by Sara Eisen
Many people believe that it was the disaster of World War I that knocked the United Kingdom off the throne, but it had actually occurred 13 years before the war started, and the seeds had been sown 45 years before that, when U.S. productivity growth leaped above that of Britain. Think about it! America, a mere colony through most of the eighteenth century, then a thorn in the side of mighty Britain in the late eighteenth and early nineteenth centuries, overtook the mother country at the beginning of the twentieth century and has been in the lead ever since. It’s not surprising, then, that the dollar replaced the pound sterling as the world’s reserve currency after World War II.
Nevertheless, currencies that other countries hold as part of their national treasuries die hard—they hate to desert old friends—so sterling did not begin to fall against the dollar until World War I, and it remained in some countries’ official reserves until well beyond World War II. We’ve been told that in the Golden Triangle, the area where Thailand, Burma, and Laos meet and the drug trade thrives, British gold sovereign coins were the medium of exchange in the 1990s, a century after they were minted. Do they still circulate?
On the eve of World War I, U.S. productivity was 25 percent higher than that in the United Kingdom, and it was 42 percent higher at the beginning of World War II. And it grew tremendously during the war as a result of new technology, flexibility of the labor force, with women working (remember Rosie the Riveter, the housewife who worked in a defense plant to replace men in the military?), and cooperation among markets, labor, and government under the threat of wartime conditions. Since America was the only major country whose productive capacity was not decimated by the war, European productivity was only 30 to 40 percent and Japan’s a mere 14 percent of the U.S. level after the war.
Military Might
Some people note that countries with international trading and reserve currencies are those with a dominant military. That’s been true historically, from ancient Greece and Rome to Byzantium, to Venice, with its forts that controlled the sea route from the Adriatic to the Middle East, to Britain in the nineteenth century, to the United States since then. But is there a distinct causal relationship?
At least since ancient times, military power didn’t create international currencies. Rather, robust productivity growth and high levels of output per worker created the economic strength that allowed countries to divert considerable resources to military spending. That was probably true of Venice in its heyday, and it was clearly true of Britain in the nineteenth century, despite the slogan, “Trade follows the flag.” It more correctly should have been, “Trade expansion promotes the flag.” In the last century, a robust, productivity-led U.S. economy was necessary to support sizable defense outlays, especially in the post–World War II era of the Cold War, the Korean and Vietnam Wars, and, more recently, involvement in Iraq and Afghanistan. Without such an economy, voters in our democracy would probably have rebelled when their purchasing power was squeezed to support a huge military establishment.
Ingredients for a Successful International Currency
This review of both history and modern reality reveals six necessary ingredients for a dominant international trade and reserve currency.
1. Rapid growth in the economy and GDP per capita, promoted by robust productivity growth. This is probably the most necessary condition for a dominant international trade and reserve currency. It was the key to British sterling’s success in the nineteenth century and the dollar’s superior position since then. It’s also necessary to support globally dominant military structures in modern democracies while still satisfying voters by providing them with acceptable standards of living.
2. A large economy, probably the world’s biggest. That was true of ancient Rome, which had an unusually effective administration and centralized control for the times. With the breakdown of communications in the Middle Ages, size became less important, allowing relatively small Italian city-states and their currencies to achieve international primacy. In modern times, Singapore and Switzerland meet my other qualifications but are just not big enough to have primary currencies.
3. Deep and broad financial markets. Internationally, money—especially today, when it can be transferred anywhere in a split second—wants to be where the action is. That requires not only a powerful and large economy, but also deep and broad markets in which to invest. Today, the U.S. Treasury market trumps all others in size and, in the eyes of investors (Figure 1-9), in safety, as witnessed by the mad rush into Treasury bonds in the ongoing European sovereign debt crisis. Similarly, America has the largest stock market by far (Figure 1-10).
