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The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance
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26 of 29 people found the following review helpful
on April 13, 2014
In this worthwhile book Eswar Prasad presents the view that the post WWII world reserve currency,the US dollar, now has a more multifaceted role. Despite record US budget and trade deficits it still maintains its reserve status and he highlights the organizations that would like to keep it that way.

He makes it fairly clear for example that the Chinese government has for years been operating a Mercantilist policy (recycling dollar trade surpluses into dollar bonds) to lower the renminbi/dollar exchange rate and support/protect their extensive export industries.

For their part the US government welcomes the perpetual Asian funding of their deficits allowing them to "kick the can down the road" and avoid the politically dangerous structural issues of cutting services or raising taxes.

Equally, US companies are happy with record profits as they move US manufacturing jobs to low cost Asian countries. They obviously want their production to stay cheap in dollar terms which means supporting Chinese dollar recycling and the general idea of free trade/free capital flows.

In turn, the US public has come to expect "Every Day Low Prices" based on Asian sourcing and this seems be part of an unwritten bargain in return for "Every Day Low Interest Rates" on their savings (if they have any) and generally low taxation (at least by European standards).

Prasad sees this as a stable but fragile equilibrium and titles the book "The Dollar Trap" to reflect the discomfort of Asian dollar bond holders with their excess capital risk and the US financial authorities with their excess funding needs. He shows Bernanke trying to defuse the situation with calls for the Chinese to revalue their currency and for Congress to tackle structural budget deficits, although it all seems to fall on deaf ears.

A problem with the book could be described as the Dani Rodrik view (ref. his book, "The Globalization Paradox: Democracy and the Future of the World Economy"). Basically Rodrik disagrees with the convenient neo-liberal view that the "World is Flat" and convincingly shows that countries that participate in world trade are at different points in the development cycle and have differing needs. US corporations go to China in search of a reliable source of long term cheap labour, whereas the Chinese view export industries as a source of technological skill development, higher employment (than importers) and a route to industrial development (i.e. they plan to learn and compete with the US higher up the value chain, which they are successfully doing).

If Rodrik is right, then the situation is not "stable but fragile", but is becoming increasingly unstable as the US loses more higher value added industries to Asia, sees increasing services outsourcing and runs even larger trade deficits, quite apart from future domestic welfare commitments.

The author could maybe also have explored more fully the "Currency War" idea. He frames mercantilism as a Currency War but doesn't show that Currency Wars are quite winnable. The victor of the 1920's post WWI currency war was undoubtedly Weimar Germany. Their large scale currency printing resulted in a very competitive export industry, buzzing factories, employment for millions of returning soldiers and the wiping out of unpayable foreign and domestic government debts. The downside of course was that by 1923, the price of a cabbage that had recently sold for 25 pf now cost 50.000.000 marks and the German middle class was ruined (see Bernd Widdig's excellent book "Culture and Inflation in Weimar Germany (Weimar and Now: German Cultural Criticism)").

Widdig's view is that Weimar budget deficits covered by money printing betrayed the people's trust in the German government but Prasad takes the line that FED printing (in the face of insufficient Asian bond purchases) will be constrained by the political power of Americas fixed income electorate such as pensioners, bondholders, insurance funds etc. This may be wishful thinking, as the German (actually mostly ethnic non-German) financial elite easily avoided hyperinflation by borrowing large sums that went straight into foreign currency and real estate and they came out of the other side with their power enhanced. There isn't any compelling reason why the US financial elite couldn't do the same, especially as 3/5 of US bonds are owned by non-Americans.

There is also an element of inertia in the use of the dollar as a reserve currency which he could have look at. It has been the standard unit of exchange since WW2 and perhaps it is just convenient to pretend that it is business as usual as long as things hold together. It's interesting in this regard that Sterling still had a partial role as a reserve currency as late as the 1970's despite Great Britain's spectacular industrial failure, large budget and trade deficits and a hard line socialist government. In their useful book, "Goodbye, Great Britain: The 1976 IMF Crisis", Burk and Cairncross show that this residual reserve role only disappeared when UK inflation hit 30% p.a. in 1975.

