SPEAKER 1: This is a production of Cornell University.
SPEAKER 2: The creation of the euro in the late 20th century challenged the US dollar's as the world's leading reserve currency. And the Chinese renminbi has also emerged as a rising competitor. Many have continued to speculate that dollar's pedestal position in the global economy will likely be displaced. Eswar Prasad's new book, The Dollar Trap, maintains that the crisis is actually strengthened the dollar's prominence in global finance and made it the most sought after currency. In a Chat in the Stacks book talk at Mann Library in September 2014, Dr. Prasad explains his surprising argument.
CATHERINE: And it is truly a pleasure for me to be here this afternoon and to have the opportunity to introduce our distinguished faculty speaker, Dr. Eswar Prasad. Now if I were to include all of Dr. Prasad's notable accomplishments and his prominence citations in this introduction this afternoon, it would eat up the entire time that we have available for this presentation. So I am going to skim right over the surface of his incredible accomplishments. And his presentation will speak to the rest. And I'm so pleased about that.
Now Dr. Prasad is the Tolani Senior Professor of Trade Policy in the Charles H Dyson School of Applied Economics and Management. He is also a senior fellow at the Brookings Institution, where he holds the New Century Chair in International Economics. And he's a research associate at the National Bureau of Economic Research. Previously, he served us as chief of the Financial Studies Division in the International Monetary Fund's research department. And before that, he was head of the IMF's China division.
Dr. Prasad has testified before the Senate Finance Committee, the House of Representatives Committee on Financial Services, and the US-China Economic and Security Review Commission. His research on China has been cited in the US Congressional Record. He was a member of the analytical team that drafted the 2008 report of the High Level Committee on Financial Sector Reforms, established by the Indian government. He serves on an advisory committee to India's finance minister and is the lead academic for the International Growth Center's India Growth Research program.
Many of Dr. Prasad's research papers and quotes from his speeches have been cited extensively in prominent media outlets, such as The Economist, Forbes, New York Times, Wall Street Journal, and Washington Post, among many others. His op ed articles have appeared widely, including in The Financial Times, The International Herald Tribune, and Wall Street Journal Asia. If he looks or sounds familiar to you, if you haven't met him or been in his class, it may be because of his frequent appearances on BBC, Bloomberg, CNBC, CNN, C-SPAN, Fox, NBC, NPR, Reuters, and many other television and radio channels.
He has a remarkably extensive publication record in top journals. And he has coauthored and edited numerous books and monographs, including several on financial regulation. His current research interests include the macroeconomics of financial globalization, financial regulation, monetary policy frameworks, and exchange rate policies in emerging markets, as well as the Chinese and Indian economies.
Dr. Prasad's latest book, and that which he will discuss momentarily, is The Dollar Trap, How the US Dollar Tightened Its Grip on Global Finance. His expertise on this topic will help us understand more about contemporary issues in international finance and how those complex factors influence the role of the US dollar on the global stage. And with that, I would like to thank you in advance, Dr. Prasad, for your insights this afternoon. Please join me in welcoming Dr. Prasad.
ESWAR PRASAD: Thank you, Catherine, for that very gracious introduction. I will try to live up to it. And thank you, Mary, for having me here. And thank you all for coming.
This is not the book I planned to write. What I planned to write actually was something entirely different. I've been working on issues related to international finance for the last decade or so. And what I wanted to get off my chest really was all that research. And there's a lot of funny things happening in international finance. For instance, all our theories tell us that money is supposed to flow from the rich countries like the US to middle income and poorer countries like China and India. It turns out, in fact, that capital has been flowing the other way.
Now when economists are confronted with facts that don't conform to their theories, we don't give up our theories. We say something must be wrong with the facts. And so a lot of my research has been trying to understand why it is that the facts and theories don't match up. So I had about 60,000 words of my book written. And then I had an epiphany. I realized that this was very interesting to me and my fellow economists, but nobody was going to read this blasted thing.
So then I stepped back a little bit and started taking a broader perspective on many of the data that I was thinking about in the context of my book. And I realized that there was a far more interesting story to tell. So that's what this book came to be about. It's a story with even more interesting twists, turns, and paradoxes than would have been in the book that I planned to write. Now, I have written books in the past that have been very-- well, boring is not the right word-- technical perhaps, which have had a limited audience.
But this one I realized was a story that had to be told in a much broader context, because I think there is a lot that virtually every one of us should care about. Because you may not care that much about financial markets, but what happens to currencies and this notion of the battle amongst currencies is a very interesting one. And trying to tell that story in a non-technical way was something that I set out to do. And in fact, this is really a book that is a product of Cornell.
First of all, being at Cornell allowed me to think these broad, ambitious thoughts. And more importantly, there was a group of Cornell students who actually turned out to be hugely important in the writing of this book, not only in terms of doing the background research, but also in terms of giving me a lot of critical advice. It was like having a dozen editors who were all unrestrained in giving me good advice on how to structure the book, how to make sure that there wasn't too much jargon in the book, and even correcting my syntax and so forth. So this is really a product of Cornell that I'm putting before you.
