Manifest currency? U.S. dollar’s global dominance not set in stone
Incumbency, it is often said, confers many advantages.
Sitting U.S. presidents certainly have reaped its benefits – in the past 80 years, only three have been unseated.
Most economists believe the same benefits apply to reserve currencies. Yes, the U.S. dollar may one day be supplanted as the leading international currency, the thinking goes, but that day is many decades away.
Then again, maybe not.
A new working paper from the National Bureau of Economic Research that looks more closely at the dollar’s own rise to the top in the 20th century suggests, among other things, that “the advantages of incumbency are not all they are cracked up to be.”
By looking at the currency denomination of foreign public debt issued by 33 countries from 1914 to 1946, the authors – University of California-Berkeley professor Barry Eichengreen and Livia Chitu and Arnaud Mehl of the European Central Bank – find that dollar-denominated bonds were nearly equal to those priced in sterling by the late 1920s. That’s about two decades earlier than the date assumed by previous scholars.
When stripping out Commonwealth countries that had strong commercial and political links with Britain, the dollar overtook sterling in 1929.
The subsequent collapse of the U.S. banking system saw sterling pull ahead of the dollar again from the mid- to late 1930s before it was supplanted again after World War II.
This shows that a bipolar rather than unipolar global currency system operated for much of the 1920s and 1930s, when the dollar and sterling shared reserve status.
As the authors put it:
Our findings challenge the presumption that there is room for only one dominant international currency.
And then, there’s that presumption about incumbency. The paper clearly shows it need not take a long time for a viable alternative to match the reigning reserve currency and eventually overtake it.
This should be welcome news to countries such as China and Russia, which have in recent years called for replacing the dollar-based system with one that uses several currencies.
But, as the authors show, the dollar’s rapid rise in the 20th century was possible because of the development of its financial system, the paper suggests.
Our results point to financial development as the main factor enabling the dollar to overcome sterling’s incumbency advantage. Its impact dwarfed those of country size and the monetary policy-cum-exchange rate regime.
That means it will probably take more financial integration in the euro zone to boost the euro’s international profile. China, meanwhile, will have to open up its domestic markets and carry out further exchange rate reform to set the stage for the yuan to become a global reserve currency.
And in this area, there are no short cuts:
The international status of a currency will rest on a solid foundation, however, only if financial deepening in the issuing country is sustainable, and not if financial innovation and liberalization simply causes a boom that eventually goes bust.