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The dollar's Demise has been long predicted

December 06, 2004 The Future of the Dollar

Economist.com | The future of the dollar: over the next few years it seems an excellent bet that there will be a large drop in the dollar. Since mid-October the dollar has fallen by around 7% against the other main currencies, hitting a new all-time low against the euro and a five-year low against the yen. The dollar has lost a total of 35% against the euro since early 2002; but it has fallen by a more modest 17% against a broad basket of currencies....
 

Markets have been rattled by concerns that foreign central banks might reduce their holdings of American Treasury bonds. Last week, officials at the central banks of both Russia and Indonesia said that their banks were considering reducing the share of dollars in their reserves. Even more alarming were reports that China's central bank, the second-biggest holder (after Japan) of foreign-exchange reserves, may have trimmed its purchases of American Treasury bonds... might the dollar lose its reserve-currency status? Over the past 2,000 years, the leading international currency has changed many times, from the Roman denarius via the Byzantine solidus to the Dutch guilder and then to sterling. The dollar has been the dominant reserve currency for more than 60 years, delivering big economic benefits for America, which can pay for imports and borrow in domestic currency and at low interest costs.... The requirements of a reserve currency are a large economy, open and deep financial markets, low inflation and confidence in the value of the currency. At current exchange rates the euro area's economy is not that much smaller than America's; the euro area is also the world's biggest exporter; and since the creation of the single currency, European financial markets have become deeper and more liquid....
 

Those bearish on the dollar are asking why investors will want to hold the assets of a country that has, by its own actions, jeopardised its reserve-currency position. And, they point out, without the intervention of central banks, which have been huge net buyers of dollars, the dollar would already be lower. If those same central banks were to begin to sell some of their $2.3 trillion dollar assets, then there would be a risk of a collapse in the dollar....
 

The [trade] deficit is at the heart of this issue. Various economists have put forward at least four arguments why the deficit does not matter and the dollar's reserve status is safe. First, the deficit is a sign of America's economic might, not a symptom of weakness. Second, sluggish demand overseas is a big cause of the deficit, so it is reversible. Third, the deficit exists largely because of multinationals' overseas subsidiaries. And fourth, central-bank demand for dollars creates, in effect, a stable economic system. It is not difficult to demolish each argument in turn....
 

Worse still, in recent years capital inflows into America have been financing not productive investment (which would boost future income) but a consumer-spending binge and a growing budget deficit. A current-account deficit that reflects a lack of saving is hardly a sign of strength....
 

For almost two decades, economists have worried about America's current-account deficit and predicted a plunge in the dollar and a hard landing for the economy. The dollar did indeed fall sharply in the late 1980s, but with few ill effects on the economy. So why worry more now? One good reason is that the current-account deficit, currently running at close to 6% of GDP, is almost twice as big as at its peak in the late 1980s, and on current policies it will keep widening. Second, in the 1980s America was still a net foreign creditor. Today it has net foreign liabilities and these are expected to reach $3.3 trillion, or 28% of GDP, by the end of 2004 (see chart 2)....
 

America has enjoyed another huge advantage in its ability to borrow in its own currency. A normal debtor country, such as Argentina, has to borrow in foreign currency, so while a devaluation will help to reduce its trade deficit, it will also increase the local currency value of its debt. In contrast, foreign creditors carry the currency risk on America's $11 trillion-worth of gross liabilities....
 

In any case, the current-account deficit cannot be corrected by a fall in the dollar alone: domestic saving also needs to rise. The best way would be for the government to cut its budget deficit.... Sterling maintained a central international role for at least half a century after America's GDP overtook Britain's at the end of the 19th century. But it did eventually lose that status. If America continues on its current profligate path, the dollar is likely to suffer a similar fate.... if America continues to show such neglect of its own currency, then a fast-falling dollar and rising American interest rates would result. It will be how far and how fast the dollar falls that determines the future for America's economy and the world's. Not even Mr Greenspan can forecast that.