There’s been a lot of talk lately about how the Dollar is the world reserve currency, and even more recently some noise about replacing it. If we take a look at how it came to be that the U.S. Dollar should find itself as the reserve currency we might discover some potential for assessing reasonable alternatives.
Following World War II it was seen as a necessity to open up trade between nations to stave off the political chaos induced by the insular competitive economies and currency blocs that plagued industrialized nations through the interwar years. One of the key conclusions of the The Bretton Woods Conference was that to create economic security the international community needed to establish a comparatively fixed-rate means of exchange to stabilize relative commodity prices and allow for freer flow of capital between markets.
Various ideas were proffered, such as the continuation of the gold standard or a basket of commodities (Keynes’ bancor). Ideally there would be a fiat currency that could allow for the flexibility of currency revaluation, but be fixed and convertible to commodities for normalizing exchange. Gold production alone was deemed insufficient to cope with the world demands for liquidity, and the basket of commodities (Keynes’ bancor) was ultimately rejected by the United States, despite its merits of neutrality and efficacy.
The U.S. was able to take such a strong stance at the negotiations at Bretton Woods, and opportunistically make the Dollar the center of the global economy due to several key factors:
- The infrastructure of the U.S. was left essentially entirely intact following the war, a contrast to ravaged European nations.
- The manufacturing base of the U.S. was so vastly expanded that it appeared most capable of meeting the world’s immediate production needs; making it the strongest economic contender in the international market.
- The position of the U.S. was to be the likely creditor to European nations while they were rebuilding, and whom were already crippled with debt.
- European countries had already moved most of their gold reserves to the U.S. during the war.
- The U.S. was eager to be the arbiter of the fundamental terms of the emerging global economy.
The combination of these conditions resulted in the international community capitulating to the view of U.S. leadership, and the result was that the U.S. Dollar became the reserve currency, backed by gold, and to which all other currencies would be pegged.
In short, the U.S. was the first to recover from the crises surrounding the war, had the largest surplus of existing reserves, had the strongest productive capacity, was capable of financing the recovery of member trade nations, and a the Dollar stood alone against a distinct lack of competitive currency alternatives (the Sterling had served this role informally previously, but had been effectively destroyed as a value-store during the war).
This seems to indicate that the primary dependent condition of a reserve currency is that it be secure and stable. Something the U.S. Dollar, and it’s backing sovereign appear lately to delight in casually putting to the test.
In 1971 due to a growing international view that the U.S. ability to actually convert Dollars to gold was becoming weakened (as U.S. gold reserves depleted continually through balance-of-payments deficits and simultaneously running trade-deficits) several nations, though France and Switzerland most notably, began to demand that their Dollar stores be converted to the gold they were guaranteed by ($35 per ounce). It was essentially a run on U.S. reserves. In response Richard Nixon broke away from the Bretton Woods system (Germany had broken away months before when it tired of inflating its currency to prop up the Dollar), and thus the Dollar became floated on the market backed by only the credit of the U.S. government. While this was a shocking development for economies around the globe, it had a side effect of further entrenching the Dollar as the world reserve currency. Having spent some 25 years in the position already, many nations had large stores of Dollars, and as a result had no recourse but to continue to hold them; as they ceased to be convertible to gold, and any fight from the Dollar would immediately devalue their existing holdings. This propped up the Dollar’s value in the market.
The result of that propping, coupled with the existing capital aggregation in the U.S., and the still tremendous productive capacity of the U.S. economy have kept the Dollar relatively strong in the face of ever increasing balance-of-payments and trade deficits over decades. Others nations were essentially backed into a condition of financing the U.S. debt to keep from crippling their own economies. The dealer-junkie relationship was cemented.
It is this condition which sets the stage for us today. That set of arrangements can endure as long as comparatively the United States still looks like a stable growth economy, and so long as there are no competitive alternatives. However, as time passed, and as the United States continued to hollow out its economy and expand its deficits; alternatives began to emerge. Alan Greenspan said in September of 2007 that, it is:
"…absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency."
According to the econometric analysis of Menzie Chinn and Jeffery Frankel the Euro could have overtaken the Dollar as the reserve by 2020 pending adoption by the UK, an expansion of the euro zone to include additional satellite nations, and a continued trend in the decline in the Dollar.
Today the Euro seems like an unlikely candidate. Their unification economically has outstripped their unification politically, and the result seems to be a vacancy of cohesive policy action to combat the financial and economic crises being faced today. Noted by Paul Krugman in his article, A Continent Adrift:
"But there’s a deeper problem: Europe’s economic and monetary integration has run too far ahead of its political institutions. The economies of Europe’s many nations are almost as tightly linked as the economies of America’s many states — and most of Europe shares a common currency. But unlike America, Europe doesn’t have the kind of continentwide institutions needed to deal with a continentwide crisis.
This is a major reason for the lack of fiscal action: there’s no government in a position to take responsibility for the European economy as a whole. What Europe has, instead, are national governments, each of which is reluctant to run up large debts to finance a stimulus that will convey many if not most of its benefits to voters in other countries."
