Currency Power: Understanding Monetary Rivalry - Hardcover

Cohen, Benjamin J.

Hardcover

ISBN 10: 0691167850 ISBN 13: 9780691167855

Publisher: Princeton University Press, 2015

Synopsis

Why the dollar will remain the world's most powerful currency

Monetary rivalry is a fact of life in the world economy. Intense competition between international currencies like the US dollar, Europe's euro, and the Chinese yuan is profoundly political, going to the heart of the global balance of power. But what exactly is the relationship between currency and power, and what does it portend for the geopolitical standing of the United States, Europe, and China? Popular opinion holds that the days of the dollar, long the world’s dominant currency, are numbered. By contrast, Currency Power argues that the current monetary rivalry still greatly favors America’s greenback. Benjamin Cohen shows why neither the euro nor the yuan will supplant the dollar at the top of the global currency hierarchy.

Cohen presents an innovative analysis of currency power and emphasizes the importance of separating out the various roles that international money might have. After systematically exploring the links between currency internationalization and state power, Cohen turns to the state of play among today’s top currencies. The greenback, he contends, is the "indispensable currency"―the one that the world can’t do without. Only the dollar is backed by all the economic and political resources that make a currency powerful. Meanwhile, the euro is severely handicapped by structural defects in the design of its governance mechanisms, and the yuan suffers from various practical limitations in both finance and politics.

Contrary to today’s growing opinion, Currency Power demonstrates that the dollar will continue to be the leading global currency for some time to come.

About this title

About the Author

Benjamin J. Cohen is the Louis G. Lancaster Professor of International Political Economy at the University of California, Santa Barbara.

From the Back Cover

"It is widely believed that we are moving away from a dollar-dominated global monetary system, just as we are moving away from a US-dominated global economy. But the consequences--for economics, finance, and geopolitics—remain unclear. No one is better qualified than Benjamin Cohen, the dean of international political economists, to make sense of these issues. In Currency Power, he succeeds in doing just that."--Barry Eichengreen, University of California, Berkeley

"Benjamin Cohen conceptualizes currency power as the capacity to avoid adjustment costs, either by delay or deflection--shifting these costs onto others. Read this book for its brilliant examination of currency power and get Cohen's contemporary analysis as a bonus."--Robert O. Keohane, Princeton University

"Benjamin Cohen, one of the world's foremost experts in the field and mentor to generations of accomplished scholars, draws effortlessly on a half century of expertise and experience with characteristic clarity. Comprehensive, yet nimble and distinctly argued, Currency Power is the go-to book for an overview of the vital and consequential politics of international money."--Jonathan Kirshner, author of American Power after the Financial Crisis

"In Currency Power, Benjamin Cohen addresses the potential for other currencies to rival the US dollar's dominant position in the international monetary system. Cohen has spent a career exploring the politics of international monetary relations and he knows the literature inside and out. The culmination of a life's work, this is the best book on the topic available."--J. Lawrence Broz, University of California, San Diego

"Currency Power promises to solidify Benjamin Cohen's reputation as the foundational author of what we know about currencies and their cross-border use. This is a tour de force on global monetary power and the world's currency system. It will sharpen the debate and have a lasting impact on the international political economy field for decades to come."--Carla Norrlof, University of Toronto

Excerpt. © Reprinted by permission. All rights reserved.

Currency Power

Understanding Monetary Rivalry

By Benjamin J. Cohen

PRINCETON UNIVERSITY PRESS

Copyright © 2015 Princeton University Press
All rights reserved.

ISBN: 978-0-691-16785-5

Contents

List of Tables and Figures, ix, 
Acknowledgments, xi, 
Abbreviations and Acronyms, xiii, 
Introduction, 1, 
1 International Currency, 8, 
2 Power Analysis, 28, 
3 Monetary Power, 48, 
4 From Currency to Power, 77, 
5 From Power to Currency, 102, 
6 Currency Competition Today (with Tabitha M. Benney), 135, 
7 The Dollar: Power Undiminished, 160, 
8 The Euro: Power Unrealized, 185, 
9 The Yuan: Power Unstoppable?, 214, 
10 Summing Up, 237, 
Notes, 245, 
References, 257, 
Index, 275, 

CHAPTER 1

International Currency

International hierarchies are pervasive.

