After the recent Draghi press conference announcing new measures to ease monetary policy in euroland, I responded to live questions from the Financial Times: “The ECB Eases,” podcast, FT Hard Currency, June 5, 2014 (including regarding my proposal that the ECB should buy dollar bonds).
And also to questions in writing from El Mercurio, June 5:
• Many critics point that these measures do not solve the economic problems of the Eurozone and in that they only benefit the financial markets. Do you agree?
But what if the ECB is told by the international community, especially the US, that it doesn’t want them to push the euro down against the dollar, that it fears a re-ignition of the currency wars? And what if the ECB concludes that it can’t buy US treasuries without US agreement? After all, it was only February of last year that the G-7 Ministers and Governors agreed not to try to influence exchange rates.
The ECB should further ease monetary policy. Inflation at 0.8% across the eurozone is below the target of “close to 2%.” Unemployment in most countries is still high and their economies weak. Under current conditions it is hard for the periphery countries to bring their costs the rest of the way back down to internationally competitive levels as they need to do. If inflation is below 1% euro-wide, then the periphery countries have to suffer painful deflation.
Most people know that the general trend in the dollar’s role as an international currency has been slowly downward since 1976. International use of the dollar as a currency in which to hold foreign exchange reserves, to denominate financial transactions, to invoice trade, and to serve as a vehicle for foreign exchange transactions is below where it was during the heyday of the Bretton Woods era (1945-1971). But few are aware of what the most recent numbers show. It is not hard to think of explanations for the downward trend. Since the time of the Vietnam War, US budget deficits, money creation, and current account deficits have often been high. Presumably as a result, the dollar has lost value in terms of other major currencies or in terms of purchasing power over goods. Meanwhile, the US share of global output has declined. Most recently, the disturbing willingness of some American congressmen in October to pursue a strategy that would have the Treasury default on legal obligations has led some observers to ask the natural question whether the dollar’s international currency status is now imperiled.Moreover some EM currencies are joining the list of international currencies for the first time. Indeed, some analysts have suggested that the Chinese yuan may rival the dollar as the leading international currency by the end of the decade! (Eichengreen, 2011; and Subramanian, 2011a, 2011b.) The trend in the dollar as an international currency has not been uniformly downward, however. Interestingly, the periods when the public is most concerned about the issue do not coincide well with the periods when the dollar’s share is in fact falling. By the criteria of international use as a reserve currency among central banks and as vehicle currency in foreign exchange markets, the most rapid declines took place during the intervals 1978-1991 and 2001-2010. (The yen and deutschemark were the rising currencies during the first period, and the euro during the second.) In between these two intervals, during the years 1992-2000, there was a clear reversal of the trend, notwithstanding a popular orgy of dollar declinism around the middle of that decade. Central banks held only an estimated 46% of their foreign exchange reserves in the form of dollars in 1992, but had returned to almost 70% by 2000. Subsequently, the long-term downward trend resumed. According to one estimate, the share in reserves declined from about 70% in 2001 to barely 60% in 2010 (Menzie Chinn). During the same decade, the dollar’s share in the foreign exchange market also declined: The currency constituted one side or the other in 90% of foreign exchange trading in 2001, but only 85% in 2010. The most recent statistics unexpectedly suggest that the dollar’s standing has again taken apause from its long-term decline. The International Monetary Fund reports that its share in foreign exchange reserves stopped declining in 2010 and has been flat since then. If anything, the share is up very slightly thus far in 2013 (COFER, IMF, Sept. 30, 2013). Similarly, the Bank for International Settlements reported in its recent triennial surveythat the dollar’s share in the world’s foreign exchange markets rose from 85% in 2010 to 87% in 2013 (preliminary global results). That the dollar has been holding up so well comes as a surprise, in light of dysfunctional US fiscal policy. Or maybe we should no longer be surprised. After all, when the global financial crisis erupted out of the American sub-prime mortgage mess in 2008, the reaction of global investors was to flee into the United States, not out. They clearly still regard the US Treasury bill market as the safe haven and the dollar as the top international currency. The explanation must be the one that is so often noted: the absence of good alternatives. In particular, the euro has its own all-to-obvious problems. Indeed the euro’s share of reserve holdings and its share of foreign exchange transactions have both fallen by several percentage points over the last three years (reserves from 28% of allocated reserves in 2009 and 26% in 2010, to 24% in the most recent 2013 figures; forex trading from 39% of transactions in 2010 to 33% in 2013). What about the vaunted yuan? According to the IMF statistics, it hasn’t yet broken into the ranks of the top seven currencies in terms of central bank reserve holdings. The top six are the US dollar and euro, followed