The Once and Future Currency

http://www.economist.com/news/finance-and-economics/21598651-new-book-examines-worlds-love-hate-relationship-dollar-once-and

          The article talks about the dark days in 2008 and Tim Geithner, the head of the New York Federal Reserve at the time, describing the need for dollars in emerging economies as lumpy, unpredictable and potentially large. “The Dollar Trap”, a new book by Eswar Prasad of Cornell University, shares the world’s ambivalence towards the currency. People expected the ’08 crisis might have eroded the dollar’s global prominence but Prasad argues, claiming it cemented it. During the final four months of 2008, America attracted net capital inflows of half a trillion dollars. The ’08 slump forced the Fed to ease monetary policy, so central banks in emerging economies bought dollars to stop their own currencies rising too fast. Swap lines are less costly alternatives to rampant reserve accumulation and serve as good business in countries like India, Indonesia, the Dominican Republic and Peru.

            Size and sophistication do not always go together. America is not only the world’s biggest economy, but also among the most sophisticated. America’s sophistication is reflected in the depth of its financial markets. We have a big external balance-sheet, an obvious strong one. Its foreign liabilities exceed its overseas assets. This might be a worry but conceals a saving grace: its foreign assets are unusually adventurous and lucrative while its liabilities are largely liquid, safe and low-yielding. So with that, America earns more on its foreign assets than it pays on its foreign liabilities. Along with its economic maturity, America also has an ageing population. This is a source of economic weakness. Prasad argues differently, claiming it may be another reason for the dollar’s global appeal.

            The dollar’s depreciation over this period is, of course, bad for anyone holding American assets. But the dollar is not merely a store of value. The dollar has become a popular “funding” currency. Banks and multinational firms borrow in dollars. Holding a role of a funding currency, the dollar tends to strengthen in times of crisis; this explains why emerging countries feel a lumpy, unpredictable need for dollars. America’s currency may not hold its value against others, but in times of stress, the appeal of a dollar asset is that it always holds its value against a dollar debt.