Looking for the next Dollar

For years, analysts have sought to predict the demise of the US dollar and its eventual replacement as the world’s preeminent global reserve currency. However aside from the ego boost of being in demand, and the not insignificant benefits of low-cost borrowing, being the world’s reserve currency carries significant mid- and long-term economic costs that history tells us may preclude any one currency from taking the lead in the 21st Century.

The role of the US dollar as the world’s reserve currency dates back decades, to the end of World War II, when the US sat as the world’s lone, relatively unscathed and economically powerful combatant and thus replaced the British Pound as the global currency of choice. The fact that US dollars rebuilt much of Europe and Japan in the years that followed significantly strengthened the global tie to the USD. In 1970, over three-quarters of global reserves were held in US dollars.

In the decades that followed, several currencies rose in strength relative to the USD, notably the Japanese Yen and the German Deutsche Mark, but none held the attractiveness of the USD and its home in the world’s largest economy. The preeminence of USD reserves held globally remained relatively unchallenged but did actually decline from 77 per cent in 1970 to 66 per cent in 1984. During the same period, Deutsche Mark holdings increased from just 1.9 per cent in 1980 to 12 per cent in 1984, while holdings of Japanese Yen grew from .1 per cent to 5.4 per cent. Some ventured to state that Germany and Japan would one-day eclipse the US as the world’s leading economy and reserve currency.

Explaining the shift in reserves away from the USD is too complex to cover adequately here. However, it suffices to say that reserves follow economic strength. The 1970s saw the US struggle under inflation, war, and the end of the Gold Standard which had pegged the US dollar to gold assets, and whose removal dented confidence in the dollar. The simultaneous growth of export-economies in Germany and Japan made them the primary beneficiaries of reserve diversification in the early to mid-1980’ss.

In the years that followed, USD holdings hit their all-time low, falling below 50% of global reserves in 1990. Not surprising, it also marked the peak for both Japan and Europe’s share of global reserves – both of which hit all-time highs in the late 1980s and early 1990s at 10% and 39% respectively (with Germany being the biggest contributor to Europe’s aggregate total).

A reversal of fortunes in the mid-1990s, however, saw the US economy rebound and with it preference for USD holdings. Conversely, Japan sagged under the weight of the appreciating Yen and a series of policy failures (Note: I briefly cover the impact of Japan’s rising Yen on its long-term economic growth here).  By 2000, the USD represented over 70 per cent of total reserve holdings versus just 19 per cent for the new EURO and just 6 per cent for the Japanese Yen. The dollar was back on top.

Its rise, however, was short-lived.

In the decade since, American debt accumulation and sluggish economic growth saw reserve diversification heat up once again. The dollar was done many claimed. This time, however, it was the EURO that slowly grabbed an increasing share of global reserves, hitting 27 per cent in 2008 and near 28 per cent in late 2009. Some, including former US Federal Reserve Chief Alan Greenspan, have mused that the EURO would one day overtake the US as the world’s primary reserve currency. Yet given historical precedents, to whom would the benefits of such reserve growth accrue?

Like Japan’s experience as a new member of the reserve club, the increasing share of EURO reserve holdings have been accompanied by a gradual appreciation of the Euro versus the Dollar since the introduction of Europe’s common currency in 1999. Evidently there are both benefits and costs associated with an appreciating currency.

On the plus side, currency strength decreases import prices which mitigate inflationary tendencies that accompany economic growth, it allows for low-cost borrowing, and it allows for international expansion and investment.  Conversely, it can also prove debilitating if a strong domestic currency acts to hollow out domestic industry and exports by making them expensive in the global market, and worse yet if it spurs reckless borrowing as it has in the US.

Europe and the Euro should be the defacto alternative to the US dollar but Europe is smart enough to know that rapid appreciation of the EURO could destroy their already shaky competitiveness. The rapid expansion of the Eurozone has seen membership extended to several highly indebted and economically fragile Southern and Eastern European countries. Greece’s recent debt debacle is just one of a series of meltdowns that could seriously harm the Eurozone economy and the stability of the Euro.

Though perhaps we shouldn’t be surprised. Back in 1998, when the Euro was launched, Nobel Laureate and economist Milton Friedman warned that the Euro might not survive a major economic recession due to its weak labour and product market flexibility. Fast forward 10 years, and we’re now seeing whether his warning will ring true.

Should the EURO continue to rise in popularity amongst sovereign investors, its appreciation against the USD would continue, which, if recent economic patterns continue, could be extremely detrimental for the European Union on a whole. While the strong EURO has been beneficial for strong economies in England, France and Germany, it has been the opposite for the poorest EU15 members in Southern and Eastern Europe. Greece’s recent debt debacle was spurred in part by the impact of the rising EURO on tourist arrivals, whose decrease led government revenues to plummet and combined the cost of economic stimulus in 2009, left the country unable to meet the most modest of its obligations. Others in the same fiscal neighbourhood include Spain, Italy and Portugal, all of whom own similarly weak economies who have suffered with the EURO’s appreciation, and simultaneously have enormous fiscal imbalances due to the past two years of stimulus spending.

