This is a revised version of ‘Reflections on Currency Regimes’ which
appeared in The International Economy – Spring 2008.

Ten years ago, in the aftermath of the Asia-Russia-LTCM¹ crisis, I was invited by Paul Volcker to prepare a report for the Group of 30 (which he then chaired) on “G3 Exchange Rate Relationships: A Review of the Record and of Proposals for Change.”² Readers will recall that, in that turbulent time, there was widespread (but certainly not unanimous) dissatisfaction with the prevailing status quo regime of managed floating exchange rates among the Group of Three – comprised of the U.S., Germany (now EMU³), and Japan. It was said by many that G3 exchange rates were not well anchored by fundamentals and were excessively volatile. As a consequence, the critics believed, the post Bretton Woods status quo for G3 exchange rates contributed to the volatility of, rather than stabilized, the global financial system of the late 1990s. Defenders of the status quo did not, in general, suggest that G3 exchange rate relationships were ideal but rather that, leading alternatives – essentially variants of target zones with hard or soft commitment to narrow or wide bands - were likely either to be inferior or, if superior in the abstract, not feasible (or more technically, time inconsistent) in practice.

In this installment of Global Perspectives, I step back and reflect on what has been learned about G3 exchange rate relationships that was not clearly foreseen or fully appreciated 10 years ago. While the reader’s 1998 crystal ball may have been better than mine at the time, here is what I have learned about G3 exchange rate relationships that I did not clearly foresee back then.

Capital Accounts Now Drive Current Accounts – G3 Exchange Rates and the Saving Glut
Some things never change, but our interpretation of them can and should as facts and circumstances change. The U.S. ran large current account deficits in the 1980s, in the 1990s, and in the first decade of the 21st century. In the 1980s and 1990s, large U.S. current account deficits were correlated with high real interest rates in the U.S. Low U.S. saving relative to average or better U.S. investment generated a current account deficit which required a capital inflow attracted by these high real interest rates. The U.S. current account deficits of the present decade widened (from an already elevated reading of four percent of GDP in 2000) in large part because of the global saving glut.⁴ The global saving glut brought down global real interest rates, both spot and forward, and this encouraged consumption and residential investment not only in the U.S., but in other countries as well (think U.K., Spain). Initially the driving source of the global saving glut (more precisely the excess of desired saving relative to desired investment at unchanged global interest rates) was Asia, with China and other emerging Asian countries joining Japan which has had its own, structural saving glut (and the current account surpluses to show for it) since the Carter administration. Notwithstanding all the focus on China, and its BWII⁵ development strategy, it is important to remember that as recently as 2003 China’s overall current account surplus was just two percent of GDP. Since 2003, strong global growth in the emerging world has triggered a commodity boom which has become a second source of excess global saving though the channel of petrodollar recycling.

The global saving glut, and the exponential explosion of gross cross border capital flows that has accompanied it, has had a significant impact on G3 exchange rate relationships. The wider current account deficit resulting from the saving glut (and the fact that much of it has been financed through central bank reserve accumulation and not private capital flows) and the bursting of the U.S. housing bubble that was, in part, caused by it have for some time and will continue to put downward pressure on the dollar. To date most of this adjustment has been borne by the euro (as well as the pound, the Canadian dollar, and Aussie dollar). Until 2005, Japan fiercely resisted allowing its exchange rate to appreciate rapidly, intervening massively (and in largely unsterilized fashion) in the foreign exchange markets to halt deflation. More recently, the yen has traded with the whim and whimsy of the pool of global capital still chasing exchange rate carry trades, still 10 years after the original crash of the yen carry trade it remains the source of much fluctuation in the dollar yen exchange rate. Plus ça change, plus c’est la même chose.⁶

Global Reserve Currency Status of the Dollar and Role of the Euro
A decade ago, there was much anticipation but also a great deal of uncertainty over the prospects for the euro as viable competitor to the dollar. There were those (and I was among them) who were skeptical that EMU would even be launched. The skeptics (and they were mostly on this side of the Atlantic) for the most part supported the creation of the European Central Bank (ECB) and the euro in the abstract, but made the judgment that, in the end, the Bundesbank, among other powerful institutions, would delay the launch or at minimum, limit it to a small, core group of countries. Of course, the skeptics were wrong and the euro and ECB have, without question, more than assumed the role in the first decade of the 21st century that the mark and the Bundesbank played in the last decades of the 20th century. Given the euro’s recent reputation as strong currency (it has been above $1.50 since late February) and very viable alternative to the dollar, it is easy to forget that the euro spent most of its first three years depreciating against the dollar, all the way from $1.18 at its launch in 1999 to $0.82 in the summer of 2001. I did not at the time judge this to reflect a market verdict against the brand new ECB, but rather a global market infatuation with U.S. internet and tech stocks.⁷ As I often remind my students, everything worth studying in international finance depends on relative not absolute valuations, and the launch of the euro coincided by chance with the peak of the internet bubble (and it should be pointed out, at the peak of market preoccupation with the U.S. ‘strong dollar’ rhetoric). Since then, the journey for the euro against the dollar has been mostly up, reflecting the forces discussed above as well as accumulating credibility of the ECB in anchoring inflation expectations and conducting a ‘one size fits all’ monetary policy that has not, to date, hamstrung European growth.

