Decline of the Dollar

The greenback is looking a bit green around the gills — and no matter where you look, the bad news for the U.S. dollar just seems to be getting worse. America’s currency has been plunging in value against the euro and the Japanese yen (and the Barack Obama administration has shown little inclination to brake the slide). Dark mutterings from the world’s other great powers about the need for a new global reserve currency have accelerated the trend. Rumors about plans to topple the dollar from its pedestal abound. And just in case someone might be inclined to dismiss all the dire talk as a foreign conspiracy, the (American) head of the World Bank went on the record last month with a warning: "The United States would be mistaken to take for granted the dollar’s place as the world’s predominant reserve currency," Robert Zoellick said in a speech. "Looking forward, there will increasingly be other options to the dollar."

Some onlookers cite the dollar’s decline as yet one more bit of evidence that the long period of American global dominance is coming to an end. The greenback’s function as the world’s leading reserve currency has been one of the key features of Washington’s privileged place in the world since World War II. For decades the dollar has been the currency the world’s countries tend to use when they do business with each other. Most central banks around the world have held the lion’s share of their foreign exchange reserves in dollars, while most globally traded commodities (like oil) have been priced in the U.S. currency, too. It’s an arrangement that translates into many benefits for the United States, most notably lower borrowing costs (because there’s always more demand for the reserve currency than others). And then there are the myriad political and cultural knock-on effects — the power and the prestige — that accrue to the currency at the top of the economic pecking order. So it should come as no surprise that predictions about the impending "demise of the dollar" tend to go hand in hand with the expectation that America’s hyperpower days are numbered.

There’s just one problem with this picture: It ain’t necessarily true. Or not yet, at least. The creation of the euro and the rise of new economic heavyweights like China are indeed opening up prospects for a global monetary system that is much less dollar-centered than today’s. For that to happen, though, will require myriad changes that are likely years, if not decades away. And in the meantime, Benjamin Cohen of the University of California-Santa Barbara, points out, "It’s clear that the dollar is still the leading currency in almost every category."

Overall, he notes, the dollar continues to remain well out in front of the pack in foreign exchange trading, trade, and international banking markets. Although most countries have been adding euros to their reserves since the European currency was introduced in 1999, the amount of reserves held in dollars is 2½ times greater — "and in terms of absolute magnitude, the amount of dollars held in reserves is still on the increase," Cohen says. In fact, he points out, the dollar’s share of the world’s global currency reserves is actually much higher than it was at the beginning of the 1990s. In 1990 the dollar accounted for just 45 percent of reserves; today the figure is 65 percent. (For what it’s worth, Cohen adds, the dollar’s share peaked at 71.5 percent in 1999, the year of the euro’s introduction. So sure, the euro has made a dent.)

Cohen and other economists — including those who are less sanguine about the dollar’s future — point out that much of the current hysteria (or, depending on where you stand, euphoria) about the greenback’s role tends to confuse two things: present volatility in the foreign exchange markets and the dollar’s medium- to long-term structural role in the global economy. Take a look at history, in fact, and the present aura of uncertainty about the dollar appears, well, historical. Some dollar doomsayers have been claiming of late, for example, that the world’s oil-producing countries are contemplating a wholesale switch to pricing oil in euros rather than dollars — a move that, the pessimists claim, would mark the virtual death knell of America’s economic dominance.

That was the thrust, for example, of a much-ballyhooed recent article, "The Demise of the Dollar," by British journalist Robert Fisk, who darkly points out that the United States invaded Iraq shortly after Saddam Hussein started pricing Iraqi oil in euros. Fisk’s piece, despite presenting minimal detail to back its claims, triggered something of a run on the dollar when it was published — a good example of the degree of the current jitteriness. In response, Harvard University economist Richard Cooper points out that the OPEC countries traditionally bring up the idea of junking the dollar pricing system periodically every time the dollar gets weak. The idea, for example, of jettisoning dollars in favor of SDRs (special drawing rights, a sort of IMF pseudo currency) that is making the rounds again has been brought up repeatedly over the years. And if they did? "I don’t think it’s a big deal one way or the other," he says.