Now as an economist, of course, one tends to get caught up in jargon. So the question is, did I manage to succeed in writing a book that a normal person could actually read? I think I hit it. And you know what told me this? When I finished the book and we were on vacation with some friends of ours, we were at dinner one evening. And the subject of the book came up, that I'd finished this book. And as you might expect, there was a rolling of eyes. Oh, my god, not another book.
But then my wife came to my defense. She looked at the others and said, you know, I read the book. And it's not that bad. And that to me was an indication that I had actually succeeded in doing something which had never succeeded before. My wife read my book. And one's family is one's harshest critic. It turns out it's not bad. So I hope you feel the same if you ever get around to reading it.
So consider this. The global financial crisis had its origins in the United States. Since the financial crisis, the United States has issued a massive amount of public debt. In addition, as you probably heard, the US central bank, the Federal Reserve, has flooded the US and global financial system with dollars. What would you expect to happen in the normal world-- that the value of the dollar and the prominence of the dollar should decline. And what happened?
It turns out that the value of the dollar, on a very broad, multilateral basis, hasn't changed that much since the financial crisis. Yes, there have been ups and downs. But the dollar fundamentally hasn't lost that much in value. And more interestingly, if you think about all this debt that the US government issued-- and let's set aside for the moment the amount of debt that has been bought up by the Federal Reserve itself and by other parts of the US government-- excluding all of that, since the end of 2007, the US government has issued $5.9 trillion worth of publicly-traded debt. Who bought this stuff? It turns out that foreign investors-- foreign central banks and other private foreign investors-- purchased $3.6 trillion on nearly 60% of this debt. This was a country that created all this turmoil in global financial markets. And yet all the debt that this country issued was willingly sought after by the rest of the world.
Now consider more recent history, October of 2013, when there was a distinct possibility that the US might default on its government debt. Now nobody really expected that the US would walk away from its obligations. But there was the possibility of the US having a technical default on its debt, which may have been short-term and technical. But still, any time any other country exposes its debt to the possibility of default, what happens, or what should happen, is that people fly out of that debt. People should get out of that currency. And the currency should fall in value. And what happened?
It turns out that the US currency pretty much held up its value against virtually every other major currency. October 17 was B day. Two days before that, the honorable Senator Ted Cruz was on the floor of the US Senate reading Green Eggs and Ham, rather than doing congressional business, although he claimed they were the same. And what happened to interest rates in the US? In any normal economy in normal times, interest rates would rise very sharply. Why? Because people would demand a higher interest rate from the government on debt where there was some possibility of default.
And some things did work according to plan. The interest rate on very short-term securities at one-month and three-month maturity did actually rise. They rose from about 0.01% at an annual rate to about 0.1% at an national rate. In other words, the government, if it held your money for one year-- say $100-- would give you back at the end of one year $100.10. And this was the highest level of short-term rates.
And what happened to this money that went out of short-term bonds? Where did it go? It turns out it went into longer-term US government bonds. So in fact, from early September to the middle of October of 2013, the yield, or the interest rate, on 10-year government bonds actually declined by about 20 basis points. That's about 0.2%.
This is staggering. An economy that creates turmoil in some broad sense, in the short run creates a great degree of uncertainty, has people coming to it. And this is not just a pattern that we saw in these two episodes. There have been repeated instances where, when there is still turmoil anywhere in the world, in the eurozone, in emerging markets, or-- and this is the great paradox-- in the US itself, money comes to the US for safety. So this is a very strange world we live in.
Now we economists like to try to simplify things. And it turns out that at heart, there is a simple story to explain all of this. It comes down, like most other things in economics, to supply and demand, supply and demand of one very specific thing-- safe financial assets. What are safe financial assets-- essentially assets where you might least expect to maintain the value of the principal that you invest in those assets and that are relatively liquid or easy to trade. And what financial instruments have these characteristics-- largely the government bonds of the major advanced economies, the US in particular.
So what happened after the financial crisis is that the demand for safe financial assets has soared. It's soared because emerging markets want more foreign exchange reserves. That is, they want more hard currency reserves that can protect them from the capital flow volatility and currency volatility that they are now exposed to because they have become much more integrated into global finance. It's much easier for capital to flow in and out of those economies. But with that ease of capital flows comes more volatility. And emerging markets want to protect themselves against that volatility. And that volatility certainly increased after the global financial crisis.
So emerging markets want more safe assets. Private investors want more safe assets to protect themselves as well. Financial institutions, in the aftermath of the crisis, are being asked to hold more safe financial assets. There are some estimates that under the new banking regulations called Basel III, the big multinational banks will eventually have to acquire an additional $2.5 to $3 trillion worth of safe financial assets for their balance sheets.