4. Free and open financial markets and economy. Foreign investors are willing to hold a country’s currency only if they are convinced that they can invest it in financial or tangible assets in that country with few restrictions. The United States is essentially open, which is necessary if the Chinese and Japanese are to continue to recycle their current account surpluses with the United States into Treasuries and other American investments.
5. Lack of substitutes. A primary global currency, by definition, has no close competitors. The risk is that the top dog gets fat and lazy while upstarts surpass it in productivity growth, and ultimately in GDP per capita or GDP per employee. That’s how the Dutch lost out to the British in the late 1700s and, in turn, the United Kingdom was overrun by the United States a little more than a century later.
6. Credibility in the value of the currency. Internationally, money is fleet-footed, is congenitally cautious, and runs from uncertainty over risk of confiscation, debasement, and other threats, as discussed in our earlier review of history. The Roman aureus, the Byzantine solidus, and the Arabian dinar all went out of international style when those empires waned, but the related debasement of those currencies speeded the exit. On the flip side, in World War I, Britain went off the gold standard, only to return in 1925 with the prewar price of gold in sterling. Given the immense wartime inflation in the interim, that action vastly overpriced the sterling, causing uncertainty and leading to a mass exodus of U.K. money to New York and elsewhere.
Figure 1-9 2010 G-7 and Eurozone Net Debt Outstanding
($ in Billions)
Source: International Monetary Fund
Figure 1-10 Equity Market Capitalization
($ in Trillions)
Source: World Federation of Exchanges
Is a Reserve Currency Needed?
Of course, my six criteria for a primary international trade and reserve currency raise the question of whether one is needed at all. And if it is, can two exist simultaneously?
Advantages of Gold
It’s hard to envision today’s global business without some international standard. Likewise, it seems unlikely that major governments would be satisfied with only their own domestic assets, financial or tangible, as reserves. Some people believe that the international standard and reserve asset should be gold, and its price explosion in recent years, at least until recently, suggests a disdain for all paper currencies (Figure 1-11). Gold doesn’t oxidize, and the total supply today is relatively stable, since new mine production is tiny compared to what has been refined and retained over the ages.
Figure 1-11 Gold Prices and CPI (Consumer Price Index)
Source: Kitco and Bureau of Labor Statistics
This is quite different from the period when the gigantic inflow of gold from the New World in the 1500s created huge inflation in Europe after centuries of price stability (Figure 1-12). Also working to keep supply stable, gold, unlike silver, has few industrial uses, although the BBC and other news media reported that Col. Gadhafi was shot and killed by an eighteen-year-old wearing a New York Yankees baseball cap using the colonel’s gold-plated pistol! And given the traditional French love of gold, French bank chieftains must wish they owned gold rather than the PIIGS sovereign issues that threaten to sink them.
Figure 1-12 U.K. Retail Price Index
(1264 5 100)
Source: measurin
gworth.com
I’ve always been agnostic on the price of gold. It’s difficult for me to sort out all the forces involved—buying and selling by central banks, new mining techniques, political and inflation/deflation fears, the Indians who buy gold when they’re rich and trade it for silver when they’re not, the actions of gold bugs, and so on. It seems that when one of these forces dominates, as did inflation fears in the late 1970s (Figure 1-11) and probably flight from all fiat currencies (paper currencies, or money with no inherent value other than the denomination printed on it) recently, gold prices react. But with disinflation starting in the early 1980s, gold prices fell for 20 years by 61 percent nominally and 83 percent in real terms as negative factors affecting its price overcame positive influences.
Drawbacks of Gold
Gold has a number of drawbacks as an international trading and reserve currency. Its price in early 2012 climbed to $1,656 per troy ounce, but it would need to leap to $8,158 just to replace the broad money supplies in the United States, Canada, Japan, the United Kingdom, and the eurozone, even if all the refined gold in the world were employed, with none left for jewelry or to plate Col. Gadhafi’s pistol. It’s expensive to store, and it has no return unless it’s lent out. It’s also heavy to carry around and at high risk of theft. Recall all those gold-laden Spanish galleons that were either captured by English buccaneers or sunk in the Caribbean, waiting four centuries or more for treasure hunters to find them.
