The U.S. dollar has been the dominant international currency since World War II, but its hegemony may be challenged in the not too distant future. The United States gains from having the dollar as the leading international currency because of the seigniorage of $500 billion that it earns, but more important because of its “exorbitant privilege” which allows it to run a larger current account deficit than other countries, which allows it consume more than it produces, and to pay less on its foreign liabilities than it earns on its foreign assets.

In this excellent book, Barry Eichengreen documents the dollar's rise to dominance in the twentieth century. This ascendance of the dollar mirrored growing U.S. economic and political dominance. It then considers the threats that the dollar's current dominance faces in the not-too-distant future. Indeed his prediction for the future is for a multipolar international currency system with the dollar sharing international status with the euro and the yuan. However, this scenario will change radically if the United States does not extricate itself from its current and prospective fiscal budget and debt malaise. In the worst case scenario, the dollar would entirely lose its exorbitant privilege and the United States would be reduced to the status of an emerging market currency like Korea's, dependent on foreign currency debt and foreign rescue funds in the event of a financial crisis.

Chapter two, “Debut,” describes the evolution of the dollar from a national currency to an international currency. In the nineteenth century, all U.S. international transactions were financed by sterling bills drawn on merchant banks in London. The United States was like many of today's emerging market countries. The U.S. dependency on sterling persisted until 1914 despite the impressive growth of the U.S. economy. This reflected its slowness to achieve financial maturity. The sterling bill market evolved in London in the eighteenth and nineteenth centuries as part of the financial revolution which paralleled the rise of British industrial strength and international economic and political power.

The key impediment to the development of a U.S. market in trade acceptances was its fragmented banking system and the prohibition on national banks having foreign branches. Nicholas Biddle, president of the Second Bank of the United States tried to set up a market in dollar bills of exchange but Andrew Jackson's veto of the bank's charter in 1832 ended that experiment. Financial fragility and frequent banking panics finally led to major reform in 1913 with the creation of the Federal Reserve System.

One of the key driving forces behind reform was the push by money center banks to make New York an international financial center and to create a market for dollar acceptances to compete with London. The Federal Reserve Act allowed national banks to open foreign branches and to issue trade acceptances. Benjamin Strong, the first president of the Federal Reserve Bank of New York, was instrumental in creating an acceptance market in New York in the early 1920s. World War I was also favorable to the international status of the dollar. Great Britain shifted from being an international creditor to a debtor to the United States. Moreover, the United States became the key international lender after the war and by the mid-1920s the dollar surpassed sterling as an international currency in terms of its share in international reserves (although sterling briefly regained its dominance during the 1930s reflecting Britain's milder experience during the Great Depression).

Chapter three, “Dominance,” covers the dollar's drive to hegemony after World War II. This was closely linked to U.S. dominance in global trade and output and the operation of the Bretton Woods pegged exchange rate system under which the dollar was the key currency. In the 1950s and 1960s the United States achieved its exorbitant privilege allowing it to run “balance of payments deficits without tears,” i.e., without deflationary adjustment. The dollar was used by the rest of the world to finance and invoice trade and as international reserves. Sterling still had a limited role as an international currency largely in the form of sterling balances held by Commonwealth countries and British colonies. After the devaluation of the pound in November 1967, sterling fell off the map and the dollar gained absolute supremacy.

The western European countries, especially France, resented dollar hegemony but they were not successful in changing things much. The Bretton Woods system collapsed between 1968 and 1973 reflecting the fatal flaws of the gold dollar standard and the Triffin dilemma, but especially the failure of the United States to follow the rules of the game for a reserve country to maintain price stability. Attempts by the international community to develop substitutes for the dollar culminated in the institution of the SDR (paper gold), which came on stream in 1970 too late to save the system.

The collapse of the Bretton Woods system was followed by the emergence of managed floating and a decade of high and variable inflation in most countries. The dollar still remained the dominant international currency through the 1970s despite abysmal U.S. monetary policy performance. This, according to Eichengreen, was because of the lack of alternative candidates for international currency status—sterling and the French franc had bad track records, Switzerland and Japan were too small, and Germany was reluctant to have the deutschmark as an international currency.

Chapter four, “Rivalry,” describes the advent of the euro as a possible contender to the dollar. The process leading to the advent of the euro is an integral part of the story of European integration. It also was a continuation of the 1960s European (French) resentment of dollar hegemony and the French preference for fixed exchange rate traceable back to the franc Poincare in the 1920s. On a more practical note, the European Common Agricultural Policy required stable exchange rates. Attempts in the 1970s, 1980s, and 1990s to link European currencies together in Bretton Woods-type arrangements of pegged rates which floated between upper and lower bands were stymied by periodic gyrations in the U.S. dollar. When the dollar weakened relative to the DM, this led to capital flows to Germany and then pressure on the exchange rates of the weaker currencies such as the lira and the franc. Dollar shocks helped destabilize the “snake in the tunnel” in the 1970s and the ERM in the 1980s. Thus one key motivation for the euro was to delink European monetary arrangements from perceived dollar instability. This chapter contains a fascinating discussion of the political machinations between France and Germany that led to the Maastricht Treaty in 1991. The French hoped to control European monetary affairs under EMU and used the World War II guilt card to rope the Germans in. In exchange for giving up the vaunted DM, the Germans were adamant on the ECB being independent with a price stability mandate to be located in Frankfurt. Also fascinating is the story of how the eurozone ended up including the Southern European countries with a history of fiscal profligacy and soft money. This occurred because of the grandfathered currency union connection between Luxemburg (which had solid fiscal credentials) and Belgium (which has always had very high debt to GDP ratios). Once Belgium slipped under the Maastricht Treaty wire, the case was made for Italy and then later Portugal, Spain, and Greece. The final EMU deal which combined hard with soft countries did not include a fiscal union. These flaws were ticking time bombs which finally went off in 2010.

