Tuesday, September 1, 2009

Decline of the Dollar

The Wall Street Journal has a story (subscription required) on the inevitable decline of the dollar's role as reserve currency.
Decades from now, the crisis of 2008 mightn't be remembered as the last days of Bear Stearns and Lehman Brothers, but as the moment the dollar lost its undisputed No. 1 ranking among world currencies.
French President Nicolas Sarkozy continues a French tradition when he writes:
"What was true in 1945 can no longer be true today," Mr. Sarkozy said last week. "The dollar cannot claim to be the only currency in the world."
and we have a Malaysian human rights activist
In Malaysia, peace activist Dr. Chandra Muzaffar has talked repeatedly about phasing out the dollar as the world's sole reserve currency. "It's one of the pillars of U.S. hegemony," he said in an interview. "The signs indicate that we are on the cusp of major change."
These last comments make no economic sense, but what of the issue that the dollar will cease to be the world's reserve currency. Nothing lasts forever. The pound was the reserve currency till the dollar took over during the interwar period. What of the dollar's future.

There is a network effect involved with a reserve currency (as with domestic as well). The fact that many people hold makes others willing to hold it. So a rapid decline is unlikely. But given large US current account deficits the dollar is bound to continue to depreciate. This means that countries that hold dollars must expect capital losses. Will they be willing to do this for a long time? Unlikely, but even talk of replacing the dollar hurts the value of their stocks today. To an extent they are stuck with the dollar because of past decisions.

Another factor that supports the dollar is the size of the US market. Many countries hold dollars to prevent their currencies from appreciating so that they can export to the US. But it is unclear that this is a sustainable force.

One factor that has supported the dollar is the lack of an alternative. The euro is, however, a more plausible alternative to the dollar than any single country's currency. The yuan or ruble are unlikely candidates -- a reserve currency must be issued by a country with open capital markets. But the euro represents a large economy with stable politics. Over time its share of world reserves is bound to grow, and the role of the dollar will shrink. How far and how fast is the question.

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