The Dollar Coin: Two Sides of the Reserve Dollar

In all the anguish over the recent decline of the dollar, two simple facts seem to have become misplaced.

1. A very large amount of the day to day positions in the currency markets and thus the negative movement in the dollar is the result of traders chasing profits. It is obvious but worthwhile to state again that these are trading markets and trading markets are all about trading profits. Currency markets are not designed, at least in their day to day valuation, to make judgments about the viability of a currency’s reserve status.
2. As soon as the Fed signals that its easy money policy is at an end a great percentage of those traders who are now avid dollar shorts will reverse and become with equal sincerity dollar longs. New punters who see profit potential in long dollar positions will soon join the ex-shorts as the Fed begins a rate cycle that might last two years and bring the Fed Funds rate back to historical norms. The dollar will follow the funds rate higher.

The world’s disenchantment with the dollar as reserve currency is new. Only eight months ago the dollar was all the rage. The world fled to the dollar and dollar assets as global financial markets imploded. If another crisis struck tomorrow it is unlikely that the world seek financial refuge in a different national script and government? The current trading equation of risk and reward is a dollar based concept; as risk rises so does the value of the dollar. This logic remains true. If this aspect of the dollar’s place in the world economic system has not really changed what then are the motivations and logic of the critics of the dollar’s reserve status?

There are four different complaints about the dollar’s reserve status. The first two are topical, that is they offer the critics a convenient way to advance their own political but not necessarily financial plans; the second two are substantive. That is they raise issues that over time could and probably will diminish dollar’s reserve role in the world economy.

1. The dollar offers substantial benefits to the US Government by allowing it to fund its deficits in its own currency. This provides the Federal Government with a fiscal support that gives its political agenda a much wider reach than if Washington had to depend solely on its own resources. For political adversaries, curtailing the dollar’s reserve role would limit American freedom of international action. A country that cannot pay for its endeavors must choose between its commitments. How long will China pay for the US Navy’s Pacific Fleet to patrol the Taiwan Strait?
2. Dollar resentment is recent and it is much closer tied to the decline of the currency since March than any realistic change its reserve status. Where were the complainers when the dollar was rising from July to March?
3. US Federal deficits, real and projected, are a new and damaging entry in the reserve equation. How long will America’s competitors continue to lend Washington money? The answer is straightforward—as long as it is in their interest to do so and no longer.
4. The creation of the Euro and its performance in this crisis has focused the minds of the world’s money managers and bankers—there is an alternative to the dollar. Though the euro has drawbacks as a reserve currency, primarily its fragmented and limited bond markets, its efficiency as a medium of exchange and its ability to retain value as defended by the European Central Bank are real and strong.

None of this means that the dollar is not gradually weakening and that it may be replaced or at least supplemented as the world’s reserve currency.

But we must be careful to differentiate between short term positioning in the currency markets that will likely be reversed by a change in Fed policy, and the long term and gradual trend down in the dollar as world reserve currency. Indeed the term itself is misnomer. There is no reserve currency created by a global bank and backed but its reserves. The dollar is the world’s most common medium of exchange and store of value because it has evolved into that role. For most of the past half century the American economy dominated world finances and trade. The ascendancy of the dollar is a product of that position in the global economy. That dominance has been slipping for at least a generation, since the first Arab oil embargo, but over the past decade it has become increasingly obvious.

The question for currency traders is not will the Fed engineer a recovery in the dollar when it begins to increase interest rates and will that quiet doubts about the dollar’s reserve role. The Fed can and the doubts will recede.

The question is how far will the dollar fall before this happens and will that fall have permanently damaged the world’s faith in its reserve currency?

Comments

[Mad Hedge F...:]

opm Will people pleeease stop incessantly nattering about the possibility of China dropping the dollar as a reserve currency? What else are they going to use? Monopoly money? Taiwanese dollars? Collectable postage stamps? At $2.3 trillion and rising fast, the Middle Kingdom’s reserves are so enormous that no other currency in the world could accommodate the switch, and no other security offers the necessary depth and liquidity but US Treasuries. China only needs to breathe on any other market for it to skyrocket, we have seen in the relatively Lilliputian commodity markets this year. And really, how likely is it that China embarks on radical new monetary policies that suddenly halves the earnings of it’s exporters, as well as its 30 year hoard of accumulated savings? The demise of the dollar has been predicted more often than the ditching of Microsoft’s Windows as the global PC operating system, and is just as likely. Hate the greenback as much as you like, but there just isn’t any other alternative. I have been hearing these arguments ever since the US went off the gold standard in 1971. First there was a perennial Arab threat to price crude in a basket of currencies. Gee, they never seem to complain when the buck is going up. Then there was the speculated emergence of the “Yen Block”, in the eighties, back when Japan was dominating international trade and the yen was bumping up against ¥80 to the dollar. Remember the book “Japan as Number One? What a laugh. Then we got all that European whining after the launch of the euro, when the weak dollar was every trader’s free lunch. Let’s face it, Europeans hate using someone else’s currency as the primary reserve instrument. Before the dollar, sterling was the de facto reserve currency, and was equally despised.

