Month: May 2022

I have been the Managing Editor of the Journal of Economic Perspectives since the first issue in Summer 1987. The JEP is published by the American Economic Association, which decided about a decade ago–to my delight–that the journal would be freely available on-line, from the current issue all the way back to the first issue. You can download individual articles or entire issues, and it is available in various e-reader formats, too. Here, I’ll start with the Table of Contents for the just-released Spring 2022 issue, which in the Taylor household is known as issue #140. Below that are abstracts and direct links for all of the papers. I will probably blog more specifically about some of the papers in the few weeks, as well.

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Symposium on Macro Policy in the Pandemic

“A Social Insurance Perspective on Pandemic Fiscal Policy: Implications for Unemployment Insurance and Hazard Pay,” by Christina D. Romer and David H. Romer

This paper considers fiscal policy during the pandemic through the lens of optimal social insurance. We develop a simple framework to analyze how government taxes and transfers could mimic the insurance that people would like to have had against pandemic income losses. Permutations of the framework provide insight into how unemployment insurance should be structured, when and how much hazard pay is called for, and whether fiscal policy should aim just to redistribute income or also to stimulate aggregate demand during a pandemic. When we use the insights from the model to evaluate unemployment insurance measures taken during the pandemic, we find that some, but far from all, of the implications of the social insurance framework were followed. In the case of hazard pay, we find that the proposal for a national program (the never-implemented HEROES Act) was both broader and more generous than a social insurance perspective would call for. We suggest that the social insurance perspective on fiscal policy is likely to become increasingly relevant as pandemics and climate-related natural disasters become more common causes of unemployment and recessions.

Full-Text Access | Supplementary Materials

“Should We Insure Workers or Jobs during Recessions?” by Giulia Giupponi, Camille Landais and Alice Lapeyre

What is the most efficient way to respond to recessions in the labor market? To this question, policymakers on the two sides of the pond gave diametrically opposed answers during the COVID-19 crisis. In the United States, the focus was on insuring workers by increasing the generosity of unemployment insurance. In Europe, instead, policies were concentrated on saving jobs, with the expansion of short-time work programs to subsidize labor hoarding. Who got it right? In this article, we show that far from being substitutes, unemployment insurance and short-time work exhibit strong complementarities. They provide insurance to different types of workers and against different types of shocks. Short-time work can be effective at reducing socially costly layoffs against large temporary shocks, but it is less effective against more persistent shocks that require reallocation across firms and sectors. We conclude that short-time work is an important addition to the labor market policy-toolkit during recessions, to be used alongside unemployment insurance.

Full-Text Access | Supplementary Materials

“The $800 Billion Paycheck Protection Program: Where Did the Money Go and Why Did It Go There?” by David Autor, David Cho, Leland D. Crane, Mita Goldar, Byron Lutz, Joshua Montes, William B. Peterman, David Ratner, Daniel Villar and Ahu Yildirmaz

The Paycheck Protection Program (PPP) provided small businesses with roughly $800 billion dollars in uncollateralized, low-interest loans during the pandemic, almost all of which will be forgiven. With 94 percent of small businesses ultimately receiving one or more loans, the PPP nearly saturated its market in just two months. We estimate that the program cumulatively preserved between 2 and 3 million job-years of employment over 14 months at a cost of $169K to $258K per job-year retained. These numbers imply that only 23 to 34 percent of PPP dollars went directly to workers who would otherwise have lost jobs; the balance flowed to business owners and shareholders, including creditors and suppliers of PPP-receiving firms. Program incidence was ultimately highly regressive, with about three-quarters of PPP funds accruing to the top quintile of households. PPP’s breakneck scale-up, its high cost per job saved, and its regressive incidence have a common origin: PPP was essentially untargeted because the United States lacked the administrative infrastructure to do otherwise. Harnessing modern administrative systems, other high-income countries were able to better target pandemic business aid to firms in financial distress. Building similar capacity in the U.S. would enable improved targeting when the next pandemic or other large-scale economic emergency inevitably arises.

