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When the Bretton Woods system crumbled just over 50 years ago, US Treasury Secretary John Connally famously told his European colleagues that «the dollar is our currency, but it’s your problem». Whose problem is the dollar today?
The dollar is the world’s problem. A lot of emerging market debt is denominated in dollars, so if the dollar strengthens, this debt becomes more expensive to service and repay. There are myriad low-income countries and emerging markets with debt servicing difficulties that are being aggravated by the strong dollar. Global commodity prices are also denominated in dollars. As a result, the strong dollar and weak local currencies are fueling inflation. From both points of view, the strong dollar is a problem for countries facing inflation and debt servicing difficulties. That means almost all countries.
Why is the dollar so strong at the moment?
Dollar strength is driven partly by the fact that the Federal Reserve is moving fast to raise interest rates. The Fed’s strong reaction in comparison to other central banks has a reason: The Fed is not facing an economy that is being crunched by an energy crisis in the same way as in Europe and doesn’t have to take into consideration a debt gap between members of a monetary union. Beyond that, we’re currently living in a turbulent and volatile world. The dollar still is a safe haven. Money moves into dollars when there is geopolitical risk. And there’s more of that right now than any time in living memory, even than during the Cold War.
The Bank of England recently had to buy a mass of UK government bonds to ensure financial stability. Was this an isolated failure or the return of global financial turbulence?
What happened there is mainly a warning, a wake-up call. There’s the possibility that the UK is the canary in the coal mine and that more financial problems coming elsewhere. We may have strengthened the balance sheets of commercial banks in response to the events of 2008, but commercial banks are only one part of the financial system. Problems could crop up in other parts. In the UK, it was pension funds. In the US, it could be private equity. We don’t really know where the financial landmines are buried. I’m not so worried about the exact pension fund problems recurring in other countries, but I am worried about financial problems more broadly. The European authorities recently issued a report saying that it would be desirable for the European Central Bank to provide a special refinancing facility for European pension funds. That’s another example of how policymakers are very good at solving the last crisis but not so good at solving the next, which is likely to take a different form.
Speaking of the ECB: What should be the ECB’s strategy right now? What should it do differently?
It certainly finds itself in a complicated situation. Odds of a recession in the United States in the next 12 months seem about 50/50 at the moment. Odds of a recession in Europe are much higher, because the energy disruption is more severe. If a central bank is looking forward to a recession, it’s unlikely to continue to raise interest rates, because the weaking economy will need support. Inflation will come down by itself owing to the weak spending that is the definition of a recession. The European Central Bank has the dilemma of whether to raise rates now and begin to actively bring inflation down, or wait for the inevitable recession, which will help to bring down inflation on its own. Then there is the problem of bond market fragmentation, which in reality should be called «the Italian problem». Eventually we will find out what the intentions of Giorgia Meloni’s government are. Recent examples of radical parties in government, Syriza in Greece or Podemos in Spain, suggest that rhetoric gets toned down once you become part of a government. But there’s no guarantee.
You wrote a book about how economic grievance can cause populist uprising. Is that something you see looming right now?
You only have to look at street demonstrations in France, in Germany, in other European countries, to know that people and households are stressed by higher energy prices, higher food prices and higher interest payments on their mortgages. More people feel like the government is not attending to their needs. In order for political coalitions to hold together and maintain sound policies, they need to address those grievances. People had been working and living their normal lives and all of a sudden their monthly expenditures explode for reasons not of their own making. This causes not only anger but also insecurity. Populism is driven as much by uncertainty about one’s economic future, as it is by actually living through hard times. It is important that European governments quickly design effective relief packages. But these packages should be targeted to people and companies that need relief the most.
Can Europe afford such policies given the already elevated debt levels?
Debt is a problem in the most heavily indebted European countries such as Italy or Greece, not yet more broadly. But untargeted subsidies to offset the increased cost of energy cannot continue year after year after year. Europe is making progress in terms of building floating LNG platforms and planning new pipelines between Portugal, Spain and France. But completing those projects will take time, and Russian energy supplies are not going to magically return. If European governments subsidize all households and firms for years going forward, that could blow a hole in budgets and create problems of debt sustainability. Germany is currently using its low-debt position, passing relief packages like no other country. This is a threat to political unity on the continent.
You are painting a bleak future for the continent. Is there any case for optimism?
At this moment, I think a recession is baked in. The energy price shock is undermining consumer confidence. Consumption accounts for two thirds of the European economy. So when consumer confidence weakens, a recession becomes likely. Then there are the chemical companies and so forth that are shutting down facilities because of the high price of energy. European governments have limited fiscal room for maneuver and can do less than on previous occasions in terms of using fiscal policy to offset the weakening of private spending, because they already took massive fiscal action in 2020 in response to the pandemic and in the wake of the financial crisis of 2008. In retrospect, not enough was done to repair the fiscal ceiling while the economic sun was shining. But the biggest mistake was made by Angela Merkel and Co.: Their «all in» on Russian oil and gas turned out to be a huge error.
Let’s focus a bit on the future of the monetary system as a whole. How does the future for the dollar look? Will it stay that strong? Or will it eventually weaken?
