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Dollar Standard: Not the End, But the Beginning of the End

The dollar is on its way out as the world's reserve currency. The decline will neither be smooth nor quick, and the US will use its political, economic and military powers to retain influence. What will eventually replace the dollar? It will not be the euro, it will be some other currency.

COMMENTARY

Dollar Standard: Not the End, But the Beginning of the End

Avinash D persaud

Since 2000, US consumers have spent 30 per cent more than they have earned this way.

The benefit of reserve status is well illustrated by the symmetrical costs of losing it when the cheques written over the years start coming back to be cashed.

The dollar is on its way out as the world’s reserve currency. The decline will neither be smooth nor quick, and the US will use its political, economic and military powers to retain influence. What will eventually replace the dollar? It will not be the euro, it will be some other currency.

This article is a shortened, updated version of a longer, more detailed lecture entitled ‘When Currency Empires Fall’ delivered at Gresham College in 2004. (http://www.gresham.ac.uk/ event.asp?EventId=260&PageId=108).

Avinash D Persaud (apersaud@mac.com) is chairman of Intelligence Capital, a Londonbased financial advisory firm for institutions and sovereigns and emeritous professor of Gresham College, London.

O
ne of the joys of being a seasoned observer of foreign exchange markets is watching the interplay of exchange rates with politics, policy and psychology across a couple of cycles. Whenever the dollar is strong and the euro weak, there is unbridled talk of euro sclerosis and the triumph of American capitalism; and whenever the dollar is weak and the euro strong, there is fervent discussion of the spiralling costs of US healthcare and how the rest of the world is unceremoniously ditching the dollar standard. What keeps these cycles repeating themselves is that there is an element of truth in every story.

Today, around 65-70 per cent of central bank reserves are held in US dollars, a similar proportion of international trade, banking and investment flows are invoiced in dollars. The euro has made strong advance in a number of areas, especially in Eurobond issuance, but we remain on a dollar standard. I believe this will change. This will not happen overnight as some of the more breathless commentary suggests, though it is likely to occur within the lifetime of the average currency trader. That said, traders with daily, monthly or quarterly investment horizons will lose a lot of money if they focus too closely on this 20 to 30 year trend to the exclusion of the many local peaks and troughs along the way. By the time the dollar has lost its status, somewhere around 2035, the Chinese renminbi or even the Indian rupee will be best placed to take over its mantle. Not the euro.

Although owners of reserve currencies down the centuries would blush and tell you, it is a Kipling-esque burden they did not choose, issuing the world’s reserve currency brings substantial benefit. It is analogous to paying for things by writing cheques that no one cashes.

The so-called “balance of payments” constraint on UK growth from 1945 to 1979 which led to a deterioration in Britain’s relative economic position was due in no small part to what was then described as the “sterling balances” problem: returning sterling reserves that owners wanted to cash in for dollars or other goods.

Insufficient Restraint

The trick to paying for things with cheques that nobody cashes, is to practise restraint. However, insufficient restraint brings benefits within a time frame that matters to politicians, and costs within a time frame that does not. It is no surprise therefore that while there have been around 12 international currencies over the past two thousand years – names readers will recall from historical literature such as the (Roman) denari, (Greek) drachmas, (Islamic) dinars and (Venetian) ducats – what little we know suggests they ended their reign in a blaze of inflation through debasement. Reserve currencies seduce their issuers into economic and military “over-reach” that decades later leads to a messy end. Recall UK chancellor Denis Healey being recalled at Heathrow to deal with the 1976 sterling crisis.

Because the end of reserve status is so messy, it will be resisted. The British used military and political influence to extend the reach and period of sterling’s reserve currency status. In the 1900s, for instance, over 60 per cent of central bank reserves were still held in sterling even though the US economy had become the largest economy some 20 years before. However, the principal owners of sterling reserves were not the then great powers of the US, France, Germany and Japan, but the great treasuries of the British empire: India, Canada and Ireland.

We should expect the US to use its military, economic and political power to

december 1, 2007 Economic & Political Weekly

COMMENTARY

prolong the position of the dollar. Irrespective of what is in Iraq’s best interests, I suspect that under the US protectorate, the Iraqi central bank will not be one of the first central banks in west Asia to diversify its reserves from dollars, loosen its currency link to the dollar or invoice its oil in euros. Indeed, the reversal of Saddam Hussein’s decision to start invoicing oil sales in euros in November 2000 has probably cost Iraq $ 25 bn over the course of the past four years, equivalent to 30 per cent of its GDP. Gunboat diplomacy in the currency field is not new. In 1944, the British negotiating team led by Keynes expected friendly terms when they began negotiating the repayment of debts the UK had built up during the war. Instead, the US insisted on strict conditions that were designed to undermine the sterling area.

The history of international currencies suggests that a key factor is the absolute amount of international trade that a country conducts. The Roman and Islamic empires were the largest trading blocs when the denari and dinar were international currencies. In the 19th century, the UK was the largest trader and sterling was the reserve currency. In the 20th century, the US was the world’s largest trader. By the middle of the 21st century, the largest trader is likely to be China. If the euro area were set for an aggressive eastward expansion, including Turkey, Russia, Ukraine, Kazakhstan and their neighbours, then the euro would be a better contender to replace the dollar, but today that seems unlikely.

Reserve Basket?

Perhaps the next reserve currency will be a basket of currencies. There are a greater choice of liquid, freely trading currencies today than in the past. I do not think this will be the case because when market participants seek a reserve currency they are looking for something that will rise in value when all else is falling and if one of the basket is expected to rise more than others, it will soon become the reserve currency.

Some people scoff at the idea of the renminbi (RMB) being the next world’s reserve currency. China does not even have a convertible exchange rate today. However, it does have a central bank, which is more than the US had in 1910. China also thinks consistently about such grand issues in a way that is not always the case in the US where policy influence flitters between “Wall Street” which favours preserving the dollar standard, and “Texas” which favours a competitive dollar. The Texans are currently in charge.

The biggest risk to a RMB standard by the middle of the century is that between now and 2035, there is likely to be political change in China. This may be as smooth as the “Velvet Revolution” in the former Czechoslovakia or it may be as tumultuous as the Cultural Revolution. However, if China is delayed by politics, it is not clear that this provides an opportunity for Euroland in 2035, or instead for India. India’s economic and political path appears well set. Moreover, given China’s one-child policy, India will end up with the largest population and, one day, the largest economy in the world.

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    Dџ. (MџѠ.) NюѤюѧ B. MќёѦ

    December 1, 2007 Dіџђѐѡќџ

    Economic & Political Weekly december 1, 2007

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