Full-Text Access | Supplementary Materials

Symposium on Economics of Slavery

“American Enslavement and the Recovery of Black Economic History,” by Trevon D. Logan

This paper reconsiders the evidence needed to answer pressing questions of economic history and racial inequality, the Third Phase of research on American Enslavement and its Aftermath. First, I briefly summarize how economists have sought to understand slavery as an institution. Second, using my family’s narrative as a lens, I show how answers to questions from economic history and economic theory can be answered by expanding our evidentiary base and methodological approaches. In the process, I highlight some areas of what these “traditional” economic perspectives miss. Finally, I briefly provide some examples from other fields—such as recent work by historians—that have sought to provide texture on some of the key dimensions of slavery and racial inequality that have been under-studied by economists.

Full-Text Access | Supplementary Materials

“The Cumulative Costs of Racism and the Bill for Black Reparations,” by William Darity Jr., A. Kirsten Mullen and Marvin Slaughter

Two major procedures for establishing the monetary value of a plan for reparations for Black American descendants of US slavery are considered in this paper: 1) Enumeration of atrocities and assignment of a dollar value to each as a prelude to adding up the total, and 2) Identification of a summary measure that captures the dollar amount of the cumulative, intergenerational effects of anti-Black atrocities. Under the first approach, the itemization strategy, we assess wage costs to the enslaved of bondage; financial gains to the perpetrators of slavery; damages to Black victims of post-Civil War white massacres and lynchings; losses from discrimination in the provision of the home buying supports from the Federal Housing Administration and the G.I. Bill; and income penalties due to racial discrimination in employment. Under the second approach, the global indicator strategy, we calculate the present value of providing 40 acres of land to freed slaves in 1865 and the current wealth gap between Black and White Americans. We conclude that the latter standard, the racial wealth gap, provides the best gauge for the size of the bill for Black reparations.

Full-Text Access | Supplementary Materials

“Slavery and the Rise of the Nineteenth-Century American Economy,” by Gavin Wright

The essay considers the claim that slavery played a leading role in the acceleration of US economic growth in the nineteenth century. Although popular among pro-slavery apologists, the proposition fails under rigorous historical scrutiny. The slave South discouraged immigration, underinvested in transportation infrastructure, and failed to educate the majority of its population. It is not even clear that the region produced more cotton than it would have under a counterfactual alternative settlement by free family farmers, on the free-state pattern. The grain of truth in recently popular narratives is that many northerners and business interests were complicit in the crime of slavery: routinely engaging in transactions with slaveholders, even promoting activities that facilitated slavery and the domestic slave trade. Complicity complicates simple historical moralism, but it is quite different from the notion that the prosperity of the nation as a whole derived from slavery in any fundamental way.

Full-Text Access | Supplementary Materials

Symposium on Childhood Interventions

“Children and the US Social Safety Net: Balancing Disincentives for Adults and Benefits for Children,” Anna Aizer, Hilary Hoynes and Adriana Lleras-Muney

Economic research on the safety net has evolved over time, moving away from a focus on the negative incentive effects of means-tested assistance on employment, earnings, marriage, and fertility to include the potential positive benefits of such programs to children. Initially, this research on benefits to children focused on short-run impacts, but as we accumulated knowledge about skill production and better data became available, the research evolved further to include important long-run economic outcomes such as employment, earnings, and mortality. Once the positive long-run benefits to children are considered, many safety net programs are cost-effective. However, the current government practice of limiting the time horizon for cost-benefit calculations of policy initiatives often fails to take this into account. Finally, we discuss why child poverty in the United States is still higher than most OECD countries and how research on children and the safety net can better inform policy-making.

Full-Text Access | Supplementary Materials

“Universal Early-Life Health Policies in the Nordic Countries,” by Miriam Wüst

Given mounting evidence on the negative impact of early-life shocks for the wellbeing of people over the life course, a growing economics literature studies whether early-life policies have symmetric positive effects. This paper zooms in on research on this topic from the Nordic countries, where all families have access to a comprehensive set of early-life health programs, including prenatal, maternity, and well-infant care. I describe this Nordic model of universal early-life health policies and discuss the existing evidence on its causal effects from two categories of studies. First, studying the introduction of universal policies, research has documented important short- and long-run benefits for the health, education, and labor market trajectories of treated cohorts. Second, exploiting modern-day changes to policy design, research for now documents short- and medium-run impacts of universal care on primarily maternal and child health as well as parental investment behaviors. I conclude with directions for future research.