— David Lake

This book is about currency and power. But before we can explore the details of their relationship, we must first establish a clear understanding of each of the two concepts considered separately. What do we know about currency internationalization? What do we know about international power? These are the essential building blocks for the discussion to follow.

Power analysis will be the subject of chapter 2. This chapter focuses on currency, outlining the nature and implications of international money as generally understood by social scientists today. The aim is to provide a baseline and context for the analysis to follow: a consensus perspective on the basics of currency internationalization. Several critical questions are addressed. What drives the process of currency internationalization, what determines which currencies will become internationalized, and what does the universe of international currencies look like? Elsewhere I have referred to this last question as the "geography of money." Most importantly, what are the presumed implications of the process for the countries that issue an international currency?

Motivations

Currencies, if attractive enough, may be employed outside their country of origin for any of a number of monetary purposes. The standard taxonomy for characterizing the roles of international money, which I can take pride in originating, separates out the three familiar functions of money — medium of exchange, unit of account, store of value — at two levels of analysis — the private market and official policy — adding up to six roles in all. Specialists today generally speak of the separate roles of an international currency at the private level in foreign-exchange trading (medium of exchange), trade invoicing and settlement (unit of account and medium of exchange), and financial markets (store of value). At the official level, we speak of a money's roles as an exchange-rate anchor (unit of account), intervention currency (medium of exchange), or reserve currency (store of value). Each of the six roles is distinct in practical as well as analytical terms. The taxonomy is summarized in table 1.1.

Currency internationalization alters monetary geography by accentuating the hierarchical relationship among currencies, expanding the domains of a few popular moneys well beyond the jurisdictions of the countries that issue them. The outcome is produced by a sort of a Darwinian process of natural selection, driven above all by the force of competition — much like Gresham's Law, except in reverse. Instead of "bad" money driving out "good," as Gresham's Law traditionally holds, the good money drives out bad. There is nothing irrational about the process. On the contrary, internationalization may be regarded as a quite natural demand response to prevailing market structures and incentives.

Analytically, the motivations for internationalization can be easily appreciated. The incentive derives from the economies of scale, or reduced transactions costs, to be gained from concentrating cross-border activities in just one or at most a few currencies with broad transactional networks. To do business in each country in a separate money is analogous to barter and clearly inefficient. Within any single economy, monetary exchange — rather than barter — reduces the expenses associated with search and bargaining. So too between states. The costs of transactions are narrowed by making use of one or just a few currencies rather than many. In the words of one study: "The necessity of 'double coincidence of wants' in a decentralized foreign exchange market may be overcome by using indirect exchange, through a generally acceptable medium of exchange instead of direct exchange of currencies." The greater the volume of transactions that can be done via a single currency, the smaller are the costs of gathering information and converting from one money to another. Monetary theorists describe these gains as money's "network externalities" or, simply, the network value of money. Network externalities may be understood as a form of interdependence in which the practices of any one actor depend strategically on the practices adopted by others in the same network of agents.

In fact, currency internationalization improves the usefulness of money in all its roles. International standing enhances a currency's value both as a commercial medium of exchange and as a unit of account for the invoicing and settlement of trade; and these effects in turn also broaden its appeal as a store of value, by facilitating accumulation of wealth in assets of more universal purchasing power. At a minimum, it will pay market agents to hold some level of working balances in a popular international currency. Depending on cross-border variations of interest rates and exchange-rate expectations, it will pay them to use it for longer-term investment purposes as well.

Moreover, once a money comes to be widely used by private actors, it is more likely to be employed by governments too, as a reserve currency, intervention medium, and anchor for exchange rates. Public actors too can benefit from the economies of scale offered by a broad transactional network. Historically, the typical pattern of internationalization is adoption first by the private sector, with the public sector then following.

