Our Dollar, Your Problem ft. Kenneth Rogoff

[00:00:07] Kenneth

But it can hurt. I mean, it can be… I mean, I don’t expect us to default. I think we’re going to have to make an adjustment. But it’s something we were just completely unprepared to make. I certainly didn’t see anyone anywhere, in the various political campaigns, making a serious suggestion of how we might do it.

[00:00:29] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:24] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely Kevin Coldiron, to host a series of in depth conversations to help uncover and explain new ideas to make you a better investor.

In the series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. And with that, please welcome Kevin Coldiron.

[00:02:01] Kevin

One of the more popular podcasters in New Zealand gave me some advice. She said, start every episode by selling your source. Let the audience know why they need to be listening to your guests. Well, today that’s pretty easy.

Our guest is the world renowned economist and chess grandmaster, Kenneth Rogoff. He’s currently professor of Economics and Chair of International Economics at Harvard. He serves as the Chief Economist and Director of Research at the IMF. He’s co-author of the book This Time Is Different: Eight Centuries of Financial Folly, which became a bestselling book in 2009 and remains very, very influential to this day.

And he’s here today to talk about his brand-new book, just released this week, called Our Dollar your Problem: An Insider’s view of Seven Trivial Decades of Global Finance and the road ahead.

So, Kenneth Rogoff, thanks so much for joining us and welcome to the show.

[00:03:00] Kenneth

Well, oh, thank you for having me. It’s going to be fun.

[00:03:04] Kevin

So, you know, there’s a lot to get into, and I think I’d like to just jump right in and kind of start with some of the basics. I mean, in the intro to the book, you do a great job of kind of concisely summarizing just how dominant the dollar is in different dimensions. I was, I was wondering if you could just maybe start by going through a few points, just so everyone listening knows what’s at stake here if things do change.

[00:03:34] Kenneth

Well, there are a bunch of quantitative measures. So, one would be the share reserves that other central banks hold. So, if you look at China, you look at Canada, you look at Brazil, India, what percent of them are what they’re holding as reserves are dollars? And the answer is a little under 60%. But that probably understates the impact of the dollar.

So, another measure would be what percent of commodities are priced in dollars, what percent of oil? And that’s a number more like 80%, for some commodities it’s even higher. We can look at goods, and it varies by country. But the case of India, it’s probably 85% of their trade is priced in dollars. In Japan, actually, it’s over 50% of their trade, even though the yen’s a big currency.

And if you go around the world, it’s only in Europe that you’re seeing such a small percentage of trade in dollars. And that is a bit of an illusion because that’s counting intra-European trade. So, when the Netherlands trades with Germany, they’re using euro. On the other hand, when Germany trades with China, they’re just as likely using dollars as they are using euro. So, that’s another measure.

The one I like to use, actually, is a sort of a calculation, not quite as simple to explain, based on what do central banks do, what do they think about? And virtually every central bank will tell you their inflation targeting, in other words, trying to stabilize inflation in some loose way. But, in truth, almost all of them attach a very big weight to the exchange rate. Why? Because a lot of their trade is in, usually, dollars. A lot of their borrowing and lending abroad is in dollars. And it’s particularly the borrowing that’s sensitive.

And so having a big movement in the exchange rate is changing a lot of relative prices. So, if you look at how much countries… Who do they choose to stabilize their exchange rate against? Now, it can be a very narrow stability – Saudi Arabia is within a micron of competitive moves around. Whereas, the Canadian dollar moves quite a bit, although not on a day to day basis. It stabilizes around the dollar but moves over longer periods. It’s sort of a continuum.

But basically almost everybody, outside Europe, with just a couple exceptions (which might include New Zealand, by the way), just a couple exceptions are stabilizing against the dollar. And within Europe, it’s the euro. Now, I should back off. That’s where I was in 2015. That’s when I had a paper about this, again, with Carmen Reinhart and also Ethan Ilzetzki.

However, when you fast forward to 2020, it’s loosened. And in particular, the Chinese currency, which was at the heart of the dollar block, Asia is 50% of the dollar block in terms of size of the economy, size of trade. And China had loosened some and they’re getting looser by the day.

So, there are various measures. I’ve given you a few. Maybe the one which is not really the most meaningful, but it captures something, is if I want to trade, let’s say, Australian dollars into New Zealand dollars, how is it done? And surprisingly, the answer is you don’t trade Australian dollars for New Zealand dollars (I’m sure you know this), but you trade New Zealand dollars for US Dollars and then trade those dollars into Australian dollars. Because those markets are so liquid that the cost of doing the two trades is less than the one trade.

The dollar takes up 90% of all trades in currency. Even countries bordering on the eurozone, often Bulgaria as an example, use the dollar more than they use the euro. But these are very indirect, of course. As your listeners well know, the global financial system is a complicated animal.

These are superficial measures. I like the one that asks, what do central banks do? Because they have a grip on all the different ways the exchange rate affects them. They’re looking at it. So, if you see their reaction function, you’re learning something broader about the economy.

[00:08:43] Kevin

Yeah, it’s funny you mentioned the use of using say the US dollar to go from Aussie to New Zealand dollars. My first job, when I worked at the New York Fed many, many decades ago, was actually to work on that survey where they compile the share of US dollar and foreign exchange transactions. They do it every three years.

[00:09:01] Kenneth

Amazing. Thank you.

[00:09:03] Kevin

Yeah, so it kind of brought back some memories there, but the numbers actually haven’t changed really that much. Even going way back, three decades ago.

In the book, you talk about those things and you say, well, here are some of the reasons underpinning the dollar’s dominance. I’m just going to talk about them very briefly. One is it’s the economy most open to trade. It has an established rule of law, one that’s particularly favorable to creditors. It has the US university system open to foreigners, so parents accumulate dollars, they can send their kids there. And it’s the largest and most important destination for immigrants.