Full-Text Access | Supplementary Materials

“Inequality in Early Care Experienced by US Children,” by Sarah Flood, Joel McMurry, Aaron Sojourner and Matthew Wiswall

Using multiple datasets on parental and non-parental care provided to children up to age six, we quantify differences in American children’s care experiences by socioeconomic status (SES), proxied primarily with maternal education. Increasingly, higher SES children spend less time with their parents and more time in the care of others. Non-parental care for high-SES children is more likely to be in childcare centers, where average quality is higher, and less likely to be provided by relatives, where average quality is lower. Even within types of childcare, higher-SES children tend to receive care of higher measured quality and higher cost. Inequality is evident at home as well: measures of parental enrichment at home, from both self-reports and outside observers, are on average higher for higher-SES children. Parental and non-parental quality are positively correlated, leading to substantial inequality in the total quality of care received from all sources in early childhood.

Full-Text Access | Supplementary Materials

“Economics of Foster Care,” by Anthony Bald, Joseph J. Doyle Jr., Max Gross and Brian A. Jacob

Foster care provides substitute living arrangements to protect maltreated children. The practice is remarkably common: it is estimated that 5 percent of children in the United States are placed in foster care at some point during childhood. This paper describes the main tradeoffs in child welfare policy and provides background on policy and practice most in need of rigorous evidence. Trends include efforts to prevent foster care on the demand side and to improve foster home recruitment on the supply side. With increasing data availability and a growing interest in evidence-based practices, there are opportunities for economic research to inform policies that protect vulnerable children.

Full-Text Access | Supplementary Materials

Features

Retrospectives: “Joan Robinson on Karl Marx: `His Sense of Reality Is Far Stronger,'” by Carolina Alves

This paper revisits why Joan Robinson turned to Karl Marx in 1942 and which insights from Marxian economics she sought to incorporate into her later works, while commenting on how her encounter with Marx was received by some her of contemporaries. By the end of the 1930s, Robinson wanted to bring academic and Marxian economics together in a search for a more realist theory of the rate of profit and income distribution, along with clarifications on Keynes’s concept of full employment and the nature of technical progress and a long-period theory within the Keynesian framework. The result, An Essay on Marxian Economics (1942), was her most important work in terms of laying the foundations of her enduring challenge to the orthodox economics. Here she relied on Marxian insights to escape Marshallian orthodoxy. It is the story of how the originator of imperfect competition pushed further into a theory of exploitation.

Full-Text Access | Supplementary Materials

“Recommendations for Further Reading,” by Timothy Taylor

Full-Text Access | Supplementary Materials

The actual economic recession connected with the COVID pandemic turned out to be extremely short, lasting only during March and April 2020. Of course, the dislocations and restrictions associated with the pandemic in areas like health, jobs, sectors of the economy, online education, and travel have continued in various forms since then. But focusing on the economic issues, what have we learned? Recession Remedies: Lessons Learned from the U.S. Economic Policy Response to COVID-19, edited by Wendy Edelberg, Louise Sheiner, and
David Wessel and freely available online, provides nine essays on different aspects of the economic policy response.

Here’s an overview of some of the issues from “Lessons Learned from the Breadth
of Economic Policies during the Pandemic,” by Wendy Edelberg, Jason Furman, and Timothy F. Geithner.

The U.S. economy experienced a V-shaped recovery of a type not seen in recent recessions. Real Gross Domestic Product (GDP) exceeded its pre-pandemic level by the second quarter of 2021 and was close to pre-pandemic estimates of potential by the fourth quarter of 2021. The unemployment rate ended 2021 below 4.0 percent, just slightly above where it was two years earlier, prior to the pandemic. …

Overall, the United States’ fiscal response appears to have been much larger
than the response undertaken by any other country; this was especially true in
2021, when fiscal policy was as supportive as it was in 2020. The U.S. GDP recovery
has been among the strongest of any of the advanced economies, but the U.S.
employment recovery has been among the weakest; this suggests that both the size
of the response and, perhaps, its character and preexisting institutions all matter. …

The economy experienced major side effects from the pandemic and associated
policy response, most notably the highest inflation rate in 40 years, far
outpacing the increase in wages and leading to the largest real wage declines in
decades. In addition, the U.S. government incurred substantial debt during the
pandemic. With the expiration of most forms of fiscal support, real household
income is likely to be lower in 2022 than in 2021 and could well be below its
pre-pandemic trend. As a result, poverty is on track to rise in 2022. Moreover,
inflationary pressures and the efforts to moderate those pressures might bring
an end to the expansion.

