Part of the job description of the Treasury secretary is to declare at every opportunity that it is in the interest of the United States to maintain a strong dollar and preserve the dollar as the world’s reserve currency. To do otherwise would risk triggering a run on the dollar and a tidal wave of political denunciation.
If, however, you were to administer truth serum to the recent occupants of 1500 Pennsylvania Ave., my guess is that they would acknowledge that the dollar is in long-term decline that is inevitable and economically desirable. The question is whether the retreat of the dollar will be gradual and orderly, or sudden and disorderly.
Why inevitable? To begin, it is worth remembering that the hegemony of the dollar was a result of two world wars that left most of our competitors in ruins and part of the world in thrall to a communist ideology that turned out to be folly.
Nearly a century later, a peaceful and revitalized Europe has begun to integrate into a large, unified economy. Its currency and financial markets are finally in a position to rival ours.
Just as significantly, developing countries in Asia and South America are in the midst of an unprecedented economic catch-up that will mean their output and productivity will grow much faster than those of advanced countries. Economic theory and history suggests that their currencies will rise as well.
Those unmistakable trends explain why just about every big corporation and lots of smart investors are busy shifting money to developing economies. Americans will profit two ways: the success of their investments, plus the bump they’ll get when converting those profits into deflated dollars.
In the nearer term, it’s a good bet that the dollar will decline as the global economy finally corrects for the massive imbalance that developed over the past 15 years between the United States and China, Taiwan and other Asian nations that artificially pegged their currencies to the dollar. The result of this currency manipulation and mispricing is too much debt-fueled consumption in the United States and too much production and reserve accumulation in the China bloc.
Now these macroeconomic imbalances have reached a tipping point. Here in the United States, they are generating intense deflationary pressures that manifest in falling real estate prices, stagnant wages and high unemployment, which require huge amounts of fiscal and monetary stimuli to offset. In Asia, it is the opposite — strong inflationary pressures are driving up wages, prices and real estate values and other financial assets, requiring increasingly heavy-handed regulation of lending and investment.
The practical effect of all this deflation and inflation is to accomplish what a straightforward exchange-rate adjustment would: Raise the relative price of Chinese goods while lowering the price of U.S. goods. The side effects from this type of backdoor adjustment, however, have become so distorting and risky that it is only a matter of time before the dollar is allowed to fall against these Asian currencies.
I realize that these kinds of discussions about currencies and macroeconomic imbalances can make your head hurt if you dwell on them for very long. But it turns out they are at the heart of most of the economic issues we’re dealing with, from budget battles to the euro crisis to the rising price of gasoline.
“All these discrete national problems are really manifestations of a global financial crisis and the failure to manage the global economy,” former British prime minister Gordon Brown said in a brilliant speech this month in Bretton Woods, N.H.
It was at Bretton Woods in 1944 when Britain’s John Maynard Keynes and the United States’s Harry Dexter White conjured up the financial architecture for the global economy that served the world rather well from the end of World War II through the early 1980s. Since then, its shortcomings have been revealed by a series of financial crises that have become more severe and more frequent, with the fixes for one planting the seeds for the next.
Despite the best efforts of world leaders, a new and better architecture has proven elusive. At the center of that 1944 architecture, of course, was the U.S. dollar, which since has been the overwhelming currency of choice for central banks around the world for settling international obligations and managing exchange rates.
The preference for the dollar reflects not only confidence that it is a reliable store of value but also that it can easily be invested in a government bond market big enough that large amounts of cash can be moved in and out quickly, reliably and cheaply.
The dollar is used worldwide as the agreed-upon unit of exchange by producers and traders to price oil, minerals and other commodities. Ditto illicit dealers in drugs, weapons and other contraband.
Because it is the currency most easily exchanged, the dollar is on one side or the other of 85 percent of the transactions on global currency exchanges. When Indians buy Chilean wine, the transaction is usually conducted by converting rupees into dollars and then dollars into pesos.
And when foreign companies, foreign governments or foreign banks want to raise capital from foreign investors, they can often do so more cheaply and easily by issuing bonds denominated in dollars rather than in their currencies.
Being home to the world’s reserve currency confers great advantages on the U.S. economy. Because of it, our government, companies and households can borrow money more easily and cheaply. And because all that demand for dollars artificially raises its value, we can import goods at a cheaper price than other countries.
But as economic historian Barry Eichengreen argues in a new book, this “exorbitant privilege” is a double-edged sword. When half of the world’s currency is pegged to the dollar, the United States winds up handing over control of its currency to foreigners who have become quite clever at using it to their economic advantage. And by making it so cheap and easy to borrow money, we have been enabled and encouraged to live beyond our means, taking on so much debt that the dollar’s role as reserve currency is now called into question.
Given the trillions of dollars piling up in foreign central banks as a result of this spending spree, and given the long-term prospects for the decline in the value of those dollars, it is likely no surprise that foreign officials have been looking to diversify their portfolio. Indeed, that was just what they were doing in 2007 and 2008, until the euro crisis raised doubts about the next-likely alternative.
“The dollar has been dominant for nearly 100 years for one simple reason — it has had no competition,” says C. Fred Bergsten, director of the Peterson Institute for International Economics.
Bergsten expects that will change over the next decade as Europe and China adopt policies and structures that will make diversification possible. In the meantime, the global system is forced to rely on the currency of a once-dominant economy that has piled up too much debt and can’t quite figure out how to deal with it.
There are two ways this dollar story can play out.
In the optimistic scenario, a credible budget deal is reached in Washington, the Fed manages to sop up all the excess liquidity it has created, and the long-term slide in the dollar remains gradual enough for the world to muddle through until a new order and a new architecture can emerge.
In the darker scenario, hinted at last week by the leading credit-rating agency, the failure to adopt a budget deal triggers a U.S. credit crisis that spawns a dollar crisis, which sets off another global financial crisis — one that makes the last one look like child’s play.
In Washington, there’s a widespread belief that what is at stake in the coming negotiations over the budget and the debt limit is nothing less than the outcome of the next election. What Washington needs to understand is that there’s a lot more at stake than that.