Hi, my name is Benjamin Jerry Cohen, I teach in the Political Science Department at University of California, Santa Barbara. Today I'd like to talk with you about the subject of currency war. How do national currencies compete? This really breaks down into two significant questions. Do currencies in fact compete? Secondly, if they compete, do they go to war? Either severe policy conflicts that lead to severe differences of opinion. We'll address these questions as we go along. But to start, I need to introduce you to three preliminary issues. The first issue is, what is a currency? Second, what is a national currency? Third, what is the International Monetary System? Just a few words on each of these. A currency, currency as a synonym for money. How do we define money? We define money by certain functions that can be performed by money. These three functions are medium of exchange, unit of account, and store a value. Anything that serves these three functions is money. Money is not necessarily limited only to national currencies, but national currencies, which I will explain in a moment, are the dominant form of money. But anything that serves these three functions. Medium of exchange. Medium of exchange simply means that this is a medium a vehicle that I can exchange for goods and services. If I sell goods and services, I will receive this money, this medium, which I can then use subsequently to buy goods and services from others. Unit of account. Unit of account means simply that money serves as a yardstick to tell us the relative cost, the relative price of various things that are that are being bought and sold. Notice I said price not value. Value and price are not exactly the same thing. Every beginning student and economics, and I began life as an economist. Every student of economics has taught the diamond water paradox. The paradox that diamonds costs so much more, they've have such a high price relative to water, at least in most parts of the world other than death valley. The price of water is so much lower, price of diamonds is so much higher, yet, from the point of view of what we need to live, we need water to live that has a very high value, we don't really need diamonds. Though, my wife might disagree about that I suppose. We don't need diamond yet their price is much higher. The answer to this paradox is simple, it's a matter of scarcity, relative scarcity. Diamonds are scarce, water is in many places, most places abundant enough to live on, and that makes the difference in price. Things that are scarce tend to be high in price, things that are abundant tend to have a low price. Then finally, in addition, a medium of exchange, a unit of account, we also have store of value. Money is a store of value. If I sell you a good or a service, and I receive this medium of exchange in return, I expect it to remain valuable, to retain purchasing power that I can use in the future, and that is what we mean by store value, it's a stored up amount of purchasing power. The second thing we need to just mention, national currency. As I said, there are many things that can perform the functions of money. But the dominant form of money is what we call national money. Money that is issued by a government, specifically by the national monetary authority or what we call a central bank. In the United States, that's the Federal Reserve, in Britain, it's the Bank of England, in Japan is the Bank of Japan, in China it's the People's Bank of China, and so on. A government issues a national money, and it does everything it can through various laws and regulations to ensure that it's money retains a monopoly within the borders, the territorial frontiers of the state, of the government's nation. The idea is that the government will have a monopoly over the supply of money over time. So what is the international monetary system? Well, we live in a world of sovereign states, a world in which world politics is divided up into a series of sovereign states, almost 200 sovereign states in the world today. These states, most of them try to maintain a monopoly in terms of their own national money within the frontiers of their territory, they try to be the monopoly supplier and manager of the money supply. But that means that there is no higher authority over them, instead, what we have is a system in which we have a large number of individual monopolies. That's what we mean by the international monetary system. Now, just a word about myself, I teach in the Political Science Department, as I said, here at the University of California, Santa Barbara. I began life as an economist, but then as time passed, I've realized that I was really much more interested in the politics of economics and not conventional economics, and I began to specialize in the political economy of money and finance, of international money and finance. Very early on, it came to me that the basic problem of the international monetary system, this collection of national monetary monopolies. The basic problem is that there is a tension between two things, on the one hand, we all have a collective interest in having a stable and efficient international monetary system. An international monetary system is like the lubricant that keeps the wheels of commerce moving. But on the other hand, that's the economics of it, but on the other hand, we also have the politics of it. The politics separate sovereign states, each with their own national monitoring monopoly. Those states will not necessarily agree on what best serves their interests, and so we have this tension between the collective interest in a smoothly functioning monetary system and the potential for conflict of interest between the various governments that create and manage a separate national money. Over time, I've written about a number of subjects under this, that embody this general tension. Subjects like exchange rates, currencies, financial markets, debt, better others, sovereign wealth, funds and so on. My aim, I can't comment on impact, but my aim has been to try to gain more understanding of how that tension can be managed. That tension between our collective interest and the individual interests, the potential for conflict among the individuals interests of countries. This is just a sample of books that I have written over the years that touch one or another aspect of that. Now, we have two basic questions, how do currencies compete? Can currency conflict be avoided? Can currency war be avoided? I have here on the slide, the two possible outcomes. On the left, is the thing that can happen if we don't manage the potential for conflict, if we don't somehow find a way to avoid currency conflict. It's a headline from September, 1929 when the stock market crashed and the Great Depression began. But there's also the other possibility that somehow conflict can be