And that brings us to the biggest question that potential dollar-dumpers find themselves compelled to answer: If not the dollar, then what’s the alternative? The most obvious candidate would seem to be the euro. Back in pre-euro days, the deutsche mark and the French franc never really posed a serious alternative to the dollar, given their comparatively small reach back then. The economic heft of the euro-area countries, by contrast, is about the same as that of the United States; both sides account for about one-quarter of global GDP. And European financial markets are relatively deep and liquid (though still not quite on the scale of the United States’). Skeptics argue that European economic growth in the decades to come is likely to remain tepid, given Europe’s rigid labor markets, dense regulation, and graying populations. And then there’s that little detail that the political underlay of the euro is an international treaty rather than a nation-state.

Still, given the rising financial problems faced by the United States — like its miserable current account deficits and exploding national debt — economists like Harvard’s Jeffrey Frankel and the University of Wisconsin-Madison’s Menzie Chinn speculate that the euro could well make a go of it, perhaps surpassing the dollar’s share of overall reserves as soon as 2015. Still, one wonders whether even this scenario really represents the fundamental transformation of the global order that some would predict. So what about, say, the Chinese renminbi or the Japanese yen? Although the latter is still widely held as a reserve currency in some parts of the world, its attractiveness has been diminished by the lackluster performance of Japan’s economy since the 1990s. As for the renminbi, even the biggest China boosters acknowledge that it will take years before China’s economy takes on the attributes needed for a global reserve currency — particularly the deep, transparent, and liquid financial markets that still attract overseas investors to the United States. Oh, yes, and moving toward genuine convertibility might not hurt, either. (Meanwhile, it should be noted, China’s dollar reserves continued to grow in the third quarter of this year.)

Another idea making the rounds involves the aforementioned SDRs. The idea has been gaining currency (forgive the pun) ever since March 23, when Zhou Xiaochuan, governor of China’s central bank, proposed that central banks shift more of their foreign exchange reserves from dollars to SDRs. Far from ordering someone in the CIA to zap Zhou with a poison dart, though, U.S. Treasury Secretary Timothy Geithner actually welcomed the suggestion. (Perhaps it had something to do with the fact that the need for greater international reliance on SDRs has been the official policy of the IMF since 1978.) At April’s G-20 meeting in London, the assembled countries then approved a massive issuance of $250 billion worth of SDRs — the first in years.

There’s just one problem, though. As Barry Eichengreen, a leading economist at the University of California-Berkeley, writes in a recent article, "[S]keptics question whether the SDR could ever replace the dollar as the world’s leading reserve currency, for the simple reason that the SDR is not a currency. It is a composite accounting unit in which the IMF issues credits to its members." Based on a basket of four currencies (the dollar, euro, pound, and yen), the SDR can only be used right now by central banks and a few international institutions like the World Bank and the Bank for International Settlements — and not, it should be noted, by companies or consumers. Expanding the role of SDRs beyond their present function and into that of a genuine global currency would entail an amount of political and economic re-engineering that few of the major powers would seem to have the stomach for as things stand now.

And that, in turn, drives home another important point: Although politics do play a major role in deliberations about the future reserve currency, they do so rather differently from the simplistic ways evoked in public discussion. The University of California’s Cohen scoffs at the notion, for example, that Gulf Arabs might be blithely prepared to toss the dollar aside for the sake of dimly defined commercial advantage. Saudi Arabia, he points out, has a long-standing agreement with the United States to refrain from actions that might seriously destabilize the dollar; in return the United States promises to guarantee Saudi security in a region that offers myriad threats. "The Saudis have much more important issues to worry about than earning a few more percentage points on their currency reserves," Cohen says. The same applies, he points out, to Japan, still bound to the United States in a military alliance as well as through an intricate web of commercial relationships. Although China has surpassed the United States as Japan’s No. 1 trading partner, that fact alone is hardly enough to compel Tokyo to shift all of its reserves to renminbi.

In short, the dollar’s continued global predominance is not a sure thing; it’s just that it looks a lot more likely than just about any of the other options. "To seriously dislodge the dollar in its international role would actually require concerted action around the world," says Harvard’s Cooper. Does he see any signs of that? "No."