The author says at various points that there is no realistic alternative to the Dollar for large institutional investors and downplays the Euro although the Euro zone has a similar share of world GDP as the US, less debt and a balanced trade account. It meets his criteria for a reserve currency and presumably German opposition to inflationary policies should also serve as a useful backstop.

In chapter 11 he proposes a rather unconvincing international insurance scheme to protect deficit nations from rapid currency outflows with the idea that deficit nations should pay larger premiums in view of their higher risk profiles, when perhaps he could have gone directly to the point and suggested making all currencies (of nations wishing to trade) freely convertible for trade in goods, services and FDI but banning the capital account and portfolio transactions that are the root of the problem

All countries would then be responsible for their own surpluses and deficits with their economic efficiency and government budget policies reflected in their exchange rates.
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13 of 14 people found the following review helpful
on January 30, 2014
Today's headlines in the financial press are all about how minor adjustments in US monetary policy (the taper) lead to major repercussions for emerging markets all over the globe with their governments having to take unpopular measures to defend their currencies. Think about for a moment and marvel how strange it is--their economies are growing faster, their financial systems haven't had to recover from a near bankruptcy, they are financing our fiscal deficits and not the other way around. So how come they are the ones who suffer when the Fed steers its policies to benefit the US economy? Professor Prasad explains this odd state of affairs in his fascinating book with its total command of economic theory and empirical data (including Wikileaks!) and with a keen eye on real-life policy dilemmas as experienced by the key policy makers. Yes, despite the US economy lurching from one crisis to another, the role of the US dollar in the international financial system keeps getting stronger and is likely to remain so for a long time to come. Faced with a world-wide savings glut and a shortage of safe assets, it is the relative position of the US dollar that matters. Economics isn't always about rewarding the virtuous. Highly recommended. As they say, read the whole thing.
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10 of 12 people found the following review helpful
on February 2, 2014
As one of my investing gurus, Barry Ritholtz recently wrote about the ups and downs of the latest gold rush, the first lesson that everyone should learn from that experience is "Beware the narrative". The same could be said about the latest history of the US dollar - the most popular narratives ("untamed inflation, which has to follow the qualitative easing...", "the flight away from the dollar following US debt downgrade...", etc.) have routinely been proven false by the actual turn of events. Professor Prasad explains why it is so in his highly readable, yet accurate and choke full of details, book. I am sure that highly qualified macro economists will share detailed observations in their reviews - my recommendation is made from an "informed general public" point of view. It is from this perspective that I can highly recommend this timely book to anyone, who wants to understand not only the latest events of global finance, but the fundamental processes, responsible for why they happened "just so". And there is no better expert than Eshwar Prasad to turn to for this story.
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3 of 3 people found the following review helpful
on January 31, 2014
This book takes the complicated intricacies of the international monetary system and presents an analysis in an engaging and understandable way. Whether you know nothing about finance, or you are a Ph.D. Economist, this book is so well written and packed with surprising anecdotes that it's a guaranteed page-turner. Not only will you learn the shocking reasons the U.S. dollar seems to have such dominance in the world, but furthermore you will discover just why this is so significant.

Before picking up The Dollar Trap, I would've never guessed a book about economics could be so witty, insightful and enjoyable to read. However I found myself constantly entertained and enlightened. A must read!
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3 of 3 people found the following review helpful
on January 31, 2014
Prasad offers an incredibly well-researched and entertaining narrative of international finance interwoven with insight into global politics. For anyone looking to understand how recent events such as the Financial Crisis or going over the Fiscal Cliff have impacted the dollar, and more importantly why, read this book. I was surprised by what I learned!
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2 of 2 people found the following review helpful
on May 7, 2014
The dollar continues to be the center of much literature these days and its position as the primary reserve currency at the center of global finance remains unchallenged. The Dollar Trap recounts how the dollar has done through the crisis, how some of the empirical facts about its use would seem counterintuitive at first but more sensible with more time for reflection and describes the landscape today along with some of the fragilities that come with the architecture. It is an informative book for those unfamiliar with the role of the dollar today in international finance as well as even handed about the perspectives of its use by the central banking and international finance community.