So the demand has soared. And what happened to the supply? Well, first of all, it turned out that the eurozone isn't quite as safe as we thought it was. We now know that a German bond is very different from a Greek bond in terms of their risk characteristics. So if you take the safe part of the eurozone and the core eurozone economies-- Germany, France, Austria, and so forth-- that accounts for only about 40% of eurozone government debt. And even that includes countries like France and Austria that have had downgrades of their debt. So that supply looks much smaller than we thought it was.
Traditional safe havens like Japan and Switzerland don't want money coming into their economies. Why? Because if money flowed into their economies, their currency values would increase and their exports would become less competitive. And these are economies that are already struggling for growth. So they become net demanders rather than net suppliers of safe assets. And then in the aftermath of the crisis, there are very few private sector securities that are considered safe anymore.
So what we have now is a huge increase in the demand for financial safe assets, a huge decline in the supply. And who's left to fill in the breach? With great graciousness, the US has stepped in to fill in the breach with the massive amount of debt it's issued, which the world is very keen and very much willing to hold.
Now at this stage, one has to take pause and say, this all sounds crazy. There must be alternatives. And that's the right question to ask at this stage. And in fact, even before the financial crisis, there was a sense that one needed to look for alternatives. And one alternative was potentially the euro.
Now when the euro was created in 1999, it did create an economic area that was as large as that of the US economy. And it seemed to have pretty deep financial markets. And indeed, in the early years of its inception, the euro started playing a very important role in global financial markets. One measure of how important a currency is in international finance is how much of global foreign exchange reserves are held in that currency. And the share of the euro, or all the currencies that went into the euro, went from about 19% in 1999, the year the euro was created, to about 27% by 2004. And this was coming out of the dollar share.
So a lot of analysts, academics, were projecting that dollar share as going down this way, the euro share going up this way. And soon the two lines were expected to cross. The euro would become dominant. In 2004, however, the euro's share flatlined. It turned out that the eurozone financial markets were not quite as deep or liquid as had been anticipated. And of course, the eurozone debt crisis a couple of years ago has dealt a very harsh blow to the euro's prominence. And the share of the euro in global FX reserves is now back down to about 21%, 22%.
The eurozone could again become a viable competitor and have the euro potentially challenge the dollar again. But it would take not just monetary union, but banking union, fiscal union, to make it a true economic union, just like in the US, we have an economic union of states. In Europe, there is a sense that this needs to be done. And there is a strong political will to do it. But as I went around Europe talking about this, I get the sense that what people think of as economic union is very different depending on whether they're in Frankfurt or in one of the periphery countries. So I wouldn't bet against Europe. But I wouldn't quite bet on them, either.
Then there is the Chinese renminbi. Now the renminbi is a really enduring story because China is an economy that is growing very fast. By certain measures, the Chinese economy might be as big as the US economy, perhaps as soon as next year. But if you do it the right way in terms of market exchange rates, I think it will take a few more years. But on its present growth trajectory, the Chinese economy is going to match the US economy in size. But it's a very different level of development. Even if, say, five to 10 years from now, the Chinese economy is as big as the US economy, the average Chinese citizen is going to have an income level that is about 1/5 to 1/6 that of the average US citizen.
Now China does not have very well-developed financial markets. It has a lot of restrictions and capital coming into and out of the economy. But just because it's such a large economic power and a very big trading power in the world, it's actually managed to get some traction in having its currency becoming an international currency. And what an international currency is, is basically a currency that is used widely in international trade and finance transactions. And over there, the renminbi is making progress.
Now to become the reserve currency-- that is the currency that other countries can hold their foreign exchange reserves in-- China would need to have a completely open capital account so money could flow freely across its borders. And it would need to have better developed financial markets so that foreign investors can actually go and buy renminbi-denominated assets that they could keep their money in. Now China doesn't have the prerequisites. And here is something interesting.
Even though China doesn't meet the prerequisites, the renminbi is already a reserve currency. It turns out, there are countries around the world, countries like Chile in Latin America, Nigeria in Africa, and a whole host of Asian countries like Korea, Malaysia, Thailand, even Japan, that have indicated they already hold or plan to hold some of their foreign exchange reserves in renminbi. Now does this make sense? My view is that this is a low-cost bet on a currency that is almost certainly going to become very prominent.
But many people have argued, look, the renminbi does not meet the prerequisites of a reserve currency. And already, it's a reserve currency. So surely when China develops its financial markets, opens up its capital account, allows its currency to float freely, the renminbi is taking over. I think not. I think not because even if China makes progress in all these dimensions-- and I believe it is making progress in its own gradual, incremental kind of way, but it is getting there.
But my sense is that we need to think very hard about another concept. We've talked about an international currency, a reserve currency. But I think there is a third concept that is different but important. And that is that of a safe haven currency. A safe haven currency is a currency that is not just one that people go to for diversification or yield purposes, but one where they feel that they can put their money for safety.