It seems to me, when I go through those four bullet points and I think about what’s happened in the last few months, that all those things are now undermined or seriously damaged. And no matter where tariffs end up, those underpinnings have now been weakened. And I was wondering, do you agree with that assessment or am I overreacting?

[00:10:05] Kenneth

You’re not overreacting. So, just to be clear, the dollar’s not going to go from its giant share to nothing overnight because there’s not any substitute. And I think when people talk about de-dollarization or a reduction, when I talk about it in my book, we’re talking about a loss of share that erodes gradually over time. But you listed the reasons why it’s going to go faster.

My book argues that actually we did peak in 2015, and gives reasons why we’re headed towards having less dominance and we can come to the importance of that. But, I mean, Trump’s been an accelerant. It’s just incredible, the damage he’s doing.

Okay, I don’t think everything he’s doing is wrong. I want to be clear. But in this dimension, the tariffs, shutting the borders to illegal immigrants – great; Legal immigrants – no. That’s the heart of our innovation systems, really, getting immigrants. Rule of law – it’s certainly under assault in a way we haven’t seen. I don’t want to blame just him. I mean, I think there have been people riding sort of subtle things. I think he is the biggest transgressor.

But the Democrats, in having all these cases they brought against him, in New York especially, that they probably wouldn’t have done if he wasn’t running for president, is really showing you the weaponization of law. This has gone in a very bad direction. I don’t know what’s going to happen, but, yeah, it’s very, very concerning.

That matters a lot to creditors. You’re putting your money in the United States. It’s even more true of financial trade then of goods trade. Of goods trade, you take some risk, you put your stuff on the boat, it takes a couple of months, you get your money back. There’s a whole apparatus around trying to protect the exporter and the importer. But it’s pretty fast, and there’s a handshake and you go home. With finance, you’re making 10-year treasuries, 30-year treasuries. You’re making these very long term commitments. You’re not just trusting the moment, you’re trusting the system, you’re trusting what goes on. And when you undermine that, naturally it reduces foreign investors appetite for US assets.

[00:12:53] Kevin

Yeah, you talked about 60% of central bank reserves in the dollar. And there’s also state linked sovereign wealth funds or pension funds that are going to be under pressure. And I’m just imagining myself sitting on the board of the Canadian pension plan or a big Dutch pension plan and having to explain to my local politician or the national government why I’ve got so much money in US treasuries now that it’s not nearly obvious that those holdings couldn’t be weaponized.

Okay, so if the dollar’s dominance is at risk, the natural question is, you know, what’s the alternative? And you spend, you spend the first part of the book going through some of the historical and current alternatives to the dollar. And right now, it seems like the three most relevant are the euro, the Chinese RMB or crypto alternative currencies.

And I was hoping we could kind of talk through the state of play of each one of those, just so we get a sense for, you know, how likely it is for one of those things to capture some of the dollar’s share and what that would mean. So, let’s start with Europe.

I mean, you had this great quote where you say, hey, the unification of European currencies is the most remarkable example of macroeconomic policy coordination in modern history. And you also admit that you were skeptical that it would succeed. And I think you’re obviously not alone in that, particularly in the Anglo Saxon world.

So, if we look at some of those key dimensions that we went through at the beginning of currency dominance, how does the euro stand up relative to the dollar?

[00:14:35] Kenneth

Well, the thing that… First of all, it is incredible what they did. I mean, I watched what happened in the early ‘90s. I knew some of the people working for Soros when they busted the pound. And I don’t know if it was the biggest killing he ever had, but it was the most famous. Maybe many of your listeners know he made a billion dollars in an hour off the UK treasury, which I think lost $7 billion altogether.

And it was a very cleverly done. They planned it for months because the markets weren’t so deep back then that if you put in all the various short positions and derivatives that they needed, a bank would have caught wind of it, if they did a whole bunch. So, they just spread it out, did a little bit of it at a time.

And then finally Soros said, I think the pound’s overvalued and I’m going to bet against it. I’m going to bet everything against it. And his reputation had built up so much that everybody just rushed in. And it happened overnight. And we saw the same thing, in various degrees, happen to the lira, the Italian lira, the Spanish peseta, during that same wave; the Finnish marka, the Swedish kroner, and we just saw one after another.

And the whole thing about the euro was they were going to merge their currencies whilst having open capital markets. They didn’t have the same inflation rates. They didn’t have the same debt levels. Didn’t have the same credibility. And how do you get close without blowing up all the time?

So, I liken it to trying to dock a spacecraft; that you have to be going exactly the same speed and touch. And what if you have a whole bunch of spacecraft all at once? If you get something slightly wrong, it blows up.

And I was skeptical. I had papers explaining why I was skeptical. They did it, they did it. It was incredible determination, probably a bit of financial repression in there that they were doing to make it work. But on the other hand, was it a good idea? I’m not so sure now. My European colleagues would just shoot my hat off for saying that. But if you ask why they did it, reason number one was to get inflation down.

You had, you know, double digit inflation in Italy, in France, worse than that in Greece, and a number of other countries. They wanted the Deutsche Mark. They remembered World War II, but they wanted the Deutsche Mark. They wanted that stability from the Deutsche Mark.

And if you’re asking how they sold it to the people, they didn’t sell it to the people. Oh, you’ll be able to travel from Austria to Luxembourg and you won’t have to change money. They don’t care. They didn’t care. I mean, it’s not that big a cost. Most people don’t do it very often. They said, we are going to get your inflation down.

And I argued, I have long argued, that if they just instituted independent central banks it would have done the job, and they wouldn’t have had the euro crisis. And maybe they wouldn’t have had the growth crisis that they’ve had. Who knows?

