The
Euro's Big Chance
By Niall Ferguson
07 June, 2004
Prospect
Magazine
"The
convention whereby the dollar is given a transcendent value as an international
currency no longer rests on its initial base... The fact that many states
accept dollars in order to make up for the deficits of the American
balance of payments has enabled the US to be indebted to foreign countries
free of charge. Indeed, what they owe those countries, they pay in dollars
that they themselves issue as they wish.
.. This unilateral facility attributed to America has helped spread
the idea that the dollar is an impartial, international means of exchange,
whereas it is a means of credit appropriated to one state."
Thus spoke Charles
De Gaulle in 1965, from a press conference often cited by historians
as the beginning of the end of postwar international monetary stability.
De Gaulle's argument was that the US was deriving unfair advantages
from being the principal international reserve currency. To be precise,
it was financing its own balance of payments deficit by selling foreigners
dollars that were likely to depreciate in value.
The striking thing
about De Gaulle's analysis is how very aptly it describes the role of
the dollar in 2004. That is itself ironic, since the general's intention
was, if possible, to topple the dollar from its role as the world's
number one currency. True, pressure on the dollar grew steadily in the
wake of De Gaulle's remarks. By 1973, if not before, the system of more
or less fixed exchange rates, devised at Bretton Woods in 1944, was
dead, and the world entered an era of floating exchange rates and high
inflation. Yet, even in the darkest days of the 1970s, the dollar did
not come close to losing its status as a reserve currency. Indeed, so
successfully has it continued to perform this role that in the past
decade some economists have begun speaking of Bretton Woods II - with
the dollar, once again, as the key currency. The question is: how long
can this new dollar standard last?
The existence of
a dollar standard may come as a surprise to any American who has been
considering a summer holiday in Europe. With the euro at $1.18 (compared
with 90 cents two years ago), talk of a new era of fixed exchange rates
seems far-fetched. But "son of Bretton Woods" is not a global
system (nor, in fact, was Bretton Woods senior). It is primarily an
Asian system. Pegged to the dollar are the currencies of China, Hong
Kong and Malaysia. Also linked, less rigidly, are the currencies of
India, Indonesia, Japan, Singapore, South Korea, Taiwan and Thailand.
As in the 1960s,
it is not difficult to make the case that this system is highly beneficial
to the US. Over the past decade or so, the American current account
deficit with the rest of the world for goods, services and loans has
grown dramatically. Add together the deficits of the past 12 years and
you arrive at a total external debt of $2.9 trillion. At the end of
2002, according to the department of commerce, the net international
indebtedness of the US was equivalent to around a quarter of GDP. Yet
as recently as 1988 the US was still a global net creditor.
This rapid role
reversal - from world's banker to world's biggest debtor - has had two
advantages for Americans. First, it has allowed US business to invest
substantially (notably in information technology) without requiring
Americans to reduce their consumption. Between 10 and 20 per cent of
all investment in the US economy in the past decade has been financed
out of the savings of foreigners, allowing Americans to spend and spend.
The personal savings rate is less than half of what it was in the 1980s.
The second payoff,
however, has taken the form of tax cuts rather than private sector investment.
The dramatic shift in the finances of the federal government from surplus
to deficit since 2000 - a deterioration unprecedented in peacetime,
according to the IMF - has been substantially funded from abroad. Had
that not been the case, the combination of tax cuts, increased spending
and reduced revenue that has characterised President Bush's fiscal policy
would have led to much more severe increases in long-term US interest
rates. Veterans of the Nixon and Reagan years can only shake their heads
enviously at the way the present Republican administration has escaped
punishment for its profligacy. To run deficits on this scale while enjoying
long-term bond yields of under 5 per cent looks like the biggest free
lunch in modern economic history. The cost of servicing the federal
debt has actually fallen under Bush, even as the total debt itself has
risen.
The reason is simply
that foreigners are willing to buy the new bonds issued by the US treasury
at remarkably high prices. In the past ten years, the share of the privately
held federal debt in foreign hands has risen from 20 to nearly 45 per
cent. Just who is buying up all these dollar-denominated bonds, apparently
oblivious to the possibility that, if past performance is anything to
go by, their value could quite suddenly drop? The answer is that the
purchases are being made not by private investors but by public institutions
- the central banks of Asia.
Between January
2002 and December 2003, the Bank of Japan's foreign exchange reserves
increased by $266bn. Those of China, Hong Kong and Malaysia rose by
$224bn. Taiwan acquired more than $80bn. Nearly all of this increase
took the form of purchases of US dollars and dollar-denominated bonds.
In the first three months of this year alone, the Japanese bought another
$142bn. The Asian central banks' motivation for doing so is simple:
to prevent their own currencies from appreciating relative to the dollar
- because a weak dollar would hurt their own exports to the mighty American
market. Were it not for these interventions, the dollar would certainly
have depreciated relative to the Asian currencies, as it has against
the euro. But the Asian authorities are willing to spend whatever it
takes of their own currency to keep the dollar exchange rate steady.
