The recent depreciation of the US dollar sparked debate about its possible dethroning in the near future. Such discussion is not new. It has occurred repeatedly each time the US dollar faces adverse circumstances. However, the recent combination of financial turmoil, a significant current account deficit, and bear speculation provides a favourable background for renewed concerns. The attention these phenomena draw themselves is understandable. But do they warrant worry about the dollar?
One view, which has been mapped onto contemporary empirical evidence in a noted paper by Menzie Chinn and Jeff Frankel, is that rankings of international currencies change only very slowly, but when they change they do so with a bang. As the story goes, although the United States surpassed the United Kingdom in economic size very early (between 1860 and 1875 depending on estimates), the dollar did not surpass the pound as the number one international currency until 1945. When it did, however, the pound sterling was permanently dethroned.
Now, Chinn and Frankel note, the US dollar has steadily lost ground in the recent past. London is usurping Frankfurt’s role as the financial capital of the euro, notwithstanding that the United Kingdom remains outside the EMU. They say that a tipping point could come within the ten-year horizon: the euro could overtake the dollar even as early as 2015.
The reason usually put forward to account for the existence of tipping points is network externalities, or if you prefer, agglomeration economies. Currencies are a bit like malls: you go there because you expect to find a variety of services. Other customers do the same and sellers understand it. In the end, the mall is amply furnished with all amenities. And thus malls or more generally markets may survive somewhat longer than the reasons that led to their emergence in the first place. Yet a point comes where the underlying geography does change so much that previously active malls become deserted. Customers just start going somewhere else. We observe the collapse of a formerly booming market place. Such are the economics of tipping points.
But what do we really know of the reasons for the long delay in the ascent of the US dollar during the second half of the nineteenth century? In recent work I co-authored with Clemens Jobst, we took a fresh look at the issue. Gathering information on the international reach of every single currency in the world, we articulated a model that enabled us to test for alternative determinants of international currency status. We found strong evidence of size effects: the currencies of large trading powers tended to circulate widely. We also found evidence of financial persistence. The currencies that were actively sought by a large number of countries tended to be more liquid and, as a result, were more attractive, which boosted their use and liquidity. Figure 1 summarizes the evidence. It compares the outcome from a history-free scenario where there is no persistence with the actual performance of alternative currencies. As seen, the US dollar was penalised by history, while some European currencies (in particular the French franc) were rewarded with a larger actual share than the history-free counterfactual suggests.
References
Marc Flandreau and Clemens Jobst (2008) “The Empirics of International Currencies: Network Externalities, History and Persistence” (forthcoming, Economic Journal).
Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency? (2007). Menzie Chinn and Jeffrey A. Frankel, in G7 Current Account Imbalances: Sustainability and Adjustment, R. Clarida (ed), University of Chicago Press.
Will the dollar lose its place as the premier international currency? This column argues that the previous episode of dethroning, in which the dollar overtook the pound, suggests that economic fundamentals, rather than network externalities, drive the choice of a great global currency. Occasionally, it takes an economic historian to remind his economist colleagues that history may not matter as much as one would want to believe.