My European colleagues don’t like to hear it. They’re very proud. They view it as a European project that’s going to work out amazingly over the long run. But I think it’s still a work in progress. I wouldn’t write off a country that’s currently in the Eurozone not being there in 25 years. They haven’t been… when they’ve been put under pressure, interest rates have been very, very low.

So, the Germans complain, but they’re borrowing for nothing or even negative amounts so they could cut a deal. That’s not true anymore. Global real interest rates have risen and, at the same time, the need for cross border transfers, especially around militarization, has zoomed. So, it’s still a work in progress. And I hope my European colleagues keep proving me wrong again, and again. But they still have a lot of challenges – for the moment, not getting invaded by Russia.

[00:19:18] Kevin

You mentioned, actually, military spending and currencies a couple times in the book. And there is this kind of symbiosis I guess between military spending and technology, which makes sense, and there’s a spillover effect from that to growth. And I’m wondering, and maybe this is far too long term, but, you know, if Europe does end up having to spend more on military, which seems likely, obviously that’s a going to lead to higher taxes, maybe higher debt in the short-term. But does that improve their long-term growth prospects? I mean, is that positive for the currency long-term?

[00:19:58] Kenneth

I don’t think it improves their long-term growth prospects. They’re paying nothing. I mean it depends on the political economy. They have these big welfare states. What kind of decisions they would make, I have no idea.

It is true that it’s been our industrial policy, in the United States. The military tries out things before anybody else does. Chips is the really big recent example. But the Internet was developed for the military. There are many, many examples where space programs too, space programs in the military have catalyzed innovation and then it spills over. And the United States has a system that makes that work. So that’ll be good.

But there’s actually some other subtle points to why being a military power helps, at least so I argue in the book. And I’ll just say, there’s a new branch of economics called geoeconomics. Maybe I had a really early version of this, 35 years ago, in an AER paper with Jeremy Bulow. But basically, everything – lending, trade, military, it’s all interconnected. I mean, you don’t have to explain that to Donald Trump. I mean that’s actually one place he gets it. They’re all interconnected. He’s very crude, but the fact that the United States is the dominant military power has absolutely played a role in why the whole global financial architecture revolves around the United States – not simply the dollar, but the United States. The way the IMF works, the way Swift (that’s the international bank transaction messaging system) works, the way the clearinghouses work.

Being in control of the military, having that as an unspoken issue when you’re having negotiations, it works. And I think that has helped us shape things in a way that’s very favorable to the United States. And countries haven’t been able to push back.

So, if Europe were able to defend itself (that’s a long ways off) and project power, say, into the Middle East, I think it’d make an enormous difference in the euro. It’d make a difference because they could push their financial system more effectively into the world. And of course, also, at some superficial but not irrelevant point, they can defend themselves. So, when you make borrowing money and somebody doesn’t have to worry about that, it means something.

[00:22:49] Kevin

So, when we wrap up the euro, here, when we look at the euro, then it doesn’t sound like it’s in a position to compete with the US in terms of dominance, but what does it look like going forward? Does it just expand its regional dominance or just remains kind of where it is? Will central banks and pension funds, do you think, hold more reserves in Europe?

[00:23:16] Kenneth

So, to back up, it’s been kind of a surprise to everybody how dominant the dollar has become. If you were to read the economics literature, I want to say 15 years ago, with the leading minds like Barry Eichengreen, as an amazing financial historian at your university, Berkeley, if you were to read Jeff Frankel at my university, Harvard, and many, many others. They were all saying, everyone agrees where the system’s going. They’re going to be three poles.

The dollar poll, which might be the biggest), but there’s going to be the euro poll steadily expanding, and the RMB in Asia. When Carmen Reinhart and Ethan Ilzetzki and I wrote our paper, now six years ago, looking to see if this had happened, it hadn’t. It just hadn’t. It’s certainly not by the broad measure we give. It hadn’t happened with the euro, it. Hadn’t with the RMB. And there are various arguments for this.

I mean, the euro had the euro crisis. It doesn’t really help underpin your claim to be a big international currency and to be borderline defaulting with some of your countries. China was not ready to liberalize its financial system.

That’s something, by the way, I teach a policy class at Harvard, have undergraduates in it, they’re great. And I often have them write papers on this topic – do you think China should move to have a more liberalized financial system and exchange rate anytime soon? And it’s a very difficult question. It’s actually a good one to set up debate on.

Well, they chose not to. I would say the technocrats complained. The technocrats wanted to do something. So, if you went to the central bank, maybe the SAFE, that’s their sovereign wealth fund, they understood that they needed to liberalize and, particularly, break free from the dollar.

But the boss, typically whoever it was at the time, just said, we’re doing pretty good, we don’t really feel like changing. And so, they didn’t. So, the dollar rose and rose, but those forces are still there. And China, obviously, is watching what we’re doing to Russia. Russia had 300… I don’t know what it was, $30 billion in foreign exchange reserves. Oops, now they didn’t. Well, they still have it, they just can’t use it until we say so. And that could be a very, very long time. And we might give some of it to Ukraine.

What’s that? I mean, that’s a default, obviously. And so, China’s looking at this. The US Is willing to selectively default. Which is, we can get into legalese about this, but it kind of has, with Russia, slightly defaulted. It hasn’t taken the money and given it to Ukraine just yet, but it’s certainly bordering on it.

China’s looking at that and saying, wait, we have $2 trillion. (That’s my estimate, by the way.) The official estimate’s $1 trillion of Chinese holdings of US reserves. And in my book, I explain why I think it’s $2 trillion. And that’s a lot of money for dealing with a government that seems to willy nilly take rights away, do whatever, in this case, the US boss wants to do. And I think everybody’s become nervous about it.

[00:27:19] Kevin

So, I guess the question then becomes, for China, what happens? They still have capital controls. I mean, they’re developing, you know. We keep hearing they have ambitions to, you know, denominate more trade in RMB. And I know some people who are involved in that effort. But the hurdle I can’t get over is what do you do with those RMB as a trading partner once you have them? And where are we on that spectrum? And do you see a loosening of that? Or can the RMB… What’s its future if they don’t loosen those capital controls?

