The International Monetary System Past, Present and Future:

1. The International Monetary System Past, Present and Future: Barry Eichengreen May 2017

2. The history of the international economy is often told in terms of the rise and fall of leading powers. • Angus Maddison told it in terms of leaders and followers and the moving technological frontier. • Charles Kindleberger told it in terms of the changing identity and but unchanging importance of the lead economy. • More specifically, this story is typically told in terms of British hegemony in the 19th century (the imperialism of free trade, the availability of cheap cotton, with Britain still being the leading trading and exporting nation as late as 1913) and U.S. hegemony in the 20th – followed by Chinese in the 21st?

3. This same story is often told through the lens of the currencies. • The 19th century international economy (first age of globalization, era of the gold standard) was organized around and dominated by sterling. • With the Bank of England as “conductor of the international orchestra” (Keynes 1930). • The 20th century international economy (or at least the second half of the 20th century, sterling remaining dominant as late as WWII) was organized around and dominated by the dollar. • As in the writings of Ronald McKinnon’s on the “gold-dollar system” and “dollar standard.” • Suggesting that the 21st century international economy will (perhaps) be organized around and dominated by the Chinese RMB. • As suggested in Arvind Panagariya’s recent writings.

4. This view is supported by theory • Network externalities are powerful. • First-mover advantage is strong. • It follows that international currency status is a natural monopoly. • There is room in the global economy for only one consequential global currency (first it was sterling, now it is the dollar, in the future it will be the RMB). • It also follows that persistence is strong. • And that an international currency can retain its dominance long after the issuer has since lost its economic, fiscal and political capacity to provide international currency services on the scale required by an expanding global economy, reflecting the hold of network effects. • Resulting in liquidity shortages in the 1920s and 1930s? • Resulting in global imbalances and doubts about the dollar after the turn of the century? • This perhaps helps us understand the chronic fragility of the international monetary system, something that has long intrigued economic historians (and troubled policy makers).

5. But that work is based on a remarkably limited empirical foundation • We know something about the currency composition of foreign exchange reserves in the decade leading up to WWI, courtesy of Peter Lindert. • “Key Currencies and Gold, 1900-1913,” Princeton Studies in International Finance (1969). • We know something this since 1973 courtesy of the IMF’s COFER data base. • http://www.imf.org/external/np/sta/cofer/eng/ • But we know little if anything of a systematic nature about the period in between.

6. Here I will report on research in which I have been engaged for some years that seeks to fill in the gaps. • It challenges the conventional wisdom as I describe it above. • It suggests replacing the traditional (or “old”) view of international currencies with a “new” view. • You can see from this terminology which view I favor.

7. Two views from economic theory • Old view: network effects • It pays to do what everyone else is doing. • Once a standard is widely adopted, it becomes locked in. • First-mover advantage is key. • Increasing returns are so strong that only one global currency can exist at a point in time. • The dollar’s dominance for the last 50 years is evidence of this. • The old view suggests that dollar dominance will continue. • New view: open systems • Interchangeability costs are not, in fact, that high. • Increasing returns are not that strong. • First-mover advantage can be overcome relatively quickly. • Multiple international currencies can coexist. • The new view suggests that the dollar will have rivals sooner rather than later.

8. The new view has support from theory as well • Including: • Paul David and Julie Bunn, “The Economics of Gateway Technologies and Network Evolution: Lessons from Electricity Supply History,” Information Economics and Policy (1988). • Joe Farrell and Paul Klemperer, “Coordination and Lock-In: Competition with Switching Costs and Network Effects,” Handbook of Industrial Organization (2007). • David Clark, “The Design of Open Systems” IEEE Internet Computing(2003).

9. More important, there is support from history • The practice of holding foreign exchange reserves was largely ad hoc before 1913. • But courtesy of Peter Lindert, we know something about their composition. • Lindert had to overcome a number of data gaps when constructing these estimates. • But the result is not obviously consistent with the “old” or “natural monopoly” view.

10. Some might dismiss the preceding evidence… • …on the grounds that forex reserves played only a limited role before 1913. • But this was no longer true in the 1920s. • Formalization of previous ad hoc practice of supplementing gold with forex reserves. • Response to perception of global gold shortage. • And this indeed facilitated some increase in the share of forex in total reserves relative to the prewar period. • To some 30% of total central bank reserves on the eve of the Great Depression.

11. What do we know about the composition of forex reserves in this period? • The answer, again, is remarkably little. • We have assertions by my teacher, Robert Triffin, that sterling continued to dominate as late as 1938 and, indeed, during World War II. • Robert Triffin, Gold and the Dollar Crisis (Yale 1960). • But these are assertions, not historically documented facts. • Motivating my research project.

