International currencies and endogenous enforcement
This dissertation is an investigation of the determinants of the international role of a currency. In the standard approach to international currencies, agents assess the desirability of a currency on the basis of a set of country and currency characteristics that serve as indicators of future transaction costs associated with the currency's international use. These characteristics, called standard determinants, are--inflation variability, exchange rate variability, inflation rate, exchange rate, financial openness, world export share, depth and breadth of the financial market, and net foreign asset position. The first four determinants relate to monetary performance, and along with financial openness, are summarily referred to as currency stability criteria.
A critical evaluation of the standard approach reveals a central weakness relating to the role of currency stability criteria as determinants of international currency status. When agents base future expectations about a currency's transaction costs on the available evidence regarding stability, they, in effect, presume that future monetary performance and financial openness will mirror the past performance of the currency. The dissertation argues that such a view is naive, because the issuer's promise of stability is not exogenously enforceable. That the issuer will not be tempted to renege ex post, that is, deviate from its previous record of stability, cannot be guaranteed ex ante.
The dissertation advocates an enforcement approach to international currencies that makes explicit the underlying agency problem. It models the relationship between the key currency issuer and foreign holders of its currency as an endogenously enforceable contract. Endogenous enforcement mechanisms elicit appropriate issuer behavior, and translate into four structural characteristics of the issuer nation, called enforcement determinants--stock of foreign direct investment assets abroad, multinational rent earnings from abroad, central bank independence, and military strength. In the enforcement approach to international currencies, agents supplement the standard currency stability criteria with these enforcement determinants, as indicators of a currency's future stability prospects. Unlike currency stability criteria, the remaining standard determinants are not subject to surprise changes, so that for them, actual observed record is a reasonable indicator of future trends.
The dissertation's model of the determinants of currency internationalization thus includes the set of standard determinants and the set of enforcement determinants. The model is estimated using time-series cross-sectional analysis for four data sets, and three different measures of international currency share. The econometric investigation indicates that all enforcement determinants are strongly significant and robust in explaining international currency share. Monetary performance related standard determinants fail to exhibit explanatory power, while the performance of the remaining standard determinants can be characterized as mixed.
Endogenous enforcement, as a theoretical framework for studying international currencies, and the dissertation's empirical results in particular, have important implications. They suggest that in the international acceptance and use of national currencies, "structure" speaks louder than "actions". While popular predictions regarding the future evolution of the U.S. dollar, the deutsche mark, and the yen envision an evolving "tripolar" world, the dissertation underscores convergence of enforcement determinants among the "big three" as crucial to the tripolar outcome.