Ultimately, the economic policy response to the COVID-19 recession should
be judged not just by its consequences in the spring of 2020, not what happened
over the next two years, but also by the longer-term effects, and whether the
response will prove to have contributed to a stronger and more sustainable
economy going forward. …

Here is a nonexhaustive list of the lessons I took away from the essays in the book. I’ll list the table of contents for the book below.

1) When the pandemic recession first hit, the effects were severe and there was no good sense of how long it might last. Thus, the priority of economic policy was to go big and fast: in particular, certain policies spent large chunks of money in rebates, stimulus, unemployment insurance, and others. Some of these handed out money in essentially untargeted ways. As one example, the Paycheck Protection Program funneled several hundred billion dollars to businesses with fewer than 500 employees, with the idea that it would protect jobs, but given that it was essentially free money from the government, a lot of it ended up going to the owners of the firms. Economic policy in early 2020 faced a choice between targeting and speed, and mostly chose speed.

2) The early goal of economic policy in March and April 2020 was not really seeking to help the economy recover: it was to help large parts of the economy shut down to minimize the chance of the pandemic spreading, but in a way that tried to support income.

3) The economic recovery from the pandemic happened faster than many people expected. Thus, when Joe Biden took the presidential oath of office in January 2021, there was a widespread sense that additional fiscal stimulus was needed. But the recession had ended in April 2020, and the vaccines had arrived. In fact, the US economy in early 2021 was in a quite different place from a year earlier. In a crisis, there is sometimes a sense that “you can never do too much.” But Continuing and extending federal support payments in 2021, as if it was still 2020, was a mistake and a contributor to the launch of inflation.

4) Compared to EU experience, the job market in the US had a much steeper fall. One reason was that US payments to unemployed workers were very high, sometimes more than 100% of previous wages, while payments in European countries typically replaced about 70-90% of lost income. Second, European countries emphasized “short-time work” policies that are like part-time unemployment. The idea was that instead of having a company lay off some workers completely, the company could reduce the hours of all workers, with the government then making up much the difference in pay. Such policies seek to preserve employer-employee ties, with the idea that such ties make it easier to return to work–and much easier for the employer to require that employees return to their jobs. There are longstanding arguments about the merits of subsidizing workers via unemployment insurance or subsidizing jobs with short-term work programs. There is probably a role for both approaches–but during a short, sharp pandemic shock, short-time work has some real benefits.

5) Near the start of the pandemic recession, there was concern that state and local governments might face severe strains, but the eventual result was more mixed. Louise Sheiner writes:

So, what happened to state and local government revenues, employment, and spending during the first two years of the pandemic? Revenues did not decline nearly as much as had been first feared and federal aid was more than sufficient to offset any revenue losses in every state. Nevertheless, state and local government employment declined sharply, and the decline has been quite persistent: employment by state and local governments in February 2022 was three percent below the January 2020 level. Looked at another way, in February 2022, the state and local sector accounted for 23 percent of the shortfall in
U.S. employment from its pre-pandemic trend. … Overall, it seems clear that the employment losses vary a lot by state in ways that cannot fully be explained. … [G]enerous
federal aid to states was clearly not sufficient to reverse or prevent all the employment losses. One important question is, why not? What did state and local governments do with the federal aid, and why didn’t they use it to increase employment?

6) The vulnerabilities of the US financial system had played a large role in propagating some recent recessions, including the Great Recession of 2008-2010 and the 1991 recession which had some links to the collapse of the savings and loan industry. But in the pandemic recession, the US banking system performed just fine. A large part of that performance was the rules put into place after the Great Recession on the capital and safety standards that banks needed to meet were effective. The Federal Reserve also played a role in extending short-run credit and making sure that financial markets didn’t freeze in place, especially in March 2020, but overall, the story in the financial sector is the success of the earlier reforms.

