The decline of U.S. dollar hegemony?
We may be facing a more volatile international money order
As the U.S. dollar falls to near record lows against the euro, many are questioning its future as the pre-eminent international currency. Can the greenback continue to retain its global position in the face of the enormous U.S. external debt and current account deficits?
Those anticipating an imminent decline in the dollar's global status recall past experience. In their respective heydays, international currencies such as the Venetian ducat, the Spanish-Mexican peso and the British pound inspired confidence abroad because of their stable value. But as the value of these currencies eroded in the face of economic troubles, foreigners turned to more trustworthy successors.
But currencies achieve international standing not just because of their stable value. Despite its declining worth, the dollar will retain acceptability abroad partly because U.S. markets and U.S.-based companies retain an important place in the world economy.
The dollar will also remain attractive for foreigners to use and hold because the U.S. houses the world's deepest and most liquid financial markets. The euro-zone countries -- let alone Japan or China -- have a long way to go before they can boast a financial market that is as attractive to asset-holders as, say, the U.S. Treasury bill market in this respect.
The dollar will also benefit from the built-in inertia of international monetary arrangements. It is costly to switch away from a familiar unit of account or medium of exchange, particularly if it is unclear whether others will make the same change. This helps to explain why the monetary influence of dominant states is often the very last aspect of their power to decline.
But these kinds of economic factors have not been the only determinants of international currencies in the past. Politics have also been significant. Think, for example, of the tight political connections between Britain and many of the "sterling area" countries in the last century who supported the pound, particularly through their reserve holdings of the currency.
In the past few years, the U.S. dollar's value has also been increasingly supported by foreign governments who have begun accumulating very extensive dollar holdings. The most dramatic build-up of dollar reserves has been in China where the government now holds more than $1-trillion of mostly dollar-denominated reserves. Other East Asian countries -- most notably Japan -- also hold very substantial dollar reserves. So, too, do a number of oil-exporting countries in the Middle East, as well as Russia.
The politics associated with these growing official dollar reserve holdings are different from those of the old sterling area. Many sterling area countries were British colonies, forced to embrace and support sterling by their subordinate status. By contrast, members of the informal U.S. "dollar area" today have more autonomy to make their own choices to support the greenback.
Economic considerations have influenced these choices, but they may not explain the whole story. At times of dollar weakness as far back as the 1960s and 1970s, analysts have noted how official dollar support by foreign states was often linked to broader political considerations within the U.S.-led Western alliance during the Cold War.
The uncertainty of the current situation stems from the fact that official dollar support no longer comes, as it did in the 1960s and 1970s, exclusively from Washington's close allies. Put bluntly, the dollar's position may be less secure in a context where the largest holder of dollar reserves -- China -- is considered by some as more of a geopolitical rival than close ally of the United States.
Many argue that China's government has little interest in seeing the dollar's value plummet since this would undermine the competitiveness of Chinese exports to the U.S. market. But Chinese officials must also weigh the financial costs of continuing to hold an enormous quantity of dollar reserves, particularly if other dollar holders begin to sell.
If the past is any guide, broader strategic concerns could also come into play if political relations between the two countries deteriorated. One need only recall how Charles de Gaulle became more reluctant to support the dollar as he carved out a more independent French foreign policy from the U.S. during the 1960s.
There are already signs that strategic views may be influencing some other dollar-holding countries. Russian authorities have recently made clear their determination to reduce their dependence on the dollar as part of their efforts to rebuild their country's autonomy and power in world politics. Some speculate that dissatisfaction with U.S. policy in the Middle East might encourage some of the Persian Gulf states to reconsider their strong support for the currency.
If the dollar's official supporters abroad grow more reluctant, the currency would not simply be replaced by the euro as the dominant world currency. A more decentralized world monetary system is the more likely result in which the euro, the dollar, as well as the yen, and perhaps even the yuan compete for influence in different regions of the world.
Since the dollar's international role has buttressed U.S. power and policy autonomy since 1945, this could be a development with important consequences for the U.S. It may also mean a less predictable and more volatile international monetary order for everyone else -- Canadians included.