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The Dollar: Dominant no more?

Barry Eichengreen

If the euro’s crisis has a silver lining, it is that it has diverted attention away from risks to the dollar. It was not that long ago that confident observers were all predicting that the dollar was about to lose its “exorbitant privilege” as the leading international currency. First there was financial crisis, born and bred in the US. Then there was the second wave for quantitative easing, which seemed designed to drive down the dollar on foreign exchange markets. All this made the dollar’s loss of pre-eminence seem inevitable.

The tables have turned. Now it is Europe that has deep economic and financial problems. Now it is the European Central Bank that seems certain to have to ramp up its bond-buying program. Now it is the Eurozone where political gridlock prevents policymakers from resolving the problem.

In the US meanwhile, we have the extension of the Bush tax cuts together with payroll tax reductions, which amount to a further extension of the expiring fiscal stimulus. This tax “compromise”, as it is known, has led economists to up their forecasts of US growth in 2011 from 3% to 4%. In Europe, meanwhile, where fiscal austerity is all the rage, these kind of upward revisions are exceedingly unlikely.

All this means that the dollar will be stronger than expected, the euro weaker. China may haves made political noises about purchasing Irish and Spanish bonds, but which currency – the euro or the dollar – do you think prudent central banks will it find more attractive to hold?

What about the alternatives?

There are of course a variety of smaller economies whose currencies are likely to be attractive to foreign investors, both public and private, from the Canadian loonie and Australian dollar to the Brazilian real and Indian rupee. But the bond markets of countries like Canada and Australia are too small for their currencies to ever play more than a modest role in international portfolios.

Brazilian and Indian markets are potentially larger. But these countries worry about what significant foreign purchases of their securities would mean for their export competitiveness. They worry about the implications of foreign capital inflows for inflation and asset bubbles. India therefore retains capital controls which limit the access of foreign investors to its markets, in turn limiting the attractiveness of its currency for international use. Brazil meanwhile has tripled its pre-existing tax on foreign purchases of its securities. Other emerging markets have moved in the same direction.

China is in the same boat. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. Yet this has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. Nor has it prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use.

So the dollar is here to stay, more likely than not, if only for want of an alternative.

With exorbitant privilege comes exorbitant responsibility

The one thing that could jeopardise the dollar’s dominance would be significant economic mismanagement in the US. And significant economic mismanagement is not something that can be ruled out.

The Congress and Administration have shown no willingness to take the hard decisions needed to close the budget gap. The Republicans have made themselves the party of no new taxes and mythical spending cuts. The Democrats are unable to articulate an alternative. 2011 will see another $1 trillion deficit. It is hard to imagine that 2012, an election year, will be any different. And the situation only deteriorates after that as the baby boomers retire and health care and pension costs explode.

We know just how these kind of fiscal crises play out, Europe having graciously reminded us. Previously sanguine investors wake up one morning to the fact that holding dollars is risky. They fear that the US government, unable to square the budgetary circle, will impose a withholding tax on treasury bond interest – on treasury bond interest to foreigners in particular. Bond spreads will shoot up. The dollar will tank with the rush out of the greenback.

The impact on the international system would not be pretty. The Canadian and Australian dollar exchange rates would shoot through the roof. A suddenly strong euro would nip Europe’s recovery in the bid and plunge its economy back into turmoil. Emerging markets like China, reluctant to see their exchange rates move, would see a sharp acceleration of inflation and respond with even more distortionary controls.

With exorbitant privilege comes exorbitant responsibility. Responsibility for preventing the international monetary and financial system from descending into chaos rests with the US. How much time does it have? Currency crises generally occur right before or after elections. Can you say November 2012?

Cross-posted from VoxEU.org.

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Comments to "The Dollar: Dominant no more?":
    • Mark Nyman

      The tables haven’t turned, we are all in this Depression together. Even if the U.S. is the leader.

      The US Dollar is still the global senior currency, because it is by far the most built in, to implementations of monetary transactions. It is built into the most contracts, computer code, office procedures, treaties, etc., of any currency. It would be a Herculean effort to dig it out and replace it.

      All these events related to the Financial Crisis which began in 2007, are all but symptoms of the Depression which began around May 2007. When Private Sector interest rates began heading toward minus infinity, plunging below that of the Fed. The Implementation won’t make it to minus infinity.

      If it wasn’t those specific events, it would be others perfuming the same sub-Functions of the Depression.

      A Depression is not the multi-step trailing symptom of a dramatically slowing Economy, as Economists think.
      A Depression is the operational reversal of the Primary Function the Monetary System is designed and built to do.

      Which is a simple Bi-Modal Positive Feedback Loop between the two types of Money. Once the Private Sector is allowed to issue US Dollar Credit, just like the Fed, and to create Monetary Assets. (Same in other currencies )

      Ever more Credit is created and rented out ( most in the form of leverage), to buy and inflate ever more Asset Valuation. Both of which are Money. (Remember, Money is Math. Anything which functions the same, is the same.)

      Being a Bi-Modal Function, it can operate in the Monetary Inflation Mode. Driving the quantity of both types of Money toward plus infinity.
      It can operate in the Monetary Deflation Mode. Driving the quantity of both types of Money toward minus infinity.

      The controlling factor between the two operational modes is the relationship between the available cost of renting Credit and the Monetary Inflation-Deflation Threshold. Which is the maximum cost of renting Credit, that makes borrowing and buying inflating Assets worth it.

      As the Monetary System becomes ever more insolvent, the Monetary Inflation-Deflation Threshold heads ever lower. Passing through below zero in 2008. (It’s now at about -3.5% and falling.)

      Since then, Central Banks have fortunately provided negative effective interest for new Credit to get below the falling Threshold. Thereby maintaining Monetary Inflation in the Private Sector for the wealthier. (QE is the same as offering sufficiently negative interest for new Credit, that the Private Sector would take it and buy the same Assets.)

      During the Monetary Inflation Mode, the Implementation of doing it can’t make it to infinity
      So at some point, the Monetary System finds itself in the Monetary Deflation operational mode (May 2007 )

      Of course the implementation of the Deflation mode also halts at some point.
      When all Money or all Monetary Machinery is destroyed.

      During the Monetary Deflation operational mode, the Total Money Supply implodes (starting from $1000 Trillion this time )
      Causing insolvencies
      Causing Monetary Transactions to stop
      Causing Economic Transactions to stop which Economists think is the Depression

      Explained in The Math Bomb
      And soon Watching The Math Bomb in Real-time

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    • Alex

      If we want to go to Europe next summer, when is the best time to make reservations with a U.S. credit card? When does the credit card co. convert the hotel charge from Euro to dollar–when you make the reservation or later? Should we try to time making the reservations to the projected strength of the dollar? When is the dollar projected to be strongest against the Euro in the next 6 months?

      [Report abuse]

    • Pierre

      This is a complex situation but we’ll soon have to take important decision if we want the money to serve the industry. The issue is the same for dollar and euro… wait and see !

      [Report abuse]

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