The book often returns to the theme that the next recession is likely to come from its own idiosyncratic cause–that is, not from a pandemic–and it is worth thinking about what policies might be put in place now that would kick in automatically when that recession hits. Here’s the table of contents for the book as a whole:

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China is taking the lead in moving to a central bank digital currency. It’s not altogether clear how much the US and other high-income countries should be worried about this. Sometimes it’s better to be the one who watches someone else go first, and then learns from their experience. For sorting out the benefits and risks, a useful starting point is Digital Currencies: The US, China, and the World at a Crossroads, edited by Darrell Duffie and Elizabeth Economy based on the discussions of a task force convened at the Hoover Institution.

I’ve described the central bank digital currency controversies before at this blog, but it’s probably useful to review. What we’re talking about here is how payments from one party to another are made behind the scenes–debit cards, credit cards, direct deposit, even old-fashioned paper checks. Duffie and Economy describe how the “bank-railed” systems of the past have worked :

For centuries, the world has relied on banks to handle the vast majority of payments via a straightforward and generally safe method. In the simplest common cases, a bank-railed payment system works like this: Alice pays Bob $100 by instructing her bank to deduct $100 from her bank account and to deposit $100 into Bob’s account at his bank. The instruction can take the form of the tap of a credit or debit card, a wire transfer, or a paper check, among other methods. In some countries, including the United States, the payment medium—bank deposits—is extremely safe, and banks take reasonable care to protect the privacy of their customers and monitor the legality of payments.

As shown in figure 1.1, many countries have been upgrading bankrailed payments by introducing “fast-payment systems,” which can make instant payments possible around the clock, largely eliminating costly delays and payment risks. The United States has a fast-payment system provided by a consortium of large banks. Not satisfied that the bank-provided solution will be sufficient, the US central bank, the Federal Reserve, will introduce its own fast-payment system, FedNow, by 2024.

With this and certain other improvements in traditional payment systems, why are most countries now considering radically disrupting their bank-railed payment systems by introducing CBDCs, or by accommodating other kinds of digital currencies? The answer is that most central banks have begun to question whether merely upgrading their bank-railed payment systems will be enough to meet the challenges of the future digital economy. They have also begun to consider whether to encourage, and how to regulate, private sector fintech innovations such as stablecoins. Moreover, some in the official sector are concerned about whether banks face sufficient competition for providing innovative and cost-efficient payment services.

How would a central bank digital currency work differently? Duffie and Economy explain:

Often in response to private fintech innovations or the declining use of paper money, some central banks are developing CBDCs. A CBDC is a deposit in the central bank that can be used to make payments. For example, Alice can pay Bob $100 by shifting $100 out of her central bank account and into Bob’s central bank account, whether on an internet website, a mobile phone app, or a payment smart card, among other methods. Depending on their designs, CBDCs can also be used for offline payments, meaning without access to the internet or a phone network. In many cases, Alice and Bob would obtain their CBDC and the necessary application software (“apps”) from private sector firms such as banks,
even though the CBDC itself is a claim against the central bank. A general purpose CBDC, often called a “retail” CBDC, would be available to anyone and accepted by anyone, much like paper currency but allowing for greater efficiencies and a wider range of uses. Special-purpose CBDCs can also improve the efficiency of wholesale financial transaction settlements and cross-border payments. …

Most CBDCs currently being developed adopt a hybrid model, according to which the central bank issues the CBDC to banks and other payment service providers, which in turn distribute the CBDC to users throughout the economy and provide them with account-related services.

In some ways, this doesn’t sound like much of a change. It sounds as if payments would still go through banks, but now, behind the scenes, the accounts would be settled with the CBDC. How does this approach provide any gains?