[00:28:03] Kenneth

Well, I think it’s actually pretty easy for them to loosen the capital controls on foreign holders of Chinese treasuries. And over the years, going to China, I’ve always told them it’s a mystery to me why they’re so tough on that. It’s one thing to not let their own people buy up the US stock market, or the European stock market, or housing. They want to keep the money in i’s financial repression, try to hold down interest rates, fuel their growth. But it’s another thing not to let money in.

Now hot money is one thing, okay, sure, you don’t want their banks to be borrowing three month loans from foreigners that can rush out. What about 10-year Chinese treasuries? There’s no danger. There’s no danger. They can print them. It’s denominated in their currency. They can inflate. It’s not really runnable in the same way that the Chinese banks are borrowing in dollars.

So, they’re gradually doing that. They’re gradually having things denominated in RMB of various sorts. If you look at Europe in the ‘60s and early ‘70s, this was actually going on with Germany. So, the Europeans were getting tired of the dollar and Nixon got tired of them first. But he pulled off the gold standard.

That’s where the title of the book, Our Dollar, Your Problem comes from. It’s when John Connally went to Rome and told his European, Canadian, Japanese colleagues who were saying, you’re inflating, we’re holding onto these dollars, and Nixon just told us we can’t have gold anymore. And he said, “well, it’s our dollar your problem.”

So, they saw that. They weren’t stupid. Even before then, they saw it coming, and they started denominating some particularly intergovernmental loans, development loans in Deutsche mark. They started denominating some things in Deutsche mark. And so, the transition today, where everything’s in euro, it didn’t happen overnight, it was going on for a while.

So, I mean, I think that transition is taking place. But what it really is, when people lose confidence in the dollar, they don’t want to use it as much, it’s just making the system more inefficient. Obviously, the euro is not as good, but you could use it. The RMB has its problems, but, particularly, let’s think of an African country which does all its trade with China to start with, or many Latin American countries. China is their big trading partner. It’s not that big of a leap of faith to be starting to hold RMB and trade. Listen, they’re definitely moving in that direction.

These political declarations from the BRICS, where Lula, he’s the Brazilian prime minister, will get together with President Xi and maybe a couple others, the Venezuelan Maduro, and they’ll say, we’re going to all use RMB. We’re done with the dollar. You know, it takes time.

An analogy I like is TikTok. I don’t know what’s going to happen to it, but I’ve asked friends who, you know, sort of know these things in a way that I don’t. Well, if we ban TikTok, can’t you just give Facebook the algorithm and can’t you just substitute? And the answer is no. It takes time to build up the network. Without the network, you don’t have the information to feed into the algorithm.

It takes time to build up all these network effects. That’s what drives the cost to be so low. So, it’s not easy to do. But if you make it painful enough to be in dollars, threatening people with partial default, which the Mar-a-Lago plan, floating around the White House, is just a partial default on foreign holdings. Yeah, you give them enough pain and they’ll do something.

[00:32:17] Kevin

Is this where China’s digital currency comes in? I mean, China’s already rolled out its digital currency, and in the book I know you’re more skeptical of how successful it’s been compared to other analyses I’ve read. But still, it’s clear this is an important project for them.

Is that the main goal of the digital currency, to create a more efficient payment system in RMB, to make it attractive for trading partners to switch out of the dollar and start using it?

[00:32:46] Kenneth

Well, absolutely.

So, there are definitely many different things they’re doing to substitute for the network of banking and finance we have to clear trade in dollars. So, when Argentina wants to trade with Peru, it often runs through dollars. They’re paying dollars, taking dollars, and that’s all being recorded somewhere, probably in the United States. China’s developing its own networks for doing payments.

The central bank digital currency is more advanced than that. It’s trying to really have a substitute for paper currency. And that is important to compete with the dollar because they’re trying to skip the paper currency version. So, the dollar’s by far the most widely circulated currency in the global underground economy. The euro is after that. And they could try to get people to hold and get used to RMB.

And they’re thinking, let’s just skip that step. Let’s get people to hold the equivalent of Venmo at the Chinese central bank and have people in Africa trade with that. They’re not yet allowing foreigners to hold it, but they 100% have that idea.

You’ll go to some, you know, fair in the middle of Ethiopia, some trade fair, and someone will have some little electronic devise, and you’ll pay on the device. It’ll be in Chinese currency. That’s what they imagine.

I think an obstacle they ran into, which is probably one reason central bank digital currencies are probably not going to win out over stablecoins. It wasn’t very innovative. I mean, people looked at Alipay, which, Of course, Xi tried to crush. That’s the Alibaba payment mechanism and some of the sister ones. And they’re so innovative. There are so many things you can do. Constant new changes and tweaks. Whereas the central bank digital currency was so boring.

So, I don’t think the future belongs to central bank digital currencies. I think it belongs to some kind of regulated stablecoin. Well, that’s hotly debated. I mean, there are concerns from economists that.

So, just to be clear, a stablecoin, the only meaningful kind of stablecoin is one that’s fixed to a fiat currency. There are all these unstable stablecoins where they’re some mix of cryptocurrencies. And I’ve heard all the variants, but they’re going to all go by the wayside. What we’re talking about is one that’s fixed to a fiat currency. And I’ve heard the problems of there’ll be bank runs on them and stuff like that. I think with regulation, all that can be solved.

That’s my guess of where things are going, at least for the next 40 or 50 years, but we’ll see.

[00:36:01] Kevin

Okay, well, that’s a good segue to talk about the potential for alternative currencies, like stablecoins, to displace the dollar. We had Richard Holden on the show last year and he’s a PhD economist from Harvard, so you may know him. And he’s written a book called Money in the 21st Century, which talks about the future of digital money. And he worries that private stablecoins have the potential for conveying enormous power to companies who operate them.

