Insights & Advice

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The Dollar Debate

Every now and then the topic of replacing the dollar as the world’s reserve currency tends to hit the front page. The subject has come up yet again over the last few weeks largely prompted by a Chinese Central Bank proposal. The proposal by Zhou Xiaochuan, Governor of the People’s Bank of China, would be to eventually replace the dollar as the world’s reserve currency in favor of a super-sovereign reserve currency.

The U.S. press immediately interpreted that as another Chinese attack on the dollar in the on-going U.S./China currency feud. Our government (as well as many others) maintains that the Chinese keep their currency at an artificially low level in order to promote the sale of Chinese exports worldwide. The Chinese, who link their currency to the value of the U.S. dollar, deny this.

So, you might ask, what is the big deal about having the greenback maintain its role as the world’s reserve currency? By definition, a reserve currency is a currency that is held by central banks and other major financial institutions worldwide as a means to pay off international debt obligations, or to influence their own domestic exchange rates.

For example, most commodities, including oil, are priced in U.S. dollars. So when the U.K. imports 50 million barrels of oil they must pay the seller in the going U.S. dollar equivalent price for that oil. They can pay in their own currency, and often do, but if the pound is weaker than the dollar it’s going to cost the Brits more to buy that oil then if the dollar were weaker versus the pound.

At the same time, if you want to export more televisions to America you might want to devalue your currency versus the greenback, thereby making the price of your goods cheaper for Americans to buy, which is what the Japanese have been doing for over a century and the Chinese are doing now.

The dollar’s status as a reserve currency has given the United States some key advantages. For one, we can run up big deficits, which the rest of the world is forced to finance. It’s like my borrowing $100 off you (my deficit) and promising to pay you back in Monopoly money, only I get to set how much each monopoly dollar is worth. If I suddenly decide to drop the price of a Monopoly dollar to 50 cents, guess what happens to the hundred bucks I owe you. Multiply that by trillions of dollars of debt held by our foreign neighbors and you get the picture.

We’ve been spending more than we’ve earned since WWII and have gotten away with it because all we need do is allow our currency to devalue against other currencies and continue spending. It is one of the reasons the dollar declined as much as it did over the last few years. Of course, these advantages, if abused too long and too often, will backfire on us. It was partially the reason that the British Pound, preeminent in the 18th and 19th centuries as the world’s reserve currency, lost its crown to the Yankee dollar in the beginning of the 20th Century.

Clearly, the last two plus years has seen our deficits skyrocket even higher as the government pumped huge amounts of dollars into the system to avert a financial catastrophe. Other nations, who hold vast amounts of U.S. dollar-denominated debt and currency, are concerned that the American government will continue to grow their deficit while allowing the value of the dollar to decline even more. So rather than take that risk, China and an increasing number of other nations are clamoring for the creation of an alternative currency or a basket of several currencies to act as a reserve for the world. This is nothing new. Back in 1944, John Maynard Keynes advocated a global currency at the Bretton Woods conference. It was at that conference that the International Monetary Fund was created. Keynes wanted the IMF to issue the Bancor, his name back in the day for a super-sovereign currency.

Although it was only created in 2002, the Euro, the European Communities’ currency, has already claimed the number two spot as a world reserve currency. It has been a slow, steady shift from U.S. dollars to Euros and it continues today. According to the IMF’s latest quarterly tally of all Central Bank foreign exchange holdings, the largest allocation is still the U.S. dollar at 62.1%, with 27.4% committed to the Euro. Much smaller allocations are held in the Pound sterling, Japanese yen and Swiss franc.

In my opinion, the main historical determinant of whose currency acts as a reserve is largely dependent upon the economic strength of the underlying country. Britain’s global supremacy during the Pax Britannia Era, where its navy controlled most of the trading lanes of the world and its industrial economic power was second to none, ensured the pound’s reign as the reserve currency for over two hundred years.

To me, it is no accident that the U.S. dollar assumed that role as our own economy and military power came to the forefront. Only now is our economic hold on the global economy being challenged. The creation of the European Economic Community combined with the growing strength of some developing nations like China, India and Brazil may make a basket of currencies approach to a reserve currency a possibility.

However, the “safe haven” value of the U.S. dollar as a reserve currency has not diminished. Every time something unsettling occurs around the world from earthquakes to the Greek sovereign debt problem, it’s the greenback that investors buy. Until other countries take up the challenge and begin to share our role as the world’s political leader as well as the world’s policeman, I don’t think any serious attempt at another form of reserve currency will get much beyond the talking stage.

Posted in A Few Dollars More, Macroeconomics