Reflection on The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance by Eswar S. Prasad

               This book made me think more than almost any other book I’ve read in the last year or two. I felt like I constantly had to stop and ponder what I was reading, which I feel like is the mark of a really good one. The book analyzes the rush to the dollar in the wake of the 2008 financial crisis and why central bankers and investors would rush to the US dollar when the crisis originated in the United States itself. He argues that whether you analyze security or liquidity, the US dollar is the best currency around right now and will continue to be the world’s reserve currency for the foreseeable future. In this book I learned more about what it means to be a reserve currency. I learned that being a reserve currency isn’t just based on being the most valuable currency (I think the Euro and Pound are worth more than the Dollar), but also based on economic strength and public/political institutions.

People rushed to the dollar in 2008 because it was a safe bet in a scary world due to the fact that the USA always pays its debts, a strong pull factor, but also due to certain push factors. The two that Prasad points out are that poor policies in emerging markets have caused too much saving, giving them surpluses of capital that need to go somewhere, and that underdeveloped financial markets have prevented those savings from being absorbed domestically into investment in those same economies. They have no safe alternatives to the dollar. It is very ironic, then that capital flows since 2000 have been “uphill,” meaning that net capital is moving from poor countries to rich ones, the opposite of what one would expect, considering how much less capital there is in total in those poor countries. To be more nuanced, though, private capital is flowing downhill but public capital (central banks) is flowing uphill, with the amounts invested by poor countries’ central banks in rich countries’ currencies overtaking the private capital flows. This is because central banks’ primary goal is not to earn money for their country, their goal is the safety of the national wealth, meaning they will seek low-yield investments, AKA the US dollar. This means that they will take the low returns or even losses as an acceptable cost to pay for the safety of their investments.  

The big issue is that at some point the dollar’s value must fall. The US wants this so that it will depreciate the value of its massive debt and increase US exports, China wants it to make the renminbi the global reserve currency, and most other countries want it so that they won’t have to depend so much on the dollar. However, this would mean that all those dollars held by countries all over the world would be worth less, meaning that they would essentially be taking a loss on their loans. This has been very difficult to accept and it is hard to imagine when the move away from the dollar will happen. It will likely be very sudden when it does come. Imagine, for example, China’s perspective- to become the global reserve currency, their currency will have to appreciate relative to the dollar. That would mean taking losses in the hundreds of billions on the more than trillion dollars of US Treasury assets they hold. It is a “dollar trap.” You’re screwed either way. From the US perspective, it is also difficult to change the current situation. To inflate its way out of the dollar trap, the United States would have to face its domestic debtholders, the largest portion of those who hold US Treasuries (at 4 trillion dollars) and the biggest portion of them are households, mutual funds, and pensions, AKA people’s life savings at 75% of the debt. That means inflation would make a lot of Americans much poorer.

               Prasad identifies only one serious competitor to the Dollar as a global reserve currency. It is the Chinese renminbi, and he argues that it will not become the global reserve currency anytime soon, though it is certainly going to cut into the dollar’s margin of dominance. This is not, however, because investors will find it to be more liquid or safe than the dollar. Rather, it is because they will seek to diversify their portfolios and befriend the rising power. China also lacks much incentive to try to overtake the dollar anytime soon. Prasad summarizes the Chinese Minister of Commerce Chen Deming in 2009, stating that “China ‘must’ buy U.S. Treasuries because insufficient depth exists in Japanese yen- and Euro-denominated debt. If China were to make larger purchases in these markets, it might raise their prices dramatically.” There is also not enough gold produced worldwide for China to use as an alternative.

               The major threat of the debt the US owes to China is not some hypothetical situation where China decides to “call it in” and break our kneecaps if we don’t pay. That situation is illegal and unenforceable by China. The real issue would be a large sell-off by China of US debt, let’s say 10%. However, while that would drive up the interest on future US debt and make it very expensive for us to borrow, it would also drive down the value of the trillion dollars that China holds, meaning massive losses for the Chinese government. China faces the same problem all US debtholders face: do you want to take your loss on the dollar now or later? Inflation keeps coming and those dollars will keep losing value over the long term. For these reasons, Prasad expects the renminbi to become a competitive reserve currency in the next decade, “eroding but not displacing the dollar’s dominance.”

               If the dollar crisis does ever come (and one must assume that it will since the dollar cannot reign supreme forever) it will potentially have many positive impacts for the United States, including an increase in exports and a profit on the currencies of other countries that it holds. However, the US would face higher borrowing costs, making new debt more expensive and higher inflation since new dollars would not find homes outside the United States so easily.

               I came away from this book tentatively thinking that the USA should try an inflationary monetary policy and try to push the rest of the world some more since that would decrease the real value of our national debt and increase our exports. It would also decrease the values of most people’s private debts, helping average Americans. It would further benefit the poor since social security and Medicare are pegged to inflation. However, it is important to consider what Prasad says at the end of the book, which is that a country stays a reserve currency so long as it is seen as trustworthy due to its strong institutions. If the USA is seen as abusing its role as the global reserve currency, it may not hold that role much longer.

Miscellaneous Facts:

• Here’s some good vocabulary: “government bonds” is a generic term for government debt securities of all maturities. In the USA, they are divided into “Treasury bills,” which mature in a year or less, “Treasury notes,” which range from 2-10 years, and “Treasury bonds,” which go over ten years.
• The Federal Reserve was created in 1913 to make the money supply more elastic and generated reason to expand the international use of the dollar.
• Recent uphill flows of capital are visible in the fact that in 2007, emerging markets were 25 percent of global GDP and just 17 percent of debt. By 2017, they were expected to be 40 percent of GDP and only 16 percent of debt. Therefore, the emerging markets are adding to global GDP while the developed countries are adding to global debt.
• Increasing dollar hegemony is the fact that the number of nonfinancial companies in the US with AAA credit has decreased from 32 in 1983 to just 4 today.
• Prasad lays out a few important aspects of a currency’s role in international finance that serve as a good guide when analyzing currency:
• Capital account convertibility: the level of restrictions on a country’s inflows and outflows of financial capital. An open capital account has minimal restrictions on cross-border capital flows, implying that the domestic currency can be freely converted into foreign currencies (or vice versa) at market exchange rates.
• Internationalization: a currency’s use in denominating and settling cross-border trade and financial transactions, that is, its use as an international unit of account and medium of exchange.
• Reserve currency: whether assets denominated in the currency are held by foreign central banks as protection against balance of payments crises.”
• About 2/3 of dollars are held outside the US totaling $750 billion. That means that with inflation at 2 percent, the world pays the US $15 billion per year.