The original proposal was from Facebook, but it could be run by any company with a large enough existing network: Amazon, Google, for instance. His point was that the company would have control over what assets it holds in the reserve to back the coin. He uses that example of a coin that’s held in a mix of currencies. Let’s say one of them was the Aussie dollar.

If the company didn’t like a particular tax policy in Australia could say, hey, we’re not crazy about this tax and if it goes into effect, we’d probably have to cut our holdings of Australian dollars, for instance. And for a big enough stablecoin that could be very meaningful. So, what do you think about this idea? Would private stablecoins transmit too much power to a small number of companies?

[00:37:17] Kenneth

Well, you have to regulate them. I mean for one thing they can’t… If you don’t have access to the Federal Reserve’s balance sheet for a dollar based stablecoin, you’re not going to last indefinitely. You’re eventually going to blow up. We have seen that again, and again, and again, and again. It’s the same problem with fixed exchange rates. It was the same problem with the bank private notes we had in the 1900s.

The government needs to have tight regulations and, in return, prevent bank runs on the stablecoins that have a way to back them. And that may sound kind of unexciting to people. I mean, that sounds like a legacy system with just a slightly different technology, maybe so. I don’t know how it’ll ultimately pan out. But if they’re regulated in that way, then they can’t go and take their big stick and go around everywhere and do stuff. It’s really no more than the dollar can. It’s just an extension of that.

And then there’d have to be a number of competing ones and not just to have one or two. If you just have one, well, basically that’s a central bank digital currency and you’ve just made it private. But I think you would want to have at least a few of them.

[00:38:42] Kevin

You talk about that in the book. You say that if a stablecoin doesn’t have access to a lender of last resort, it’s going to experience a run unless it’s completely backed by T bills.

I was thinking about that from the perspective of the US right now. The government has to sell a lot of debt. Wouldn’t it prefer to have a large captive buyer? So, maybe requiring stablecoins to be fully backed by T bills is a feature, not a bug.

[00:39:13] Kenneth

Well, it is and it isn’t. We’ve had the idea of narrow banks, which is what that is, since the 1930s. So a narrow bank is a bank that only can hold treasury bills. You never ever run, in theory, and they do whatever banks do. So, the delicate thing that I think regulators are facing in trying to figure out how quickly to move ahead with stablecoins/central bank digital currency (and again, we’re not talking about bitcoin, we’re talking about these things backed by fiat), is that everybody loves to hate banks. I don’t.

But I’m just saying it’s very, very easy, certainly at Harvard, to find a crowd and tell them how awful the banks are, and they’ll just all shake their heads and think it’s great; whatever you’re saying is brilliant. It has not proven that easy to find another way to make loans: car loans, small business loans. There are devices (maybe car loans wasn’t the perfect example), but hardware loans.

We know how to do the bond market. We know how Coca Cola doesn’t really need banks. They could be perfectly happy with stablecoins and their bonds. But most, a very large share of small businesses need access to banks where they have a relationship, where they can have some long term stability. And if you clean deposits out of the banks, who’s going to do that?

Now there are ideas. There are ideas out there. You may not remember it or more likely never noticed it, but Larry Kotlikoff, who’s a professor at BU, ran for president in 2016. Yes, he really did. And one of his big ideas is narrow banks. He’s gung ho on that.

And he had ideas for how he would do the loans. You would basically have the same people that make loans at the banks taken into consortiums that would basically create mutual funds consisting of a super diverse range of things and we’d buy them. And if you made money, great. If you lost money, you’re tough luck. But the banking system would be cordoned off. That was in his… You just can’t say that it was never in anyone’s presidential platform. It was, but it’s just not that easy to do.

There are countries that have tried it and it’s just not that easy to do. Maybe it’s a management problem. Maybe with AI we’ll be able to figure it out. There are things like the lending club, it’s an Internet lender. China has a thousand of them. They just don’t work that well. And I don’t know, I don’t want to talk down the stock, maybe it’s really high. But it hasn’t yet got to where the regulators are thinking, okay, the era of banks is over. We’re just bringing in digital currencies. We don’t really need you.

And at the same time, banks, of course, are being innovative and finding ways to make you feel okay that, although you don’t have a stablecoin, you have something that’s very liquid. In fact, the FedNow system, which was introduced at the end of 2023, is a way of doing clearing when the banks are closed – have instantaneous clearing. It’s still a work in progress, to be honest. It hasn’t worked as great as advertised, but it’s modeled out for some other countries who do it.

That’s an example of the banking system trying to produce, in its own way, something like stablecoin, where obviously you can use it 24 hours a day, you just need access to the app. Whereas the banks, you can use it 24 hours a day, but they aren’t able to clear instantly on a lot of things and they’re working to solve it.

[00:43:25] Kevin

Okay, well, let’s try to be more concrete here about what’s at stake if the dollar loses its dominance or if it becomes less important, as you’re suggesting it will.

In the book you call this the perks of currency dominance, and I’m simplifying wildly here, but the two main perks seem to be number one, we get lower long-term interest rates. And two, because the demand for dollars goes up in a crisis, the US government’s able to borrow in times of great need. They can fund military expenditure or deal with a global pandemic, et cetera, and that’s hugely valuable.

So, let’s take the first one. What are the key reasons dollar dominance gives us lower rates? And how much higher could we expect rates to be if that dominance disappears? I know that’s a difficult one to estimate and maybe an unfair question, but anyways, I’m going to ask it anyway.

[00:44:26] Kenneth

It’s a perfectly fair question. So, first of all, a point I’ve been making for more than 10 years, and I have a paper I’m very excited about that’s in a recent American Economic Review. I talk about that and some related things in the book. People had this view that regardless of how much we were borrowing, regardless, interest rates would just come down, and down, and down.