Nov 08 11:49 AM

[Mr. G:]

I suspect as long as the US remains the largest GDP, the dollar will remain as the reserve currency. So far, Japan, China and the Eurozone have not been able to displace our supremecy. I do not think that these disparate economies can unite into one currency structure to displace dollar status.

Nov 08 12:15 PM

[paxjds:]

At a minimum we should expect the G20 to want a new world currency tied to a basket of currencies and perhaps 10% tied to gold. These countries will want a check and balance on the $dollar printing presses, along with checks on the other currencies in the basket as well.
Uncle Sam's massive printing that is underway has spelled the demise of the $ as the worlds reserve currency. Other nations printing more will prevent them from becoming a "reserve status". Look for a Basket Deal to come forth with a Review Board to make quarterly adjustments to the basket currency percentages.
Personal Gold/Silver best for long term protection of savings.

Nov 08 02:07 PM

[Donald Ingram:]

"Absolute power corrupts absolutely". For over 60 years the USD has held sway as the globes international currency of choice. The privileges and benefits that this unique status has bestowed upon America, have now been subverted and cheapened, to the point that it now is in danger of being toppled from that lofty position.

The rot and hubris that infects the upper echelons of political and financial power in this country has finally been able to even bring destruction down upon themselves. Unfortunately they drag the rest of the country along - with their outright greed, dishonesty and complete lack of respect for the principles set forth in the Constitution, to which they swear fealty on the one hand and violate with the next.

Nov 08 03:00 PM

[Old Trader:]

"Only eight months ago the dollar was all the rage. The world fled to the dollar and dollar assets as global financial markets imploded."

That period was an anomaly in a long term trend...not something I'd hang my hat on.

Nov 08 03:02 PM

[Nick B D:]

Great summation. Complex subject made clear and succinct.

Nov 08 03:10 PM

[Boxed Merlot:]

…The dollar is the world’s most common medium of exchange and store of value because it has evolved into that role…


This is a crazy circular form of reasoning that befits a sleeping populace’s dream state ignorance of reality.
The dollar was/is a physical metallic coin that was replaced by a promissory note published by the Federal Reserve in such vast quantities that it was chased into hiding only to resurface occasionally to mock those who believed the lie of “evolution”.

Nov 09 12:44 AM

[Wilson Siu:]

Speaking about short term versus long term.

LOL. The writer says in the short term if the Fed changes its interest rate and quantitative easing policy the US dollar will reverse its decline.

True, if the Fed does change its policy the dollar will reverse its decline, but HOW THE HECK CAN THE FED CHANGE ITS POLICY WHEN UNEMPLOYMENT RATE IS 10.2% AND UNDEREMPLOYMENT RATE IS LIKE 9%?

SO THE CONCLUSION IS THAT UNTIL EMPLOYMENT RATE IMPROVES, THE FED WILL NOT CHANGE ITS POLICY. THUS IN THE SHORT TERM THE FED WILL NOT CHANGE ITS POLICY.

If Peter Schiff sees this article, I do not think he shall be as polite as me in replying to the author's article.

Nov 09 10:25 AM

[Joseph Trev...:]

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The Fed will, sooner or later, and I believe much later, raise rates. I agree that the Fed will not do so until unemployment has peaked. Mr. Bernanke has said so more than one or twice there is no reason not to believe him. When the Fed does begin or the market thinks it has a horizon on the beginning it will boost the dollar, be that fourth quarter 2010 or later. I would make a large bet that wherever unemployment is the Fed will not raise rates before next year's election.

The Fed and rates are a different issue than the dollar reserve roll. It is true that there is no adequate or even passable current replacement for the dollar. But you only have to look at the increase of euro holdings since the creation of the currency to see the market desire for a choice.

In the context of the evolution of reserve currencies a Fed rate increase in a year is short term, I should have made that clearer.

Nov 17 04:48 PM