The world is in the midst of a crisis and so is the US dollar. Having served as the world’s reserve currency for nearly 100 years, is its long-standing predominance now coming to an end? The dollar has been depreciating versus the euro and the yen for quite some time now, raising doubts about its stability. Harvard economist Kenneth Rogoff already forecasts US inflation to reach 5 to 6 percent in the coming years. According to Rogoff, this would be the best way, politically, to ease the debt burden. It would also mean the next financial crisis is a foregone conclusion as, in the long run, China will no longer be willing to finance growing US debt.¹

One result is mounting international pressure on the dollar. China and Russia are demanding change and calls for a new multipolar international monetary system are being heard increasingly in Europe, too.² The collapse of Lehman Brothers, growing public-sector and household debt, as well as rising US external debt are all causes for concern. Some governments already see the euro as the future number one—and hope for growing prestige for Europe’s still young single currency. However, other currency regimes are also conceivable: the Chinese and the Russians, for instance, are calling for the Special Drawing Rights (SDRs) of the International Monetary Fund (IMF) to be established as the new global currency. They envision a currency that is physically backed by gold or other commodities, or a currency basket as this would ensure greater stability than the—in their view—volatile dollar.

Who is to blame?

Since the beginning of the decade the dollar has been under pressure from large US current account deficits. The reasons behind the large deficits (and correspondingly large surpluses mostly in Asia but also in Germany) are manifold: while the Chinese propensity to save persists, thanks in part to high corporate earnings, the Americans are ruthlessly satisfying their desire for consumption. However, lately the savings ratio has risen markedly in the United States while China still seems unimpressed: the yuan remains pegged to the dollar, and is only allowed to appreciate gradually, if at all.

Nobody is calling upon the Chinese population to give up traditional patterns of behaviour. If the Chinese have an inclination to save, they should not be kept from doing so. This, in fact, is an advantage of the globalized world: the transformation of current into future consumption and vice versa has become easier and more profitable since Chinese savers have begun to lend their money to consumption-prone foreigners. But this behaviour is also influenced by government measures—especially in China. Artificially supporting the undervaluation of the yuan will hurt the entire world currency system in its ability to function. No new global currency can solve this problem. Savings from China will still need to find borrowers. With an extensive economic stimulus package and large-scale credit expansion on the part of domestic banks, the Chinese government has taken the first steps toward boosting domestic spending. Equally desirable, however, would be a more flexible stance regarding the domestic exchange rate, i.e. further appreciation of the yuan.

The Unites States also bear considerable responsibility. For several years now, we have wondered how large a current account deficit would have to become to be considered unsustainable. It is difficult to find a precise answer. Just as one example of the complexity involved, yields on investments made by foreigners in the United States are about one-third lower than yields of US investments abroad. If this relation holds, the United States can sustainably spend more than it produces. Additionally, the considerably higher birth rate in the United States and related economic momentum make it easier to fund high external deficits on a long-term basis. Nonetheless, a big current account deficit is only possible as long as foreigners remain willing to finance the massive consumption habits of US debtors. Once the belief in the ability of those debtors to repay is shaken, creditors will be much less willing to lend.

In the European Monetary Union, too, the gap is widening between debtor and creditor countries, not least because the single currency has led, and is still leading, Italy and Greece to lose their competitiveness because of their lack of cost discipline. Despite a higher degree of convergence in the past decade, the economic structures between the EMU states continue to differ to such an extent that emerging needs for readjusting costs have to be addressed if momentum is to be maintained.

Changing the reserve currency—the long road ahead

The pound sterling, the dominant reserve currency up until the end of the 19th century, was replaced in this role by the US dollar after World War II. This change was driven by developments in both countries: more than 50 years earlier, the United States had overtaken the United Kingdom in terms of economic performance. Following World War II, Britain turned from being the United States’ creditor into its debtor. In the end, the dollar was the only currency convertible into gold, which represented the decisive step toward supplanting sterling.

As the pound-to-dollar transition shows, changing to a new world-reserve currency is possible. However, it takes a long time to complete the difficult process, from initial discussions to final execution. This inertia results from the fact that many participants are accustomed to using a particular currency for a particular purpose, here in its international role. Central banks use the dollar because many other countries also hold dollar reserves—and similarly, companies do business in dollars on the understanding that others will do the same. Anyone who pins their hopes on a new currency too quickly will become isolated and be compelled to return to the unpopular unit of exchange. As with an established global language, the issue is not primarily about the intrinsic value of the instrument but rather the cost and coordination efforts involved in replacing it. The fact that it has proved itself for nearly 100 years is currently benefiting the dollar.

However, sterling’s replacement by the dollar has also shown that the United States should not depend on the dollar maintaining its status forever. If all states agreed that a different currency would be better suited to promoting their interests, the era of dollar predominance would soon be over. Once this decision has been made, change can be quick and long-lasting, especially if the currency is expected to lose considerably in value.

The question then, is where do we stand in this process today? Is it the creditors with sizeable stocks of dollar reserves and their concern that their holdings might lose value or the lack of an alternative which is currently keeping up the status quo?

Creditors running out of patience?

Asian emerging markets and the oil-exporting countries have built up foreign exchange reserves over the last few years that dwarf anything seen so far. Never before have global forex reserves reached such heights—at $6.5 trillion, reserves have tripled within the past ten years. As the largest creditor, China holds the lion’s share (almost $2.5 trillion), while the reserves in the Arab world may be equally large but are unreported. According to an IMF report, the dollar still constitutes over 60 percent of global forex reserves—and its share is highest in the industrial countries at nearly 70 percent. Moreover, countries with considerable natural resources and Asian states have pegged their currencies to the dollar. Between 2005 and 2008 this dollar peg has led to a substantial acceleration of inflation in these countries. China reacted by adjusting its currency regime and allowing an appreciation of the yuan in 2007/2008. Most other countries refrained from such a move. They paid in high inflation and exploding real estate prices.

