By Mike Whitney
Information Clearing House
October 29, 2009
Interview with Menzie Chinn
1-Mike Whitney: What is the present composition of reserve holdings in central banks–and has there been a substantial falloff in US dollar reserves in recent years? (Are central banks ditching the dollar?)
Prof. Menzie Chinn: I’ve found it puzzling that there’s all this talk about the prospects for the dollar, in the wake of the G-20 meetings, and more recently World Bank President Zoellick’s comments about the primacy of the dollar as a reserve currency. My puzzlement arises from the fact that many of the concerns now being voiced have been voiced before.
As I’ve noted on previous occasions, Jeff Frankel and I have outlined the conditions under which the dollar could lose primary reserve currency status to the Euro. In short, calamitously bad policies that induce rapid currency depreciation, or high inflation, would do the trick. Our results, last updated in early 2008″ might seem somewhat out of date given all the turmoil that has occurred in the meantime. But it’s important to realize that it’s the relative performance (US versus euro area) that matters, and I see no greater reason to believe that the conditions are in place for a drastic “reversal of fortune” than before. I’d note that part of our results for the euro displacing the dollar depended on a London greatly overtaking New York as a financial center; well, that remains to be seen….(see: “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” Menzie Chinn and Jeffrey A. Frankel http://www.ssc.wisc.edu/~mchinn/chinn_frankel_euro.pdf)
In thinking about the prospects for the dollar, I think it’s useful to break the forces affecting it into separate pieces. In particular, reserve currency status is not directly linked to the dollar’s value, although they are of course related. The dollar could lose value without losing primary reserve currency status, and could gain reserve share without gaining value…
Safe Haven Effects reinforces the notion that dollar weakness, for now, is a function of the return of risk appetite. The spike in the dollar from September 2008 through the beginning of 2009 was flight to the safety of Treasurys. In this sense, the dollar decline is a good thing as it highlights the success of policymaker measures to normalize the financial markets. (for more on this topic see: Econobrowser, http://www.econbrowser.com/archives/2009/09/the_dollar_in_d.html)
Menzie Chinn: Reported reserves have declined substantially, but since many central banks — including China’s — do not report reserves, some educated guesses are necessary. Then, the dropoff in the dollar share seems less marked.
(MW Note: Present composition of reserve holdings: Dollar roughly 62% total holdings, Euro roughly 28% total holdings)
2-MW: Is there any plausible scenario in which the US dollar could lose its position as the world’s reserve currency in the next 5 years?
Menzie Chinn: If the US administration were to pursue highly irresponsible policies, such as massive deficit spending for many years so as to push output above full employment levels, or if the Fed were to delay too long an ending to quantitative easing, then the dollar could lose its position. But I believe these scenarios are unlikely — although the policies of 2001-08 did make the dollar more vulnerable than otherwise.
3-MW: What is the role of “deep, well-developed financial markets” in determining which currency will be the reserve currency?
Menzie Chinn: Deep financial markets mean that it is less costly to transact in that particular currency. The US dollar has benefited enormously from the existence of a large market in liquid government debt. Such a thing does not exist for the euro, for instance.
4-MW: Is the euro gaining on the dollar, and do you think Fed policymaking has increased those gains?
Menzie Chinn: The euro is probably gaining on the dollar, but mostly as a consequence of debt accumulation during the Bush years.
5-MW: Do you think that the Fed’s quantitative easing program has weakened the dollar? (or the perception of the dollar?)
Menzie Chinn: The Fed’s measures have probably weakened the dollar over the short term; but in staving off a worse recession in the US (and a collapse in the financial system), it has probably meant a stronger currency over the medium term.
6-MW: How will it effect the US economy if the dollar loses its position as the world’s reserve currency?
Prof. Menzie Chinn: If the dollar does indeed lose its role as leading international currency, the cost to the United States would probably extend beyond the simple loss of seigniorage narrowly defined. We would lose the exorbitant privilege of playing banker to the world, accepting short-term deposits at low interest rates in return for long-term investments at high average rates of return. When combined with other political developments, it might even spell the end of economic and political hegemony. These are century-long advantages that are not to be cast away lightly.” (“Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” Menzie Chinn and Jeffrey A. Frankel http://www.ssc.wisc.edu/~mchinn/chinn_frankel_euro.pdf)
7-MW: Its widely believed that China will not abandon the dollar because of the nearly $1 trillion it has in USD reserves. Do you agree with this idea?
Menzie Chinn: It is true that each Asian central bank stands to lose considerably, in the value of its current holdings, if dollar sales precipitate a dollar crash. But we agree with Barry Eichengreen (2005) that each individual participant will realize that it stands to lose more if it holds pat than if it joins the run, when it comes to that. Thus if the United States is relying on the economic interests of other countries, it cannot count on being bailed out indefinitely.” (“Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” Menzie Chinn and Jeffrey A. Frankel http://www.ssc.wisc.edu/~mchinn/chinn_frankel_euro.pdf)
8-MW: What are the effects of the current account deficits on the dollar?
Menzie Chinn: Most recent assessments of the sustainability and adjustment of the US current account feature substantial depreciation of the dollar in the future, whether adjustment then operates via expenditure switching or a valuation effect. Our results suggest that such dollar depreciation would be no free lunch, and could have profound consequences for the international monetary system. These consequences include the loss of the exorbitant privilege of easy financing of large US deficits, both government and national. The political influence that American policy makers have internationally, including in international institutions, could also be diminished.” (“Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” Menzie Chinn and Jeffrey A. Frankel http://www.ssc.wisc.edu/~mchinn/chinn_frankel_euro.pdf)
All quotes used by permission from Prof. Menzie D. Chinn
Robert M. La Follette School of Public Affairs
Department of Economics
University of Wisconsin
Madison, WI 53706-1393