Choices

Why are there so few international currencies? Within individual countries, the role of a single money can be promoted by the coercive powers of the state. Sovereign governments can deploy legal-tender laws, exchange controls, and related regulatory measures to force residents to make use of the national currency for all legitimate monetary purposes. Inside their borders, states enjoy a de jure monopoly on the creation and management of money. But at the international level, the capacity for coercion is more limited. Compulsion is of course possible in colonial or quasi-imperial clientalistic relationships. But in the more normal case, in relations among independent nations, monopoly is replaced by competition, and actors must be persuaded rather than compelled to make use of one currency rather than another. Rivalry for market share, as a rule, is the essence of the process of internationalization. Typically, to gain standing, a money must be competitive.

And what makes a money competitive? What determines which currencies will prevail in the Darwinian struggle? The principal qualities required for competitive success are familiar to specialists and hardly controversial. Both economic and political factors appear to be involved.

On the economic side, demand seems to be shaped most by three essential attributes. First, at least during the initial stages of a currency's cross-border use, is widespread confidence in the money's future value. The historian Carlo Cipolla, in his magisterial survey of the early moneys of the Mediterranean world, laid particular emphasis on "high unitary value and intrinsic stability" as essential conditions for the emergence of a dominant international currency — in other words, a proven track record of relatively low inflation and inflation variability. High and fluctuating inflation rates increase the cost of acquiring information and performing price calculations. No currency is apt to be willingly adopted for cross-border purposes if its purchasing power cannot be forecast with some degree of assurance.

Second are the qualities of exchange convenience and capital certainty — a high degree of transactional liquidity and reasonable predictability of asset value. The key to both is a set of well-developed financial markets, sufficiently open to ensure access by outsiders. Markets must not be encumbered by high transactions costs or formal or informal barriers to entry. They must also offer considerable depth, breadth, and resiliency — the three most fundamental characteristics of an efficient financial sector. Depth means the ability to sustain relatively large market orders without impacting significantly on an individual asset's price. Breadth means trading volumes and enough market competition to ensure that the spread between ask (sell) and bid (buy) prices is small. And resilience means the ability of market prices to recover quickly from unusually large sell or buy orders. Secondary markets must be fully operational for most if not all financial claims.

Finally, a money must promise a broad transactional network, since nothing enhances a currency's acceptability more than the prospect of acceptability by others. Historically, this factor has usually meant an economy that is large in absolute size and well integrated into world markets. A big economy creates a naturally ample constituency for a currency; the potential for network externalities is further enhanced if the issuing state is also a major player in trade. As economist Jeffrey Frankel has suggested, "the currency of a country that bulks large in the world economy has a natural advantage." No money has ever risen to a position of international preeminence that was not initially backed by a leading economy. The greater the issuer's weight in global commerce, the stronger will be the "gravitational pull" of its currency.

On the political side, both domestic and international considerations may play a role. Domestically, political stability and effective governance in the country of origin would seem critical. Potential users are unlikely to be attracted to a currency that is not backed by adequate protection of property rights and genuine respect for the rule of law. Nor will they be drawn to a regime that lacks a demonstrated capacity for successful policy management. As Andrew Sobel points out in an important historical study, success in the Darwinian struggle among currencies rests heavily on the key microfoundations of political stability and accountable government. In past episodes of currency internationalization, from Britain's pound sterling to the US dollar and today's euro, there was never any doubt about the durability of these key attributes. Issuing governments could be counted upon to faithfully enforce contractual obligations. Had circumstances been otherwise, it is hard to imagine that any of these currencies would have gained much traction in international markets. Why would actors deliberately expose themselves to serious political risk if they do not have to do so?

Internationally, the experiences of the pound and dollar suggest that security considerations may also be of considerable importance. At the private level, a militarily powerful nation can provide a "safe haven" for nervous investors. A strong defense ensures a more secure investment climate. At the official level, currency preferences of governments may be influenced by broader foreign-policy ties — traditional patron-client linkages, informal security guarantees, or formal military alliances. Could the timing of sterling's ascendance in the nineteenth century, paralleling the emergence of the formidable British Empire — the empire on which the sun never set — have been a mere coincidence? Can it be an accident today that with the conspicuous exceptions of China and Russia, most big dollar holders around the world are formal or informal allies of the United States? The greater the ability of an issuing state to project power beyond its borders, the more likely it is that friends and allies will feel comfortable using its money.

