Dec 2nd 2004
From The Economist print edition
How long can it remain the world's most important reserve currency?
THE dollar has been the leading international currency for as long as most people can remember. But its dominant role can no longer be taken for granted. If America keeps on spending and borrowing at its present pace, the dollar will eventually lose its mighty status in international finance. And that would hurt: the privilege of being able to print the world's reserve currency, a privilege which is now at risk, allows America to borrow cheaply, and thus to spend much more than it earns, on far better terms than are available to others. Imagine you could write cheques that were accepted as payment but never cashed. That is what it amounts to. If you had been granted that ability, you might take care to hang on to it. America is taking no such care, and may come to regret it.
The cost of neglect
The dollar is not what it used to be. Over the past three years it has fallen by 35% against the euro and by 24% against the yen. But its latest slide is merely a symptom of a worse malaise: the global financial system is under great strain. America has habits that are inappropriate, to say the least, for the guardian of the world's main reserve currency: rampant government borrowing, furious consumer spending and a current-account deficit big enough to have bankrupted any other country some time ago. This makes a dollar devaluation inevitable, not least because it becomes a seemingly attractive option for the leaders of a heavily indebted America. Policymakers now seem to be talking the dollar down. Yet this is a dangerous game. Why would anybody want to invest in a currency that will almost certainly depreciate?
A second disturbing feature of the global financial system is that it has become a giant money press as America's easy-money policy has spilled beyond its borders. Total global liquidity is growing faster in real terms than ever before. Emerging economies that try to fix their currencies against the dollar, notably in Asia, have been forced to amplify the Fed's super-loose monetary policy: when central banks buy dollars to hold down their currencies, they print local money to do so. This gush of global liquidity has not pushed up inflation. Instead it has flowed into share prices and houses around the world, inflating a series of asset-price bubbles.
America's current-account deficit is at the heart of these global concerns. The OECD's latest Economic Outlook predicts that the deficit will rise to $825 billion by 2006 (6.4% of America's GDP) assuming unchanged exchange rates. Optimists argue that foreigners will keep financing the deficit because American assets offer high returns and a haven from risk. In fact, private investors have already turned away from dollar assets: the returns on investments in America have recently been lower than in Europe or Japan (see article). And can a currency that has been sliding against the world's next two biggest currencies for 30 years be regarded as “safe”?
In a free market, without the massive support of Asian central banks, the dollar would be far weaker. In any case, such support has its limits, and the dollar now seems likely to fall further. How harmful will the economic consequences be? Will it really undermine the dollar's reserve-currency status?
Periods of dollar decline have often been unhappy for the world economy. The breakdown of Bretton Woods that led to a weaker dollar in the early 1970s was painful for all, contributing to rising inflation and recession. In the late 1980s, the falling dollar had few ill-effects on America's economy, but it played a big role in inflating a bubble in Japan by forcing Japanese authorities to slash interest rates.
This time round, it is a bad sign that everybody is trying to point the finger of blame at somebody else. America says its external deficit is mainly due to sluggish growth in Europe and Japan, and to the fact that China is pegging its exchange rate too low. Europe, alarmed at the “brutal” rise in the euro, says that America's high public borrowing and low household saving are the real culprits.
There is something to both these claims. China and other Asian economies should indeed let their currencies rise, relieving pressure on the euro. It is also true that Asia is partly to blame for America's consumer binge: its central banks' large purchases of Treasury bonds have depressed bond yields, encouraging households in the United States to take out bigger mortgages and spend the cash. And Europe needs to accept, as it is unwilling to, that a weaker dollar will be a good thing if it helps to shrink America's deficit and curb the risk of a future crisis. At the same time, Europe is also right: most of the blame for America's deficit lies at home. America needs to cut its budget deficit. It is not a question of either do this or do that: a cheaper dollar and higher American saving are both needed if a crunch is to be avoided.
Simple but harsh
Many American policymakers talk as though it is better to rely entirely on a falling dollar to solve, somehow, all their problems. Conceivably, it could happen—but such a one-sided remedy would most likely be far more painful than they imagine. America's challenge is not just to reduce its current-account deficit to a level which foreigners are happy to finance by buying more dollar assets, but also to persuade existing foreign creditors to hang on to their vast stock of dollar assets, estimated at almost $11 trillion. A fall in the dollar sufficient to close the current-account deficit might destroy its safe-haven status. If the dollar falls by another 30%, as some predict, it would amount to the biggest default in history: not a conventional default on debt service, but default by stealth, wiping trillions off the value of foreigners' dollar assets.
The dollar's loss of reserve-currency status would lead America's creditors to start cashing those cheques—and what an awful lot of cheques there are to cash. As that process gathered pace, the dollar could tumble further and further. American bond yields (long-term interest rates) would soar, quite likely causing a deep recession. Americans who favour a weak dollar should be careful what they wish for. Cutting the budget deficit looks cheap at the price.