The short-term gain for US consumers is that payments could be faster and cheaper. Duffie and Economy write:

North Americans pay over 2 percent of their GDP for payment services, according to data from McKinsey, more than most of the rest of the world pays, particularly because of extremely high fees for credit cards. US payments are also processed and cleared slowly, often taking more than a day before they can be used by the recipient. And Americans’ primary payment instrument, bank deposits, is compensated with very low interest rates relative to wholesale money-market rates.

The longer-term benefit has to do with financial innovation and competition. Say that we shift away from a “bank-railed” system, where financial transactions take place between banks, and that other financial technology companies would also be able to have a CBDC account at the central bank. A number of US companies are among the innovators in payment systems. Duffie and Economy mention “Arbitrum, Avanti Bank, Betterfin, Celo, Chime, Circle (USD Coin), Coinbase, Diem, Electric Capital, Imperial PFS, Jiko, JP Morgan, Mobile Coin, Optimism, Paxos, Plaid, Polygon, R3, Ripple, SoFi, Stellar, Topl, Varo Bank, Venmo, Yodlee, and Zelle.” But whatever services these firms offer, in the US economy they are ultimately, behind the scenes, operating through banks. If they instead could have CBDC accounts at the central bank, new types of financial communication could be unlocked.

Duffie and Economy emphasize that when it comes to financial technology and payments technology, large Chinese firms have taken the lead: “In China, for example, 94 percent of mobile payments are now processed by Alipay and WeChat Pay, with 90 percent of residents
of China’s largest cities using these services as their primary method of payment … Building on Alipay, the Ant Group provides relatively low-cost and widely accessible small-business credit, wealth management, and insurance. Alipay now reaches small-tier cities and many
rural areas in China.” In addition, China has been experimenting in major cities with a new central bank digital currency, the e-CNY, and plans to launch it more broadly later this year.

China’s public posture is that the e-CNY is really just for domestic use. But one potential concern for the United States is that the system would, at least in concept, allow international payments as well in a way that would circumvent the SWIFT (Society for Worldwide Interbank Financial Telecommunications) system that is now the standard coordinator for international financial payments–and also a primary tool for imposing financial sanctions on other countries.

I’ve written about the risks of a CBDC in the past, and won’t repeat it all here. Might such a system pose risks to conventional banks? If conventional banks face standard financial regulation, with its costs and requirements, what regulations are appropriate for non-banks that would have a pipeline into their own account at the Fed? For example, banks face “know-your-customer” rules aimed at limiting money-laundering or financing other illegal activities. Would all the non-banks need to abide by similar rules? If not, do these nonbank financial firms create a risk of financial instability? A CBDC based on US dollars would be one of the preeminent targets for computer hackers all over the world. How would a CBDC be related to cryptocurrencies and blockchain-related innovations? What degree of privacy would a CBDC involve? In China, there doesn’t seem to be much of a problem with the idea that the central bank would oversee all the accounts in this system: in the US and other high-income countries, such a step might be more controversial.

Finally, remember that these non-bank financial firms aren’t necessarily just about payments. They might also offer loans, or assurances of kinds of contractual financial payments. They might offer insurance or investment options.

I’m underconfident that the Federal Reserve is ready to launch a central bank digital currency, and US financial markets and innovation are rather different from those in China. But China’s experiment with launching the e-CNY is worth watching.

Oleg Itskhoki was just awarded the John Bates Clark medal, given each year by the American Economic Association “to that American economist under the age of forty who is judged to have made the most significant contribution to economic thought and knowledge.” It’s sometimes called the “baby Nobel,” because when the recipients get close to or enter retirement someday, they will often be among the top contenders for a Nobel prize in economics. For those interested in knowing more about Itskhoki’s work in international finance and trade, he offers a readable overview of one slice of his work on “Dominant Currencies” in the most recent NBER Reporter (March 2022). He writes:

While the US dollar accounts for a disproportionate share of international trade, there is a small subset of currencies that are actively used in this trade alongside the dollar, most notably the euro, but to a lesser extent the pound, the Japanese yen, the Swiss franc, and the Chinese yuan. In some bilateral trade flows these currencies play as important a role as the dollar [see Figure 1], with considerable variation in currency use across individual firms even within narrowly defined industries. The dollar and the euro have emerged as the two leading currencies in accounting for international trade flows, with the role of the euro elevated by the fact that a large portion of international trade happens among European countries or involves one of the European countries. A distinctive feature of dominant currencies is that the same currency is equally prevalent in both imports and exports, a feature common to both the dollar and the euro, which is also at odds with standard international macro models that assume a greater role for many currencies to be present in global trade. Nonetheless, a clear distinction between the dollar and the euro is that the dollar in many cases is also a vehicle currency, not used domestically by either the importing or the exporting country. One can thus think of the dollar as the dominant global currency and of the euro as the dominant regional currency,

