The future of the dollar: currency challenges in a globalized world.

Steil, Benn

"They get our oil and give us a worthless piece of paper," exclaimed Mahmoud Ahmadinejad at an OPEC summit in November 2007. Unkind words about the American currency from an Iranian president could normally be dismissed as political bluster, but in this case it was bluster with a disturbing kernel of truth to it. Over the course of 2007, states with large dollar holdings were becoming increasingly fearful about the dollar's long-term global purchasing power, but they simply had less incentive to sound the alarm about it.

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A dollar was once redeemable for a fixed amount of precious metal, but has for four decades now been redeemable only for near-worthless metal--pennies, nickels, dimes, and quarters. It is valuable only to the extent that vast numbers of people believe that vast numbers of other people will continue, of their own volition, to exchange intrinsically valuable things for it. Should this confidence evaporate, the dollar is truly just "a worthless piece of paper."

It is hard to imagine that this confidence could be fatally undermined any time soon. History, however, does not provide kind testimony to the durability of national monies. Many dozens of them lost more than half of their purchasing power between 1950 and 1975 alone--including the dollar, which lost 57 percent.

The Iranian president was not alone, however, in disparaging the dollar on the world stage in autumn 2007. The dollar is "losing its status as the world currency," Xu Jian, a Chinese central bank vice director, told a conference in Beijing on November 7. "We will favor stronger currencies over weaker ones, and will readjust accordingly," said Cheng Siwei, vice chairman of China's National People's Congress, at the same meeting. Their concerns were echoed two weeks later by Chinese premier Wen Jiabao. "We have never been experiencing such big pres-sure," Wen said. "We are worried about how to preserve the value of our [US$1.5 trillion in] reserves."

On the same day as Xu and Cheng's comments, the price of gold climbed to US$833.50 per ounce, a record high in nominal terms (though in real terms still substantially below its peak in the early 1980s). Oil prices leapt to a record high US$98 a barrel. The stock market tumbled. The ABX indexes tied to high-risk mortgages fell sharply. The newswires also reported an estimate that US banks would have to write down as much as US$600 billion as a result of the housing market bust and the associated collapse of the Structured Investment Vehicle (SIV) markets. Last but not least in the parade of worrying economic news, the dollar fell to a record low 1.46 dollars/euro, down more than 75 percent from its high in 2000.

Teasing out cause and effect at any given moment is never simple in financial markets, but the signs are recognizable from the 1960s. Like China and the dollar-saturated Persian Gulf states today, European governments made similar remarks in the '60s about the reliability of the dollar as a store of value--just a few years before President Nixon demonetized gold in order to pre-empt a run on America's dwindling gold stock. In the private markets, the illustrious French economist Jacques Rueff noted that people were turning to "tangible goods, gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity or the demand for them." Sound familiar? Indeed, this is the story of our decade to date. In the 1960s, Rueff pinned the blame squarely on "the growing insolvency" of the dollar. Then, as today, US monetary policy was spreading inflation to countries importing such policy through fixed exchange rates, encouraging them to seek out other more reliable long-term stores of wealth.

Today, of course, foreign governments are not asking the United States for their gold back, as it reneged on its redemption pledge long ago. But they are warning that they will begin exchanging their growing hoards of dollars for other currencies and assets. Even a gradual diversification would mark the coming of a new age in international monetary relations. It would end the age of what Rueff called "the precarious dominance of the dollar" in the global monetary markets.

Financial Globalization

During the life of the Bretton Woods system, up until the early 1970s, capital flowed across borders mainly to settle current account deficits, in such a way that current account transactions largely determined capital flows. This has changed in recent decades with the globalization of finance.

According to the McKinsey Global Institute, the sum of international financial assets and liabilities owned and owed by residents of high-income countries leapt from 50 percent of aggregate GDP in 1970 to 100 percent in the mid-1980s to 330 percent in 2004. I calculate that one part of the international capital flows of the United States, total trade in long-term securities, increased from US$373 billion in 1982 to US$52.1 trillion in 2006, while total US trade in goods and services only increased from US$575 billion to US$3.65 trillion in the same period. Therefore, this portion of capital flows is now more than fourteen times the dollar volume of US trade in goods and services. Most of these capital flow transactions are autonomous, in the sense that they are not carried out to finance current account deficits. Instead, they take place as part of an ongoing worldwide diversification of investment.

Private capital entering the United States declined sharply with the collapse of the dot-coms in the early part of this decade. Yet the vacuum left by the evaporating private inflows was filled with foreign official capital inflows, most of it owned by central banks. They were invested primarily in US Treasury bonds, which in terms of risk are similar to those issued by governments of other major countries, such as Germany, France, or the United Kingdom. Yet the yields paid on US securities, when adjusted for persistent dollar depreciation, have been consistently lower than those paid on securities issued by these other governments.

