THE DOLLAR TRAP: HOW THE U.S. DOLLAR TIGHTENED ITS GRIP ON GLOBAL FINANCE by Eswar S. Prasad

Princeton University Press 2014. ISBN 978-0691161129

In this worthwhile book Eswar Prasad presents the view that the post WWII world reserve currency,the US dollar, now has a more multifaceted role. Despite record US budget and trade deficits it still maintains its reserve status and he highlights the organizations that would like to keep it that way.

He makes it fairly clear for example that the Chinese government has for years been operating a Mercantilist policy (recycling dollar trade surpluses into dollar bonds) to lower the renminbi/dollar exchange rate and support/protect their extensive export industries.

For their part the US government welcomes the perpetual Asian funding of their deficits allowing them to "kick the can down the road" and avoid the politically dangerous structural issues of cutting services or raising taxes.

Equally, US companies are happy with record profits as they move US manufacturing jobs to low cost Asian countries. They obviously want their production to stay cheap in dollar terms which means supporting Chinese dollar recycling and the general idea of free trade/free capital flows.

In turn, the US public has come to expect "Every Day Low Prices" based on Asian sourcing and this seems be part of an unwritten bargain in return for "Every Day Low Interest Rates" on their savings (if they have any) and generally low taxation (at least by European standards).

Prasad sees this as a stable but fragile equilibrium and titles the book "The Dollar Trap" to reflect the discomfort of Asian dollar bond holders with their excess capital risk and the US financial authorities with their excess funding needs. He shows Bernanke trying to defuse the situation with calls for the Chinese to revalue their currency (and help the US trade deficit) and for Congress to tackle structural budget deficits, although it all seems to fall on deaf ears.

A problem with the book could be described as the Dani Rodrik view (ref. his book, "The Globalization Paradox: Why Global Markets, States, and Democracy Can't Coexist"). Basically Rodrik disagrees with the convenient neo-liberal view that the "World is Flat" and convincingly shows that countries that participate in world trade are at different points in the development cycle and have differing needs. US corporations go to China in search of a reliable source of long term cheap labour (equals higher profits), whereas the Chinese view export industries as a source of technological skill development, higher employment (than importers) and a route to industrial development (i.e. they plan to learn and compete with the US higher up the value chain, which they are successfully doing).

If Rodrik is right, then the situation is not "stable but fragile", but is becoming increasingly unstable as the US loses more higher value added industries to Asia, sees increasing services outsourcing and runs even larger trade deficits, quite apart from future domestic welfare commitments.

The author could maybe also have explored more fully the "Currency War" idea. He frames mercantilism as a Currency War but doesn't show that Currency Wars are quite winnable. The victor of the 1920's post WWI currency war was undoubtedly Weimar Germany. Their large scale currency printing resulted in a very competitive export industry, buzzing factories, employment for millions of soldiers returning from the war and the wiping out unpayable foreign and domestic government debts. (top)

 The downside of course was that by 1923, the price of a cabbage that had recently sold for 25 pf now cost 50.000.000 marks and the German middle class was ruined (see Bernd Widdig's excellent book "Culture and Inflation in Weimar Germany (Weimar & Now: German Cultural Criticism)").

Widdig's view is that Weimar budget deficits covered by money printing betrayed the people's trust in the German government but Prasad takes the line that FED printing (in the face of insufficient Asian bond purchases) will be constrained by the political power of Americas fixed income electorate such as pensioners, bondholders, insurance funds etc. This may be wishful thinking, as the German (actually mostly ethnic non-German) financial elite easily avoided hyperinflation by borrowing large sums that went straight into foreign currency and real estate and they came out of the other side with their power enhanced. There isn't any compelling reason why the US financial elite couldn't do the same, especially as 3/5 of US bonds are owned by non-Americans.

There is also an element of inertia in the use of the dollar as a reserve currency which he could have look at. It has been the standard unit of exchange since WW2 and perhaps it is just convenient to pretend that it is business as usual as long as things hold together. It's interesting in this regard that Sterling still had a partial role as a reserve currency as late as the 1970's despite Great Britain's spectacular industrial failure, large budget and trade deficits and a hard line socialist government. In their useful book, "Goodbye, Great Britain: The 1976 IMF Crisis", Burk and Cairncross show that this residual reserve role only disappeared when UK inflation hit 30% p.a. in 1975.

The author says at various points that there is no realistic alternative to the Dollar for large institutional investors and downplays the Euro although the Euro zone has a similar share of world GDP as the US, less debt and a balanced trade account. It meets his criteria for a reserve currency and presumably German opposition to inflationary policies should also serve as a useful backstop.

In chapter 11 he proposes a rather unconvincing international insurance scheme to protect deficit nations from rapid currency outflows with the idea that deficit nations should pay larger premiums in view of their higher risk profiles, when perhaps he could have gone directly to the point and suggested making all currencies (of nations wishing to trade) freely convertible for trade in goods, services and FDI but banning the capital account and portfolio transactions that are the root of the problem.

All countries would then be responsible for their own surpluses and deficits with their economic efficiency and government budget policies reflected in their exchange rates.

UPDATE 25th October 2015:

Another aspect of the book is that it (perhaps) assumes that when these political/economic factors are corrected the U.S. can return to the higher employment and balanced budgets of the 1950's 1960's. This may not in fact be the case since the international OECD, PISA rankings of maths/science/reading skills of high school students is an excellent predictor of a country's future economic performance with Singapore, Hong Kong, China, Taiwan and Korea at the top and the United States at the bottom and still falling (now at the level of Greece and Portugal), so there may be some more fundamental factors at work here.