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.
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.
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.