The Dollar Abides

On January 28, 2012, in Federal Reserve, monetary policy, by Jon Lewis

Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Barry Eichengreen. Oxford University Press 2011, pp. 215, $27.95 The Great Recession, precipitated in part by excessively low interest rates in the early 2000s, has caused more Americans to pay attention to monetary policy than they have in [...]

Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Barry Eichengreen. Oxford University Press 2011, pp. 215, $27.95

The Great Recession, precipitated in part by excessively low interest rates in the early 2000s, has caused more Americans to pay attention to monetary policy than they have in the past. Governor Rick Perry, former Speaker Newt Gingrich, and Congressman Ron Paul, to various degrees and in different ways, all made criticism of the Federal Reserve components of their presidential campaigns. Academics and policymakers have debated the necessity and wisdom of the Fed’s two quantitative easing initiatives. Unquestionably, the fiscal and monetary outlook of the United States is not nearly as rosy as it looked when President George W. Bush took office, a time when the United States was running a budget surplus.

Is the current situation in the United States so perilous, however, that we should worry about an imminent dollar crash? And if so, who would be to blame for an occurrence that would have far-reaching financial and geopolitical implications? In Exorbitant Privilege, a nuanced study of how the dollar became the international reserve currency and what the future might hold for the dollar, Barry Eichengreen concludes with his assessment, “that the only plausible scenario for a dollar crash is one in which we bring upon ourselves.” In contrast to those who contend that China can, or will, cause the dollar to crash, Eichengreen contends that the dollar’s fate is in our hands, making it “within our grasp to avoid the worst.” The United States, it would seem, is not a passive actor, merely biding its time before it is swept away by a rising China. Not yet anyway.

In this comprehensive and clearly written academic monograph, Eichengreen argues that, while the dollar is now by far “the most important currency for invoicing and settling international transactions,” this may not necessarily be the case in the future. According to Eichengreen, the dollar’s status as a reserve currency does not make as much sense now as it did fifty years ago when the United States was more economically dominant.

For much of the period since the Second World War, the United States benefitted from what former French finance minister Valery Giscard d’Estaing critically termed America’s ‘exorbitant privilege.’ The noted statesman was referring to Washington’s ability, due to the dollar’s sole status as the international currency, to run an external deficit amounting to the difference between what it must pay on its liabilities and the rate of return on the country’s foreign investments. In other words, cheap money from abroad allowed Americans to live beyond their means.

As specific examples of exorbitant privilege in action, the author cites how, in 2008, when the financial markets were in turmoil, Washington was able to borrow at low interest rates because foreign investors flocked to the dollar, believing it to be the safest currency at the time. Likewise, in 2010, when market volatility spiked, investors went for treasury bonds, lowering the cost of borrowing for the federal government and, subsequently, mortgage interest rates.

Eichengreen criticizes what he perceives to be the conventional wisdom regarding the dollar’s current status and its likely future. He contrasts the view that widespread use of a country’s currency internationally gives it geopolitical power with his belief that “it is a country’s position as a great power that results in the international status of its currency.” He also criticizes the notion that incumbency is exceedingly advantageous in the global competition for reserve currency status, citing how the dollar began to rival sterling by the mid-1920s shortly after the Federal Reserve system was established in the United States.

Most significantly, Eichengreen argues that, “the idea that the dollar is doomed to lose its international currency status is equally wrong.” Both the euro and the renminbi, he suggests, have their problems, arguing that, “the fundamental fallacy behind the notion that the dollar is in a death face with its rivals is the belief that there is room for only one international currency.” It is the author’s belief that the late twentieth-century, when the dollar reigned supreme as the world’s reserve currency, was unique by historical standards.

Eichengreen foresees the possibility of a global economy wherein countries bordering China may use the renminbi, countries close to the Eurozone utilize the euro, and countries transacting with the United States will make use of the dollar. Reserve currency status, therefore, may not be a zero-sum game. “The world for which we need to prepare,” contends Eichengreen, “is thus one in which several international currencies coexist.” The dollar may have future international competition, he suggests, but it won’t decline just yet because of external pressure from China.

In conclusion, the dollar is not about to crash tomorrow. Eichengreen is most likely correct in his contention that, “the plausible scenario for a dollar crash is not one in which confidence collapses on the whims of investors or as the result of a geopolitical dispute but rather because of problems with America’s own economic policies. The danger here is budget deficits out of control.” Sobering words indeed.

Jon Lewis (c) 2012

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The Banking Dead

On January 10, 2012, in banking, Federal Reserve, monetary policy, moral hazard, by Jon Lewis

Zombie Banks: How Broken Banks And Debtor Nations Are Crippling the Global Economy. Yalman Onaran. Bloomberg Press, 2012, pp. 184, $34.95 Over the past several years, both the Tea Party and Occupy Wall Street (OWS) have been at the forefront of criticizing the federal government’s bailout of large financial institutions. While their criticism is generally [...]