Now what is required for a currency to become a safe haven currency in addition to the traditional prerequisites of a reserve currency? In the book, I argue that institutions matter. Now what do I mean by institutions? By institutions, I mean an open and transparent democratic system of government, an independent judiciary, and public institutions that domestic and foreign investors trust.
So let's think about this again in the context of the US before we go back to China. Let's step back to the numbers a little bit. Now the amount of gross public debt in the US is about $17.6 trillion right now. Other parts of the US government, like the social security trust funds, hold about $5 trillion worth of this debt. The Federal Reserve holds about $2.3 trillion of this debt. That leaves about $10.3 trillion that is held by other investors.
Of this $10.3 trillion, $5.9 trillion-- again, roughly 60%-- is held by foreign investors, including foreign central banks. That share, 60%, it's much higher than in any other reserve currency economy. In Japan's case, about 11% of net debt is held by foreign investors. In the case of the UK and Switzerland, it's about 25%. In the case of the eurozone, estimates are that it's about 17% to 18%.
So the US is in the perfect position to soak foreign investors. Why? It's a lot of debt the US has accumulated. And one way to pay off this debt is to print more dollars. And if you print more dollars, that increases inflation. US investors get hurt as well. But foreign investors get doubly hurt. Not only do they lose out on the value of the bonds because of higher inflation, but also. Almost certainly, the dollar would depreciate in value. So if you're a Chinese investor, you're going to get fewer units of your local currency, the renminbi, because the dollar has fallen in value relative to the renminbi.
So why is it that foreign investors seem to have this almost childlike faith in the US? This is where institutions become important. Now I said that political institutions are important. I spend a decent bit of time in Washington. And you might think I've become completely delusional if I'm arguing that the US political system works well. It doesn't. It's stuck in gridlock. But this is not the first time the US has been stuck in gridlock.
There are times when US senators and congressmen have behaved even worse towards each other. What is important is that the system does eventually respond to political pressures. And perhaps one might consider this as somewhat optimistic reading of history, but it does have a self-correcting tendency over time. And this is important once you go back to these numbers.
I said that $5.9 trillion of the $10.3 trillion of publicly-traded debt is held by foreign investors. Who holds the other roughly $4 trillion? It turns out it's held by pensioners. It's held by retirees, state and local governments, insurance companies, all of which are politically very powerful. So if the US central bank and the government engineered a burst of inflation as a way of reducing the value of the debt, domestic investors would get hurt. And a lot of retirees happen to live in politically important swing states like Florida. So they would exact a political toll on the incumbent government. So it's not like it couldn't happen. But the political system and the fact that it responds to political pressures makes it less likely that it will happen.
Now what about the possibility that China's debt is written off by the US government? So the US simply says, I'm going to pay all my domestic investors, but not the Chinese government or not the Russian government. This is where the legal system becomes important. It turns out that statutorily, the US government cannot discriminate among different classes of bond holders. Now this becomes very important when you think about the nature of the legal system. There aren't that many countries in the world where the government can get taken to court. And quite frequently, the government loses.
Everybody here has to live by the rules of the law. You may not like the rules. You may not like the particular formulation of them. But they are applied in a reasonably fair and consistent manner. So in that sense, foreign investors know that first of all, political pressures in the US make it unlikely that the value of their debt holdings would be inflated away. And second, it also makes it highly unlikely that they can be discriminated against. And of course, the public institutions like the Federal Reserve, which is independent and which has the task of maintaining low inflation, that institution has built up a tremendous amount of credibility over time.
So it's this complex set of institutions that has created what I call this magic sauce that keeps the US as the dominant safe haven. Economic size and depth of financial markets are very important. But the institutions play a critical role as well. And this is why I think the renminbi is not going to threaten the dollar, because China is moving forward-- again, with fits and starts-- on its process towards becoming a more market-oriented, liberalized economy. But the president has made it very clear-- President Xi-- through a series of documents issued last fall, and if you've been watching what's happening in Hong Kong, that any notions of judicial independence where the judiciary has dominance over the party or any sort of institutional reforms to free up the political system or other institutions are pretty much off the cards.
So my sense is that the renminbi over the next couple of decades, assuming that China's growth does not stumble, assuming that China continues to move forward in financial market reforms-- and I'm betting on both of those-- my sense is that the renminbi will become a viable and indeed significant reserve currency, perhaps accounting for as much as 5% to 10% of global foreign exchange reserves. So it will erode but not seriously threaten the dollar's dominance. So I don't see any viable alternatives to the dollar at hand.
Now when I came to this part of the story, I wanted to do something different. Because as every author hopes for and wishes for, I would like to sell more books. And one thing I realized is that disaster sells. People love catastrophe scenarios. And so far, everything that I've pointed out seems very paradoxical. And what I wanted to do was to say, this is nuts. We've ended up in a situation which does not make sense, which is clearly very fragile. And it's going to come apart. And I'm going to tell you how it's going to come apart. And when things do finally come apart, you will come and pay obeisance to me because I, the wise one, told you how it would happen.