There were people who say, oh, don’t do it, the debt’s too great. And yet as our debt went from 30% of GDP in 1980, to 60% in 2005, to 120% as the pandemic is unfolding. Interest rates just seem to come down, and down. And my friend and brilliant colleague Larry Summers said this is because of secular stagnation. We’re never going to invent anything again. We’re all getting old and interest rates are just really low. And he had a couple other twists on it of inadequate demand.

And I would go around the world debating him and saying, you’re looking at this short period in history. He eventually goes back to 1980 when and we started trying to conquer inflation. But that’s nothing.

If you look at a longer time period, real interest rates (and we’re talking about long-term real interest rates), they’re really volatile. And you know what? They’re probably mean reverting. And I think I’ve shown that.

And so, I think a lot of what’s happened recently, a lot of the pain we’ve had much, much more than the loss of exorbitant privilege (if we do lose it, that’s to benefit the US) is that we’ve had a normalization of long term real interest rates. And suddenly debt is a free lunch. All these marches about, everything’s austerity. You listen to the progressives. Anytime you’re not maximally spending, forgiving student loans, spending on everything, they say it’s austerity. What is the logic of that?

It’s kind of painful to think, but it has to be. It is because they think debt is a free lunch. They just think, well, the debt can go up and up. I think Paul Krugman commented on a blog, one of his blog posts, why not have 200% debt? Why not hire? What’s the problem? And that was fine if you thought interest rates would keep going down and they haven’t.

So what’s painful about if we lose exorbitant privilege where, think of it as a half a percent to a percent premium that we get of paying less. We’re already paying more. We have an unsustainable debt trajectory and it’s just sort of insult added to injury if the interest rate goes up on top of that. So, it’s not the only thing going on, but it is a major thing going on.

One, this is maybe getting too in the weeds, but to talk about the half a percent, a percent, you kind of have to control for how much do you borrow? Obviously, our debt now is 121% of GDP. If our debt was 60%, I promise you our interest rate would be lower. That’s why Germany’s interest rate was lower.

And when Germany suddenly, you know, got rid of its debt break very recently, and suddenly its debt’s going to go from 60% to 80%. Its interest rates have been marching up. So, you get a lower interest rate, given how much more borrowing you do.

And if you can just forgive me to make one other point about this, the people would just go on, and on, and not just on the left, on the right, about that we care about deficits, but we don’t care about debt. We just… The starting point… Believe me, they’re all writing this in technical terms, in the AER, not to mention Ocasio-Cortez, but also a lot of leading opinion makers in economics. They said, I don’t care if your debt starts at 100 or 130. It’s just… It’s irrelevant. Just look what happens going forward. Olivier Blanchard famously argued this in his 2019 American Economic Association presidential address. There’s no effect on growth, whether you’re 60% or 130%.

And what I find so odd about that is that if you ask any of these people, well, okay, if I let you do an extra stimulus, is that good? And they say, oh, that’s fantastic. I love stimulus. If I can do stimulus, the multiplier for every 1% of GDP debt you let me run, I’ll give you 2% growth. That’s on the high side. But they’ll say that.

They say, okay, so you say the level of debt doesn’t matter to you but you think you could get a lot. Well, what if I had the debt fairy come and suddenly our debt was 60% of GDP instead of 120% of GDP and you can spend 2% extra the next 30 years? (I’m rounding and ignoring compound interest.) Would you like to do that? Obviously, it’s an incredible disconnect. Their brains don’t know how to handle it because of course it matters.

As your debt goes up, you have less option value to use borrowing when you really need it, you pay higher interest rates. And we’ve gotten to the point where I believe it’s a problem, with this possible reduction, not quite loss, but reduction in exorbitant privilege, adding insult to injury. Even without it, even if Donald Trump had not done this very hard to rationalize tariff war policy, I think we were in trouble.

[00:50:53] Kevin

Yeah, that seems pretty important. I mean, a crisis is a time where people want to lend, so having the ability to borrow in a crisis is a valuable option. The loss of that ability or having to pay more for it seems pretty consequential.

[00:51:10] Kenneth

But it’s just true for everyone. That’s true for the United Kingdom. We can go faster, we can go higher, but it’s true for everyone. Borrowing is great.

Owing a lot of money is not great. And your listeners may have a hard time understanding this or appreciating it. We’ve gone 15 years and believe me, I was all alone on the other side, practically, arguing this, where people thought it just didn’t matter. They would come out with proposals which just let the debt drift up to a few hundred percent, 500%. They said it just doesn’t matter.

You just don’t want to do what Biden did, which is he poured too much stimulus too fast. You gave everybody money at once. And then of course, they’re all spending it. You’ve got inflation. But if you do it out in a measured way, there’s no reason ever to think about where you’re starting.

[00:52:05] Kevin

We’ve talked about the perk of being able to borrow in a crisis. And the reason we can do that, the reason the US can do that, is that the dollar has been seen as a safe haven. Its value tends to go up in a crisis. We saw that in 2008, 2020. But this time around the dollar’s fallen and that strikes me as very significant.

Do you think the fact that the dollar has gone down during this recent crisis is a sign that we’ve now moved on to a new era and that that aspect of exorbitant privilege has been lost?

[00:52:40] Kenneth

So, you know, it’s going to be hard to make a definitive statement and we’ve seen a few things. But my book talks about how it drives me crazy when people describe long-term treasury bills as safe debt. There’s nothing safe about it because we can inflate on you. It’s clearly something where you’re taking a risk.

