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Gauging the Dollar Decline

Interviewers: Benn Steil, Senior Fellow and Director of International Economics, Council on Foreign Relations, and Roya Wolverson, Staff Writer, CFR.org
October 19, 2009

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The U.S. dollar has dropped by roughly 10 percent in value against other major currencies so far this year, prompting a flurry of speculation about its future. Federal Reserve Chairman Ben Bernanke said at an October 19 conference that it was "critically important to maintain confidence in our economy and confidence in our currency" (FT). CFR Senior Fellow Benn Steil says continued weakness in the dollar could be costly for the U.S. economy since the United States will spend more on critical imports like energy, which it cannot produce enough of domestically to meet demand. But he says the United States is "doing nothing that would actually encourage the dollar to strengthen against other currencies." Steil adds that "U.S. insouciance in the face of a further dollar decline" could provoke a run on the dollar, which could lead to higher inflation and rising U.S. interest rates in future.

What's causing the recent dollar drop?

The dollar rose significantly during the height of the crisis, as investors sought the safety and liquidity of U.S. Treasuries. As fears of another Great Depression subsided in recent months, investors' risk-tolerance revived and they began re-diversifying into higher-yielding foreign assets. As the Federal Reserve drove short-term interest rates down near zero, the dollar emerged as a so-called carry-trade vehicle: investors borrowed dollars in order to sell them for currencies, which they could then lend at higher rates. This is a risky strategy, as investors who borrowed yen to invest in Icelandic krona learned during the crisis. But it is a sign that the world, having been dollar-hungry a year ago, is dollar-saturated today.

What is the risk of a sharper decline of the dollar?† Of a dollar crash?

Both monetary policy and fiscal policy are extremely loose in the United States at the moment, and this is fueling nervousness among the Chinese and other major foreign holders of dollar assets that the global purchasing power of those assets will be much lower in the future. The dollar accounts for an enormous two-thirds of global reserves and global trade, which means that it has a long way to fall in the currency markets should the euro, its nearest rival, rise to the level of co-equal. This would likely mean higher inflation and, almost certainly, higher interest rates in the United States.† It would also mean that the sort of extraordinary monetary and fiscal stimulus the U.S. has pursued during the current crisis would be impossible in the future, as the world will not be nearly so hungry for dollars.

Both Treasury Secretary Timothy Geithner and White House economic adviser Larry Summers recently reemphasized the U.S. commitment to a strong dollar. Meanwhile, there's speculation that the U.S. actually wants to devalue the dollar, essentially making its debt worth less. Is that a viable strategy?

The U.S. is in the fortunate position of being the master of the dollar's destiny, in the sense that the world has no incentive to move to any radical alternative, provided the U.S. can offer credible assurance that it will not take actions to undermine the dollar's global purchasing power.

"Strong dollar" is an administration talking point to avoid undermining foreign faith in U.S. economic policy, but the U.S. is doing nothing that would actually encourage the dollar to strengthen against other currencies.† Quite the opposite. They believe that a weaker dollar is necessary to stimulate exports and reduce the trade deficit. There are a number of problems with this strategy. One is that the U.S. does not currently have the capacity to substitute domestic production for imports in a number of critical areas, most significantly energy. So a lower dollar means more money spent on certain major imports. More importantly, the world is very conscious of the incentives the U.S. has to inflate away its burgeoning debt, meaning that U.S. insouciance in the face of a further dollar decline could provoke a run on the dollar in the currency markets. Again, this could mean higher inflation and interest rates in the U.S. in the years to come.

Is the dollar ultimately headed for demise?

Chinese central bank Governor Zhou Xiaochuan last March mentioned the problem of the "Triffin Dilemma" -- the problem that any national monetary authority issuing the de facto international currency will always create one of two problems for the world: too little liquidity or too much. From the perspective of America's major creditors in Asia and the Middle East, the current fear is that the U.S. is printing far too many dollars, and that this will seriously undermine the future purchasing power of their huge stock of dollar assets. The U.S. created the same problem in the 1960s, and crushed global confidence in the dollar. It was fortunate not to have had viable competitors in the 1970s and '80s; there are alternatives today.

If we are moving to a dollar alternative, how do we get there and when?

China's initiative to conduct trade with Brazil and Russia without dollars is one that could catch on.† Unfortunately, to the extent that it does, it is a real threat to the multilateral trading system. As these countries will not want to stockpile one another's currencies, they will need to pursue trade discrimination practices that balance trade bilaterally across trading partners. Any large-scale shift away from dollars as the global reserve and trade currency to euros would necessarily result in a huge appreciation of the euro and a rapid rise in eurozone current account deficits. This would produce a massive protectionist backlash in Europe, and is therefore also a threat to global free trade. The only other viable alternative I see is privately produced gold-backed money. There are already many "gold banks" in operation, which allow account holders to store, receive, and transfer digital shares of gold.† If the phenomenon grows, it will naturally lead to the issuance of gold debit cards. This would allow you, for example, to walk into a cafť in Sao Paolo and pay for your cappuccino with a swipe of your card for a tenth of a gram of gold. Governor Zhou's suggestion that the International Monetary Fund's Special Drawing Rights (SDRs) could be transformed into a major global reserve currency is a nonstarter, as the U.S. will not cooperate. John Maynard Keynes advocated such an idea during World War II, and the U.S. rejected it outright.

Is there a way to induce the U.S. into ceding its dominant currency position?

Not willingly, no.† The U.S. is in the fortunate position of being the master of the dollar's destiny, in the sense that the world has no incentive to move to any radical alternative, provided the U.S. can offer credible assurance that it will not take actions to undermine the dollar's global purchasing power.

China has suggested the possibility of using the IMF's Special Drawing Right as a global reserve currency. Wouldn't China prefer to use its own currency, the yuan, as a global reserve to give it more flexibility?

Yes, but there is a major tradeoff involved. China would have to substantially eliminate capital controls, and take major steps to facilitate the emergence of deep and liquid domestic markets for yuan financial assets, free from arbitrary government interference. China is currently unwilling to take such steps, fearing that it might undermine domestic economic and political stability.

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