The Dollar's Reign as Reserve Currency: «The Dollar: Dominant no more?: If the euro’s crisis has a silver lining, it is that it has diverted attention away from risks to the dollar. It was not that long ago that confident observers were all predicting that the dollar was about to lose its ‘exorbitant privilege’ as the leading international currency. First there was financial crisis, born and bred in the US. Then there was the second wave for quantitative easing, which seemed designed to drive down the dollar on foreign exchange markets. All this made the dollar’s loss of pre-eminence seem inevitable. The tables have turned. Now it is Europe that has deep economic and financial problems. Now it is the European Central Bank that seems certain to have to ramp up its bond-buying program. Now it is the Eurozone where political gridlock prevents policymakers from resolving the problem.
In the US meanwhile, we have the extension of the Bush tax cuts together with payroll tax reductions, which amount to a further extension of the expiring fiscal stimulus. This tax ‘compromise’, as it is known, has led economists to up their forecasts of US growth in 2011 from 3% to 4%. In Europe, meanwhile, where fiscal austerity is all the rage, these kind of upward revisions are exceedingly unlikely…. Ten years from now the renminbi is likely to be a major player in the international domain. But for now capital controls limit its attractiveness as an investment vehicle and an international currency. Yet this has not prevented the Malaysian central bank from adding Chinese bonds to its foreign reserves. Nor has it prevented companies like McDonald’s and Caterpillar from issuing renminbi-denominated bonds to finance their Chinese operations. But China will have to move significantly further in opening its financial markets, enhancing their liquidity, and strengthening rule of law before its currency comes into widespread international use. So the dollar is here to stay, more likely than not, if only for want of an alternative.
With exorbitant privilege comes exorbitant responsibility
The one thing that could jeopardise the dollar’s dominance would be significant economic mismanagement in the US. And significant economic mismanagement is not something that can be ruled out. The Congress and Administration have shown no willingness to take the hard decisions needed to close the budget gap. The Republicans have made themselves the party of no new taxes and mythical spending cuts. The Democrats are unable to articulate an alternative. 2011 will see another $1 trillion deficit. It is hard to imagine that 2012, an election year, will be any different. And the situation only deteriorates after that as the baby boomers retire and health care and pension costs explode. We know just how these kind of fiscal crises play out…. Previously sanguine investors wake up one morning to the fact that holding dollars is risky. They fear that the US government, unable to square the budgetary circle, will impose a withholding tax on treasury bond interest – on treasury bond interest to foreigners in particular. Bond spreads will shoot up. The dollar will tank with the rush out of the greenback.
The impact on the international system would not be pretty….
With exorbitant privilege comes exorbitant responsibility. Responsibility for preventing the international monetary and financial system from descending into chaos rests with the US. How much time does it have? Currency crises generally occur right before or after elections. Can you say November 2012?»
(Via Brad DeLong.)