The End of Dollar Supremacy?
Given the current account deficit in the United States of more than five per cent and a negative net foreign investment position of over twenty per cent of its gross domestic product, it is the relative stability of the US dollar that needs explanation and not the fact that the effective exchange rate of the dollar has declined by twenty per cent since late 2002. It is even more remarkable that U.S. interest rates did not have to rise as might have been expected in order to attract foreign investment as a compensation for the deficit in the current account.
Balance of payments numbers such as those the United States currently has would have broken many other currencies and would have triggered severe financial crises in other countries much earlier. But the United States is different. It holds a privileged position within the international monetary system and its path to ruin may be longer and smoother than that for other nations. Nevertheless, even for the U.S. there is a limit and the country seems to be getting closer to it every day.
The relative strength of the US dollar despite the deteriorating external position results from the role of the dollar as the world's global reserve currency and because the pillars on which the dollar's supremacy rests do still seem intact. Furthermore, there is not yet a ready substitute for the dollar in sight which could replace it as a functioning global currency.
Compared to its potential rivals such as the euro or the yen, the US dollar has a historical and a quantitative advantage. For more than half a century, the world-wide use of the US dollar has been common practice. The dollar is the unrivalled global currency, a currency whose position as an international means of exchange rests on a prolonged experience. The dollar's origin as to its source of production is the visible power of the United States in terms of its national unity and its global military presence. Additionally, the dollar's predominance rests on the strength of the U.S. economy as there is no other economy of size which could match it in terms of productivity and innovation.
All these pillars have strengthened since the early 1990s. The use of the dollar has become more widespread on a global scale with the integration of the former Communist countries into the world economy; the position of the United States as the principal global political and military player has strengthened with the fall of the Soviet Union; and, particularly since the mid 1990s, the American economy has experienced a period of outstanding dynamism and resiliency.
So why the jitters about the imminent decline and fall of the US dollar that have emerged? Isn't there reason to believe that the dollar's supremacy will remain undisputed in the future as well?
Unfortunately, the outlook is more dramatic than the question may suggest at first glance. The dramatic statement says that—at least for a while—the dollar will not be replaced by another global means of exchange but that the dollar may lose its supreme role nevertheless. A fall in the dollar from its pedestal with no substitute to replace it would be the very disturbing outlook suggested by an interpretation of the current trends. The disastrous consequences of the demise of the dollar as the global currency with no other means of exchange to replace it refers to the outlook that we may enter a period of currency chaos and a global economic contraction.
Losing trust does not mean that there must be a ready substitute. On the contrary: when distrust will emerge towards the US dollar this would affect the attitude towards all paper currencies. In the final stages of the currency crisis, the dollar will most likely devalue not so much against the euro and the yen, but all of these currencies and most of the rest will devalue drastically against gold.
There is neither a theoretical nor an empirical reason to believe that the dollar should be different from the other fiat currencies that have emerged and disappeared in the past. Even more so, given the unique position of the dollar in the current monetary system, the temptation to abuse this privilege has been greater for the United States than that which inflicted other nations and led to their decline.
From early on, the United States has taken advantage from the privileged position of the dollar in the modern monetary system, but it has been essentially only since the early 1980s when the enjoyment of a privilege began to turn into an abuse; and it is only in the past couple of years or so when the abuse has turned into an almost complete lack of consideration. In due course, confidence of private investors has begun to erode.
In the past couple of years there has been a massive fall of foreign direct investment flowing into the United States and in 2002 the flow became negative (see table 1). In 2001 the basic balance turned negative and reached 218 billion US dollar in 2002. This signifies that there is less capital inflow to compensate for the expanding current account deficit.
United States. Current account and composition of capital account 2000–2002 (a)
|Net long-term capital|
Basic Balance (b)
(a) in billions of US dollars
(b) Current account plus net long-term capital
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table II.4
It has been mainly due to the buying of bonds by foreign central banks that a dollar crash has been averted so far. The massive buying of U.S. bonds by central banks in 2001 and 2002 has led to an increase in global US dollar reserves which surged by 219.8 billion in 2002 reaching a total of 1,751.4 by the end of that year (see table 2).
Annual changes in official foreign exchange reserves 2000-2002 (a)
(a) in billions US dollars at constant exchange rates
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table V.1
The major buyers of U.S. debt among the central banks are now located in Asia, and here particularly in China, Hong Kong and Taiwan (see table 3). This trend—that central banks substitute private investors and thus stabilize the dollar—will hardly be sustainable.
Annual changes in official exchange reserves. Selected areas (a)
(a) in billions US dollars at current exchange rates
(b) mainly China, Hong Kong SAR, and Taiwan
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table V.1
A situation like this which has emerged over the past few years implies an increasing financial vulnerability of the United States. If the buying spree by foreign central banks should stop or even reverse, the impact would affect the dollar exchange rate, the treasury market and the domestic price level with the consequences of a sinking dollar, a sharp rise of domestic interest rates and an increased inflation rate. It is highly unlikely that the American economy would prove resilient enough to withstand such a triple blow.
The coming of a dollar crisis would expose the internal fragilities of the U.S. economy which currently are largely hidden. Along with the end of the favors for consumers to indulge in spending and for private and public debtors to have their investment and budget deficits financed by foreigners, a decline of the dollar would expose the lack of a balanced industrial structure in the United States. More than twenty years of persistently high trade deficits have led to an industrial structure which has made the United States highly dependent on foreign imports with a lack of domestic suppliers that could readily substitute dearer imports.
What would happen if the dollar should surpass the threshold and a crisis of confidence emerges? The consequences would not be confined to the United States itself. The dollar crisis would affect the rest of the world and it would put the current international monetary system at stake with the potential of bringing it down. While the pillars on which the dollar stands may still seem to be intact today—the statue itself may come down. But when the dollar should fall, the pillars on which it has stood, will crumble too.
Given the trend that the U.S. foreign debt position will continue to deteriorate, a severe dollar crisis seems almost inevitable. But this is only half of the story. The dramatic part of the enfolding scenario is that there is no ready substitute for the dollar as a global currency and that the dollar crisis will put the overall economic and political position of the United States at risk. With the loss of the privileged position of the dollar the economy would weaken and this in turn would undermine the political role that the Unted States plays presently as the world's hegemon.
International finance is closely intertwined with international politics. While a predominant role in international finance does not come without the basis provided by politics, it is sound finance on which the continuation of the dominant global role will depend later on. Both of these, however, have a more profound basis: it is basically the ethical attitude to the matters of money and finance, the deeply rooted sense for prudence and rectitude, which is required to be maintained in order to keep the privileged position.
Near the end of the Hapsburg Empire, before the outbreak of World War I, Eugen von Böhm-Bawerk wrote in his essay "Our passive trade balance"1 that all those theories brought forth to explain the persistently negative trade balance of the Austro-Hungarian Empire—such as a surge in industrial strength and its attractiveness for foreign investment—do not stand a more profound analysis. These argument would imply that the "passivity" would be transitory. The persistency of the trade deficits requires that the situation be analyzed beginning with the capital balance, and this way, Böhm-Bawerk pointed out, the negative trade balance had its roots in a lack of domestic savings, the unproductive use of resources and "wasteful consumption" (pp. 509).
A "change of mind" had occurred, said Böhm-Bawerk, and the accumulation of massive deficits reflected a "lack of morality" (p. 511): "We slithered from surpluses into a phase of easy-hearted and willing expenditures, and we continued to slither even after the surpluses were long gone."2