And if you look at economics books, you will find that mostly it's [INAUDIBLE] that say that all hell is breaking loose or things are going to get worse over time that sell well and make you seem wise. So I tried. I tried very hard to think about potential disaster scenarios. And they're not that difficult to discern.
So China officially holds about $1.3 trillion worth of US government securities. The actual number is probably much larger. But let's take that number as given for a second. Now let's say China said, I know that if I create turmoil in US government bond markets, prices of bonds will fall. I will get hurt. But it's a price I'm willing to pay because I don't like US policy towards Tibet, Taiwan. And even though I'm shooting myself in the foot, I want to shoot the Americans.
Now that's one possibility. You don't even need to have a foreign agent create turmoil in US government bond markets. Despite all this debt, despite all this money floating around the US financial system, it turns out that people expect inflation in the long-run to be pretty modest, in the 2% to 2.5% range. And this, again, is very odd.
One day, a set of bond holders might wake up and say, this doesn't make any sense. I better get out of US bonds. And once you have a small set of investors thinking this, that can quickly have a cascading effect. And it's very important to think about these scenarios. Because if anything, the financial crisis has taught us that we can be blindsided by shocks that we did not anticipate. Or even if we did anticipate the shocks-- like the housing market slowdown in the US-- we may not expect the enormous cascading effects it might have on the entire financial system. So are we missing something?
So I go through a lot of these scenarios in the book. Now in every one of them, it turns out there is a common element. In every one of them, you will have turmoil in US government bond markets. When you have turmoil in US government bond markets, which are seen as the safest, deepest, most liquid in the world, that will very quickly affect all US financial markets, equity markets, asset-backed securities markets, and so forth. If US financial markets are affected, it will infect the entire world-- again, as we saw in the financial crisis.
So we have turmoil everywhere. And what happens when there is turmoil? You as an investor want safety. And where do you go for safety? Back to the US dollar, because it turns out there is no other place to go. And this is not a figment of my imagination. It turns out if you look at what has happened in the US, when for instance, Standard and Poor's-- the rating agency-- downgraded US debt, what happened? In any other economy with any other instrument, a downgrade immediately leads to a spike in the interest rate because people want greater compensation for holding that risky instrument. The currency would fall in value.
What happened in the US? The day after, the US dollar, if anything, strengthened against every other currency. And bond deals in the US fell. Russia, a couple of months ago, threatened to take some of its money out of its holdings of US treasuries. What happened? Next day was calm. The day after, bond deals fell. And the reality is that once you start talking about significant sums of money, it turns out there is no market deep enough, liquid enough, to put money.
Now perhaps there are people in this room who have a few millions or control a few billions of dollars. If you have that sort of money, you can look at alternative instruments. You can look at putting some of your money into renminbi. You can put some of your money in gold, maybe bitcoin. But once you start talking in the tens of billions or hundreds of billions of dollars, it turns out there is no other market that can absorb this sort of money without creating enormous turmoil. And this is why we see it repeatedly, that even when the turmoil originates in the US itself, money comes to the US for safety.
So at this stage, we don't seem to have an easy way out. So in the last few minutes of my talk, let me envision a different kind of world, a better world, where we may not have these paradoxes. What would it look like? So one possibility is a world when you have a balance of power among different currencies. Perhaps the euro crisis to prominence once again, if the Europeans get their act together. The renminbi becomes an important currency. You then have three currencies that are very important.
Now this would create a lot more discipline on the US. And in fact, the story that I've been saying would seem to stack the odds completely in favor of the US. And certainly, it's true. At one level, a strong dollar means that the US gets much cheaper imports from the rest of the world. And moreover, it gets dirt-cheap financing from the rest of the world for buying those goods. So China is basically saying, take my goods. And I will give you money to buy those goods. And you basically pay me nothing and interest. That's a heck of a deal.
But the problem, of course, is that it means fewer jobs, fewer exports from the US. And I think the real concern is that it doesn't exert influence or discipline on US economic policies. Very few other countries could generate this sort of debt increase and have the rest of the world finance it without having any serious consequences. And in the US, again, if the US issues more debt, that creates more instability. And people come even more eagerly, clamoring for that debt.
So it creates a situation where the US has a lot less discipline. So in this tri-polar world, you would have a lot more discipline. If the US or Europe ran bad policies, people would go to the renminbi. But as one goes down this line of thinking, there is an even more fundamental question that one has to ask. Why have reserve currencies at all? And we have reserve currencies because you need a safe place to put money.
Countries in particular need a safe place to stock their foreign exchange reserves. And they want to hold foreign exchange reserves because they're exposed to very volatile capital flows. They're not able to absorb these flows of money coming in from abroad and put them in productive investments. So what if we had a better world, where emerging markets, for instance, how much better and deeper financial markets so that when money came in from abroad, rather than fueling asset market bubbles and busts or housing market booms and busts, that money could be productively channeled into long-term investments that would be good for the economy.
