Media Briefings

The Next Global Currency? Lessons From The Dollar’s Dethroning Of The Pound

  • Published Date: April 2009


Will the dollar lose its place as the premier international currency? New research by Marc Flandreau and Clemens Jobst 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.
Their study, published in the April 2009 issue of the Economic Journal, explains the apparent mismatch in the first half of the 20th century between the dollar’s limited role in global commerce and the US share of the global economy: first, the United States was not a leading trade power in Europe until fairly late, so its share of global GDP mismeasures its importance in trade; and second, it was not near the routes of European commerce, so it was not conveniently located to capture a significant share of trade financing.
The depreciation of the dollar against the euro since the summer of 2008 sparked debate about its possible dethroning in the near future. Such discussion is not new. It has occurred repeatedly each time the dollar faces adverse circumstances.
But 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 concerns about the dollar?
One view, which has been mapped onto contemporary empirical evidence in a study 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 UK in economic size very early (between 1860 and 1875), the dollar did not surpass the pound as the number one international currency until 1945. When it did, however, sterling was permanently dethroned.
Now, Chinn and Frankel note, the dollar has steadily lost ground in the recent past. London is usurping Frankfurt’s role as the financial capital of the euro, notwithstanding the fact that the UK remains outside the euro-zone. They say that a tipping point could come within ten years: 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 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 changes so much that previously active malls become deserted. Customers just start going somewhere else. We see
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 dollar during the second half of the nineteenth century? Flandreau and Jobst’s research takes a fresh look at the issue. Gathering information on the international reach of every single currency in the world, they test for alternative determinants of international currency status.
They find strong evidence of size effects: the currencies of large trading powers tended to circulate widely. They also find evidence of financial ‘persistence’: 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.
Next, the study examines whether currencies that had once reigned supreme would always reign supreme. The results unambiguously reject this stronger form of persistence. History matters, but its importance ought not to be overstated.
The importance that economists assign to agglomeration economics stems from the mismatch in the first half of the 20th century between the dollar’s role in global commerce and the US share of the global economy. The evidence of this study suggests that fundamentals can explain this mismatch:
First, the United States, a protectionist economy in the 19th century, was not a leading trade power in Europe until fairly late, so its share of global GDP mismeasures its importance in trade.
Second, the United States and New York were not near the routes of European commerce, so they were not conveniently located to capture a significant share of trade financing. Distance matters since the trade consignments themselves are natural collateral for such financing.
In plain words, a large fraction of the ‘delayed’ ascent of the dollar in the 20th century is fully in line with fundamentals – once they are properly measured. We do not require references to the forces of history and agglomeration economics.
ENDS
Notes for editors: ‘The Empirics of International Currencies: Network Externalities, History and Persistence‘ by Marc Flandreau and Clemens Jobst is published in the April 2009 issue of the Economic Journal.
A Vox column on the study is available here: http://www.voxeu.eu/index.php?q=node/1443
Marc Flandreau is at the Graduate Institute, Geneva. Clemens Jobst is at the Austrian central bank.
For further information: contact Marc Flandreau on +41 22 908 58 17 (email: marc.flandreau@graduateinstitute.ch); or Romesh Vaitilingam on 07768 661095 (email: romesh@vaitilingam.com).