These words were written 14 years ago:
“Serious economic and financial mismanagement by the United States is the one thing that could precipitate flight from the dollar.
“And serious mismanagement, recent events remind us, is not something that can be ruled out.
“We may yet suffer a dollar crash, but only if we bring it on ourselves. The Chinese are not going to do it to us.”
Barry Eichengreen, professor of economics at the University of California, Berkeley, published that passage in the wake of the 2007-09 financial crisis.
And they came to mind last week when Martin Whetton, the head of Westpac’s financial markets strategy, made a startling observation about the current chaos in our global economy.
Mr Whetton said it was “staggering” to witness on Wednesday last week, in the market dysfunction triggered by Donald Trump’s tariffs, how traders had stopped treating the United States as a financial safe haven.
He said he’d never seen anything like it.
He said it signalled the end of US exceptionalism and “exorbitant privilege.”
“The US has enjoyed the prime position in global finance since the end of WW2, cemented with Bretton Woods a generation ago,” he said.
“Giving [up] that hegemony, that authority, that liquidity and reserve status … perhaps not willingly, but flippantly and without due consideration, is not something you just ‘get back’.”
When he shared his thoughts on the extraordinary situation, in a note on Thursday, he gave his note a tombstone inscription: “Exorbitant privilege: 1946-2025.”
It emphasised the point he was making.
And his note quickly circulated through Australia’s community of market analysts and economists, with many people agreeing with him.
What is exorbitant privilege?
While analysts debate Mr Whetton’s argument, it’s worth understanding what he meant by “exorbitant privilege.”
Given everything that’s happening in Trump’s America, it may help to explain some of the trading behaviour we’ll see in financial markets in coming years.
Professor Eichengreen explained the concept in his 2011 book, “Exorbitant Privilege: The rise and fall of the dollar and the future of the international monetary system.”
It’s where the quotes at the top of this piece come from.
The phrase “exorbitant privilege” was coined in the 1960s by Valéry Giscard d’Estaing (then French minister of finance), to refer to the financial privileges the US has enjoyed in the post-World War II era, due to its currency being the international reserve currency.
How did the US currency become the world’s reserve currency?
In the aftermath of World War II, a new international monetary system was created.
Under the new system, dozens of countries agreed to peg their currencies to the US dollar (directly or indirectly), while the US dollar was pegged to the price of gold.
It was designed that way to replace the old rigid gold standard, which had disintegrated in the Depression, with a more flexible system.
“In practice, however, the system afforded the greatest flexibility to the United States, which enjoyed substantial freedom to pursue its domestic policy objectives as well as the ability to run sustained balance-of-payments deficits,” Ben Bernanke, a former US Federal Reserve chair, has pointed out.
That’s the gist of it.
What kind of privileges are there?
Now, as Eichengreen explains, with the US economy sitting at the centre of the global system in the post-war period, the US dollar became the most important currency for invoicing and settling international transactions, including for imports and exports that never touched the shores of the United States.
He says it made sense to do things that way when the US economy accounted for more than half of the combined economic output of the so-called ‘Great Powers’ immediately after the war.
But that situation gave the US financial privileges.
“America being far and away the largest importer and main source of trade credit, it made sense for imports and exports to be denominated in dollars,” he explains in his book.
“Since the United States was the leading source of foreign capital, it made sense that international financial business was transacted in dollars.
“And with these same considerations encouraging central banks to stabilise their currencies against the dollar, it made sense that they should hold dollars in reserve in case of a problem, in foreign exchange markets.”
Under such a system, since there was so much demand for dollar-denominated assets, it meant the US could borrow at lower interest rates than other countries and pursue domestic and foreign policies with more freedom.
“This effect is substantial,” Eichengreen wrote in his book.
“The interest rate that the United States must pay on its foreign liabilities is two to three percentage points less than the rate of return on its foreign investments.
“The US can run an external deficit in the amount of this difference, importing more than it exports and consuming more than it produces year after year without becoming more indebted to the rest of the world.
“Or it can scoop up foreign companies in that amount as the result of the dollar’s singular status as the world’s currency.
“This has long been a sore point for foreigners, who see themselves as supporting American living standards and subsidising American multinationals through the operation of this asymmetric financial system.”
Are there more exorbitant privileges? Yes, there are.
According to Mr Eichengreen, another benefit for the US is the real resources other countries have to provide the United States to obtain US dollars.
“It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries have to pony up $100 of actual goods and services in order to obtain one,” he wrote.
And there are others.
In the post-war period, traders have traditionally flocked to the US during periods of economic and financial crisis, and that has even happened when the crisis has been created by the US itself.
“In 2008, in the throes of the most serious financial crisis in 80 years, the [US] government was able to borrow vast sums at low interest rates because foreigners figured that the dollar was the safest currency to be in at a time of great turmoil,” he wrote.
“And again in the spring of 2010, when financial volatility spiked, investors flew into the most liquid market, that for US treasury bonds, pushing down the cost of borrowing for the US government and, along with it, the mortgage interest rates to American households.
“This is what exorbitant privilege is all about,” he said.
A world of multiple reserve currencies
The post-war financial system has evolved significantly since the 1940s, and the US’s economic dominance has weakened as countries such as China have risen.
There’s a debate about how significant the US’s exorbitant privilege is nowadays (which often highlights how the system has come with costs for the US too).
With the creation of the Euro, the US’s reserve currency status has also had a small and imperfect competitor in recent decades (with ambitions to enjoy its own exorbitant privileges).
But Mr Whetton’s point, that we saw something historic last week when traders uncharacteristically turned away from the US during a moment of extreme market dysfunction, is obviously worth noting.
What does it mean for the future?
In 2011, Mr Eichengreen argued we should all be preparing for a multi-polar world with multiple reserve currencies.
“Aside from the very peculiar second half of the twentieth century, there has always been more than one international currency,” he wrote.
“There is no reason that a few years from now countries on China’s border could not use the renminbi in their international transactions, while countries in Europe’s neighbourhood use the euro, and countries doing business with the United States use the dollar.”
Given last week’s financial market dysfunction, has the world taken a substantial step towards that future?