Zombie Banks: How Broken Banks And Debtor Nations Are Crippling the Global Economy. Yalman Onaran. Bloomberg Press, 2012, pp. 184, $34.95

Over the past several years, both the Tea Party and Occupy Wall Street (OWS) have been at the forefront of criticizing the federal government’s bailout of large financial institutions. While their criticism is generally merited, it is unclear whether it would have been realistic, not to mention politically viable, to have let the big banks fail. Such a move truly could have had devastating effects on the American economy, dwarfing the Great Recession and its aftereffects.

Letting the banks survive to see another day, however, led to the creation of financial zombies, dead, but still living. Not only do they linger in our midst, zombie banks are also holding back our economic recovery. Such is the thesis of Yalman Onaran’s recently published Zombie Banks: How Broken Banks are Crippling the Global Economy. Onaran, a reporter at Bloomberg News, builds upon the notion of zombie banks, a concept first utilized by finance professor Edward J. Kane in a 1987 academic paper. “In its simplest form,” writes Onaran, “[a] zombie bank refers to an insolvent financial institution whose equity capital has been wiped out so that the value of its obligations is greater than its assets.” In its simplest formulation, these are banks that are, for a lack of a better term, broke, but kept alive through government intervention or, as the case may be, non-intervention.

Onaran’s intention in writing this book was to provide a big picture analysis of the global financial crisis. The author argues that many of the current policies employed by both European and the American polities have resulted in the creation of zombie banks. These financial zombies remain alive due to, among other factors, government backing of bank debt and near-zero interest rates. Onaran contends that, “it’s the taxpayer money that zombie banks eat and that’s where their harm to society is.” In a series of vignettes written in a lively, accessible journalistic style, he is generally successful in showing the interconnectedness of the distressed banking sector, government policies on both sides of the Atlantic, and economic stagnation. Indeed, he boldly contends that, “despite their claims to the contrary, politicians worldwide have not tackled the structural problems in the financial system underlying that crisis.” Temporary fixes, it could be said, are not solutions.

Onaran utilizes a comparative approach, one that is notably lacking in many journalistic accounts of the financial crisis. In detailing the differences in how Iceland, Ireland, and the United States handled their respective countries’ banking difficulties, he provides particular insight into the problem of zombie banks. The United States took somewhat of a middle course between the two aforementioned island nations’ approaches to troubled banks, a trajectory more akin to that taken by Germany, which created its own zombies.

Whereas the Irish government initially guaranteed the liabilities of the country’s national banks in 2008 in response to the credit crunch, the Icelandic government embarked upon a starkly different course, seizing the banks and restructuring them, effectively letting the bad banks die. “So while one island’s banks were kept alive as zombies for two more years before they brought down the whole country with them,” writes Onaran, “the neighboring island’s troubled banks were allowed to die.” He points out that, while Iceland has not had it easy since 2008, the country did two notable things correctly; first, private bank debt was not converted to public debt and second, Reykjavik did not prop up failed banks, allowing them to continue artificial lives as zombies.

The relationship between the private debts of financial institutions and sovereign debt is a significant one. “As is the case with most financial crises,” posits Onaran, “the problems of the banks are closely associated with the debt overhang society faces after a decade or two of binging on cheap credit.” He raises thought-provoking issues regarding central bank policies that keep interest rates at a near-zero level.

Onaran contends that these exceedingly low interest rates designed to keep zombies alive and to aid them in healing their balance sheets has harmful societal effects and terms it “a wealth transfer from pensioners and others relying on fixed returns of their savings to the banks’ coffers.” This results, for a segment of society, in reduced disposable income and reducing spending. He also highlights what he perceives to be the connection between quantitative easing and events abroad, positing that it has led to commodity price increases and bubbles in emerging markets. Cheap money, it would seem, needs a home. One could easily imagine a future study detailing the largely unforeseen effects that quantitative easing had had on the politics of foreign lands.

In conclusion, Zombie Banks is a useful addition to the growing corpus of literature on the global financial crisis. While the author could have devoted more attention to the issue of moral hazard in banking regulation, free market advocates will be heartened by Onaran’s contention that propping up banks that should have died is not fair to competitors. “In a real market economy, those companies that take the wrong risks and lose out are supposed to fail, their customers and market share shifting to the surviving firms that were more prudent.” Onaran’s suggestion that governments need to kill the zombies off so that economies can recover is perhaps theoretically correct, though it is probably politically impossible at this time, at least in the United States. Bailouts may be, for better or worse, the new normal. If that is the case, then zombies will continue to stagger among us.

Jon Lewis (c) 2012

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