Here’s the Figure 1 mentioned in the above quotation, which focuses on Belgium. Belgium is a smallish economy in Europe (its GDP is about the same size as the American state of Michigan). It uses the euro as its currency and is highly integrated into the economy of Europe and the global economy. The export/GDP and import/GDP ratios for Belgium are about 80%; for comparison, the comparable export and import ratios for the US economy are in the range of 12-15% in recent years.

The figure shows the use of the US dollar and the euro for Belgium’s international trade with different countries. The left-hand panel looks at Belgium’s exports. As you can see, Belgium’s exports to the US are mostly invoiced in US dollars. Belgium’s exports to India are about 40% US dollar and 40% euro. Belgium’s exports to Japan are about 30% euro and 15% US dollar–with the rest of those imports probably being invoiced in Japanese yen.

With this kind of data for many countries, a researcher can study the determinants of what currency gets used for what reasons, and thus get insights into why the US dollar and a few others are dominant currencies–and what the effects would be of shifts in dominant currencies. Itskhoki lays out the theories of currency choice, which are based on the canonical three functions fulfilled by money.

Medium-of-exchange theories emphasize that a currency is adopted if it guarantees the lowest transaction costs or maximizes room for mutually beneficial exchange. These theories stress country size as a fundamental force, as well as the likelihood of multiple coordination equilibria and other macroeconomic factors that make it too costly to use currencies of developing countries … Store-of-value theories link currency choice in exports with the currency of financing of the firm as part of a combined risk-management decision. Finally, unit-of-account theories postulate that a price is set in a given currency and is not adjusted in the short run …

One basic insight here is that firms producing in one country and selling in another must figure out how to deal with a risk of shifting exchange rates–and the currency for a given transaction will be chosen with this issue in mind. For example, imagine a Belgian firm that imports lots of inputs from the US, and then exports back to the US. For that firm, using the US dollar to invoice both its imports and exports means that it is protected from fluctuations in the exchange rate of the US dollar. Similarly, it turns out that firms with cross-border ownership are more likely to invoice in US dollars. Most real-world examples are more complex that this, of course, but the decision about currency ends up involving the extent to which higher costs incurred in one currency can be passed through to a buyer in another currency.

One of the questions I am asked repeatedly is when or whether the Chinese renminbi yuan will become the world’s dominant currency. Such shifts of dominant currency have historically happened only slowly and occasionally. But here’s Itskhoki on how shifting conditions could foster such a change:

One possibility is that the US dollar strengthens its position as the dominant global currency. This could happen with greater globalization of production and more intensive reliance on global value chains; our results show that cross-border foreign direct investment — a proxy for global value chains — is associated with more US dollar currency invoicing. This would render exchange rates less relevant as determinants of relative prices and expenditure switching in the global supply chain. In contrast, fragmentation and localization of production chains, which might happen in response to a global pandemic shock, can reverse this trend and speed up the transition to a multicurrency equilibrium, with more intensive regional trade and greater barriers to cross-regional trade. This, in turn, may increase the expenditure-switching role of bilateral exchange rate movements.

Alternatively, a shift in the exchange rate anchoring policies of the major trade partners, such as China, could trigger a long-run shift in the equilibrium environment. If China were to freely float its exchange rate, encouraging Chinese exporters to price more intensively in renminbi, then the equilibrium environment would change for exporting firms around the world. In particular, this would alter both the dynamics of prices in the input markets as well as the competitive environment in the output markets across many industries. As our results show, the currency in which a firm’s imports are invoiced and the currency in which its competitors price are key determinants of an exporting firm’s currency choice, and hence this shift could dramatically change the optimal invoicing patterns for exporting firms.