Of course, gold could be deposited safely and paper certificates issued against it. Ancient Chinese paper currency was backed by and denominated in strings of coins. U.S. dollar bills used to be silver certificates backed by Treasury silver holdings. But as was shown in ancient China, once paper is issued, it’s hard to limit its linkage to metal to strict amounts. So you’re pretty much back to the current system where the tie of paper currencies to anything else is tenuous at best.
Furthermore, if gold is the only money and any paper issued against it is strictly limited, governments have no monetary control. William Jennings Bryan, in his “Cross of Gold” speech that helped him win the Democratic presidential nomination in 1896, argued for the free coinage of silver to break the gold monopoly of the money supply. Western farmers and ranchers who wanted plenty of money and cheap credit to expand were pitted against eastern bankers who liked high returns on their loans. Well, Bryan lost to William McKinley, who was assassinated and succeeded by Theodore Roosevelt. Go figure.
In 1971, President Nixon was forced to sever the dollar’s link to gold when a run on the yellow metal threatened to exhaust U.S. gold reserves, as noted earlier. The recent run-up and then nosedive in gold’s price (Figure 1-13) suggests that it continues to be subject to rallies and retreats, at least in relation to the dollar. And the system could be thrown into chaos if huge new sources of gold were discovered, comparable to the New World finds in the 1500s.
Figure 1-13 Gold Prices
(Dollars per Troy Ounce; Nearest Futures Contract)
Source: Thomson Reuters
If gold were money and any paper currency issued against it were strictly limited, what would occupy central bankers? Like the individual eurozone banks since the advent of the ECB, whose mandate does not allow them to print money, would they essentially spend their days counting coins and bills? Conventional monetary policies, that is, raising and lowering interest-rate targets to either fight inflation or stimulate economic growth, would still be possible, but if interest rates got to zero, as at present, central banks would be impotent. Quantitative easing, which injects more money into the economy by purchasing financial assets, would be out, since central banks could no longer create money out of thin air. (Of course, the Ron Pauls of the world, who want to abolish central banks—and perhaps some other antagonists of Fed Chairman Bernanke as well—would probably be happy to see this state of affairs.)
Two vs. One?
These problems with gold suggest that despite the current concerns over the dollar and other fiat currencies, gold is unlikely to become the primary global trade currency and reserve asset. But could two international currencies exist simultaneously? Until the eurozone sovereign debt crisis erupted in 2010 and a hard landing in China became more widely expected, many observers saw the dollar losing its primacy to the ascending euro and, later, the Chinese yuan. Some Middle East oil producers shifted meaningful amounts of reserves into euros.
In the seventh century, both the Byzantine solidus and the Arabian dinar circulated internationally, although the solidus was on the way out along with Byzantium, while the dinar was ascending in line with Arab conquests. Similarly, both sterling and the U.S. dollar were international reserve currencies in the early 1900s, when the United States was rising in global power and the United Kingdom was slipping. In both cases, dual international currencies existed not in periods of stability but during the transition from one to the other.
The expected rise in the euro as a currency in wide use outside the eurozone was probably responsible, at least in part, for the weakness in the dollar in the 2000s (Figure 1-14). But the eurozone crisis has cut off the ascendancy of the euro, and those Middle Eastern countries have apparently moved their reserves back to dollars.
Figure 1-14 U.S. Dollar Index
(Vs. Major Currencies)
Source: Federal Reserve
The Dollar’s Scoreboard
Is the dollar likely to remain the world’s primary international trade and reserve currency in coming decades? To see, let’s examine the greenback against my six criteria for this status.
