On the threshold of the new decade, it seems fitting to take a long-term view. There are a plethora of issues that crystal-ball gazers could usefully contemplate. For those involved in global finance, one of the most critical is whether the US dollar will continue to be the currency of choice in the international monetary system a decade from now. After all, both savers and investors need to consider the appropriate numéraire for evaluating their portfolios over a ten-year perspective, or even longer.

Could it be that ten years from now a portfolio denominated in real, rubles, rupees, or renminbi—or perhaps even gold—would provide a higher real rate of return than US dollars? This is not an idle question.

Back in 1969, the late Charles Kindleberger of MIT cautioned about “exchange rate illusion.” He observed that a high rate of return in a depreciating currency may actually be a loss when using an alternative numéraire. Investors tend to be blind-sided by thinking of returns in home-currency terms, especially if that currency plays a major reserve role, as does the US dollar.

Much ink has been spilled on the issue of reserve currencies: their characteristics, history, the benefits and costs, and the implications of moving from a unipolar to a multipolar world. Many analysts worry about the disruption to globalization and, as a result, try to conjure steps that the new and old powers among the G-20 could take to ensure that the world economy makes a smooth transition, or at least as smooth as feasible, to a new international financial order.

It is almost quaint that some political leaders seem to believe that such a new order could be designed and implemented if only there were sufficient recognition of the need for change and the political will to do so. This group would seem to include not only the Chinese and the Russians, who admittedly are both relatively new to these questions and, as major new creditors, have a clear stake in the outcome. More surprising, it would seem, is the public posture of US Treasury and French Ministry of Finance officials who really should know better.

The clock cannot be turned back

The world has changed and there is no going back. It is useful to recall briefly why those harking after the lost holy grail of the gold standard—or anything close to it—are delusional. Historically, international exchange has been based upon the use of sound currencies issued by the dominant creditor countries. Indeed the system itself was “designed” to favor the interests of creditors—to ensure that they were repaid in value. These creditors created payments systems to safeguard their interests.

For debtor countries, the rules of the creditor-dominated systems often required tough adjustments to guarantee repayment in sound currencies—whether gold, sterling, deutschemarks, or dollars—at various times under the gold-exchange standard or the Bretton Woods system. When the hegemonic creditor could no longer impose its will, the debtors would frequently revolt. Such upheavals occurred when creditor-debtor relations were changing fast, faster than public perceptions. Hence the United Kingdom was unwilling to adhere to the gold standard in 1931 and the United States broke with Bretton Woods’ rules in 1971.

The parallel with today’s dollar overhang is worrying. Last year, Zhou Xiaochuan, governor of the People’s Bank of China, followed the lead of Russian President Dmitry Medvedev in suggesting the creation of a “supersovereign reserve currency” to replace the dollar over the long run. He would sharply enhance the global role of Special Drawing Rights (SDRs), the international asset belatedly created by the International Monetary Fund (IMF). The world’s new creditors are seeking ways to preserve the value of their assets.

Markets are in control

That doesn’t mean, however, that they will be able to sit down across a conference table and hammer out a new system. Globalization, open capital accounts, and pervasive real-time markets have radically reduced the scope for government action to influence the choice of reserve currencies. Monetary systems are no longer designed in the White House library or by international committees.

There is a lingering nostalgia for elite plutocrats to effectuate a payments system adequate to the needs of the 21st century. The problem is that it is just wishful thinking. Especially in the aftermath, hopefully benign, of the massive government intervention to avert a catastrophic depression last year, we understandably tend to place too much faith in governments and international institutions. In the last decade, if the G-7 could not foster monetary cooperation, then don’t hold your breath for the G-20. Despite the talk and photo ops, it will not happen.

Quite frankly, there is no basis for creditor and debtor countries to agree. The creditors, as always, want an international monetary system that ensures that they will be repaid with interest in real terms, whatever the numéraire. Debtors, whatever they might say publicly, would not mind some deterioration in the real value of their debts.

Against that backdrop, the current situation is dramatic. As already noted by other writers in this series, the past decade has seen an unprecedented change in global financial forces. Emerging economies have shifted from being debtors to becoming the dominant creditors in the world economy, and the erstwhile creditor countries such as the United States and the United Kingdom are now the leading debtors. The global crisis merely accelerated this trend.

It is clearly unsustainable for the international monetary system to remain dominated by the “new” debtor countries. Given the inherent inflationary bias in this situation, the “new” creditors will eventually have to impose their conditions to continue to provide financing. It will be more far-reaching than simply raising their representation on the boards of the IMF and World Bank.

All this is not to suggest that the markets, left to themselves, will handle with care the job of determining the emerging reserve currencies of the new decades. In fact, far from it. It’s just that to presume that mass-participation democratic governments will make tough choices before they are absolutely forced to do so is naïve. With zero percent US interest rates, a massive and rising debt, and a low national savings rate, it is hard to imagine that the market will allow the dollar to remain the leading “reserve currency.” But it’s not obvious that the real, ruble, rupee, or renminbi are ready to fill the void. In fact, except for the ruble, the others are all still subject to capital controls, and the Russians may yet be forced to revert to controls as the Brazilians did last year.

So, by default, the markets will decide, and it is likely to be a chaotic and destabilizing process in the absence of coherent governmental guidance. In regard to the future of the dollar, Keynes probably got it right, when, in the famous Chapter 12 of The General Theory, he wrote that: “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence … amounts to little and sometimes to nothing.” He observed that forecasts are based on a “convention”—that is, “our usual practice being to take the existing situation and to project it into the future, modified only to the extent that we have more or less definite reasons for expecting a change.”

So by implication, the dollar may continue to rule until suddenly it no longer does. Unlike the United Kingdom, whose dethronement as issuer of the leading reserve currency was gradual, markets may not be so tolerant with the United States when sentiments do finally change. After all, in 1945, the United Kingdom was still a creditor country, albeit diminished in scale. The United States, as the world’s largest debtor, is unlikely to experience such a measured retreat in the dollar’s role.

One thing is certain: currencies of creditor countries, as in the past, will be preferred by markets. In today’s world, such creditor countries could include China, Japan, Russia, South Korea, and Saudi Arabia. Of course, the other characteristics of reserve currencies must also be realized: President Medvedev’s vision of an international role for the ruble may not be so far-fetched. In the end, whether the dollar continues to play its central reserve role a decade from now depends above all on US economic policies. However, absent a politically suicidal effort to adjust the American economy with belt tightening and a paying down of its debts, it may well be that the new creditors could be thrust into leading roles sooner than they think.

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