Types of currency hierarchies

In the above sections we argued that different levels of marginal liquidity premium functions of currencies create a currency hierarchy. In such a hierarchy three groups can be distinguished.

From the existing around 180 currencies a very small number takes over international functions and can enjoy the privileges linked to it. These currencies have the highest levels of liquidity premiums. What is specific for these currencies is that they do not only take over national functions but in addition international ones. Demand for these currencies is high as also foreigners desire to keep them. In the present historical situation international functions are mainly taken over by the US dollar which is dominating. On second place is the euro and all other currencies play small or no international role (see Table 9.2).

A second group of currencies take over all national functions. Obviously, the liquidity functions of these currencies are high enough that economic agents living in the currency areas keep the national currency as a store of wealth and massive capital flight is prevented. Generously counted, around 25 currencies may take over all national functions of money. These are the currencies mainly issued by the advanced industrialized countries, for example by Canada, Australia, Sweden, Denmark, Singapore, etc.

The remaining currencies have — to different degrees — low levels of marginal liquidity premium functions. To keep them does not deliver a lot of convenience for their holders and especially as asset safeguarding quality of the currency must be considered to be low. These countries are confronted with the problem that economic agents prefer to keep a large proportion of their monetary wealth in foreign currencies which are on top of the currency hierarchy. Even worse, many of these countries suffer from dollarisation (or euroisation). This means that these currencies only partly take over national functions and foreign currencies take over the most important money functions (De Paula et al. 2017; De Conti and Prates 2018).

Historically currency hierarchies can have different characteristics. Two especially important ones should be mentioned here. First, the integration of global financial markets can have different degrees. As long as there are high capital controls, a suppression of dollarisation in most countries in the world and it is difficult for economic agents to hold foreign currencies, the competition between currencies is reduced.

Strict capital controls and government-supported or even government- driven domestic credit expansion is an option for developing countries and can protect and trigger a sustainable domestic credit expansion. China (mainland) is the latest successful example of such a policy (Herr 2010). Countries such as early Japan, South Korea or Taiwan followed similar policies before (Stiglitz and Uy 1996). Today for many developing countries this is difficult because of the integration in global markets.

There is a second specific characteristic of currency hierarchies. The competition on top of the currency hierarchy can be very intensive or not. In the latter case we can speak about a hegemonic currency hierarchy. In a hegemonic currency system one currency is uncontested with clearly the highest asset safeguarding quality and fulfils all functions of money internationally. It is also likely, not guaranteed, that the country issuing the hegemonic currency takes the responsibility to keep the currency’s value stable, being an international lender of last resort, and also keeps its markets open in world crisis constellations. It then provides the international economic public good of systemic stability of the global financial system. However, a hegemon can exploit its position at the cost of other countries, and therefore, may destabilize the system (Kindleberger 1967,1986; Herr 1992).

On top of the currency hierarchy also a small number of countries can compete and create a multi-currency system (Herr 1992). The whole logic of money is that one thing takes over money functions. This already shows that many currencies with international functions can become very problematic. It leads to higher transaction costs due to limited economies of scale of each of the currencies. But what is much more important. Economic and political developments can lead to quick and substantial shifts in the evaluation of a currency in the eyes of economic agents and can potentially lead to violent shifts of monetary wealth from one international currency to another. Exchange rates between key currencies will be unstable and create shocks for the world economy. The level of uncertainty becomes high. Friedrich von Hayek (1976) stressing the advantages of currency competition would be happy about several international currencies. His main argument that the competition between currencies would lead to disciplined macroeconomic policy making. Also the advantage for wealth owners to diversify wealth holding and risk is mentioned (see also Frankel 2009; Eichengreen 2009).These arguments are certainly valid. But from a monetary Keynesian perspective the disadvantages of a multi- currency system are even bigger. The possibility' of frequent shifts of monetary wealth from one internationally important currency to another destabilises the world economy. Governments and central banks are stimulated to follow too restrictive policies to fight for a dominant position for their national currency. This can push the world economy into an overall very' restrictive macroeconomic constellation with low growth. In addition, no country' may be able and willing to provide the public good of systemic international stability' (Herr 2011; Kindleberger 1986). Under such a system, the development chances of countries with low-quality currencies may be further reduced.

In what follows, we analyse the top of the present currency' hierarchy in some detail especially looking at the US dollar, the euro and the renminbi as potential new international currency After its introduction in 1999 the euro became the closest rival to the US dollar (ECB 2018).Yet,Table 9.2 shows that the US dollar sustains its dominant role in official international reserves, as a unit of account for internationally important products, in transaction volumes of foreign exchange markets, and for denominating international credit contracts. The international role of the US dollar was most dominant in the 1970s and then slightly decreased. An indicator is the development of official international reserves. In the early 1950s, around 30% of international reserves were held in US dollar and over 50% in pound sterling. Then the role of the pound sterling eroded quickly and the US dollar gained in the 1970s a share of 80% (Schenk 2009). Overall, the euro has not been able to increase its importance after its introduction. Until today the role of the renminbi as international currency is unimportant in spite of some increases from a low level.