This, then, is Bretton
Woods junior: an Asian system of pegged exchange rates which keeps the
Asian economies' exports competitive in the US while at the same time
giving Americans a seemingly limitless low interest credit facility
to run up huge private and public sector debts.
In one respect,
at least, the claim that the world has unwittingly reinvented Bretton
Woods is convincing. Taking a long view, the real trade-weighted exchange
rate of the dollar has proved remarkably stable. It experienced bouts
of appreciation in the early 1980s and the late 1990s, but then reverted
to something like a mean value. Right now it is less than 10 per cent
below where it was in 1973. And where the new system differs from the
old is to the advantage of the former. The original Bretton Woods was
premised on a fixed link between the dollar and gold. Remember the plot
of Goldfinger? The prosperity of the cold war era supposedly rested
on the foundation of the Fort Knox gold reserve. But that made the system
vulnerable to speculation by foreigners who, like De Gaulle, decided
they would rather hold gold than dollars. This time around there is
only the dollar. The world's monetary system is built on paper.
But here's the catch.
The proponents of the new Bretton Woods seem to see it as a system with
a boundless, rosy future. The Asians, so the argument goes, will keep
on buying dollars and US treasuries because they so desperately need
to avoid a dollar slide, and because there is no theoretical limit on
how much of their own currency they can print purely in order to make
their dollar purchases. In any case, why should foreigners not want
to invest in the US? It is, as numerous Wall Street practitioners have
told me over the past few months, the place to invest now that recovery
is under way. "Where else are they going to go?" one Wall
Street banker asked me last month, with a rather superior sneer. "Europe?"
But this optimistic
conventional wisdom overlooks a number of big differences between the
1960s and the present. American deficits under the old Bretton Woods
system were insignificant; the US was running current account surpluses
throughout the decade. People then were worried about the fact that
Americans were investing quite substantially abroad, though that was
counterbalanced by inflows of foreign capital. But mainly they were
worried that overseas dollar holdings were outstripping the Federal
Reserve's stock of gold. Today the US is running up huge deficits, while
international capital flows are much larger. So, consequently, are the
potential strains on a system of fixed exchange rates.
Whatever its virtues,
the Bretton Woods system did not last long. If you count only the period
when the dollar and the major European currencies were truly convertible
into gold at the agreed rates, it lasted ten years (1958-68). There
are reasons to think that this Asian son of Bretton Woods could prove
equally ephemeral. And the aftermath of its breakdown could be as painful
as the crisis of the mid-1970s.
For all the mystical
appeal of the dollar bill, it is not a piece of gold. Since the end
of gold convertibility, a dollar has been little more than a flimsy
piece of printed paper that costs around three cents to manufacture.
The design with which we are familiar dates back to 1957, since then,
as a result of inflation, it has lost 84 per cent of its purchasing
power. Tell the Japanese that they are the lucky members of a "dollar
standard" and they will laugh. In 1971 a dollar was worth more
than 350 yen; today it hovers around 100.
Until very recently,
the frailty of the dollar has not really mattered. We have forgiven
it the periodic bouts of depreciation for the simple reason that there
has been no alternative. The sheer scale of American trade (the prices
of so many commodities from oil to gold are quoted in dollars) means
the dollar has remained the world's favourite currency and the first
choice for settling international balances.
Yet no monetary
system lasts forever. A hundred years ago, sterling was the world's
number one currency. Yet Britain's soaring indebtedness during and after
the first world war created an opportunity for the dollar to stake a
claim first to equality and then to superiority. This pattern could
repeat itself, for there is a new kid on the international monetary
block. And few Americans have grasped that this new kid, despite the
flaws of his parents, is a plausible contender for the top job.
Whatever you may
think about the EU as a political entity, there is no denying that the
currency it has spawned has what it takes to rival the dollar as the
international reserve currency. First, eurozone GDP is not so very much
less than that of the US - 16 per cent of world output in 2002, compared
with 21 per cent for the US. Second, unlike the US, the eurozone runs
current account surpluses; there is plenty of slack in European demand.
Third, and in my view most important, since the creation of the euro,
more international bonds have been issued in euros than dollars. Before
1999, around 30 per cent of total international bonds were issued in
the euro's predecessor currencies, compared with more than 50 per cent
in dollars. In the past five years, the euro has accounted for 47 per
cent to the dollar's 44 per cent.
Could this mark
a turning point? Last month, at a dinner held in London by one of the
biggest US banks for around 18 clients at other major City institutions,
I posed the question: who thought the euro could plausibly replace the
dollar as the principal international reserve currency? No fewer than
six thought it could - and were prepared to admit it before their American
hosts. When I asked a smaller group of Wall Street bankers the same
question, they were more doubtful - though one observed that the euro
is already the preferred currency of organised crime because, unlike
the Fed, which no longer issues bills with a value above $100, the European
Central Bank issues a high-denomination E500 note. That makes it possible
to cram around E7m into a briefcase - which can come in useful in some
parts of Colombia. Maybe on Wall Street too.
