Days the Dollar Didn’t Die

Professor Eswar Prasad of Cornell University is touring India promoting his new book, The Dollar Trap. In his book, Prasad says, he seeks to explain a seeming paradox: why the US economy plunged into crisis while the US dollar went from strong to strong.

The US printed money like crazy, issuing trillions of dollars in debt. It was the origin of the subprime crisis that levelled much of the world financial sector in 2008-09. The US political system became gridlocked. Washington even teetered on the edge of defaulting on its debt. And yet the dollar didn’t stumble.

As Prasad notes, the effective exchange rate of the dollar is more or less what it was before the crisis. The US printed an ocean of bonds — $5.5 trillion since 2007 — and 60% were lapped up by foreign buyers. Even during the default crisis of 2013, short-term T-bond interest rates rose by all of six cents to the dollar. Buyers who dumped short-term bonds, notes Prasad, just switched the money to long-term T-bonds — which experienced a decline in interest rates.

Why did the dollar not die? 

Size matters. The US economy remains, by a long shot, the largest economy in the world today. There was no other liquid stable financial asset in such quantities in the world. If you were China, says Prasad, you had no choice but to buy American bonds, as there was no other place to park your hundreds of billions of dollars.

However, Prasad’s real argument is that the US’s economic strength was only part of the story. Undergirding this economic might is the strength and credibility of the US’s institutions: the strength of the US central bank, the independence of its judiciary, the fairness of its regulators, and, ultimately, the stability of the US political system. Thus, the US government cannot treat differently, say, a US and foreign buyer of a T-bond — it’s in the law books, and the judiciary has ruled that all must be treated equally. This is reassuring for an investor. So, when the world economy seemed to be off its moorings, the US’s safe haven status trumped its domestic economic condition. Everyone flocked to the Stars and Stripes, even if it was a bit threadbare. (George Soros noted just after the subprime crisis that “the dollar is the weakest currency except for all the others.”)

Prasad’s argument that institutions were the “magic sauce” of the US fits into numerous studies that have shown democracies traditionally have a better record of honoring their debts and maintaining their financial credibility — all the way back to ancient Greece.

This is slightly reassuring for India. Though the Indian economy is a mess right now, it continues to receive strong ratings (such as by Millken) for its financial and regulatory institutions, especially when compared to other emerging nations. It implies that New Delhi could leverage its financial regulation and institutions to compensate for the smallness of its GDP in comparison to, say, China. This would seem to be evident in the amount of foreign capital that flows into India, which is relatively high in comparison to similar emerging economies (China excepted).

At one of Prasad’s talks in New Delhi, someone in the audience asked, if what Prasad was talking about applied in a messy sort of way to India as well — checks and balances, free media, independent judges, and so on — then did the future lie with India? This person was a foreigner. The largely Indian audience smiled, but reassured him he was on the wrong track.

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