Looking at the preconditions for the international role of currencies the dominance of the US dollar, the stagnating role of the euro and the continued small role of the renminbi are not surprising (see Table 9.3). China became an important power and ready for an international role of the renminbi when the macroeconomic indicators like relative size of the Chinese GDP or trade indicators are taken. Following the Global Firepower (2019) Index,also the military power of China is high, and it ranks in the field of conventional weapons closely behind the US and above Europe. But the strict capital controls, restriction in the capital account, the highly regulated domestic financial system and the low indicators of the rule of law prevent a market-based substantial international role of the renminbi.

Macroeconomic indicators in the euro area and also openness to cross-border finance are comparable with the United States. But political and military power of the euro area is not united. It lacks the character of a state, managed the crisis




US Dollar



US Dollar



US Dollar



Currency in which official foreign exchange reserves are held, % of total foreign exchange reserves (1999, 2009,2019)'’










Foreign exchange transactions,

% of total foreign exchange transactions (total: 200%) (1998, 2010,2019)b









International debt securities,

% of total international debt securities (Q4 of 1999 and 2009, Q3 of 2018)'










International loans and deposits, % of total international loans and deposits (Q4 of 1999 and 2009, Q3 of2018)d







Cross-border monetary transactions by banks, % of total cross-border monetary transactions by banks (2012 and 2018)'







Source: ^International Monetary Fund (IMF) (2019a); b)Bank for International Settlements (BIS) (2019a);c) BIS (2018); ^BIS (2019b); c)SWIFT (2019)

Table 9.3 Major preconditions for currency internationalisation

US or US Dollar

Euro area1 or euro

China or Renminbi

GDP size2, % of world (2017)a




Share of export of goods and sendees, % of world (2019)b




Share of imports of goods and services, % of world (2019)c




Export diversification index3 (2014)d




Capital controls4 (2016)'




Chinn-Ito index of freedom to cross border capital flows’ (2018)f




Inflation differential from the average of developed economics (G7) (2018)s




General government debt to GDP, % (2019)h




Rule of law (2017)‘




Military power6 (2019))




Notes: 'For the euro area the simple average is calculated except for GDP, exports and imports and government debt; 2PPP GDP, constant 2011 international dollars; 'higher values indicate lower export diversification; 41 indicates fully liberalized capital account; 4a high number indicates more freedom to cross-border capital flows, potential values go from 0 to 10; ’a higher index indicates more freedom for cross-border financial flows, in 2018 the values ranged from 2.33 to —1.92; '"military power index for conventional weapons, including factors such as quantity and diversity of weapons, geography, natural resources, industries development, available manpower, alliance, financial stability, political and military leadership, the United States, Russia and China are the top three in military power ranking as of 2019; 0 means highest military power.

Sources: 11WI )1 (2019); M c,IMF (2019b), ‘"■’’’IMF (2018); "'Fraser Institute (2019);''Chinn and Ito (2018);;-illMF (2019c); ’’Worldwide Governance Indicators (2019);''Global Firepower (2019);own calculations after 2008 because of a lack of a fiscal centre and until 2012 very limited role of the European Central Bank as lender of last resort for public households and the asymmetric policy of the Troika to stabilise the euro area in an extremely poor way, and has many unsolved problems of further integration (Herr et al., 2019; Heine and Herr 2021). This prevents the euro to take over the same international functions as the US dollar (for the debate see Eichengreen 2019; Maggiori et al. 2018; Efstathiou and Papadia 2018).

The international monetary system in the post-Bretton Woods era moved in the direction of an inherently unstable system, meaning that it is uncoordinated and characterised by unstable capital flows and has high exchange rate volatility between leading currencies (Corden 1983).To speak about a substantial erosion of the international role the US dollar would be wrong. However, the euro is at least until today strong enough to create some currency competition. The very unstable US exchange rate after the end of the Bretton Woods System in 1973 was caused by rather volatile capital in- and outflows to the United States.These destabilising capital flows were mainly caused by changing evaluations of the liquidity premiums of the world key currencies, especially of the US dollar. This instability at the top of the currency hierarchy contradicts with a globalised financial system with large international credit relationships. Depreciations and appreciations have the same destructive effects for international credit contracts as inflations and deflations for national credit contracts. And a dominating international reserve currency with an unstable exchange rate does not deliver a satisfactory asset safeguarding quality for wealth owners. From this point of view, the Gold Standard before 1914 with free capital flows and fixed exchange rates was a more functional world currency system than the existing one.The Bretton Woods System and even more Keynes’ (1969) idea of an international currency union with fixed but adjustable exchange rates and some capital controls was a compromise between a functional international monetary system and economic autonomy of nation states and delivered the framework for the prosperous development after World War II.

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