This short, accessible book about the U.S. dollar by Barry Eichengreen, an economics professor at the University of California, Berkeley, may be one of the most important published this year. Whether the dollar remains king will have a tremendous impact on American businesses, and some will lose, and others will gain. Just as importantly, the relative strength of the buck will help determine the fiscal options available to the U.S. government in the years ahead.
Most of Exorbitant Privilege is spent building a historical foundation for Eichengreen's conclusions and predictions regarding the global status of the dollar. The author takes the reader on a quick tour of early American monetary history, from the use of commodity monies, such as wampum or tobacco, to the growing use of coins and paper money, whether in the form of "continentals" during the American Revolution or Spanish silver pesos, the most important global currency from about 1550 to 1850. This history serves to remind us that the dominance of the dollar even in the U.S. was a relatively recent affair.
We witness the birth of dollar dominance with the creation of the first and second Bank of the United States, and then with the founding of the Federal Reserve System in 1913. The link between the rise of the dollar and the Fed's creation of a New York-based market in trade acceptances to rival London's is one of the book's most important insights. If China is determined to dethrone the dollar, Eichengreen's analysis of how the greenback overpowered the pound comes close to providing a how-to.
History reminds us that the pound sterling did not go down without a fight. The final struggle began in July 1944, in Bretton Woods, N.H., at the international conference held to establish a new monetary order. The initial design of Bretton Woods was relatively neutral regarding currencies, due to the efforts of Britain's chief negotiator, economist John Maynard Keynes, who held out hope for a revival of the pound. But the Bretton Woods process quickly morphed into a dollar-backed reserve system.
Keynes' hope for the pound did not truly die until well after his own death, when the 1956 Suez Crisis finally exposed the hollow foundation underlying both the British economy and its political influence. The history of Britain's extended overseas engagements and the related demise of the pound as a dominant currency should serve as a warning to the U.S.
Central to Eichengreen's analysis is what became known as the "Triffin Dilemma," named after economist Robert Triffin, who warned in 1947 that a system in which the U.S. promised to provide two reserve assets—dollars that were then convertible into gold at a fixed exchange rate—would be doomed as long as the supply of one of these (dollars) was elastic, while the other (gold) was not. For global trade to flourish, the U.S. would be obligated to provide an almost unlimited amount of dollars. Yet that would be inconsistent with dollar convertibility into a fixed price of gold, a contradiction that led to President Nixon's abandonment in 1971 of the dollar-gold link.
In one of the book's few weak spots, the author repeats the flawed conventional wisdom about deregulation and derivatives causing the 2008 financial crisis. But he does explain how global capital flows increased liquidity in the U.S. and reduced interest rates, contributing to the housing bubble.
The history lesson eventually brings us to the current state of the dollar and its future path. Since the benefits of being the world's primary reserve currency are vast but also nearly invisible to the non-economist, the analysis of these benefits, and their potential to be lost, relates the discussion back to the everyday decisions of businesses, households and governments. When the dollar is eventually forced to take a lesser role in world affairs, international demand for the dollar will decline, pushing up interest rates and reducing American living standards, particularly America's ability to consume beyond its means.
That holds doubly true for America's government. As Eichengreen argues, the dollar is likely to fall in prominence, but the extent of that fall, and whether it is simply to become an equal with the euro and the Chinese renminbi, is open to question. Much depends on budgetary policy. The longer we delay getting our fiscal house in order, the greater the dollar's decline.
Mark Calabria is director of financial regulation studies at the Cato Institute.
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