The book is split into 4 parts but the first one titles "setting the stage" is just that, a short 2 chapters on the role of the dollar through the financial crisis and through quantitative easing and the euro sovereign crisis. Despite the financial crisis originating in the US, the dollar remained the asset of safety; a result that many would be considered counterintuitive. The first major part of the book is titled "Building Blocks". Starting with economic principles the author discusses how traditional economic theories of capital flows do not correspond to what happens in practice. Capital ought to flow from where capital is abundant to where it is scarce as the relative return would justify more investment where its marginal utility is higher. Thus from this lense of neoclassical growth poor countries should be the recipient of capital flows with the flows coming from the developed world. In practice the asian tigers, japan and China have all achieved growth while running account surpluses (asian financial crisis aside). The author discusses why this happens and discusses various perspectives but focuses on the role of the dollar as a macroeconomic stabilizing tool.

The author then moves on to the framework of the international monetary system and the differences in institutional quality around the world in the third section titled "Inadequate Institutions". With the Fed engaging in quantitative easing to try to ease monetary conditions with the belief that investment from lower rates would spur growth there was a spillover into exchange rates globally. The dollar would relatively weaken as participants would prefer to earn higher yields in other currencies (baring in mind that quantitative easing does not have a uniform record of weakening the dollar and as such the above argument can be true at times but is one of many background processes). In a time with subdued domestic demand, the export channel has been extremely important for many emerging economies and relative strength of the exchange rate became a political issue. The author discusses the economics and politics of this channel as well as the economic perspectives of both emerging markets and of the US. He also discusses classical arguments in favor of flexible exchange rates and then emerging market practical arguments for their failures. He includes counterintuitive narratives about how even better institutions might create new inflows and be counterproductive (ie usually economists would argue that if an economy cannot handle hot money flows it should develop better financial markets but there could be cases where better financial markets ceterus paribus would change the relative desirablility of the destination with better markets such that the improvement would be counterproductive). One gets a true sense of how interconnected the financial world is and local improvements to global problems might not be incrementally beneficial. Coordination is often required when a system is brittle to change. The author ends with a proposal for global insurance that is based off real time policy decisions by countries which would determine the premiums paid. It is an interesting idea though practically it is hard to see it happen anytime soon.

The author finally moves on to the competitors for the dollar. The fourth section is titled Currency Competition. The hegemonic position of the dollar and why is the topic of much of the book so the end focuses on whether there are competitors to it in the making. The author spends the most time on the RMB and discusses where it has grown, how the authorities are handling its introduction (which is gradualist) and what is needed for reserve currencies. The author notes that China, though incredibly important economically and as a trading partner does not fulfill the qualities of a reserve currency as in a world that is based off capital and financial flows rather than trade flows the depth, breath and liquidity of the reserve asset matter more than where the goods are being traded (though in the long run it is hard not to see a relationship between those two). The author also discusses the idea of dollar fragility but dismisses it in todays context by noting the self-reinforcement of the system. This is not to make the claim that the system is stable but rather than todays dynamics are locally self reinforcing.

The Dollar Trap is a comprehensive overview of the role of the dollar in a world of increasing financial and capital flows. Some of the attributes of the dollar at first seem counterintuitive but when looked at as the relatively most attractive asset in a world of scarce safe scalable assets the paradox's disappear. This is not encouraging as the use dollar can lead to complacence by the US and its fantastic institutions might not be sufficient at some point though that some point might be far in the future. It is interesting to note the Euro was not discussed at much length despite it being the 2nd reserve currency; its problems are quite obvious today but nonetheless speculaltion about a slow drift to a more consolidated fiscal region is not considered. All in all there is a lot of solid insightful information in this work. I dont think that it has a strong thesis though, it is just informative by its practical description of the landscape today. So at times the organization doesnt lead to a natural flow. Nonetheless it is a worthwhile read for those interested in the global monetary system as it stands today, what its vulnerabilities are and where it might be headed.
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5 of 6 people found the following review helpful
on February 6, 2014
For someone who usually skips economics news articles because they are too technical and/or speculative, this book is uniquely gripping, incisive, and coherent. Eswar Prasad combines scholarly rigor, revealing anecdotes, and a humorous narrative to make this highly relevant book a true pleasure to read.
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6 of 8 people found the following review helpful
on September 19, 2014
If you only read one book on the possibility of a dollar crash and a hyper-inflationary scenario this should be it. It is an excellent examination of the mechanics of global finance and economics. That said, the perfect companion piece, and contrary view, is James Rickards, Death of Money, an update on his recent Currency Wars.