So, backing up, the dollar is always described as a safe asset. Everyone rushes into dollars. Not if the US is the source of the instability. I mean, it depends on the nature of it. The global financial crisis we caused, but We’d infected the whole world. But here, let’s just say the crazy is sort of centered in the United States. And the world doubts our governing capacity. They doubt the stability of our government at the moment. And by stability, I mean the stability of the decision making. I mean, maybe that’ll prove unfair. I mean, I’m rooting for the United States. I’m not rooting for it to blow up. And I’m not political at all in my book. And so, you know, maybe Trump will pull a rabbit out of his hat and (even though it probably wasn’t planned), he. can say it was all planned and it just worked out great.

But the world’s not thinking that at the moment. They’re thinking you don’t have a plan. You don’t know what you’re doing. You said tariffs are great even though every economist disagrees with you except his tariff Rasputin, you know, that he’s got. But virtually everyone else thinks tariffs are terrible for all the reasons that are happening. Everyone thinks uncertainty of all this deal making is bad. And okay, maybe he’ll prove right. I hope so.

But the rest of the world, right now, is voting with their feet. I think it’s very likely (we don’t know the numbers), very likely foreign central banks are reducing their treasury holdings as far as somebody could be, as you said, you mentioned sovereign wealth funds.

[00:54:55] Kevin

Okay, well, let’s talk about how this situation gets dealt with. You say there are three basic tools of dealing with high debt. There’s default, inflation, and financial repression. Financial repression is forcing Americans to hold government debt.

Default was traditionally thought of as impossible, but with Trump, I think it has to be considered on the table, although not a first option. Inflation is possible, but as you say, we need very high inflation for a long time to make a dent in the debt because so much of it is short-term. If we had higher inflation rates would go up and then short-term debt would get rolled over at those higher rates.

So basically, that leaves us with financial repression. So how do you think this will look? I mean, what form will financial repression take?

[00:55:46] Kenneth

Well, we’ve seen some already. Now, after the financial crisis, banks and other financial institutions were forced to hold much, much more “safe” debt so that they wouldn’t have a run. And that is financial repression. That’s what they do in India and China and everywhere in the world. And Europe did it even much more than the United States did.

And there’s no question this is a piece of what held down interest rates. However, the king of financial repression in the advanced economies has to be Japan. Japan has a debt/GDP ratio twice that of the United States. And another thing that drives me crazy is people will say Japan proves you can have as much debt as you want. It’s going back to Krugman’s comment.

You just have as much debt as you want. There’s no crisis in Japan, it’s fine. Well, there’s no crisis. But in order to fund that debt, they’ve had to ram it down the pension funds, the insurance companies, the banks, all their savings plans. And we’re not having vibrant investment in the economy. You’re breaking the system.

I said everybody likes to dump on banks. But the fact is, banks are really important and you’re paralyzing the banking sector, the financial sector, from helping create innovation.

[00:57:19] Kevin

And you’re talking about crowding out.

[00:57:22] Kenneth

Yeah, absolutely yes, yes, that exactly what I’m talking about. And where you’re crowding out and using force a bit to crowd out, not just size.

And so, Japan’s performance has been horrible. Okay, everyone’s done badly compared to the United States. So maybe not a fair comparison. But if you did… I was a visitor at the bank of Japan in the early 1990s. That was Japan at its absolute richest. They had per capita income higher than the United States. I was a professor at Berkeley at the time. And the cost of my very nice two bedroom apartment, well, it wasn’t very nice, but it was a two bedroom apartment, a cement apartment in Berkeley in a good location. It was, I don’t know, a quarter what a much more modest apartment was in a small part of Tokyo.

Japan had higher per capita income. You could see it everywhere. They were just incredibly successful. And today they were ahead of the United States, in per capita income, by some measures. But if you do purchasing power, parity, they never quite caught up, but they were darn close. But they were way ahead of France, Germany, not to mention Italy. Now they’re behind all the large European countries. It’s not just the United States. They have collapsed. They’ve gone through this era of low growth.

And yeah, they’ve had some years where it’s been okay. So, you can have financial repression, but if you’re planning to compete with China, you better hope China is doing terrible, which maybe it is at the moment. But it’s a short-term solution. If you lean on it indefinitely, you’re going to suffer.

[00:59:24] Kevin

Okay, well, how would you, you know, handle this situation? I mean, let’s say you were treasury secretary or advisor to a new administration. What policies would you try to put in place? What are the most important steps we can take to deal with the situation without, you know, going through those three steps of default, inflation or financial repression?

[00:59:49] Kenneth

I mean, I’m a big believer in central bank independence and I’m sure your listeners all know there’s like a little war going on here in the United States about that. I think I wrote the first paper on why you should have an independent central bank back when nobody had independent central banks. And when I wrote it, by the way, I just would mention, not that your listeners would necessarily care, I had an impossible time getting it published because people were using complicated game theory models and I was proposing an institutional solution.

And they said, well, that’s not hardheaded. That’s not using a lot of math. You’re just saying, what if you had an independent central bank and gave it these powers. I want to see a lot of math.

And I had math, but I didn’t have tons of math. I had this core idea, and it’s worked really well. It has worked beyond my imagination. It works in what Ronald Reagan would call (forgive me) banana republics. It works. And if you keep that, then you preserve the stability of the dollar, you preserve the stability of the financial system and you have to find other ways to deal with that.

You could pay more taxes. We could change the way we do transfers. I don’t want to make choices, but there are choices. That’s what economics is, the dismal science. It’s not ‘debt is a free lunch’. Everything’s free. Which has been the mentality on both sides of the aisle here. The Democrats want to spend as much money and use debt. The Republicans want to cut taxes as much and use debt, without any thought that there’s some sort of reckoning.

I don’t have an easy answer to your question because, politically, we haven’t prepared people. You can go tell them what needs to be done, but if they don’t want to hear it, you get voted out of office. And the only ones who really can force the government to do something is the bond market.