avoided. Best example of that took place in 1944, the next to last year of the Second World War, when all of the Allied nations, there were 44 of them led by the United States and Britain, representatives gathered together at a small resort town in northern New Hampshire called Bretton Woods. In this hotel, this hotel called the Mount Washington Hotel, in the background you can see Mount Washington itself, the highest peak in the White Mountains of North New Hampshire. At that conference at Bretton Woods in 1944, governance settled on the rules that would govern the International Monetary System in the period after the end of the war. That was an example of successful avoidance of conflict. So two questions. Start with, how can there be competition between currencies if each one of them is a monopoly? The answer obviously is that each of them is only a monopoly within its own borders. But they can compete across borders. That's where currency competition comes in. There are two forms of currency competition. What we call currency substitution, and what we call currency internationalization. Currency substitution is what happens when a country like, let's call it, Peru, experiences a high rate of inflation. People become suspicious about the value of the national currency called Peruvian [inaudible].They begin to look for an alternative to substitute for their own national currency. In Peru, that would probably be the dollar, which is why we call this process of currency substitution dollarization. There may be other currencies that are used in this way, but the bulk of it is done in the US dollar. Currency internationalization is different. Currency substitution is one currency substituting for another for domestic purposes within a country like Peru. But we also have currency internationalization. What is that? That's the process by which certain national currencies come to be used for international purposes. What's that all about? Well, the point is very simple. If each country has a legal monopoly within its own borders, then there's no global currency that can be used for transactions between national monetary monopolies. There's no world central bank, there's no world currency. Instead, certain national currencies come to be used for international purposes, come to be used to settle trade transactions, to make international investments, to transfer remittances from one member of the family who migrated to others who are still back home. Currency internationalization is the process of adoption for International use. There can be competition between the currencies that are used for this purpose. Both of these processes: currency substitution and currency internationalization, are driven by demand, by market preferences, by the preferences of all the many people who have to be engaged in monetary transactions, whether domestically or internationally. Governments cannot force people in other countries to use their currency. However, popularly the US dollar is, the US government cannot force people in Peru or anywhere else in the world to use the US dollar. US government can try to make the dollar attractive so that it might be more popular, but it's the people who use currency, the demand side of the market, it's those people who determine, what currencies will be substituted, what currencies will be internationalized. Let's talk a little about currency substitution. Currency substitution, as I said, involves extensive use within the borders of a country like Peru, extensive use of a popular foreign currency, which many residents prefer to the local currency. That's what we mean by currency substitution. In effect, It's the equivalent of a powerful or strong currency invading the territory of a country with a weak currency. We have many examples of that. It goes on around the world. It goes on in Latin America, in the Middle East and Central Asia, parts of Africa, Southeast Asia, the Balkans. We have many examples of this process by which residents in a country begin to express a preference for a foreign currency rather than their own domestic currency. Why did they do that? They do it because the local currency, for one reason or another, becomes suspect. The most obvious problem has to do with inflation. Governments have to have money when they want to spend things on goods and services and the like. Governments can raise taxes in order to have money to spend or they can borrow. But if they have reached a limit on how much they can raise in taxes, and if they've reached a limit on how much they can borrow, there is one other alternative. If they have a national monetary monopoly, they can create more money. They can simply run the printing presses, we call it the printing press method of monetary management. Governments have that right. If they have a monopoly over the money supply, they have that ability, that capacity. But if they abuse it, if they spend too much money, if they create too much money, that's going to have the situation of too much money chasing too few goods and the result will be inflation. Inflation means the money becomes less valuable and the purchasing power embodied in the money declines. Residents naturally then look to a popular foreign currency, which we'll have more stable value. In the western hemisphere, that would be the dollar. In the European area or Africa, it might be the euro, the common currency of the European Union. That's the principal reason why currency substitution takes place. Because of the fact that the local currency is losing purchasing power due to inflation. Now, what we then have is a situation in which some currencies gain in the competition. Those are the currencies that we think of as the main currencies, the big international currencies. Other currencies lose their attraction and begin to fail. If we take the population of national currencies in the world as a whole, that amounts to what I have called the currency pyramid. At the very top, the most powerful currencies like the US dollar or the euro, Japanese yen, British Pounds, Swiss franc, and then down through the pyramid, currencies that are weaker and weaker. Currencies at the bottom that are regarded by the market as simply junk currencies. Why does it matter? Why would I let into local government be concerned about currency substitution? Why would it not simply say, go ahead, just use the dollar instead of the local peso. But there are three big losses that are involved, and the government experiences three significant losses. The first one is that it loses control over monetary policy. It's a familiar fact that if a government wants to try to manage the overall performance of the national economy, it only has two instruments, what we call monetary policy, what we call fiscal policy. Monetary policy is the management of the money supply and its price, which of