12. What we find is again inconsistent with the old or natural monopoly view Global forex reserves, 1929 • Here is my reconstruction of the global picture circa 1929. • Note also how the franc and the mark, after having been important before 1914, have all but disappeared from this picture.

13. We can buttress this view with evidence on currency denomination of trade credit

14. Evidence on currency denomination of international bonds

15. Evidence on the currency denomination of international oil market transactions

16. What then happened after WII? • The answer is uncertain. • Typically, analyses start in the 1970s, when the IMF’s COFER data become available. • Jeffrey Frankel and Menzie Chinn, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” NBER Working Paper no.11510 (2005). • But, using published IMF sources and the archives, it is possible to do better.

17. Thus, it is the second half of the 20th century that is exceptional • And even it is not that exceptional.

18. I conclude, therefore, that there is nothing unusual about an international monetary and financial system made up of a number of competing national currencies. • But which ones?

19. This one?

20. This one?

21. This one?

22. These being the only 3 currencies with the scale to achieve true international currency status

23. Let me now analyze the challenges facing them in turn

24. Challenges for the dollar

25. At this point, the role of the dollar is holding steady • Continues to account for 60%+ of global reserves, according to most recent COFER data. • Still involved in 85% of currency trades worldwide. • And the $ strengthened following the election.

26. At this point, the role of the dollar is holding steady • Indeed, I will argue that most of the prospective economic changes under the Trump Administration are likely to be strongly dollar positive. • But therein, ironically, lies the threat.

27. Trump’s economic agenda • It has multiple elements, but the relevant ones in this context are: • Deregulation • Fiscal stimulus • Cut in corporate tax rates • Cut in individual income tax rates • Increase in infrastructure spending • 10-20% import tariff

28. Deregulation • Less financial regulation, less environmental regulation, less restrictive competition policy. • Designed to stimulate investment. • But in a fully employed (4.4% unemployment rate) economy, more investment will mean the reallocation of resources toward the production of capital goods. • Households will have to look elsewhere to satisfy their demand for consumption goods. • They will have to look toward foreign sources. And the way to make imports more attractive is a stronger dollar.

29. Corporate tax reform • High nominal rates, 35% (39% if one includes state and local taxes), vs. 20% in other countries, encourage US firms with foreign profits not to repatriate them. • Yet effective rates are lower due to deductibility of interest, expensing of capital expenditures and other loopholes. • So there is a case for simplification that removes the incentive for US firms to shelter their earnings abroad and to rely excessively on debt finance.

30. May still involve a border adjustment tax (BAT) • Under a BAT, output is taxed where it is consumed, not where it is produced. • Imports by US firms would no longer be deductible, and the export revenues of US firms would no longer be taxed. • Interest expenses would no longer be allowed. • Has the efficiency advantages that • (a) the incentive to locate business operations outside the US is eliminated, and • (b) that incentives to borrow (to utilize debt finance) are reduced. • Has the political advantage that, since US imports > US exports, lower headline rates can be financed.

31. But the effects will differ significantly across sectors • As you can see at right. • Maybe $ would appreciate so as to exactly offset the penalty on import-dependent sectors. • If, that is, exchange rates behave as the textbooks say. • And a 20% destination based corporate tax would have to be offset by a 20% appreciation of the dollar.

32. But how will the dollar react in practice? • The argument that it will appreciate by exactly 20% on impact assumes a 1-1 mapping from I-S to relative prices. Since there will be no change in I-S, there can be no change in relative prices. • But say that a more efficient tax system is good for investment. (That, after all, is what the proponents have in mind.) Then the US current account deficit must widen. Then the $ must rise by more than 20%. (Driven by capital inflows and repatriation of profits.)

33. Individual income tax reform • This will start with reducing top marginal rates from 39.5% to 33%. • Continue with abolishing the AMT. Eliminating estate tax. Reducing taxes on capital gains and dividends. • Administration contends that these cuts can be made self-financing by a combination of eliminating deductions and prompting faster growth. • But one man’s deduction is another man’s entitlement. • The Tax Foundation estimates that growth would have to accelerate from 2% to 4 ½% for this to be self-financing.

34. You can lay all the economists in the world end to end…

35. And we know the implications for the $ of this monetary/fiscal policy mix Courtesy of these men And this experience

36. Infrastructure spending • Here I think is where traditional Republican skepticism of the merits of big government is most likely to bite. • $1 tr. over 5 years is unlikely. • But we will get something of symbolic value.