A strong EURO thus puts Europe’s weakest members at significant risk of default, mitigated only by the generosity of tax payers in Europe’s economic core who will fund the subsequent sovereign bailouts. The theoretical solution moving forward would be to have all fiscal budgets set by Brussels rather than self-interested national capitals but I’m of the belief that the EU is still a collaboration amongst nations and not a supra-nation in and of itself – countries will not give up sovereign control over domestic spending. But neither will taxpayers in France, Germany and England look favourably upon massive bailouts of their poorer neighbours. A strong Euro amongst weak members is thus a recipe for the dissolution of the European Monetary Union.

If not the EURO, and if a priori the Dollar is in decline, then which currency might rule the 21st Century as the Dollar did the 20th?

Famed economist Nouriel Roubini believes it might be the Chinese Renminbi. He sees China’s relative position to the US as similar to the US’ position vis-à-vis the United Kingdom prior to WWII: a creditor country, flush with cash, and laden with strong economic growth prospects.

Yet China has so far proven to be very reluctant to allow the Yuan to appreciate. Currency reforms proposed by the G20 have been met with blank stares from China. And should we blame them?

The Chinese economy if far from diversified and strong enough to withstand the impact of a dramatic increase in the value of the Yuan. Having learnt from the experiences of neighbouring Japan, whose 1985 Plaza Accord agreement to allow a near 40 per cent increase in the value of the Yen versus the dollar, helped depose any future economic growth, China is very unlikely to accept anything but a minimal appreciation of their currency. Many believe a 3-8 per cent increase is likely and necessary to keep inflation in check.

But ultimately China is far from a likely to allow a fully-tradeable Chinese currency for fears that speculators and investors would flock to it, causing a significant increase in the cost of Chinese exports, and a long-term decline in the country’s competitiveness. Having already lost its crown as the world’s great power in the 16th century, Chinese pride is unlikely to let it happen again.

So as the Dollar is shunted aside, the Chinese won’t fill the gap, and neither will Japan or Europe.

No one wants to be a reserve currency.  And really, no one should.

Thus, perhaps everyone should.

In a world of inter-connected and inter-dependent trade and financial flows, it makes little sense to have one party absorb the majority of the benefits and costs of reserve status. It fit over the past one hundred and fifty years of empire led by the UK and then the US, an age where influence and power was held by one and at most two global powers. Reserve currency status was a means of both exploiting and extending the reach of that power through unimpeded borrowing and the creation of a mutually-destructive end-game.

However as power becomes more diffuse around the world, notably with the rise of China, India, Brazil, Russia and more recent emerging powers in Turkey, Iran and South Africa, having one primary reserve currency makes little sense.

Unless, perhaps, that reserve currency was as diffuse and inter-dependent as the world around it.

Hence the most logical replacement for the US Dollar isn’t the Euro, the Renminbi or any other single currency. Rather, if we continue to see global power shared amongst a growing number of nations, the same will be true of currency reserves – measured through a standard basket of currencies handled most likely by the IMF, in a similar fashion to its existing Special Drawing Rights receipts except with a much-broader basket of convertible currencies.

The world’s new reserve currency would be comprised of weighted-allocations of individual currencies; weighted on the basis of their annualized share of global GDP or some other merit- rather than power-related rationale.

This isn’t a call for a global currency, rather for a global reserve currency. The two are extremely different.  A global reserve currency would limit the destabilizing effect of currency appreciation and speculation in the reserve country, it would limit the moral hazard of reckless borrowing seen under our empiric reserve system, and finally, it would lower the borrowing costs for all countries involved, thus acting as a means of more equitably distributing investment and wealth around the world.

These benefits notwithstanding, there are undoubtedly some major challenges for a global reserve currency to develop. Notably, it would require an unprecedented level of cooperation, if not interference, amongst and within national economic policies. The subsequent incursions against national fiscal and monetary sovereignty make it unlikely to happen but that doesn’t mean it can’t or shouldn’t.

In fact, if the US dollar reserve status is replaced by any single currency, then the costs borne by Americans (and by extension Canadians, Brits and the EU) will be enormous. Financial default by the US wouldn’t be out of the question. The subsequent impact on the world’s export leaders (yet still developing economies) in China, India, Brazil amongst others would be equally severe. Who would rise from the rubble of real economic collapse? And could it be done without military intervention? The risks would be enormous.

Luckily there’s a way to avoid that calamity: by developing a global reserve currency that diffuses risk and reward to reflect the new diffusion of power and influence in the world.

Whether it happens or not will depend on whether the age of empire has truly ended or whether we’ve simply moved to its next chapter.

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