course is the interest rate. Fiscal policy is the government's own budget, the level of taxes, the level of spending by the government. You have undoubtedly heard at one time or another of how important the Federal Reserve is to the management of the US economy. That's because the Federal Reserve has the ultimate authority over the supply of dollars, and the interest rates that are charged on those dollars. If currency substitution takes place, then we have a situation in which the government can no longer manage the money supply because money supply is created by a foreign central bank, the Federal Reserve, rather than by the local central bank, the central bank of Peru. That's a big loss from the point of view of a national government to lose one of the two main instruments for the management of the economy. Secondly, there's a loss of what we call seigniorage. Seigniorage is an old Latin based word for the fact that whoever creates money benefits because it doesn't cost that much to create money, but you can buy a lot of valuable goods and services with that money. That's what we call seigniorage. My phrase for it is that you can make a lot of money by making money. A government that no longer controls the national money supply because of currency substitution, is a government that loses the seigniorage. Thirdly, governments lose a symbol of national identity, these are important. Cultural anthropologists have taught us how important it is for governments to cultivate a patriotism, to cultivate a love of country through the use of various symbols, a flag, a national anthem, national sports teams, postage stamps, and money. Money is an important symbol of national identity, which is lost if currency substitution takes place. What can the local government do? One thing that local government can do is to simply give up. We've been invaded, we can't resist, so we'll give up and we'll just adopt the popular foreign currency. Believe it or not, there are a number of countries that have done that, including Ecuador in the year 2000, including El Salvador, a year later, Zimbabwe, more recently, there are a number of countries that have done this, have simply given up on trying to provide a national currency, and they have surrendered in effect, their monetary sovereignty to someone else. You can understand, as you can anticipate most governments are resistant to that, so the examples of what we call formal dollarization are quite few. Another possibility is to form a monetary union or monetary alliance, just as in war. You can gain strength by having an alliance rather than fighting on your own. Governments might form a currency union. That doesn't involve a surrender of monetary sovereignty as does the first choice. But it does involve a subordination, sharing of sovereignty, which may be very uncomfortable for some government. There have been many governments around the world that have talked about the possibility of a monetary union. I was personally involved in one attempt in Latin America among Argentina, Brazil, Uruguay and Paraguay. I asked them what name would you give your currency because, Brazil speaks Portuguese, Argentina and the others speak Spanish. They said, well, one of the few words we share in common is gaucho. My students here at UCSB are always amused by that, since our sports teams are named the Gauchos. But the alliance option, is also not used very often because of the fact that it means giving up part of your sovereignty. The last is to do everything you can to defend your currency, and that is what governments have generally chosen to do. Fifteen or 20 years ago there was a great debate among economists about whether currency substitution was going to lead to the elimination of a lot of so-called junk currencies. That's the reason why I have this cartoon on the slide. People talked about the global money supply, a number of monies being reduced significantly contracting, I call that the contraction contention. It turns out that most governments have chosen the defense option. Now, what about currency internationalization? Currency internationalization is not a case like currency substitution of a strong currency invading a weak currency. Rather currency internationalization and the risk of conflict among them, has to do with the fact that we're talking about strong currency versus strong currency, they compete with one another for popularity. I've already explained why we need to have national currencies internationalized. Because of the fact that we don't have a global currency, we have to have these national currencies to perform international functions. Which is the same currencies that are popular for it's substitution, the US dollar, or the Euro, and a small handful of others. I've listed here the main attributes that make a currency popular, for international purposes. First of all, the issue where it has to be a big economy, you wouldn't expect the currency of some small, a country like shall we say Thailand, to become internationalized. But we would expect the currency of a country as big as the United States to become internationalized. Secondly, there must be a well-developed financial market because of the store of value function, people are not going to accept your currency for an international transaction if they have no assurance that it will retain its value, or that it even be profitably invested. Foreign policy ties and military reach, our political considerations that make some currencies more populated than others. Effective governance is extremely important and people are not going to use a currency for international purposes that is not managed well. Must competition among international currencies result in conflict, and war? The answer is no. We have examples of countries whose currencies have become popular internationally, and yet they did nothing to try to promote that. That was true of West Germany back before the introduction of the Euro, that was through West Germany, who's Deutschmark was very popular in Europe and some other parts of the world, but West German government did nothing to promote it. The same was true of Japan after World War II when its economy recovered and its currency, the Yen became very popular. But it can happen, and the biggest risk, of course is the risk of a conflict between the United States and China. Because China has made no secret of the fact that it wants to compete with the dollar for international purposes. Bottom line, currency competition is natural, it occurs in the form of both currency substitution, and currency internationalization. But currency war can be avoided under certain circumstances, we can have a Bretton Woods outcome, rather than a Great Depression outcome. But it all depends on the politics of negotiation among sovereign governments. Thank you very much for your attention.