India needs a lot of infrastructure investment. So if you had a good market for corporate bonds, US investors could eagerly share in the India growth story with less risk. And it will be less risky for India as well, because that money could be channeled into investments that are good for India's long-term growth. If you had even the advanced economies having a better mix of policies, where all the economies are not relying just on central banks to do the right thing in terms of maintaining financial stability, maintaining high growth, low inflation, maybe if you had structural reforms kick in-- in Europe, we know that lots of labor market and product market reforms are needed. Even in the US, we clearly need tax reform and a variety of other reforms.
If all of those were working in the right direction and helping monetary policy, rather than just expecting central bankers to manage the entire macroeconomic mess we are in, maybe things would be better, because monetary policy inherently has these spillover effects. If the US raises or lowers interest rates, that affects the rest of the world much more directly through capital flows. So if you had a better mix of domestic policies, then perhaps you would need less protection from volatility.
And third, if we had a better international governance system so that emerging markets didn't feel the need to sort of self-insure by building up reserves for a rainy day, if they felt so long as they did the right thing, if all hell broke loose, there would be an institution they could turn to that would help them out-- say an institution like the IMF that I used to work. That would make it less necessary for them to accumulate reserves. Now the problem is that the IMF, for instance, is still seen as an institution that is largely run by and for the benefit of the advanced economies. The perception among emerging markets is that the way the IMF dealt with Europe is very different from the way they might deal with an emerging market economy that was in trouble.
So we have a lot of these problems right now. We have this issue with domestic policies in virtually every major emerging market and advanced economy not being very well-balanced. We have this problem with the financial markets in the emerging markets in particular not working very well. And we have an international governance system that is not working very well.
So let me leave you then with one final thought. Given where we are with this mix of policies, given where we are with international governance, perhaps having one currency at the center is not such a bad thing, because think back to what happened during the financial crisis. It was a very difficult period where there was a lot of uncertainty, volatility. And there was a loss of trust, and loss of confidence. If we had multiple currencies that were playing an equally important role, people may actually not know where to turn. Having one currency that was at the center of the global financial system, one currency that everybody was willing to trust and turn to, may actually have prevented things from getting worse.
It's not really encouraging to end a lecture by saying it could have been worse. But that's the reality we live in today. So nothing that I have said today is really a story about American exceptionalism. And my story has been interpreted as such, as saying that the US is so great that nothing is ever going to be able to challenge the dominance of the US.
It's not that. I think US policy, as I, again, point out very clearly in the book, have a lot of lacunae, a lot of problems with them. But in international finance in particular, everything is relative. And relative to the rest of the world, the US still looks in pretty good shape, given the nature of the institutions here, given the size of the economy, given the deck of the financial markets.
So to get to this better world, I think the solution would not be for one country to sort of try to displace the dollar or to think about an alternative currency that would have a supranational element to it. Because to have that sort of currency work, you would need better international governance. And we don't have that right now. The emerging markets do have a seat at the table at the G20. But by and large, it's still the advanced economies that are running the agenda to a very significant extent.
So we can all hope for a better day, when in fact, emerging markets have better functioning financial markets, better regulatory systems. We can hope for a day when even the advanced economies have a better mix of policies so they are not relying so much on the central bankers to do all the heavy lifting. And we can hope for a day when the international governance system works a lot better. And all of these would have to happen for the international financial system to be more stable. And that, I fear, is a lot to ask for. So for the foreseeable future, given where we are with our institutions and our markets, I suspect we are pretty much stuck with the dollar track. Thank you.
So we have a few minutes for questions. Yes, [INAUDIBLE]?
AUDIENCE: You know, after the financial crisis, which is still not-- [INAUDIBLE] --about regulations. [INAUDIBLE] Can you reflect on that?
ESWAR PRASAD: OK. Clearly the financial system needed some work. And you have probably heard about attempts to impose more discipline on the financial system. So the bad news is that we haven't fixed all the problems that need to be fixed. The good news is that the banking system is safer today than it was back in 2007. So there have been some regulations that have been put in place in the US as well as in other countries that, for instance, require banks to hold a lot more capital. So capital essentially provides a buffer so that when a bank has a lot of depositors coming to its door or other claims on its liabilities, it can meet those liabilities, without having to draw down too much of its illiquid assets. And it's too many banks trying to sell their illiquid assets at the same time that creates problems in the financial system.
So if you ask banks to hold more capital, and especially ask the bigger banks to hold more capital, you've made things somewhat safer. But the concern, of course, is that some of the activities that were getting mixed up on the banks' balance sheets are just moving to different institutions or to different balance sheets. There is a very large, relatively unregulated part of the banking system. Words like hedge funds strike fear in the minds of the ordinary people. But the hedge funds are really not the ones that cause the problem. Because the hedge funds are exposed to a lot of volatility, but they don't create a systemic problem like a big bank collapsing.