by the yen and pound (the latter quietly reclaimed the number three position in 2006 and has been running neck-and-neck with the yen recently), and the Canadian dollar and Australian dollar (also running neck-and-neck). According to the BIS statistics, China’s currency has finally broken into the top ten in forex trading; but its share is only 2.2% of transactions. This is behind the Mexican peso at 2.5%, and still farther behind the Canadian dollar, Australian dollar and Swiss franc. (See Table 1 and Figures 2 & 3). Since 2.2% is much less than China’s share of world trade, it would be more accurate to say that the renminbi is becoming a normal currency than to say that it is becoming an international currency, let alone the top international currency.Despite recent moves by the Chinese government, the yuan still has a long way to go. Of the three kinds of attributes that a currency needs to become widely used internationally the yuan has two – size of the home economy and the ability to hold its value – but still lacks the third: deep, liquid, open financial markets. What might account for the recent stabilization of the dollar’s status? What do the last three years have in common with the preceding period of temporary reversal, 1992-2000? Both intervals saw striking improvements in the US budget deficit, both structural and overall. The federal deficit is now less than half what it was in 2009 or 2010; and the record deficits of the 1980s were converted into record surpluses by the end of the 1990s. Perhaps the fiscal observation is a coincidence. It would be foolish to read too much into two historical data points. It would be even more foolish to believe, just because American politicians have failed to dislodge the US dollar from its number one status over the last forty years, that they could not accomplish the job with another few decades of effort. Pound sterling had the top spot in the nineteenth century, only to be surpassed by the dollar in the first half of the twentieth century. It is not an eternal law of nature that the US currency shall always be number one. The day may come when the dollar too succumbs in its turn. But that day is not this day.
Figure 1: The share of the dollar in central banks’ foreign exchange reserves stopped its downward trend in 2010-2013
source: Menzie Chinn (2013), based on IMF’s COFER.
Table 1: The share of the dollar in global foreign exchange trading reversed its downward trend in 2010-2013
The recent release of a revised set of GDP statistics by Britain’s Office for National Statistics showed that growth had not quite, as previously thought, been negative for two consecutive quarters in the winter of 2011-12. The point, as it was reported, was that a UK recession (a second dip after the Great Recession of 2008-09) was nowerased from the history books — and that the Conservativegovernment would take a bit of satisfaction from this fact. But it should not.
Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement. The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP. A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks. In other words, the target is cyclically adjusted. The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.
Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet. Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961. Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007. Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable.
My preceding post bemoaned the tendency for many US politicians to exhibit a procyclicalist pattern: supporting tax cuts and spending increases when the economy is booming, which should be the time to save money for a rainy day, and then re-discovering the evils of budget deficits only in times of recession, thus supporting fiscal contraction at precisely the wrong time. Procyclicalists exacerbate the magnitude of the swings in the business cycle.
This is not just an American problem. A similar unfortunate cycle — large fiscal deficits when the economy is already expanding anyway, followed by fiscal contraction in response to a recession — has also been visible in the United Kingdom and euroland in recent years. Greece and Portugal are the two most infamous examples. But the larger European countries, as well, failed to take advantage of the expansionary period 2003-07 to strengthen their public finances, and instead ran budget deficits in excess of the limits (3% of GDP) that they were supposed to obey under the Stability and Growth Pact. Then, over the last few years, politicians in both the UK and the continent have made their recessions worse by imposing aggressive fiscal austerity at precisely the wrong time.
Any solution to the euro crisis must meet two objectives. One is short run and the other is long run. Unfortunately they tend to conflict.
The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt to GDP is declining rather than rising. Austerity won’t restore debt sustainability. It has raised debt/GDP ratios, not lowered them. A write-down would do it. New bigger bail-outs might too, or might not. But either write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.
The Hour of the Technocrats has arrived. In desperation from debt crises that their gridlocked political systems have created, Italy and Greece both in November chose new Prime Ministers who are technocratic economists rather than politicians: Mario Monti and Lucas Papademos, respectively. One can even describe them as professors: Monti has been president of the prestigious Bocconi University when not a European Commissioner in Brussels, and Papademos has been my colleague at Harvard Kennedy School in the year since he finished his term as Deputy Governor of the European Central Bank (even teaching a class I usually teach).