37. What if it is financed by tax credits for private investors in infrastructure? • Do we know the elasticity of infrastructure spending w/r/t tax credits? • This depends on the tax equity market. • Construction companies don’t have cash flow and tax liabilities initially, so they sell their tax credits, in complex deals, to other entities (banks) with taxable liabilities. • This market (for sustainable energy investments primarily) is relatively small and volatile. • $1 tr. of investment over 5 years suggests scaling it up by roughly a factor of ten, which is unlikely.

38. Bringing us to the tariff question • Trump’s other policies, if successfully implemented, are likely to increase in the trade deficit (including the manufacturing trade deficit). • More pressure therefore to respond with import tariffs. • More tempting insofar as this is a front on which the president can move without Congressional assent. • More tempting still insofar as it is the kind of highly visible, easily grasped action toward which Mr. Trump is inclined.

39. And he can do so by invoking: • Trading with the Enemy Act of 1917 • US has to be at war for this to be applicable, but US special forces in Syria and Libya presumably qualify. Used by Nixon in 1971. • Trade Expansion Act of 1962 • President may take such actions as he deems necessary if import “threaten to impair the national security” or if “material interests” of the United States are adversely affected. Used by Reagan in 1982. • International Emergency Powers Act of 1977 • National emergency is not defined. Is loss of jobs to Mexico and China a national emergency? • Trade Act of 1974 • May impose tariff up to 15% on all goods for up to 150 days if there is “an adverse impact on national security from imports.” • NAFTA 1993 • President may proclaim “such additional duties as [he] determines to be necessary or appropriate to maintain the general level of reciprocal and mutually advantageous concessions with respect to Canada or Mexico…”

40. With what effects? This is where I came in… Any stimulus in the short run will be offset in the long run by exchange rate appreciation. More than offset insofar as there are negative efficiency effects. And what happens in the short run will depend on whether the economy is at full employment or has excess capacity. It will depend on whether or not you are in a deflationary environment. Under present circumstances, I doubt there would be significant positive aggregate effects in the short run. And the implications, once again, for the global financial system?

41. I was amused the other day to see that Morgan Stanley Research agrees with me… Ironically, this is where I came in…

42. Bottom line is that there will be multiple actions pushing up the $ • Business-investment-friendly deregulation • Corporate income tax cuts • Personal income tax cuts • Increased infrastructure spending • Trade restrictions

43. And that stronger $ may become a considerable source of frustration • To a president seeking to bring “good manufacturing jobs back to the United States.” • If past performance is a guide, he will look for a villain. • And the most likely villain is of course:

44. And that stronger $ may become a considerable source of frustration • To a president seeking to bring “good manufacturing jobs back to the United States.” • If past performance is a guide, he will look for a villain. • And the most likely villain is of course:

45. So herein lie the risks to the dollar’s international currency role • Trump will be able to appointment 5 members to the Board of Governors in the next year. • Will he appoint people who will try to drive down the dollar and let inflation rip? • Will his fiscal policies raise questions about debt sustainability? • Will he also lash out against foreign central banks and governments for manipulating their currencies, and threaten them with loss of access to their US treasury balances? • Will the dollar’s safe haven status be placed at risk? • This is not my central-case scenario, but it is worth pondering.

46. Trump risk more generally • And then there are any number of other scandals swirling around the President, which have already been pushing the dollar down. • Could this trend accelerate (dramatically)?

47. Challenges for the euro

48. Here I am going to give you my contrarian view • I am going to argue that the euro has failed to make more progress as an international currency for three reasons: • Lack of a normal central bank. • Absence of a proper banking union. • Confusion over fiscal policy. • I will then argue that the first two problems are now largely solved. • And that the third one has an obvious solution, if anyone cares to look.

49. In thinking about provision, a useful framework is “club theory” • When tastes are relatively homogenous, spillovers are significant and there are increasing returns to collective action, decision making should be centralized. • But where spillovers are more limited and tastes are heterogeneous, responsibility should be decentralized. • Viz. James Buchanan, “An Economic Theory of Clubs,” Public Choice(1965). • Viz. The Principle of Subsidiarity. • Let me now return to my four minimal conditions and how they fit into this framework.

50. A normal central bank • I define a normal central bank as one able to pursue flexible inflation targeting and to backstop banking systems and markets in government bonds, thereby protecting the euro area from potentially self-fulfilling crises. • Theory and evidence argue strongly for centralized provision. • Spillovers of monetary policy and of doubts about the integrity of the euro area are powerful. • Preferences over inflation are not that different (er….) • This function was not provided initially. • The ECB’s two-pillar strategy focused on inflation and monetary aggregates but not lender- and liquidity-provider-of-last resort functions. • Even inflation targeting was asymmetric. • In addition, the ECB concentrated on headline rather than core inflation, causing it to raise interest rates in 2008 and 2011.