At the moment, the dollar is at exceptionally high levels. It’s kind of a no brainer to say it will fall; it’s just difficult to say when. A number of events could cause the dollar to weaken: The Fed might stop tightening because the US economy weakens more than expected. Or resolution of the war in Ukraine could diminish safe haven flows toward the dollar. Sanctions against Russia have shown the potential for the US to weaponize the dollar. I think we will see more countries contemplating their exposure towards the US gradually shifting their reserves and transactions away from dollars, US banks and SWIFT. In the Russian case, this weaponization of monetary affairs would have been difficult to escape: the issuers of alternative reserve currencies such as the euro, the pound sterling and the yen were also onboard with the sanctions. In a future scenario, the US and Europe might not on the same wavelength, however.
Further sanctions might be introduced if China invades Taiwan. What would that do to the world’s monetary system?
Such an event would not only affect the monetary system, it would affect the economic system. It would cause a shock to international trade and international financial flows, as well as to the use of currencies, on an order of magnitude more serious than anything we’ve seen in recent years. China has a much bigger economy than Russia. Depending on how you measure these things, Russia contributes to approximately 3 percent of the global economy. China is closer to 20 percent. An invasion of Taiwan would cause trade between the West and China to stop. Exchange rates and currencies would fluctuate violently. But currency affairs would be the least of our worries; the massive worry would be about exports and imports. The only cause for reassurance is that Chinese leaders hopefully understand that an invasion of Taiwan would be a massive shock to their own economy. The Communist Party’s legitimacy has traditionally derived from its ability to row the economy and produce higher living standards for people. That would be interrupted in a violent way by the countermeasures to the invasion. We have to hope that Chinese leaders in their wisdom don’t want to go there.
The Chinese Communist Party wants to create an alternative to dollar dominance with the renminbi. How is it faring with this pursuit?
China is working as hard as it can to internationalize its currency. It is encouraging other countries to use the renminbi and Chinese banks not only in their transactions with China itself, but in transactions amongst third countries. Not much has happened so far: If you look at the latest SWIFT data, the dollar accounts for about 40 percent of global transactions messaged through the system. The renminbi accounts for about 3 percent. China is building what it calls its cross border interbank payments system as an alternative to the US CHIPS Clearinghouse and Fedwire. But China’s system has only about 10 percent as many banks participating, and it does only about 2 percent as many transactions by value. For some countries, China’s system might be seen as a fallback option or a form of insurance against the possibility of being shut out of the American payment system. But the disproportion between the two systems is still very great.
What does a currency have to offer to become leading reserve currency?
Four years ago, I wrote that the secret sauce has three ingredients. Firstly: Size, as it has to be the currency of a large economy that does a lot of trade. Secondly: Stability, which means a stable currency of a stable economy. And finally: Liquidity, which means that it’s easy and convenient for people to buy and sell the currency. Now I would add another component: The presence of a reliable political system. Mr. Putin singlehandedly decided to go into Ukraine. He’s an autocrat, not subject to political checks and balances. President Xi increasingly looks like an autocrat, not subject to political checks and balances. So if you were an international bank or a central bank, would you park your reserves with these guys, knowing that they can change the rules and limit your access at their discretion? I’m not sure that recent events enhance the prospects of the renminbi as an international currency; they could even trigger the opposite reaction. Before the pandemic, I went to China to talk about such issues with Chinese economists and central bankers. I would tell them that every true international and reserve currency in history, the dollar, before that the pound sterling, before that the Dutch guilder, before that the currencies of Venice and Genoa, were the currencies of political republics or democracies, where there was a Republican Parliament or assembly that could act as a check on the executive or the ruler. My Chinese audience would listen respectfully to my views, but they wouldn’t respond to them.
The past 50 years have been described as the monetary non-system, because there are literally no rules governing monetary affairs on an international level Post-Bretton-Woods. What’s your take on the era’s performance so far?
I am fond of invoking Winston Churchill’s statement about democracy: It’s the worst possible system, except for all the others. In a world of high capital mobility, it works better than pegged exchange rates, which at some point become vulnerable to collapse. It also works better at a global level than an imaginary single world currency. Europe is grappling with the difficulties of having a single currency without a single treasury. Politically, we’re not going to settle on a single global treasury and in a world of nation states with very different views. There has been convergence of opinion and policy in Europe, which makes the euro work tolerably well, but something like that couldn’t work on a global scale. Without pegged exchange rates and without a single world currency, we have what we have.
How will the monetary system change in the future?
We will gradually move in the direction of a more multipolar version with less dominance of the dollar. Both the currencies of the other two large economies, the euro area and China, will gradually acquire a larger role. We will also see more use of non-traditional reserve currencies: With new technologies such as digital platforms for trading currencies and electronic liquidity provision algorithms, it’s easier to trade small currencies such as the Canadian dollar, the Australian dollar, the South Korean won and the Norwegian krona. So the direction is towards a more multipolar, more decentralized, less dollar dominated version of the same. But you’ll still be able to recognize it as a descendant of the current system 20 years from now.
Will less dollar dominance also bring less geopolitical influence of the United States?
The fact that everybody uses the dollar has convenience value for the United States. When other countries experience financial turbulence today, they need swap lines from the Federal Reserve, which gives US institutions some additional authority and leverage. So on that margin, US power might diminish a bit if countries shift away from the dollar. But to repeat what I said before, my forecast would be for gradual evolution. Assuming no reelection of Donald Trump in 2024, in which case the possibility of sharp changes in the stature of the United States in the world economy could not be ruled out.