The pressure on countries to either revalue their currencies or accept high inflation rates has lately led to increasing criticism of the global reserve currency. There is growing concern, especially in China, that a depreciation of the dollar would mean a large-scale loss of value for the country’s forex reserves. If the United States tries to bring down its debt by allowing inflation to rise, creditors who hold on to their dollar-denominated bonds will suffer. Meanwhile, any country that pegs its exchange rate to the dollar and fails to adjust it, is likely to experience an ensuing export boom that will lead to growing dollar reserves. In that case, they will have to accept the risks of a weakened dollar. Of course, excessive consumption in the United States has also contributed to this situation. So while a revaluation of the yuan would not have erased global imbalances, it would at least have helped to mitigate them.

So is it the lack of alternatives that ensures that the United States can continue to enjoy its “exorbitant privilege”³ ?

Special drawing rights as new instrument?

China and Russia are currently calling for Special Drawing Rights (SDRs) to be established as the new world currency. This artificial currency was introduced by the IMF to create greater independence from national currencies. Its value is based on a basket of the most important internationally traded currencies. The shares of these currencies are recalculated on a regular basis. It was hoped by many that if SDRs became the new global currency, they would lead to lower volatility in the valuation of forex reserves thanks to the greater diversification of the currency shares in the basket.

Nonetheless, I believe that the United States do not have to fear a change of regime to SDRs: not in the slightest do SDRs provide the liquidity required for a global currency, nor can long-term stability be expected when there are frequent changes in the composition of the basket, due in part to politics. Thus, SDRs are unsuitable as a replacement for the dollar, as has been proven by the failure, after 35 years, to gain significant momentum. Equally unrealistic is any expectation that the yuan, which is still subject to large-scale capital market controls, could serve as reserve currency in the foreseeable future. Which leaves the euro as the strongest contender competing with the dollar in international forex markets.

Where does the euro stand?

The euro has established itself as number two in the global forex markets and is increasingly being used as a reserve currency. Its share in global forex reserves has risen from 18 percent at the time of its inception to more than 25 percent currently.⁴ Participation of new countries in the euro area could intensify this trend. Scenario analysis by Menzie Chinn and Jeffrey Frankel has shown that the euro could succeed the dollar in 2015. As a precondition, the dollar would have to depreciate further by 4 percent per year (the average of the last 20 years) and at least 20 percent of all forex deals would have to be conducted in the euro area via the city of London. Moreover, all members of today’s EU-27 would have to join the EMU by 2015.⁵ Besides reputational gains for the euro, income from seigniorage would provide an—admittedly small—financial injection for the ailing government budgets.

If this were to happen, the euro would also come to feel the disadvantages of its increasing external use: the single currency would appreciate further and thus considerably hurt European companies’ international competitiveness. Germany’s export-driven economy would be hit hard by such a move. Euroland countries presently suffering from excessive costs like Spain or Italy probably would suffer even more. A slow but steady increase in importance, however, would be less harmful.

Is it desirable to replace the dollar?

The composition of foreign exchange reserves and the continued use of exchange-rate pegs shows the dollar’s predominance on the international stage. The status quo, however, is being challenged by a growing chorus of critical views voiced especially by those who have gathered inconceivable levels of dollar reserves over the last five years. Explicit doubts as to the stability of the dollar’s value expressed by strategic investors such as Warren Buffett, as well as by the above-mentioned holders of large-scale forex reserves, seem to suggest that the dollar’s continued reign is at risk. Massive monetary expansion through the purchase of toxic assets by the Federal Reserve and the dramatic increase in US government debt resulting from bail-out packages for the banking sector and economic stimulus measures to levels near 100 percent of GDP—Italian proportions—have raised doubts as to the government’s ability and/or willingness to repay debt and keep inflation at bay. Over the coming years, this will likely jeopardise the dollar’s reputation as reserve vehicle.

While the possibility of the dollar’s unseating is plausible, there seems to be no compelling argument for a particular alternative. When the dollar went weak in the knees in the mid-1970s, SDRs were also considered a candidate for change, but little came of it. Back then, the German mark would have been the best alternative. And today there can be little doubt as to what could be an alternative to the dollar: not the yuan—which is not convertible and will not be made convertible by the Chinese government in the near future because of an ongoing need for capital controls—but the euro. The euro is backed by a credible central bank committed to price stability. There is no doubt as to the liquidity of this currency (it’s the largest cash provider worldwide and it is almost as big in bonds as the United States), nor to the very low level of transaction costs and remarkable quality of transaction settlement. For all these reasons, the euro will gain in importance as a reserve currency. This will be the case for the same amount of time as it takes for the United States to correct its imbalances and regain its stature as a dynamic and stability-oriented country.

¹ Kenneth Rogoff, interview with Frankfurter Allgemeine Sonntagszeitung, August 16, 2009.
² French President Nicolas Sarkozy at the G8 Summit in L’Aquila, Italy, July 10, 2009.
³ French finance minister Valery Giscard D’Estaing, 1965.
⁴ European Central Bank research.
⁵ Menzie Chinn and Jeffrey Frankel, “Why the Euro Will Rival the Dollar,” International Finance, 2008, Volume 11, Number 1, pp. 49 –73.

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