So we've made some progress. But the cost of that progress has been the following, that because we learned that after Lehman, we cannot allow too big an institution to fail. We've essentially ended up in a situation where the capital requirements and new regulations have led us to increased concentration in the banking system. So we have fewer banks that are left after all this mess. And those banks are the larger. Banks and even though they are subject to more discipline, we all know that the government will never tolerate a Lehman moment again.
And that too-big-to-fail problem has not being entirely solved yet. Because now those banks, although they are asked to hold more capital and so on, have the incentive to take on more risky activities. But there, too, there is some progress in terms of separating out the core banking activities from the somewhat more speculative activities that these banks were undertaking.
So there is progress. But we haven't really found the mechanism for making finance, which is intrinsically unstable, much safer. Now finance, especially banks, are intrinsically unstable. Because what they are doing is taking short-term liabilities-- that is deposits-- and investing it for the long-term. So they are serving a useful function. But that's what creates problems in the banking system. Because the liabilities are all short-term. The assets are all long-term. So if too many depositors come to the door asking for the deposits at the same time, it creates a problem. That's why we have a deposit insurance and so on to get around part of the problem.
But there is an inherent instability to finance. The question is whether we have allowed finance to become such a big part of the economy that it infects the entire system. And we have a ways to go still. So there is progress. And some of that progress I think actually is in danger of being pushed back a little bit right now. So we're not there yet. But we've made some progress. I don't want to minimize the progress in entirely. Yes?
ESWAR PRASAD: So that question was about the new banks set up by the BRICs, economies the big five emerging market economies. And the question is-- I'll interpret it as a question about whether these are a challenge to the IMF and the existing international institutions. And I was a bit skeptical to begin with about this, because this is a group of emerging markets that have some broad interests but have a lot of conflicting interests as well. But now that they've put money on the table, a commitment to finance this bank to the tune of a hundred billion dollars, that changes the nature of the game. Because now there is real money on the table.
The other aspect that the BRICs economies were trying to put together was what was called a contingent reserve arrangement, which would essentially be an insurance mechanism. Because these emerging markets hold a lot of reserves. And the idea was instead of building up even more reserves, why not pool the reserves so that if one country gets into trouble, they can use money from this pool? But the reality there is, again, the lack of trust.
India doesn't want to be in a position where China and Russia have to sign off on getting money from that pool. South Africa doesn't want to sign off from India. And this is where, despite all the fulminations about the US from the rest of the world, people fundamentally trust the US. They trust that the value of their investments here will not be expropriated by the government, and so long as they know the rules of the game, that those rules are going to be obeyed.
So my perception of what the BRICs bank will accomplish is actually catalyze changes in the big institutions like the IMF. Right now, because of-- the US actually pushed very hard for changing the structure of the IMF to give the emerging markets more voting power. The administration pushed hard for it. But it turns out that the way the thing is set up, the national governments have to ratify it. And every country in the world has ratified it except for the US.
And the issue of the IMF governance changes has become a political football. And the Republicans have been asking the administration for too high a price. [INAUDIBLE] It's in the interests of the US. But this is where my optimistic story about US politics probably needs to be shaded a bit. So my hope is that the BRICs bank will generate momentum for changes there.
The Chinese banks are becoming important players. They look very good on paper, but they have a lot of risks embedded in them. But at least in terms of their increasing dominance on the world stage, I think at one level, they might play a positive role. Because again, more bank competition, at least at one level, is not such a bad thing so long as you have good regulation. Yes?
AUDIENCE: [INAUDIBLE] question in my mind is that those whole 35 years where inflation [INAUDIBLE]. Now they say [INAUDIBLE] in reverse of that. However, [INAUDIBLE] of inflation. What are the tools now that the feds and the treasury use to fight inflation? Because in the old days, [INAUDIBLE]. But I understand it's more complicated now.
ESWAR PRASAD: Things have gotten more complicated. Because what the Fed has been doing over the last three or four years is very unconventional. They've essentially been directly getting involved in US government securities markets, not just for open market operations, but also in order to try to keep down long-term rates. Because what affects economic activity is long-term interest rates. And in a normal world, the Fed has access to a policy tool, which is it can affect short-term interest rates. And it tries to send a signal to the markets.
But what the Fed has been trying to do, of course, is directly affect long-term interest rates by buying long-term US treasury securities. So it's a very dangerous situation right now, because the Fed has about $2.3 trillion worth of treasury securities on its balance sheet. So it's almost effectively funding the US government. And that's very dangerous, because once markets get the perception that the government is not very disciplined in terms of its budget policies and those budget deficits are going to be financed by printing money, that stokes inflation.