The future of the
Asian Bretton Woods system - and indeed of this year's US recovery -
depends on the willingness of Asian institutions to go on (and on and
on) buying dollars and dollar-denominated bonds. But why should they,
if the Japanese economy is - as now seems to be the case - finally coming
out of its deflationary slump? In any case, Japan's intervention has
not been wholly successful in stemming the dollar's slide: over the
past two years, the yen has gone from 135 to 110 against the dollar.
In yen terms, the returns on the Bank of Japan's dollar portfolio have
been decidedly negative.
Moreover, reliance
on exports to the US may not be a long-term option for Asia. In a recent
lecture in Washington, Larry Summers, the former US treasury secretary,
argued that the US has no alternative but to increase its savings rates
if it is to extricate itself from "the most serious problem of
low national saving, resulting in dependence on foreign capital, and
fiscal unsustainability, that we have faced in the last 50 years."
His conclusion is that the world can no longer count on the US to be
the consumer of first resort, which means in turn that "the growth
plans of others that rely on export-led growth will need to be adjusted
in the years ahead."
The Asian dollar
dilemma is the euro's opportunity, both economically and politically.
First, if the US does cease to be the only functioning engine of global
demand, it is imperative that the eurozone step up to the plate, and
soon. For too long the European Central Bank has made price stability
the "magnetic north" of its policy compass. It has not spent
enough time thinking about growth in Europe and the world. For too long
ECB interest rates have been about a percentage point above the Fed's,
despite the fact that deflation is a bigger threat to the core German
economy than it ever has been to the US.
The president of
the ECB is now a Frenchman. Maybe Jean-Claude Trichet should remind
himself of some history. Thirty-nine years ago, the dollar was coming
under pressure as US entanglement in a messy postcolonial war began
to grow. It was Charles De Gaulle who called time on the Bretton Woods
system, which, he alleged, obliged European economies to import American
inflation. This is the moment for someone to call time on Bretton Woods
junior. Asians and Europeans alike need to sell their goods somewhere
other than to profligate America. And they need to recognise that the
emergence of the euro as an alternative reserve currency to the dollar
creates a chance to fundamentally shift the centre of gravity of the
international economy.
If the Europeans
seize their chance, Americans could face the end of half a century of
dollar domination. Does it matter? You bet it does. For if Asian institutions
start rebalancing their portfolios by switching from dollars to euros,
it will become harder than it has been for many years for the US to
fund its private and public sector consumption at what are, in terms
of the returns to foreign lenders, low or negative real interest rates.
(Do the maths: the return on a US ten-year treasury a year ago was around
4 per cent, but the dollar has declined relative to the Japanese currency
by 9 per cent in the same period.)
Losing that subsidy
- in effect, the premium foreigners are willing to pay for the sake
of holding the world's favourite currency - could be costly. For a rise
in US long-term interest rates to the levels recently predicted by the
economist Paul Krugman (a ten-year bond rate of 7 per cent, a mortgage
rate of 8.5 per cent) would have two devastating economic consequences.
Not for big US corporations - they are hedged (more than five eighths
of all derivative contracts are based on interest rates). But a 3 percentage
point jump in long-term rates would whack first the federal government
and then US homeowners with considerable force. For neither the US treasury
nor the average US household is even a little bit hedged. The term structure
of the federal debt is amazingly short: 35 per cent of it has a maturity
of less than one year, meaning that higher rates would feed through
almost instantly into debt service costs (and into the deficit). Meanwhile,
even as rates have been nudging upwards, the proportion of new American
mortgages that are adjustable-rate rather than fixed has risen from
around 12 per cent in late 2002 to 32 per cent.
The geopolitical
implications of this are worth pondering. A rise in American interest
rates has the potential not just to slow down the US recovery; it could
also cause the federal fiscal deficit to leap even higher. Under the
circumstances, the pressure will increase to reduce discretionary spending,
and that usually turns out to mean defence spending. It will get steadily
harder to sell an expensive occupation of Iraq to a population groaning
under rising debt service payments and alarmed by spiralling fiscal
deficits. Meanwhile the Europeans will have added another string to
their internationalist bow: not only will they be bigger contributors
to aid and peace-keeping than the US; they will also be the supplier
of the world's favourite money.
Such historical
turning points are hard to identify. It is not clear when exactly the
dollar usurped the pound. But once it did, the turnaround was rapid.
If the euro has already nudged in front, it may not be long before oil
producers club together to price their black gold in the European currency
(an idea that must surely appeal to anti-American producers like Venezuela
and Malaysia). World money does not mean world power: the EU is still
very far from being able to match the US when it comes to hard military
power. But losing the position of number one currency would without
question weaken the economic foundations of that hard power.
As the ghastly implications
of the demise of the dollar sink in across the US, the spectre of General
De Gaulle will savour his belated vindication.
Niall Ferguson's
latest book is "Colossus: The Price of America's Empire" (Penguin).
He is professor of history at the Stern School of Business, New York
University.