Will the Dollar Remain the World's Reserve Currency?

Includes: UDN, UUP
by: David Goldman

That was the question I addressed on a segment of The Kudlow Report Thursday night.

The answer is “Yes, of course,” for the time being. China and Japan, America’s top creditors, have the most to lose if the dollar ceases to be a reserve currency, in which case their $4 trillion of reserve holdings would shrink by a huge margin. It would take them a long time to accumulate enough gold (for example) such that the increase of the value of gold would compensate for currency losses in their portfolios. And no other country or group of countries has the capability or political will to replace the dollar, least of all the struggling euro, which may face attrition due to the PIIGS crisis.

It could happen, though. The point of Quantitative Easing according to Bernanke’s academic theory is to force negative real returns on safe assets like cash and bonds so that investors shift into productive assets, spurring economic growth. The trouble is that investors may do no such thing and instead buy stores of value (which to some extent is already happening). One of many flaws in the model is that it looks only at one country. The Fed will tell you that it is pursuing a monetary policy that is best for the US and others should do what is best for them, which means in practice that everyone else should revalue their currency. In other words, there is a component of competitive devaluation in the policy. Push this nonsense long enough and the rest of the world may start moving more aggressively into gold and other hard assets; a snowball effect could ensue.

Ask the BRIC central banks, and they will tell you the Fed should raise interest rates slightly. And they are right. The old Mundell mix that started the Reagan recovery was lower taxes and tighter money. And it’s still the right one.

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