By Samir Junnarkar
I recently had some time to peruse through the National Bureau of Economic Research’s (NBER) database of economic papers. Indeed, there was a plethora of pieces regarding all sorts of topics, but the current state of global finance has received quite a bit of attention over the past few years. In particular, two general questions were of particular interest: first, the value of the American financial system as it stands today, second, the viability of the US dollar remaining the global reserve currency of choice. In this article, I will attempt to piece together the views of three eminent scholars to help provide a glimpse of one side of current economic theory regarding these aspects of finance.
A 2008 paper by Jiandong Ju of the University of Oklahoma explains when the size and sophistication of a financial sector becomes a source of comparative advantage. Financial development is typically measured by the size of the financial market in terms of the ratio of domestic credit to gross domestic product (GDP) or the ratio of the entire stock market cap to GDP. His research shows that countries with developed financial systems tend to allow growth in industries reliant on external finance. Today, and for the short-to-mid-term the world’s largest financial centers are New York and London. Ju attributes this to the presence of well developed institutions. Legal systems in the United States and the United Kingdom are relatively transparent and effective, and both financial centers enjoy the benefits of institutional inertia. This is particularly important because as long as New York and London remain attractive to financiers across the globe, both nations would continue to enjoy the benefits. Capital intensive and research and development heavy industries would continue to flourish in both countries, as financing theoretically would be readily available.
However, one large factor that is closely linked to whether the United States will remain an attractive financial hub and a favorable place to invest will be the future of its currency. In 2008, Martin Feldstein of Harvard University published a paper arguing that the current account imbalances will most likely be corrected by the devaluing of the US dollar and the increase in the US savings rate. As most Stanford students who have taken Econ 1b would recall, net exports equals savings minus investments. Thus, unless investment drops for some reason, the only way to sustain such expenditures would be to increase national savings. Feldstein asserts that it is equally imperative that Americans buy more US goods. This would be aided by a purportedly inevitable decline in the real value of the dollar courtesy of exchange rate fluctuations caused by the current imbalance.
And it is the notion of currency devaluation that Barry Eichengreen of Berkeley considers in his 2008 historical analysis of the fall of Britain’s Pound sterling as the global reserve currency of choice. His research sheds light on a rather complicated period of financial history. From 1920 to 1940, New York and London (and Paris to a lesser extent) competed for global reserve currency status. Whereas previous papers have supported the notion that incumbent reserve currencies benefit from institutional and financial inertia, Eichengreen’s work shows that the US Dollar became the most popular reserve currency in the mid-1920s, lost its status in the 1930s, and later regained it in the 1940s. Eichengreen argues that this suggests that incumbency is not as powerful as it was previously thought to be, and that central banks are actually willing to have more than one reserve currency. Furthermore, central banks are actually willing to change the composition of their portfolios. Accordingly, even if the current financial turmoil results in a flight from the US dollar and the depreciation of the currency, there is a reasonable chance that proper monetary policy can woo central bankers back towards the dollar.
These papers all suggest that the short-to-mid term probably will not by rosy, but it certainly does not signal the end of America’s significance in certain key areas. Intelligent monetary policy would ensure that the US dollar remains an attractive currency. Devaluation in the near future would nearly guarantee that unsustainable trade imbalances are corrected. And proper legislation and regulations would make certain that New York remains a good environment for banking. As the hundreds of other economic papers in NBER’s database would indicate, the next several years may be a dark age for US finance, but this may not be a completely devastating period after all.