Chapter five, “Crisis,” retells the now overworked story of the subprime mortgage crisis of 2007/08. Eichengreen attaches key importance to the failure of U.S. regulatory authorities to prevent the housing boom and bust and subsequent banking crisis, for allowing the securitization of mortgages, the proliferation of the Value at Risk model, excessive leverage, off balance sheet structures, credit default swaps etc. He is highly critical of the free-market philosophy of Larry Summers, Robert Rubin, and Alan Greenspan for helping create the permissive climate that led to the excesses of the 2000s. He also throws into the blame soup expansionary Fed policy in 2002–2005 and Bernanke's Asian global savings glut hypothesis. The key conclusion for his story about the dollar however is that when the crisis became global after the failure of Lehman Brothers in September 2008, the world shifted from other currencies into dollars as the safest haven currency. This phenomenon, as in the 1970s, reflected the absence of effective currency rivals.

Chapter six, “Monopoly No More,” considers the possibility that the dollar will lose its mastery to the euro and the yuan. He posits that each of these currencies at present is not ready to surpass the dollar. The eurozone is a monetary union without a government and hence doesn't have the political heft that the dollar had in the twentieth century. China is still an emerging market country with underdeveloped financial markets and an inconvertible currency sheltered by capital controls. Nevertheless, he believes that as the eurozone and China grow and mature in the next few decades, the world will become multipolar and that we will have several international currencies. Financial and technical innovation will reduce the value of incumbency and diminish the network externalities that currently protect the dollar.

Chapter seven, “Dollar Crash,” considers several doomsday scenarios which could knock the dollar off its perch sooner rather than later. One scenario involves a political struggle between the United States and China, which leads China to dump its dollar holdings. However, he points out that this scenario is unlikely because China would lose more. The more likely bad outcome would follow if the United States doesn't get its fiscal house in order. He worries that future social security and Medicare entitlements and political gridlock could lead to ballooning fiscal deficits and debt ratios leading to the risk of default or inflation. In such a scenario, the world would dump its dollar holdings and the United States would lose its exorbitant privilege. The cost to the United States would be substantial. He values exorbitant privilege as worth $1 trillion. The loss of dollar dominance would also require a reduction in the current account deficit to GDP ratio by 3 percentage points, which would imply a big cut in domestic expenditure and the necessity to raise exports which would be facilitated by a one-third depreciation of the dollar.

More importantly, Eichengreen argues that U.S. firms and the federal government would have to borrow abroad in foreign currencies just like an emerging market country with “original sin.” Moreover, the Federal Reserve would lose much of its policy independence and would have to get foreign help to allay future financial crises just as Bank of Korea did in 2008.

The historical narrative in this book is fascinating and I highly recommend it to both specialists and nonexpert advanced readers. I agree with the author's principal conclusion that the world could very likely shift from having one dominant currency to a multipolar arrangement later in the twenty-first century. The dollar will still be important but not omnipotent. This will reflect the United States' inevitable decline in relative and political economic importance as the big emerging countries grow up. The process echoes the rise of the dollar and the decline of sterling in the twentieth century.

I was less convinced by the doomsday scenarios in chapter seven. The United States will most likely solve its budget and debt problems as it has done in the past and has been done by other stable advanced countries. The fiscal histories of the United States after World War II and the 1990s, Canada in the 1990s, and other countries makes the point that fiscal deals get made when the stakes get high enough.

In addition were the United States to lose its exorbitant privilege, it would become more like the United Kingdom and advanced countries with floating exchange rates that experienced this, or like countries such as Canada, Australia, and Sweden that never had exorbitant privilege. These countries have been able to borrow abroad in their own currencies since the 1970s. Their central banks have policy independence and can act as lenders of last resort during financial crises. The United States runs no risk of becoming an emerging market country again. The comparison between the United States and Korea is both farfetched and misleading.

I have some very minor quibbles. First, on page 24, Benjamin Strong was not at the Jekyll Island conference in 1910.Footnote ¹ Second, there is little discussion in chapter three about the Great Inflation of the 1970s and its connection to dollar instability. Third, the discussion of the 2007/08 crisis leaves out the role of U.S. housing policy and its possible connection to rising inequality. It also blames the repeal of Glass Steagall but doesn't mention the consequences of investment banks going public. It also doesn't mention that some countries like Canada, Australia, New Zealand, and the Nordic countries avoided the crisis because they had sound banking systems and effective regulation.