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Worldwide reserves denominated in all international currencies increased from a US$2 trillion equivalent to a US$5.7 trillion equivalent from 2001 to 2006. About 60 percent of the increment, or about US$2.2 trillion, was denominated in dollars. The total increase in reserves was equivalent to 178 percent of the total level of reserves in 2001. Central banks of developing countries account for 82 percent of this increase, mostly owing to exports of oil, other commodities, and, in the case of Asia, non-commodity goods and services. They more than doubled their reserves between 2004 and 2007, to what the IMF estimates as US$4.1 trillion.

Why have central banks been willing to accumulate such historically unprecedented levels of dollar assets? Two main motivations are apparent, and they are not mutually exclusive. The first is that the Asian currency crisis of 1997-98 taught governments that they needed huge war chests of dollars to ward off potential runs on their domestic currencies. The alternative--going begging to the IMF and US Treasury in times of crisis--is now considered politically and economically unacceptable. The second is mercantilism: by keeping their currencies pegged to the dollar at a rate below that which the market would establish, governments believe they are helping their exporters. This strategy leads to a continuous net inflow of dollars. Both of these strategies lead to the need for the central bank to sterilize the inflow in order to keep it from generating domestic inflation, which works like this: (1) the US sends dollars to, say, Chinese exporters for their goods; (2) the exporters send the dollars to the Chinese central bank for renminbi; (3) the central bank sends the dollars back to the US for treasury bills and removes the excess renminbi from the Chinese economy by selling government bonds. If the central bank cannot sell enough bonds, inflation accelerates, as witnessed in 2007.

Over the course of this decade, the burden of keeping the global monetary markets stable has fallen on these foreign central banks, which tend to be in developing countries. And they are certainly not holding on to the dollars for the sake of global stability, but to serve their own domestic purposes. We should therefore expect a change in their calculation as to what dollar accumulation policy serves their interests if inflation and dollar depreciation continues to erode their wealth.

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The exchange rate of the dollar relative to the euro has, since the euro's creation in 1999, been closely associated with the geometric ratio of the nominal interest rates set by the Fed and the European Central Bank (ECB). This is consistent with the structural change that the international economy has been undergoing over the last several decades: namely, that capital flows, rather than trade flows, are increasingly determinant in the balance of payments and, therefore, in their macroeconomic impact. That is, when the Fed lowers dollar interest rates relative to those of, say, the Eurozone, demand for dollars falls because dollar-denominated financial instruments pay lower yields relative to euro-denominated instruments. Similarly, when US interest rates rise, the demand for dollars increases as well. This relationship has broken down since the onset of the virulent global credit crunch last summer, which led to a massive repatriation of US private capital seeking the safety of Treasury bonds. Yet if the large gap between inflation-adjusted euro yields and dollar yields persists, it is likely only a matter of time before the euro resumes its climb.

The Euro as Understudy

Could the euro fill the global gap should the dollar fall victim to a crisis of confidence? No other currency enjoys the breadth of use that would be necessary to do so.

The creation of the euro and the growth of worldwide confidence in it since 1999 is a remarkable achievement. Many prominent political and economic commentators had argued in the 1990s that the euro was either impossible or doomed to quick failure. One (Martin Feldstein) even suggested it could lead to war. Such was the power of the belief in the economic and political importance of the bond between money and national sovereignty.

Yet the dollar has, since the euro's creation, shown remarkable resilience. One might have expected the role of the dollar in the international monetary and financial marketplace to decline in tandem with its depreciation since 2001. The share of the dollar in central bank reserves has fallen by about seven percent since 2001, yet its share in mid-2 007 was still noticeably higher than in 1995. The share of the dollar in the long-term debt of developing countries has also increased in the last few years. By 2006 it was around 64 percent, almost the same as its share in central bank reserves. On the flip side of the ledger, the share of the appreciating euro in central bank reserves was slightly lower than that of its component currencies in 1995. There has been no general uptrend in non-Eurozone use of the euro, in trade invoicing or debt issuance, in recent years. Ten to fifteen percent of euros in circulation are held abroad, compared with 60 percent of US dollars. These figures illustrate the considerable staying power of an international currency.

Chinese and OPEC-nation officials who have expressed public concern about the dollar's erosion might wish that their reserve holdings were more heavily euro-weighted, but they have little incentive to initiate a significant diversification. This would put further downward pressure on the dollar, thus driving down the international purchasing power of their reserves even further. Having said this, no one involved in a Ponzi scheme wants to precipitate its collapse, yet Ponzi schemes invariably do collapse. People sell when they expect others will otherwise sell first. The United States cannot, therefore, afford to be insouciant regarding foreigners' views of the dollar as a long-term store of value. Whereas tremendous network externalities support an incumbent international currency (people use a currency because others use it), once a tipping point is reached the shift from one currency to another can be very rapid. As late as 1940, the level of foreign-owned liquid pound sterling assets was still double the level of foreign-owned liquid dollar assets. Yet by 1945 this statistic had reversed. Sterling never regained its luster.

