Mostly Economics

TIm Sablik of Richmond Fed in this article looks at the question of whether dollar dominance will continue:

While there may not be a single obvious replacement for the dollar, that doesn’t mean that countries haven’t been diversifying into other currencies. The dollar’s share of global foreign exchange reserves fell to a 25-year low at the end of 2020, to 59 percent from 71 percent in 1999.

Serkan Arslanalp and Chima Simpson-Bell of the IMF and Barry Eichengreen of the University of California, Berkeley, referred to this development in a recent IMF working paper as “the stealth erosion of dollar dominance.” The dollar isn’t being replaced on bank balance sheets by another single currency like the euro or renminbi, they found. Rather, most of the shift away from dollars has been into dozens of smaller currencies. They cited a greater desire for portfolio diversification on the part of central banks as well as the falling cost of transacting in smaller currencies as factors that have contributed to this change. This has led some economists to speculate that we could be heading toward a “multipolar” world of many different competing currencies, which could have some advantages.

“Just like biodiversity makes for a more robust global ecology, a multipolar system will be more robust,” says Eichengreen. “In addition, an expanding global economy needs additional international liquidity to grease the wheels of globalization, and the U.S. can’t provide the requisite safe and liquid assets all by itself.”

New Triffin dilemma:

Indeed, many economists point to a new kind of Triffin dilemma as a greater risk to dollar supremacy than the use of sanctions. Just as the United States faced a crisis of confidence in its ability to back the dollars in circulation during the Bretton Woods era, economists have warned that it could face a similar challenge in the coming years to supply enough safe assets to meet global demand while simultaneously maintaining confidence in its ability to repay its debts. Having more options for safe assets to choose from in the form of different currencies could solve this problem, but not all economists agree that a multipolar system would necessarily be more stable. Competition among countries to grab the reserve currency crown could lead to coordination challenges and questions about which assets are truly safe.

Moreover, the transition from the dollar regime to its successor could be unstable. “One historical precedent is the coexistence of dollar and sterling during the interwar years,” the late Harvard University macroeconomist Emmanuel Farhi told Econ Focus in a 2019 interview. “It’s not a particularly happy precedent; it was a period of monetary instability. You saw frequent rebalancing of international portfolios into one reserve currency and out of another, which created a lot of volatility.”

History teaches that dominant currencies change infrequently and often over long transition periods. But crises can be the catalyst for those transitions, as was the case when the British pound’s centuries-long reign started to unravel after World War I. While almost no economist predicts that the dollar will be replaced soon, market confidence is fickle, and the types of crises that spark a changing of the reserve currency guard are inherently hard to predict.

Isabel Schnabel of the ECB in this speech discusses the major challenge for monetary policy in a monetary union is to remain united in diversity:

One illustrative symbol of this unity in diversity are our euro coins, with the map of Europe on one side and a country-specific symbol on the other. The euro unites us.

Yet, diversity also brings about challenges – and that is what I will talk about today.

The euro area consists of 19 – soon 20 – different countries, each with its own economic structure, societal governance and fiscal policy. The natural consequence is that shocks that hit the euro area, be it a financial crisis, a pandemic or a war, affect each euro area country differently.

Today’s inflation is a case in point. Harmonised consumer price inflation in the euro area as a whole is at a record high, reaching 8.1% in May according to the most recent flash estimate. But there are large and unprecedented differences across countries (Slide 2). In Estonia, for example, inflation stood at 20% in May, while it was less than 6% in Malta and France.

How countries produce and use energy accounts for a large part of these differences. But energy is only part of the story. The war, like the pandemic, has had differential effects on consumption, investment and fiscal policy, and hence on underlying price pressures.

The pandemic was a stark reminder that such differences can seriously impede the conduct of monetary policy. In the spring of 2020, concerns about some countries’ perceived lack of fiscal space to deal with the pandemic led to a sharp divergence of financing conditions across euro area economies, thereby severely disrupting the transmission of monetary policy.

I will argue that the vulnerability to such fragmentation risks will only disappear with fundamental changes to the euro area’s institutional architecture. Therefore, monetary policy needs, at times, to respond to market developments that undermine the smooth transmission of monetary policy.

That said, the progress we have made over the past years in strengthening the resilience of the currency union, on both the fiscal and the monetary side, has helped to reduce the likelihood that disruptive and self-fulfilling price spirals in government bond markets threaten the cohesion of the single currency.