The outbreak of the global financial crisis was preceded by an extended period of persistent financial imbalances. These imbalances stemmed from the symbiotic relationship between the US, with its huge current account deficits, and China (as well as some other countries) that had equally persistent trade surpluses and which financed the US deficits with large capital inflows. These imbalances were fueled further by the very sharp increase in oil prices that occurred after 2003, leading to large surpluses in oil exporting countries. As global cross-border flows exploded during this period, along with accommodative monetary policy in the United States, severe pressures emerged that affected exchange rate determination across the world. The US dollar tended to depreciate significantly with respect to most other floating currencies. As a consequence, with much international trade being transacted in dollars, some countries intervened in their foreign exchange markets to restrain currency and monetary volatility in order to maintain domestic financial stability. That led to increases in dollar prices of many commodities and a spiral of further reserve accumulation. With the outbreak of the global financial crisis after the Lehman episode, the initial reaction in world financial markets was capital flight to US “safety,” which led to a rise in the value of the dollar, even though the crisis originated in the dollar’s home country. Such is the status of the United States in the global political economy and in global markets. This is also why the dollar is the world’s primary reserve currency, the unit of exchange, and store of value. It was only after financial markets began to return to some degree of normalcy that fundamentals seemed to reassert themselves in the dollar’s valuation. Now, as the dollar has depreciated, concerns have arisen regarding its status as the world’s reserve currency.

The current concern over the future of the dollar has arisen only recently. It is primarily a product of large global imbalances that have emerged in the past five years and associated exchange-rate volatility. The use of any currency as a reserve currency is predicated on its stability. The world’s premier currency is not only expected to exhibit stability in its own value but is also expected to contribute to world financial stability. These conditions have clearly been violated in recent years. Although rigidities in exchange rate policies in some countries also existed for extended periods during the 1990s and earlier, the United States did not exhibit serious macroeconomic imbalances back then. In fact, when budget deficits reversed to surpluses during the Clinton years, global confidence in the US economy was strengthened, despite recurrent current-account deficits. On the political economy front, the fall of the Iron Curtain, the persistence of Japanese malaise, and slow European growth, all combined to increase global faith in the United States and, hence, its currency. The conquering of inflation in the Volcker years and resurgent productivity in the 1990s led to the great moderation, providing further confidence in the dollar as the world’s primary reserve currency.

During the current decade, however, starting with the dot-com crash, followed by 9/11 and associated wars in Iraq and Afghanistan, US monetary and fiscal policies have both had to be largely accommodative. The attempt to tighten monetary policy in 2005–06 ended in the subprime crisis, followed by the more generalized global economic and financial crisis, and deep recession. The extraordinary but timely fiscal and monetary policy responses have, on the one hand, resulted in a heavy fiscal overhang, and on the other, a cheap dollar, giving rise to the dollar carry trade. Both of these consequences have aroused fears regarding the ability of the United States to weather this fiscal and monetary overhang within a reasonable period of time. Countries with large dollar reserves clearly see the depreciation of the dollar as a threat to the current value of their reserves; and doubts related to the prospects of medium-term fiscal recovery as a threat to their future value. The fear essentially is that these issues will lead to inflation, threatening the role of the dollar as a stable store of value. The associated increase in exchange-rate volatility would also have consequences for the dollar’s ability to act as a medium of exchange and as a unit of account.

What then is the future of the dollar? Whatever the dollar’s drawbacks, the world will not easily find a reliable and durable alternative in the near or medium term. The possible alternatives, euro, yen, pound, yuan, and Special Drawing Rights (SDR), all have significant shortcomings as dominant reserve currencies, though they can and do serve supplemental roles.

