The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser).   It makes sense.  The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries.  The economic dynamism — most striking in Dubai –  is admirable and fascinating as a longer term phenomenon, but also now clearly shows signs of overheating.  Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers.   An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies.   This would be an improvement.   Kuwait, for example, made this switch a year ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be.    Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be.   A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks.  But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. 

Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor.  But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg.   I have laid out the case elsewhere (including also for the case of Iraq).  I call the proposal PEP, for Peg the Export Price.   I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”

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My friend Barry Eichengreen, together with Marc Flandreau, has written a column in today’s Financial Times, that appears under the headline “Why the euro is unlikely to eclipse the dollar.”     The body of the article is a claim that network externalities and tipping points are not important, or perhaps that they once were but no longer are.   

The first two steps of their argument are:
(1) a multiple-currency system is the historical norm.   The dollar-denominated system that we have experienced for more than 60 years is an aberration, so network externalities (aren’t) important.
(2)  The dollar surpassed the pound in the 1924-25, not in 1948, so lags and tipping phenomena are not important.

Regarding (1), I have always thought that Barry has a good point that a multiple-currency system has one advantage, that it gives the lead currency some competition, which discourages it from abusing its position by excessive deficits, money creation, inflation and depreciation.   But I disagree that network externalities are not also important:  there will always be an advantage to having a lead currency internationally, just as there is an advantage to having a single money within each country.

Regarding (2), I have no problem dating the pound’s loss of supremacy from the 1920s, if that’s what the eminent economic historians say.    But I don’t see how this affects any of the arguments.   For one thing, the US surpassed the UK in economic size in 1872, and in exports in 1915.    So there is still a lag of between 10 and 53 years.    

More importantly, these propositions have no bearing on the central claim that Menzie Chinn and I have made:     based on our statistically estimated effects of economic fundamentals, such as the size of euroland — which has recently passed the US economy — the euro now has the potential to rival or even displace the dollar as lead currency.  We think we have also found statistical evidence of inertia and non-linearity, which imply a tipping point.   But this doesn’t really matter. The scenario that we most emphasize leaves the dollar with an estimated share of central bank reserves only a little less than that of the euro even in the long run.   Regardless what one believes about how fast it will occur or how complete the de-throning will be, our claim that the euro will challenge the dollar stands.

My post last week suggested that the euro may overtake the US dollar as premier international currency. One might ask why this would matter. Some of the reasons it matters are economic: we would lose the “exorbitant privilege” of being able to finance our international deficits easily. But there are also possible geopolitical implications.

In the past, US deficits have been manageable because our allies have been willing to pay a financial price to support American global leadership;  they correctly have seen it to be in their interests.   In the 1960s, Germany was willing to offset the expenses of stationing U.S. troops on bases there so as to save us from a balance of payments deficit.   The U.S. military has long been charged less to station troops in high-rent Japan than if they had been based at home. Repeatedly the Bank of Japan, among other central banks, has been willing to buy dollars to prevent the U.S. currency from depreciating (late 1960s, early 1970s, late 1980s).   In 1991, Saudi Arabia, Kuwait, and a number of other countries were willing to pay for the financial cost of the war against Iraq, thus briefly wiping out the U.S. current account deficit.

Unfortunately, since 2001, during the same period that the US twin deficits have re-emerged, we have also lost popular sympathy and political support in much of the rest of the world. Now the hegemon has lost its claim to legitimacy in the eyes of many.  In sharp contrast to international attitudes at the dawn of the century, opinion surveys report that the U.S. is now viewed unfavorably in most countries.    Next time the US asks other central banks to bail out the dollar, will they be as willing to do so as Europe was in the 1960s, or as Japan was in the late 1980s after the Louvre Agreement?  I fear not. 

The decline in the status of the pound during the course of the first half of the 20^th century was part of a larger pattern whereby the United Kingdom lost its economic pre-eminence, colonies, military power, and other trappings of international hegemony.   As some wonder whether the United States might now have embarked on a path of “imperial over-reach,” following the British Empire down a road of widening budget deficits and overly ambitious military adventures in the Muslim world, the fate of the pound is perhaps a useful caution.   The Suez crisis of 1956 is frequently recalled as the occasion on which Britain was forced under US pressure to abandon its remaining imperial designs.  But the important role played by a simultaneous run on the pound, and President Eisenhower’s decision not to help the beleaguered currency through IMF support unless the British withdrew its troops from Egypt, should also be remembered.  

Question from The International Economy Survey of Experts: 
Ten years from now, which will likely be the next great global currency?

My answer: 
Contrary to fevered popular speculation in the 1990s, the yen and the mark never had the potential to challenge the dollar as premier international currency:  their home economies were smaller than the US and their financial markets less well developed and liquid than New York.   The euro, however, is a credible challenger:  Euroland is roughly as big as the United States.  Indeed, evaluated at the most recent exchange rates, the euro economy has just now surpassed the US economy in size.   Also the euro has shown itself a better store of value than the dollar.   These are two of the most important determinants of international reserve currency status.

To be sure, rankings of international currencies change only very slowly.    Although the US surpassed the UK in economic size in 1872, in exports in 1915, and as a net creditor in 1917, the dollar did not surpass the pound as number one international currency until 1945.   In 2005, when Menzie Chinn and I used historical data on central bank holdings of foreign exchange reserves to estimate the determinants, even our pessimistic scenarios did not have the euro overtaking the dollar until 2022.   Thus we could not have asserted that the dollar would be dethroned “ten years from now.”  But the dollar has continued to lose ground.    We have now updated our calculations, particularly to recognize that London is usurping Frankfurt’s role as the financial capital of the euro, notwithstanding that the UK remains outside of EMU.   It is also relevant that — at the most recent exchange rates — the GDP of euroland has surpassed that of the US.   Now we find that the tipping point could come within the ten-year horizon: the euro could overtake the dollar even as early as 2015.

Simulation of central banks’ reserve holdings: € passes $ around 2015 .
Scenario: Only accession countries join EMU in 2010 (UK stays out),
but 20% of London turnover counts toward Euro area financial depth,
and currencies depreciate at the 20-year rates experienced up to 2007.
Source: Chinn and Frankel (2008, Figure 7).