None of these attributes is a constant, however, as history amply demonstrates. Quite the contrary, in fact. Every one of a currency's attractions is subject to erosion with time, particularly if an issuing authority imprudently abuses the privileges derived from internationalization. Market preferences, which determine the outcome of the competitive process, may well change substantially from one period to the next. Shakespeare's words are as apt for money as they are for monarchs: "Uneasy lies the head that wears the crown." No currency has ever enjoyed a permanent dominance for international use.

Candidates

Few currencies are able to meet all the demanding economic and political qualifications for internationalization. That is not pessimism but realism. Given the substantial stakes involved, the competition that is at the core of the process of internationalization is bound to be unforgiving.

In some cases, currencies are effectively disqualified because they fail to perform all three of the standard functions of money. They are not full-bodied moneys. That is especially true of so-called artificial currency units like the Special Drawing Right (SDR) of the International Monetary Fund (IMF) or Europe's old European Currency Unit (ECU), which have existed primarily as notional units of account. Neither the SDR nor the ECU was ever available for use as a medium of exchange. The same was also true of the "transfer ruble" created by the former Soviet Union for denominating trade within the Soviet-led bloc of "socialist" nations before the end of the Cold War. Trade among bloc members was based on strict bilateral balancing. Monetary values were expressed in transfer rubles, but these existed solely for accounting purposes. Trade with non-bloc members was done entirely in dollars or other Western currencies. The ruble that was used inside the Soviet Union was tightly regulated and rarely adopted for transactions abroad. Despite the Soviet Union's geopolitical importance at the time, its national currency never had any real international standing.

In other cases, currencies are disbarred in practical terms by inconvertibility. Technically, Article VIII of the Charter of the IMF imposes a convertibility obligation on all Fund members. To this day, however, a majority of the Fund's membership — mostly the least developed economies — still take advantage of a legal loophole afforded by the Charter's Article XIV to prolong rigid exchange and capital controls. No one would ever consider any of their currencies credible candidates for internationalization. A money need not be fully convertible to attain some measure of use by at least a few market actors or governments. But some minimal measure of transferability is essential if a currency is to go far in the Darwinian struggle.

Among more fully convertible currencies, many fail to appeal internationally because they lack one or more essential attributes. Some issuing states may have a poor record on inflation or lack sufficient depth and liquidity in their financial markets. Others may simply not be big enough to offer a broad transactional network or to project power effectively. And others may lack the requisite political stability or rule of law.

Incumbency also matters. International currency use is highly path dependent. The playing field is by no means a tabula rasa; at any given moment, market actors and governments are already locked into established patterns of behavior. Newcomers, therefore, start at a distinct competitive disadvantage that may be difficult to overcome. As the late Ronald McKinnon noted, "there is a tremendous first-mover advantage to the national currency already ensconced as international money."

In fact, currency choice is notoriously subject to inertia owing to the often high cost of switching from one money to another. The same network externalities that promote the use of a first mover can long delay the rise of other currencies. Why would market actors go to the trouble of adapting financial practice to a different money unless they can be sure that others will make use of it, too? A challenger must not just match at least some of the qualities of existing international currencies. It must somehow also offer advantages sufficient to persuade agents to risk making a potentially costly change. As we shall see in later chapters, lags are an inevitable part of the process, though scholars debate over how long (or short) the delay might actually turn out to be.

In practical terms, it is not easy to compete with a money that is already as well established as the US dollar has been since World War II. America's greenback enjoys undoubted incumbency advantages. Not least is the fact that the language of its issuing country, English, happens as well to be the universal language of international business. The idea of converting from one money to another is less appealing if it also means switching from one language to another.

In recent experience, the currencies that have managed to achieve even marginal acceptance for cross-border purposes can be counted on the fingers of two hands. Over the post–World War II period, the dollar has dominated. Among all the world's other currencies, only West Germany's old Deutsche mark (DM), Japan's yen, and the euro have for a time been competitive enough to also gain a significant share of the market for international money. Others have exhibited lesser degrees of market appeal.

(Continues...)

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Edition details

• Publisher: Princeton University Press
• Publication date: 2015
• Language: English
• ISBN 10: 0691167850
• ISBN 13: 9780691167855
• Binding: Hardcover
• Number of pages: 304