Prasad glosses over the possibility of gold being used as a currency standard in the future and the viability of bitcoin, as well as offering only two examples of tipping points that might push the dollar in a different direction than his conclusion of continued preeminence. Other tipping points that Prasad excludes include terrorist acts and natural disasters.

Rickard suggests China could sell of all of their Treasuries in a financial war. He then anticipates the objections that those like Prasad make, that it would be suicide to do so: selling off Treasuries would panic the market, reducing the value of remaining T's so that billions of dollars would be lost.
According to Prasad, just selling off $100 billion of China's approximately $1 trillion ownership would panic the markets and create a sell-off.

Prasad proposes two Tipping Points that might upset his prognostication that the dollar retain preeminence for some time:
1) investors lose faith in the ability of the US to honor its debt obligations without resorting to inflation, which causes them to dump Treasuries which drives interest rates up, which increases the interest expense of the US government.

2) China might consider the use of its Treasury holdings as a weapon against the U.S. But, not according to published statements, plus China would be shooting themselves in the foot. They would lose billions on Treasuries as they tried to sell out them because the market would panic, sending their price plummeting. Plus, what is the alternative investment for them? The gold market is too small and other markets don't have the safety, depth, or liquidity

Rickards' counter, in Currency Wars, is that China has plenty of ways to get around this and to wage other financial war on America that would create net gains for China and net losses for the US. One he suggests is that China could systematically lower the maturities of its Treasuries, rolling them over into Bills, instead of selling them off. Then they just let the Bills mature.

But, Rickard seems to underestimate the sophistication of the financial markets and the US government with this strategy. There is no reason to believe a marked change in Chinese portfolio allocations would be any less of a warning signal to markets.

Plus, Rickard consistently ignores at least three issues relative to China waging financial war on America, which Prasad elucidates in his book. First, China depends on America's consumer demand to support their export oriented economy. If this is upset, they have internal problems on their hands. Additionally, they are in what most experts (Stratfor) agree is a 5-7 year transition to a consumer based economy that will decrease their dependence on America. Second, all experts agree that China does not have the breadth or depth of financial markets to support global investment on the scale of the major industrial nations. They are in the process of developing financial centers, but again, are at least five years away. And, third, and most important, China does not elicit near the level of trust and confidence among global investors that is true of the United States. Trust and confidence depend on my things: history, breadth and depth of markets, liquidity, confidence in the political and economic structure, confidence in rules of law, etc. China is presently lacking in all of these.

One weakness of Prasad's presentation is that he doesn't think through enough possible tipping points, he does not extrapolate present U.S. economic, political, or financial weakness. For example, there are quite a few "Black Swans" one can imagine in the day and age we presently live in that could upset things: terrorist events, natural disasters, another market crash, or even the assassination of President Obama which would likely result in racial strife and even martial law.

These are just a few of the possibilities that our nation has not had to endure in the past, but could be part of our future.

There are times Prasad doesn't appear to think militantly enough: he appears willing to take Chinese statements at face value, believe the best of their intentions, and assume that the US will have continued economic dominance through the dollar's preeminence. In the example above, for instance, he doesn't examine the possibility that losing $1 trillion in Treasuries might be a drop in the bucket for China if the dollar crashed and the renminbi is now valued relative to Chinese commodity and gold holdings. In that, or a like, scenario, China could buy up all the assets in the U.S. within the next year. But, perhaps its because his explanations of global financial mechanisms rule out that scenario.

Rickard comes from a financial/military perspective; Prasad writes from an economic/political perspective. Both views have validity and truth; but, neither view by itself is comprehensive and complete. Perhaps the truth is somewhere in the middle; or, perhaps eventual outcomes will depend on the times and who is making the decisions, relative to either, as Rickard calls it, correlations, or as Prasad labels it, tipping points.