So, could the euro overtake the dollar as the leading international currency? Menzie Chinn and Jeffrey Frankel investigated one aspect of this question: use of the euro as a central bank reserve currency. Applying a regression analysis based on past macroeconomic data, they show, consistent with our discussion above, that the dollar's future performance in terms of inflation and depreciation are the critical variables. If the dollar were, going forward, to depreciate at the broadly measured 3.6 percent annual rate it experienced from 2001-2004, while the euro appreciated at the 4.6 percent rate of this period, the euro would overtake the dollar as the leading reserve currency around 2024. If the UK were to adopt the euro, however, the euro would overtake the dollar approximately four years earlier, around 2020.

Statements from the ECB and the Fed in late 2007 also appeared to indicate a stronger commitment from the former to inflation-fighting going forward: with inflation at 3.1 percent in the Eurozone and 4.3 percent in the United States, the ECB was warning of higher interest rates to push down inflation while the Fed was signaling lower rates to prevent recession. (To put the inflation numbers into context, in July 1971, a month before President Nixon imposed price controls and suspended convertibility of the dollar into gold, US inflation was 4.4 percent--only 0.1 percent higher than in November 2007.) For the first time since the ECB's creation, the ECB's "single mandate," price stability, stood in both stark philosophical and practical contrast to the Fed's "dual mandate," price stability and maximum employment. The ECB's stronger stance on maintaining purchasing power is apt to engender increased international confidence in the euro as a store of value, at least relative to the dollar.

There are good reasons, however, to be doubtful about the euro's prospects as a much more significant international currency. The first is that it would require a degree of economic adaptation that Eurozone members are unlikely to embrace. A growing demand for euros internationally means growing Eurozone current account deficits and euro appreciation, both of which Eurozone politicians are likely to counter with increased protectionism and confidence-jarring political pressure on the ECB. Recent episodes of economic stress have evoked concern in Italy and elsewhere about the euro's contributory role, raising questions about the durability of the political commitment to monetary union across the Eurozone. The second reason is that if international confidence in the dollar were to be mortally compromised, it is far from clear that the euro would effectively address the world's concerns. The ECB, after all, has never in its history actually hit its inflation benchmark of "close to but below two percent." Furthermore, when Moody's in January 2008 declared the United States' triple-A credit rating "under threat," it referred to soaring government commitments on healthcare and retirement spending With an aging population and comparably ominous long-term government spending commitments, the Eurozone as yet offers no clear promise of superior long-term monetary and fiscal outcomes.

The Importance of Sustaining the Dollar

The period of the 1990s through the early years of the new millennium was a golden age for the fiat US dollar. Following on the heels of the Volcker Fed's defeat of infla-tion expectations in the 1980s, investors around the globe bought up dollar-denominated assets and central banks sold off their gold reserves, believing they were no longer necessary or desirable. This allowed not only the United States, but the world, to enjoy the fruits of a sustained period of low interest rates and low inflation.

The soaring commodities prices which accompanied the Bernanke Fed's slashing of interest rates in late 2007 and early 2008 reflected rising concerns of a collapsing fiat currency bubble. People were looking, as they have for the better part of human history, to hard assets as a store of wealth. Monetary psychology was reverting to its historic norm. Once the transatlantic banking and credit crisis eases, this shift, if not short-circuited by a sustained period of Fed monetary tightening, will become entrenched and globally traumatic. A further soaring euro cannot fill the breach without provoking a major European protectionist backlash that will undermine the euro's political sustainability. And emerging private monetary alternatives--like digital gold banks, which use shares in gold bars as cur- rency, and which grew rapidly in tandem with the dollar's decline against gold--will clash head on with ever more intrusive state efforts to criminalize them.

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The best hope for salvaging financial globalization, then, is a renewed statutory framework for the Fed, one which explicitly acknowledges the global role of the dollar and the dependence of the American economy on foreign confidence in it. This would no doubt lead to very different Fed behavior when faced not only with rising inflation, but with evidence of persistent dollar selling in favor of alternative monetary assets, like gold. Without foreign confidence in a dollar which is used globally, the Fed's ability to guide interest rates, control inflation, and contain financial crises domestically will dissipate to the point where its sovereignty is meaningless. What Charles de Gaulle once called America's "exorbitant privilege," printing the world's reserve asset, is one which America will in the future have to do far more to sustain.

Benn Steil is senior fellow and director of international economics at the Council on Foreign Relations. This article draws heavily on the author's forthcoming book with Manuel Hinds, Money, Markets and Sovereignty (Yale University Press, 2009).