of multiple international and reserve currencies they will have alternatives—they will have somewhere to go. The result could then be sharp changes in exchange rates. The consequence could be high volatility that would wreak havoc with national and international financial markets. So while a world of multiple international currencies has benefits, it also entails risks. Policy choices—and politics—will determine whether the risks or benefits dominate in the end.
Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley. His books include Hall of Mirrors, Exorbitant Privilege, Globalizing Capital, and The European Economy since 1945. Arnaud Mehl is principal economist at the European Central Bank. Livia Chiţu is an economist at the European Central Bank.