But I think there is an understanding right now that these are very special times. But there is still an open question. When the Fed starts pulling back some of this money, will interest rates in the US spike up enormously, affect activity? And there is this preternatural sense of calm in financial markets. Everybody seems convinced that the Fed will be able to manage this right. But it's a very dangerous game.
Right now, the US economy seems to be doing reasonably well. But US labor markets, which have repaired themselves to some extent, still have a lot of slack in them. The unemployment rate is down from its peak near 10% back in 2008 to about 6.1% now. The economy is generating an average of about 200,000 non-farm payrolls jobs. That's pretty good.
The employment level is higher than the pre-crisis level. We had lost about three million jobs during the worst of the recession. But the labor force participation rate has declined by about three percentage points. So there are fewer people in the labor force, working-age people. Part-time employment has risen. So the labor market has a lot of slack. And that may be why we are not seeing wage pressures and inflationary pressures. But that could change on a dime.
And the other problem is we see asset market bubbles building up. So it's a very delicate balancing act for the Fed, trying to support the economy while trying to talk down asset market bubbles and maintain inflationary expectations. And remarkably, it's all held together so far. And remarkably, the markets seem to be very confident that this can be managed. And knowing the very competent people at the Fed, I think we are fortunate to have people like that in charge of policy. I mean, the fact that Bernanke, with this very clear view of history, took as aggressive actions as he did is one of the reasons why the US is in a better spot right now than the other major advanced economies.
But the problem, again, is that we put all our chips on Bernanke. And none of the other policies really contributed very much. And that, I think, is the fundamental problem right now. It's not just about monetary policy, but monetary policy pulling in one direction and all the other policies sort of trying to pull in the other direction and holding back monetary policy.
AUDIENCE: [INAUDIBLE]. I'm curious [INAUDIBLE] not only [INAUDIBLE]. On the other hand, [INAUDIBLE] and just going to [INAUDIBLE] economies to borrow money [INAUDIBLE] kind of [INAUDIBLE]. And at the same time, [INAUDIBLE]. So how do you [INAUDIBLE]?
ESWAR PRASAD: So the question was whether China's use of its foreign currency reserves, as some have interpreted it, in a way to increase not just its economic influence but also its strategic influence, political influence around the world. It's a good way to use reserves. And that's a fraught question. I mean, China has a lot of money. It holds about $4 trillion worth of foreign exchange reserves. Its sovereign wealth fund now has a market capitalization of another $500 billion dollars. So this is a lot of money.
The question for China, of course, is whether it will continue with policies that lead to more and more accumulation of these reserves. Because it requires a particular set of policies in China that are not necessarily, as I have long argued, in China's own interest. So if it had a more open capital account, a better financial system so that domestics could be better disintermediated into domestic investment in China, maybe you wouldn't have so much domestic savings in the first place. And you would have better growth potential because of better investment, rather than more investment. So I think the fundamental question for China is how to get its financial system operating better.
There are concerns in the rest of the world that China is using its money as a device to get political influence. And it's very hard to separate this out because a lot of the investment is being done by state-owned institutions. They seem to be operating on a profit motive in regions like Africa. But they also seem to have a different perspective on this, rather than thinking about just the short-term return. So in some African countries, the money is welcome because it comes without too many strings attached. And because China has so much money, because Chinese institutions have so much money, they are willing to take a slightly longer term perspective. But are there really no strings attached? It's hard to say.
But this again, I think, must be turned around to ask, why is it that in these countries that have good growth potential, why are they not be able to attract private investors? And the answer, again, is that you have endemic problems like corruption. You have problems like inadequate infrastructure and so on. So if you had some of these things taken care of domestically, better financial markets, you wouldn't need to rely on a Chinese state or an institution investing in you. So I think ultimately, these countries have to look at what needs to be fixed so that they will perhaps have to rely less on Chinese money.
So I'm a professor. I could go on talking all evening, all night. But I think you've been very patient already. so I should thank Lynn and Evelyn for setting this up. And Mary and Katherine, thank you very much for being here. And thank you all for coming.
SPEAKER 1: This has been a production of Cornell University on the web at cornell.edu.
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The creation of the euro in the late 20th century challenged the U.S. dollar's position as the world's leading reserve currency, and the Chinese renminbi has also emerged as a rising competitor. With the recent global financial crisis brought on by political dysfunction in the United States, many continue to speculate that the dollar's pedestal position in the global economy will likely be displaced.
Eswar Prasad, author of 'The Dollar Trap,' maintains that the crisis has actually strengthened the dollar's prominence in global finance and made it the most sought-after currency. He explained this in a Chats in the Stacks book talk at Mann Library Sept. 24, 2014, touching on contemporary issues in international finance--including the influence of emerging markets, the currency wars, the complexities of the China-U.S. relationship, and the role of institutions such as domestic judiciaries and international lending agencies.
Prasad is the Tolani Senior Professor of Trade Policy at Cornell's Dyson School of Applied Economics, senior fellow at the Brookings Institution, and research associate at the National Bureau of Economic Research.