As we look ahead to the next 10 years, is it likely that the euro supplants the dollar as the global vehicle currency? I for one do not think so. By vehicle currency, of course, I mean the role that the dollar plays not just in the reserve holdings of global central banks, but also in the daily trading in the foreign exchange market, the interest rate derivatives markets, and as the currency of invoice for global commodity trade and also much trade in goods and services. To date there is no compelling evidence that the dollar’s market share as a vehicle currency has materially declined, not withstanding a substantial depreciation since 2001 and somewhat higher U.S. inflation as compared with EMU inflation. There is some evidence (for example, the IMF COFER⁸ data) that the dollar’s share as a global reserve currency has peaked and is on a path of gradual decline. While I expect this trend in reserve diversification to continue, I expect it will resemble an evolution and not a crash landing. There is a crucial difference between the dollar’s share as a reserve portfolio holding – in which it makes good sense to hold a diversified portfolio – as contrasted with the dollar’s role as a vehicle currency in the currency, derivatives, and commodity markets where, owing to economies of scale and scope, there is likely to be only one dominant currency.

Over the longer term, the euro could conceivably supplant the dollar at least as a global reserve currency. The best recent research on this is by Jeff Frankel and Menzie Chinn published in a volume I edited on G7 Current Account Imbalances.⁹ Chinn and Frankel argue that, absent the U.K. – and thus the London financial center – joining the EMU, it is unlikely that the euro – lacking a country with a global financial hub – would be expected to overtake the dollar as a global reserve currency. However, with the U.K. (and London) in EMU, the authors describe plausible scenarios in which a persistently weak dollar (and presumably higher U.S. inflation) could trigger a gradual, but material shift in global currency reserves to the euro. I would say this is not implausible, but not likely.

The Exorbitant Privilege – $500 Billion a Year and a Source of a Weaker Dollar

Fact 1: Between 2001 and 2006, the U.S. ran cumulative current accounts deficits in excess of 3.1 trillion dollars.

Fact 2: Between 2001 and 2006, the U.S. net international investment position improved, its net foreign liability position fell by more than 200 billion dollars.

How could the U.S. run large current account deficits without running up a commensurate increase in its net foreign liability position? The answer reflects the 21st century exorbitant privilege that accrues to the U.S. as the provider of the global reserve and vehicle currency.¹⁰ As is by now much better understood than it was a decade ago, there are two sources of the privilege. While virtually all of the U.S. gross external liability (which at year end 2006 was in excess of 18 trillion dollars) is U.S. dollar denominated, most of the gross U.S. holdings of foreign assets (which at year end 2006 was in excess of 16 trillion dollars) is denominated in foreign currency. As a consequence of its ability to borrow massive amounts in its own currency, U.S. investors benefit from a capital gain (and European, Japanese, and other investors suffer from a capital loss) when the dollar depreciates against the euro, yen, and other currencies. Because of the immense gross holding of foreign assets by U.S. investors, even an orderly decline in the dollar generates a large and growing net capital gain to U.S. investors. In 2002, 2003, 2004, 2005, and 2006 the net capital gain from a weaker dollar accruing to U.S. investors totaled more than 1.3 trillion dollars. The second and larger source of the exorbitant privilege results from the fact that U.S. investors in the aggregate own a riskier, higher average return portfolio than do foreign investors in the U.S. American investors’ portfolios abroad are weighted toward equity and FDI¹¹ investments, while foreign claims against the U.S. are more concentrated in government and agency securities and bank deposits according to BEA data. As a consequence, in recent years capital gains (in local currency) on U.S. investments abroad have far exceeded the capital gains enjoyed by foreign investors in the U.S.

¹ Long-Term Capital Management

² http://www.columbia.edu/~rhc2/Spring2006/G6904/Papers/Clarida_99.pdf

3 European Monetary Union

⁴ I made this point internally as Assistant Treasury Secretary in 2003 and publicly in a February 2004 speech at the IIE when I said “The U.S. current account deficit is a global general equilibrium phenomenon that reflects…a post bubble excess supply of global saving relative to profitable investment opportunities.” The term ‘saving glut’ would be introduced 14 months later in a speech by then Fed Governor Ben Bernanke.  My speech is available in Posen, ed., The Euro at Five, IIE, April 2005.

⁵ Bretton Woods II

⁶ The more this changes, the more it is the same thing.

⁷ I recall vividly a lunch with Otmar Issing in Frankfurt in July 2001 when I briefed him on some econometric work I had done that placed fair value of the euro north of $1.20 when it was at $0.85. As I recall, we both agreed that was fair value, but that the currency markets are not always fair.

⁸ Currency Composition of Official Foreign Exchange Reserves

⁹ Chinn, M. and J. Frankel, “Will The Euro Eventually Surpass the Dollar as a Leading International Reserve Currency” in R. Clarida, ed., G7 Current Account Imbalances: Sustainability and Adjustment; University of Chicago Press, 2007.

¹⁰ Although originally attributed to De Gaulle, ‘exorbitant privilege’ was actually introduced by then Finance Minister Giscard D’Estaing in February 1965.

¹¹ Foreign Direct Investment