The euro is seen as the best candidate. The euro area is now larger in economic terms than the United States. And as euro-related financial and capital markets grow further, and greater integration takes place, the use of the euro as a reserve currency will certainly increase. However, a number of factors will constrain its role. First, its capital markets are still not as liquid as those of the United States. The holding of reserves, in particular, requires the availability of sovereign assets with the highest credit quality, and deep, liquid markets where these assets can be traded with ease. The various sovereigns issuing treasury securities in euros exhibit significant differences in perceived credit quality. In addition, the size of each issue is limited to the fiscal need of each country and hence cannot be very large and liquid. Thus the use of the euro as the dominant reserve currency is likely to be circumscribed. The expected pattern of European demographics could bring further doubt as to the credit quality of euro-denominated government securities. The leading European countries are exhibiting demographic pressures from aging populations, which will have their own consequences for fiscal sustainability. With tax rates in these countries already relatively high, further doubts arise about their room for fiscal maneuvering in the future. Furthermore, the eurozone is not politically unified. , Thus the euro violates another condition of reserve currencies, that the issuer should exhibit palpable political power in the world.

The yen and pound display some similar characteristics. They of course do not suffer from their issuing jurisdictions being fractured politically. Although both have liquid markets for treasury securities, they are not large enough individually to really function as reserve-currency jurisdictions and they do not exhibit political power.

The yuan also has drawbacks as a reserve currency, at least in the short term. First, the yuan is not yet convertible. Second, China’s financial and capital markets have a long way to go. Third, at present, it is China that needs a haven for its surpluses. And fourth, international financial markets would still exhibit doubt regarding the long-term political stability of China. Over the long-term, these doubts could disappear. China’s economic size and potential political power could certainly rival that of the United States, allowing the yuan to emerge as a reserve currency. In the short- to medium- term, however, the probability of this taking place is low.

That leaves the SDR, which also has serious weaknesses. At present, the SDR is only a medium of account used by governments and some international institutions. It does not serve as a medium of exchange and has very limited use and potential as a store of value for reserves. Even after the current agreement to increase the magnitude of issuance by SDR 250 billion, a more than eight-fold increase from the extant magnitude, it is only a small fraction of the total reserves in the world, which exceed US $5 trillion. Even further feasible increases in its magnitude will not suffice to make it a credible haven for countries’ reserves. In addition, the credit quality of SDRs has to be backed up by the credit quality of the contributing countries. That cannot be independent of the dominant world economic powers: in fact, it can only be broadly proportionate to the current distribution of world economic weight. That brings us back to the credit quality of the United States and the eurozone. Furthermore, while it is possible to imagine its use as a unit of account and even as a medium of exchange, the inertia inherent in the world financial system will militate strongly against this happening.

Where does that leave us? We come back to the US dollar and the United States. The world is stuck with the United States and the United States is stuck with the use of its currency as the premier reserve currency for the present. But both are threatened. For the dollar to continue in this role, its value has to exhibit greater stability than it has in the past. Thus the fiscal and monetary policies of the United States also need to inspire greater confidence than at present. US monetary policy has been far less consistent than in other advanced countries in the years since Volcker presided over the Fed, resulting in greater swings in US interest rates and exchange rates than may be optimal for the rest of the world. The high volatility in commodity prices, particularly that of oil, is also related to these swings, which then feed back into the system, increasing the demand for foreign exchange reserves. On the fiscal side, there is great need for the articulation of a credible exit from the current untenable situation. Finally, both the US current account deficit and the Chinese surplus have to be reduced. There is no way that the world can cope with the pace of increase in foreign exchange reserves that has taken place in recent years. This requires structural changes in both countries. In the US, the incentives for savings need attention and there must be tighter and more effective financial regulation in the future. Credit financed consumption and housing need to be reduced. On the Chinese side, the excess savings issue may be related less to the behavior of households and more to a corporate structure that generates continuing high corporate profits and retained earnings, which lead to excessively high savings.

We thus come back to the issue of global imbalances. If these imbalances continue in their current form, there is no doubt that the role of the dollar as a reserve currency will come under increasing threat. If the current pace of reserve accumulation continues, it is difficult to foresee where these reserves can be invested. Thus the issue of reserve currency cannot be divorced from some of the basic structural issues that need to be faced by the leading economies. These issues can only be resolved if we stop looking for illusory quick fixes and focus on the basics. That the issue has only arisen in the last five years suggests that solutions are not difficult to find and are feasible. The United States has to demonstrate credibility in its medium-term strategy for restoring fiscal responsibility and a more stable monetary policy. Only then can the dollar reclaim international confidence and the global financial system continues in its current form.

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