According to Rickard, a correlation refers to two or more threats originating externally that produce adverse shocks either because they are correlated or one acts as a catalyst for the other. Prasad takes the term, tipping point, from Malcolm Gladwell, to mean the point at which critical mass occurs.

Rickard misses Prasad's finer points about the global financial/monetary system that Prasad believes will keep the dollar trap in place for the near future. On the other hand, Prasad himself hedges his bet, addressing avalanche theory, and admitting that in the complexity of the system we live in, anything is possible. Avalanche theory, relative to global financial and monetary systems, or more specifically, self-organized criticality in nature, is from a paper by Bak, Tang, and Wiesenfeld in 1987.

That both authors engage is thoughtful discussion of systems and complexity, yet concede to the unexpected, makes it difficult to assert that Rickard is too alarmist and dogmatic in his insistence that the system is f*** and will come apart, or, that Prasad is equally irrational in his declaration that it will continue to hold together with the dollar at the top of it for the foreseeable future. Both outcomes are equally possible, over the short or even medium term. Perhaps, the only sure thing - and agreement between the two - is that eventually it is likely to come tumbling down.

And this conclusion points to the reason it is so difficult to make decisions relative to portfolios when appraising the issue of loss of reserve status and the possibility of a dollar collapse. Investment, by nature, must be built on probabilities, not once in a lifetime possibilities. And though it is possible that the system will collapse and the dollar will fail - at some point in the not too distant future, because, even as Prasad would admit, many of the elements for it are developing and moving into place - it is by no means sure that it will happen in one quarter, one year, or even five years. And these are the more natural periods for allocation determinations and risk and return variables.

In the world in which we live in, it seems wise to embrace Prasad's view, but not to ignore his exceptions (tipping points), or Rickard's warnings.
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1 of 1 people found the following review helpful
VINE VOICEon September 10, 2014
If you are interested in the global monetary system, then this book may be for you. If you are a gold bug, you may become frustrated and disappointed with the discussion.

In essence, that author takes the reader on a journey of `inside baseball' of central bankers' trials and tribulations. However before you begin, the potential reader should be somewhat familiar with macro economic theory or you might get bogged down in the minutia. If you do dig in and move forward, then the story is a counterintuitive one with respect to the global monetary system we used to understand. In days gone by, when a country printed too much money the result was usually inflation that eventually decreased the value of the currency leading to a devaluation. Unlike then, we live in a different (and topsy turvy) world where the more you print the stronger the incentive for people to want that currency (specifically the US dollar at least for the next several years).

Think of the board game of monopoly except with 100 different players with 100 different currencies. As everyone goes around the board, eventually a few run out of money. The remaining players that are left playing do not want those past players currencies any longer so they get sold at say half price. Run a Monte Carlo simulation and you eventually only have 1 or 3 currencies remaining. Sound familiar to today? Seems so as the more the Big 3 print, the others are getting pushed out of the global marry-go-round.

All in, a worthy read if the macro central bank stuff interests you. Included below are a few other recommendations that may prepare you and your pocket book for the future:

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny
Balance Sheet Recession: Japan's Struggle with Uncharted Economics and its Global Implications by Richard Koo
The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation by A. Gary Shilling
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1 of 1 people found the following review helpful
on March 6, 2014
Prasad explains how the dollar has strengthened its role in global finance since the financial crisis, despite
the rising debt burden of the US government that may threaten its fiscal solvency and increasing competition from emerging markets currencies, such as the renminbi, as well as alternatives, such as gold and bitcoins. His insightful analysis makes a compelling case that the dollar will remain the leading reserve currency for a long time, and a somewhat worrying picture that it has no close competitors.

I especially like the chapter in Building Blocks where Prasad first introduces theories that economists use to think about international capital flows, which predict that financial capital should flow from capital-rich countries to capital-poor countries, and then uses data to refute those theories. Over the last decade, private investors has moved from advanced economies to emerging markets, as the theories predict, but official capital has moved in the opposite direction, making capital-rich countries like US a net capital importer and capital-poor countries like China a net capital exporter. He further explains this paradox, which is a timely read that helps me better understand the ongoing emerging currency crisis.
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