Productivity Growth
In the last decade, productivity growth was rapid in countries like Estonia, Poland, Hungary, the Czech Republic, and Slovakia, which have been catching up as they shake off the last vestiges of Soviet repression (Figure 1-15). South Korea’s productivity growth, 4.3 percent per year in the 2000–2010 decade, was rapid, but as the country becomes more and more a developed country, it is less and less able to grow rapidly by emulating the leaders. Indeed, annual South Korean productivity growth has dropped consistently from 7.9 percent in 1985–1990 to 4.4 percent in 2005–2010. Unfortunately, reliable data for China are not available, but its productivity growth is probably slowing as opportunities to acquire Western technology play out.
Figure 1-15 Productivity Growth
(2000–2010 Calculated Annual Growth Rate)
Source: Organisation for Economic Co-operation and Development
Among developed countries, the United States, with 2.2 percent annual productivity growth in the last decade, was clearly the leader. Japan struggled at 1.6 percent per year. The United Kingdom was even lower, 1.2 percent. The countries in the eurozone ranged from zero in Italy to 2.0 percent in Ireland, and averaged 0.8 percent. Notice that the other PIIGS benefited from the euro, with Greek productivity gaining 1.5 percent per year, Portuguese 1.1 percent, and Spanish 1.1 percent, but those numbers will be hard to sustain in the aftermath of the current eurozone sovereign debt crisis. In contrast, annual productivity growth was only 0.9 percent in stalwart Germany and 0.8 percent in France.
The level of productivity, measured by GDP per hour worked, is also the highest in the United States, $59.5, with few exceptions (Figure 1-16). Luxembourg is concentrated in banking and other high-value-added industries, Norway has a small population and big petroleum revenues, and the Netherlands has a well-educated and homogenous population. But beyond that, even the hardworking Germans had lower GDP per hour worked in 2010 than the United States, $53.4, and when the less-diligent Club Med countries are included, the Eurozone as a whole was much lower, $49.1. The United Kingdom ran $46.7, and, surprisingly, the dedicated Japanese produced only $39.4 in GDP per hour worked in 2010. But then the Japanese economy remains a combination of a highly efficient export sector and an inefficient domestic component.
Figure 1-16 2010 Productivity
Source: Organisation for Economic Co-operation and Development
Normal and Fast
&n
bsp; Furthermore, the recent productivity growth rate in the United States is normal. Annual nonfarm business-sector productivity, averaged by decades, has been between 2 percent and 2.5 percent since 1900 (Figure 1-17). Even in the 1930s Great Depression, it averaged 2.4 percent as the new technologies of the 1920s, such as the electrification of homes and factories, telephones, and mass-produced autos, continued to gain importance, even in the flagging economy.
Figure 1-17 Productivity in the U.S. Nonfarm Business Sector
(Average Annual Growth Rate by Decade)
Sources: National Bureau of Economic Research (NBER); Bureau of Labor Statistics (BLS)
The exception was in the 1970s and 1980s, when first Vietnam disrupted the economy, and then the inflation spawned by huge Great Society spending on top of oversized military outlays led to serious price increases. Respect for authority virtually disappeared, and the postwar babies entered the workforce as undisciplined, raw recruits. Since then, of course, U.S. productivity growth has returned to its century-old trend.
American productivity growth will probably remain robust in the decades ahead. For nine distinct reasons (Figure 1-18), I expect slow U.S. economic growth in future years, averaging 2 percent annually for real GDP. This compares with the post–World War II average of 3.2 percent and the rapid 3.7 percent rate in the 1982–2000 salad days, when inflation was unwinding and American consumers were on a borrowing and spending binge. In the ongoing environment of slow corporate revenue growth, businesses will no doubt continue to promote productivity and otherwise cut costs. The recent surge in temporary employment should continue, since those people work only at the time of day or season of the year that they’re needed, and their benefits tend to be much lower than those of full-time workers.
Figure 1-18 Nine Causes of Slow Global Growth in Future Years