Clinton, who I think was a great president in the 1990s, he was the last one to really get chased by the bond vigilantes. He had to adjust. He made changes in the early 1990s he couldn’t imagine. And by gosh, he got reelected after he did it. And I think we’re going to see that again. But it’s a more difficult situation because the debt level is just way, way higher than it was.

And when the bond vigilantes come after you… And what we really mean by that is something pushes up the interest rates. We had a taste of that in the week Trump announced the tariffs and bond yields mysteriously started going up, even though expected inflation had not.

We’ll have to deal with that. We will. I mean, we defaulted in 1933 and came in, I think the Supreme Court ruled that. I think that’s correct. We defaulted under Alexander Hamilton. Many countries have defaulted. But it can hurt. I mean, I don’t expect us to default. I think we’re going to have to make an adjustment. But it’s something we’re just completely unprepared to make. I certainly didn’t see anyone anywhere in the various political campaigns making a serious suggestion of how we might do it.

[01:03:22] Kevin

Yeah, I agree. I mean, I definitely heard that from market professionals, the Fed won’t allow bond yields to rise. It’s like everyone’s just expecting that if bond yields do go high enough, the Fed is going to be forced to buy government bonds or to restart QE.

[01:03:38] Kenneth

What I think a lot of people don’t understand, particularly those who think it’s a free lunch is, when the Federal Reserve buys debt, they have to pay at least the short-term rate. So, you can convert long… So, if the long rate goes up and the short rate’s not going up as much, when the Federal Reserve “prints money”, it’s issuing short-term debt. It’s bank debt, but it’s exactly the same as short-term treasury debt and they’re buying the long-term treasury debt.

So, we paint ourselves into a situation where you’re kind of gambling on rates going down because if they go down you’re going to feel very smart to have absorbed some of the long-term debt. You’re basically retiring it when the Fed buys it and issuing short-term debt. But if they go up more, you’re in trouble.

So, you better be pretty sure that you have a government putting things in place, that you’re not just having politicians will things. I do think interest rates are going to go over 5%. I think that’s coming and I think the big driver is going to be people are going to realize that there has to be a chance of having a burst of inflation. As great as the Fed is, its independence is clearly not sacrosanct. And no, I thoroughly expect to see interest rates, to be clear 10-year treasuries over 5% at some time in the next few years.

[01:05:11] Kevin

10-year tip yields are around 2%, now. We’ve been talking about an environment of high inflation risk and you know, just general uncertainty. And I look at that and I think, well, 2% guaranteed real return over 10 years, sure, you don’t get rich off that. But seems fairly attractive given all the uncertainty. Do you agree with that or do you think that the inflation protection piece might be gamed or adjusted kind of like a stealth default on TIPS?

[01:05:42] Kenneth

Well, I mean if the Fed right now only 10% of our debts in TIPS. If we had 80% of our debt in TIPS, the inflation option’s not there and you have to have some form of default.

Now, financial repression, it’s a tax, but it’s sort of a form of default. But there are limits to how much TIPS they can issue before it starts constraining the government. But yeah, TIPS seem like… I mean, there’s a question of whether 10-year rates are going to go up in general, but I would sure want to be hedging against inflation. It’s not easy to do. There aren’t many things that you can do.

[01:06:31] Kevin

Okay, well, that’s a good place to wrap up.

I mean, there’s a funny part in your book where you say that in 2009, your book This Time is Different, rose to number four on Amazon, right behind the three books in the Girl with the Dragon Tattoo series. Yeah, I might be one of the few people who’ve read all four of those each of the Dragon Tattoo series and your book

[01:06:56] Kenneth

I’ve read them all, too.

[01:06:58] Kevin

Well, I checked on Amazon this morning and none of the Dragon Tattoo books are in the list anymore. So hopefully it means that you’ve got aA clear road for this book to go to the top.

[01:07:10] Kenneth

Well, for me, I mean, particularly with this book, there are ideas I want to get out there, I feel I’ve certainly written professional journal articles. I have written articles about: why you can’t assume there’ll never be inflation again, why you can’t assume real interest rates will be lower forever, why you can’t assume China will go to the moon or start going to the moon again, why you can’t assume the dollar will maintain its current position.

And I find myself very much in a minority. Okay, maybe I’m wrong. I accept that. But it’s been difficult to even get my ideas out there. I will mention that at the America, I’m one of the 10 or 12 most cited authors in economics. And when I submit papers to the, say, a session to the American Economic Association, I’m treated very well. Not when it’s about debt. They have no interest.

In fact, I think someone at Hoover did a word count of the most used words in American Economic association abstracts (what they have at their annual meetings, just to be clear), in the abstracts and in the titles, and debt and deficits does not appear in the top 25 words in any year.

And I, from personal experience understand why. And the top words are, I’m not even going to say them, but very politically correct words. And I think it’s time for the profession to wake up. Oh, inflation didn’t appear until this year. It’s the first year in 15 years. And I think it’s time for the profession to wake up from this incredible complacency about macro issues: There’s never going to be inflation. There’s never going to be debt problems. We just need to concentrate on solving inequality, an important problem. But we don’t need to think about these other issues anymore.

And so, for me, part of why I hope if some of your listeners read the book, it’s written in a rather colorful way and I’m saying things… I try to have written it in an engaging way. I use a lot of personal anecdotes, but I have something to say, and I want to get it out there. And so, I know from experience you have to hit escape velocity to sort of snap any attention into people. And that’s what I’m hoping.

[01:09:55] Kevin

It really is an engaging book and couldn’t be more timely. We appreciate you joining the show to tell us about it. Again, Kenneth Rogoff’s brand new book is called Our Dollar your Problem. Please make sure to get a copy and follow Kenneth’s work because I think you can tell from this conversation, these topics are not being discussed enough on mainstream media. So, for all of us here at Top Traders Unplugged, thanks for listening and we’ll see you next time.

[01:10:25] Ending

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