Mars or Mercury? The Geopolitics of International Currency Choice

This article summary is part of my personal background research work. The post has a detailed summary of the article.

DOI link

Mars or Mercury? The geopolitics of international currency choice*

Summary. We assess the role of economic and security considerations in the currency composition of international reserves. We contrast the ’Mercury hypothe

OUP AcademicThorsten Beck

Keywords

• Geopolitical factors
• Economic size
• Currency composition
• International reserves
• Military alliances
• Pecuniary factors
• Reserve currency choice
• Global foreign reserves
• Pre-World War I
• Security guarantees.

Summary

The article explores the dual influences of economic and security considerations on the currency composition of international reserves. The authors, Barry Eichengreen, Arnaud J. Mehl, and Livia Chitu, contrast two hypotheses: the "Mercury hypothesis," which posits that currency choice is driven by economic factors such as economic size and credibility, and the "Mars hypothesis," which argues that geopolitical factors, including military alliances, play a significant role. Using historical data from 19 countries' foreign reserves before World War I, the study finds support for both hypotheses. Military alliances are shown to significantly boost the share of a currency in the partner's foreign reserve holdings, highlighting the impact of geopolitical factors. The study's findings are relevant to current discussions about the potential consequences of U.S. disengagement from global geopolitical affairs, suggesting that such a move could increase U.S. long-term interest rates. The research employs a panel data set, instrumental variable strategy, and various econometric models to test the hypotheses, ultimately concluding that both economic and geopolitical factors significantly influence international currency choice.

Issues (threats and opportunities)

• Geopolitical Influence on Currency Choice. Military alliances significantly increase the share of a currency in a country's foreign reserves, indicating that geopolitical considerations play a crucial role.
• Economic Size and Credibility. Larger economies with credible monetary policies tend to have their currencies held as reserves, showing that economic fundamentals are also important.
• Impact of U.S. Disengagement. A hypothetical U.S. withdrawal from global geopolitical affairs could raise U.S. long-term interest rates by up to 80 basis points, due to a shift in global reserve compositions.
• Security Premium. The U.S. benefits from a security premium on its dollar due to its role as a global security provider, which lowers its borrowing costs.
• Historical Context. The period before World War I offers a unique context where both economic and geopolitical factors influenced currency choices, providing valuable insights for contemporary analysis.
• Data Limitations. The sensitivity and confidentiality of modern foreign reserve data limit the ability to build large and representative samples for current analysis.
• Instrumental Variable Strategy. The study addresses endogeneity using diplomatic representation as an instrument, enhancing the robustness of its findings on geopolitical influences.
• Policy Implications. The findings suggest that geopolitical stability and alliances are critical for maintaining the international role of a currency, with implications for current U.S. and global policies.
• China's Role. As China gains global influence, the renminbi's international role could expand, supported by China's geopolitical strategies.
• European Cooperation. Enhanced European cooperation in security and defense could bolster the euro's international standing, emphasizing the interplay between economic integration and geopolitical stability.

Methodology

The authors utilize a panel data set covering the foreign exchange reserves of 19 countries from 1890 to 1913, distinguishing five reserve currencies: sterling, French franc, German mark, U.S. dollar, and Dutch guilder. They employ an instrumental variable strategy to address endogeneity, using diplomatic representation data to measure geopolitical influence. The study also uses various econometric models, including ordinary least squares, two-stage least squares, and panel tobit estimators, to test the Mercury and Mars hypotheses, while controlling for economic size, credibility, trade relations, and financial depth.

Results

The study finds that both economic and geopolitical factors significantly impact the choice of international reserve currencies. Specifically, military alliances can increase the share of a partner's currency in a country's foreign reserves by approximately 30 percentage points. Additionally, the credibility of a country's monetary policy, as indicated by its adherence to the gold standard, positively influences its currency's share in global reserves. Larger economies also tend to have their currencies held as reserves, though the statistical significance of this factor varies.

Furthermore, the study employs an instrumental variable approach using diplomatic representation to address endogeneity issues. This robust analysis confirms the substantial role of geopolitical factors in international currency choice. The findings suggest that both economic fundamentals and strategic geopolitical relationships are crucial determinants of a currency's international standing.

Implications

The key results of this study have significant implications for policymakers, investors, and international relations. For policymakers, the findings highlight the importance of maintaining strong geopolitical alliances to support the international role of their currency. For instance, U.S. disengagement from global security commitments could lead to higher long-term interest rates and reduced demand for the dollar as a reserve currency.

Investors can use these insights to better understand the factors influencing currency stability and make more informed investment decisions. Countries seeking to enhance their currency's international role should not only focus on economic policies but also strengthen their geopolitical ties. This dual approach can help them secure a larger share of global reserves and enjoy the associated economic benefits.

Research Questions

1. How do shifts in military alliances affect the composition of international reserves in the short and long term?
2. What specific geopolitical factors (beyond military alliances) have the most significant impact on the choice of reserve currencies?
3. How does the economic size of a reserve currency issuer correlate with changes in the currency composition of international reserves?
4. What are the key indicators of credibility that influence a country's choice of reserve currencies?
5. What are the potential economic consequences of U.S. disengagement from global geopolitical affairs on global reserve currency compositions?
6. How would changes in global reserve currency compositions impact U.S. long-term interest rates?
7. How does the presence of a security premium benefit the issuer of a reserve currency?
8. What would be the estimated economic impact on the U.S. if the security premium on the dollar were reduced?
9. How did geopolitical factors before World War I influence the stability and choice of reserve currencies?
10. What lessons from the pre-World War I era can be applied to current global economic policies?
11. What methods can be used to improve the transparency and availability of modern foreign reserve data?
12. How do current limitations in data availability affect the accuracy of research on international reserve compositions?
13. How effective are instrumental variable strategies in addressing endogeneity in economic research?
14. What alternative methods could be used to assess the impact of geopolitical factors on currency choice?
15. What policy measures can be implemented to enhance the credibility of a country's currency as a reserve option?
16. How can international cooperation and alliances be leveraged to support a currency's international role?
17. What geopolitical strategies is China employing to promote the renminbi as an international reserve currency?
18. How effective have China's geopolitical efforts been in increasing the global adoption of the renminbi?
19. How can enhanced European cooperation in security and defense impact the international standing of the euro?
20. What are the potential economic benefits for Europe if the euro gains a larger share of global reserves?

Five Key Research Needs

1. What are the potential economic consequences of U.S. disengagement from global geopolitical affairs on global reserve currency compositions? Understanding the potential shifts in global reserve currency compositions is crucial for anticipating economic impacts. This knowledge can guide policymakers in making informed decisions to mitigate adverse effects on global financial stability and U.S. economic interests.
2. What geopolitical strategies is China employing to promote the renminbi as an international reserve currency? Analyzing China's strategies provides insights into the mechanisms through which geopolitical influence can enhance a currency's international role. This understanding can inform other countries' approaches to increasing their currency's global presence.
3. How does the presence of a security premium benefit the issuer of a reserve currency? Investigating the benefits of a security premium helps quantify its economic advantages, offering a clearer picture of the incentives for maintaining strong geopolitical alliances. This can support arguments for sustained or enhanced security commitments.
4. What policy measures can be implemented to enhance the credibility of a country's currency as a reserve option? Identifying effective policy measures can help countries improve their currency's credibility, making it a more attractive option for international reserves. This has direct implications for economic policy and international financial relations.
5. How did geopolitical factors before World War I influence the stability and choice of reserve currencies? Historical analysis offers valuable lessons that can be applied to contemporary economic and geopolitical strategies. Understanding past influences helps predict future trends and inform current policy decisions..