While their strongest economies may be strong enough to endure some systemic shock, their politics don’t appear to share the same benefit. The combination of that disparity, and the lag in recovery it will create will likely push the euro to a diminishing, rather than increasing, role as an alternative reserve currency (contrary to previous trends), because of it’s apparent lack of security. As we roll through the first and second quarters of 2009 it will be interesting to look for trend changes in the composition of global reserves as tracked by the IMF’s COFER database.
So, if not the Euro, are there any other competitors to the Dollar? In my opinion, the answer is: maybe. What, not the decisiveness you were looking for?
If we reference the conditions from earlier that set the stage for the U.S. Dollar as the reserve currency:
In short, the U.S. was the first to recover from the crises surrounding the war, had the largest surplus of existing reserves, had very strong productive capacity, was capable of financing the recovery of member trade nations, and a the Dollar stood alone against a distinct lack of competitive currency alternatives.
One can ascribe many of those conditions, or nearly congruent ones, to China today. Some purported early success of their stimulus and financial restructuring to pave the way for recovery, massive productive capacity, net savings, and its already a massive creditor nation.
The conventional wisdom that prevents this from happening is the fact that China is holding so many Dollars, and that divesting themselves from them would destroy too much of their remaining value, and further that China needs to maintain a weak position of their own currency against the Dollar to maintain the ability of U.S. consumption to fuel their export economy.
Both things are in fact true. However, I’ve begun to wonder if conditions are brewing that might make China moving away from Dollar reserves the lesser of two evils, and further that if they play their hand well they can largely mitigate the pain of doing so.
- Chinese central-bank officials have displayed frustration with the fact that their Dollar peg (or at least their narrow band of allowed variance to the Dollar) prevents their central bank from having broad monetary policy control to deal with inflationary and deflationary pressures. An immediate problem as they’re facing deflation at a time when they’re trying to stimulate domestic demand, and a problem previously as they were constantly fighting inflation as the dollar was sinking.
- While China has seen a massive explosion in their trade-surplus relatively recently, it appears predicated largely on a decline in their imports as they begin to source intermediate goods domestically for use in production of their exports. Indicating that while their exports still make them vulnerable to external shocks, they’re on the path to mobilizing their domestic economy.
- Currently Chinese exports are collapsing due to massive decline in global demand, and more notably the decline in U.S. demand, which appears to be aggravating Chinese political officials as they watch us bungle our financial recovery. Signaling that China is acutely aware of the perils of our mutually intractable trade arrangement.
- Allowing the Yuan to float and increase in value could provide increases in global net demand where China can improve purchasing power of foreign goods precisely at a time when foreign economies need to correct their trade imbalances in exactly the opposite direction of the Chinese surpluses, and somewhat mitigate the need for vastly more of the last thing anybody needs; additional scads of Chinese goods production. Foreign production could potentially fill the gap to satiate a means for a Chinese consumer economy.
As previously unthinkable as it may have been, it’s not hard to paint a picture where the Chinese may view exiting the dealer-junkie relationship on their terms (or at least where they’re finally sure they’re the dealer and not the junkie), as their best long-term bet. They’ve seen the conditions of this relationship as a roadblock to fully developing their domestic economy, and the there appears an opportunity to capitalize on the current economic weakness of its trade partners in the same way the U.S. did at the end of World War II with its partners.
International capital is still running to the Dollar, because in all the turmoil it still seems like as much a safe-haven as one can find. However, if stability and growth can be found in another value-store while the backer of the current reserve currency is positioned precariously atop its own mountain of debt, and with no apparent will or ability to reform its markets to prevent a protracted collapse, then the value of holding those Dollar reserves becomes increasingly dubious and dangerous. With the emergence of an alternative, one could imagine an accelerated trend of the micro-flight to the Euro prior to the current crisis.
If the Chinese can be first to recovery before any other significant economy, continue to spend their massive net-savings on mobilizing their domestic economy, and the U.S. continues to flounder (effectively destroying China’s Dollar reserves of its own volition), then removing the Dollar peg on the Yuan, and letting it float in a market hungry for growth and stability might venture into the realm of the possible from the previously unthinkable. Considering China’s desire for greater economic self-determination the risk may start to look downright attractive; compared to the alternatives.
It’s certainly a lot of "ifs," and the conditions aren’t for a lack of obvious shortcomings (the downward pressure on employment as domestic production technology advances, and whether or not the Chinese are ready to be a consumer economy; to name a couple), but In light of the similarities between China now, and the position the U.S. sat in when it formally overtook control of global exchange, I’m not as convinced the idea is without merit of being examined as I once was. The conventional wisdom seems worth challenging.
Of course, there’s a better than average chance I have no idea what I’m talking about, and I just like thinking about systems and their interactions with each other. So, by all means rip it apart, chew on it, and spit it back at me half-digested. Provided with contrary evidence I’ll happily back away from any assertion or position, and I’ll even thank you for it. However, my primary assertion is that a reserve currency is all about security and stability, and the more insecure the Dollar appears to be, the more likely a challenger will be sought.