AS THE US dollar tumbles, concern is growing that its weakness may augur the end of the US currency's 62-year reign as the world's specie of choice for trade, financial transactions and central-bank reserves.
But to paraphrase Mark Twain, reports of the dollar's death have been greatly exaggerated. The dollar owes its position as the world's premier international currency to its status as a haven during times of turmoil, the absence of a suitable rival, weak domestic demand in other countries and plain old inertia. Geopolitics also plays a role.
If the dollar falls from its perch, which currency might supplant it? Some folks figure the yuan. But currently that's a non-starter. China's currency isn't even freely traded.
The most likely candidate is the euro, a widely traded currency backed by deep capital markets, a respected central bank and a large economy. The 13 countries that use the euro constitute a US$10.5 trillion economic bloc.
Still, Europe's common currency has drawbacks: The UK isn't a member of the euro area. That deprives the region of London, which arguably rivals New York as a global financial centre. Frankfurt isn't in the same league. The euro is also identified more with the European Central Bank than any single country and doesn't command the national support other monetary units enjoy. Italian politicians have suggested exiting the club, whereas no US state has seceded since the Civil War ended in 1865. Moreover, European political union isn't on the horizon. And no nation-state has ever been built on the back of a central bank. It's always the other way around.
What's more, next to the US, the euro area is a military midget, and geopolitical muscle counts. It's a major reason why oil and other commodities are priced in dollars. Sterling's loss of reserve-currency status followed the UK's loss of military might, its colonial empire and economic primacy.
The US is also the world's buyer of last resort, and US imports are a major engine of global growth. Other countries haven't developed sufficient domestic demand and thus rely on exports for growth and employment. To keep their exports competitive, Asian countries, especially, maintain undervalued exchange rates by buying hordes of dollars.
'Conventional theory says the dollar will only lose its dominance when countries become saturated with dollar holdings' and stop buying and even sell dollars, Thomas Palley, Washington-based head of the Economics for Democratic & Open Societies Project, wrote in a web posting last year. But 'countries have no incentive to sell dollars, as this would kill the golden goose of export-led growth'.
History of dollar depreciation
The dollar fell to a record US$1.4731 to the euro two days ago, and has sunk to multi-year lows against the currencies of the UK, Australia, Canada, Sweden and Norway.
Buffeting the dollar are traders' suspicions that the US mortgage crisis will retard US growth and prompt the Federal Reserve to cut interest rates further, while other countries reduce their dollar reserves. To be sure, the dollar's decline is eroding its reputation for stability and as a store of value. Some also suspect the Bush administration is purposefully pursuing a weak-dollar policy to boost exports.
Still, dollar depreciation is nothing new: The currency plummeted in 1977-79, 1985-88 and 1993-95. From 1978 to 1980, the need to attract foreign investors prompted the Treasury to sell US$6.4 billion of 'Carter bonds', denominated in deutschemarks and Swiss francs.
The dollar survived these episodes with its No 1 status intact. The dollar's share of global official reserves fell from 79 per cent in 1977 to 49 per cent in 1992. Now it's back up to 65 per cent, with the euro a distant second at 26 per cent, according to the International Monetary Fund.
Reserve-currency status allows the US to enjoy low interest rates and reduced transaction costs. It enables the US to borrow large sums in its own currency, which French President Charles de Gaulle criticised as America's 'exorbitant privilege'.
And being able to deal in dollars makes doing business easier for US importers, exporters, lenders and borrowers, while creating opportunities for US financial institutions. It also boosts the demand for US financial assets, pushing up stock and bond prices and driving interest rates lower.
Then there's seigniorage, technically the interest-free loan the US receives from the millions of dollar bills held offshore.
Because it allows the US to amass huge trade deficits, unconstrained by market sanctions that other nations must contend with, Americans can consume more than they produce. 'If the dollar loses its reserve-currency status, the US would magically have to move from an US$800 billion trade deficit to a trade surplus so that the US could earn enough euros to pay for its imports of oil and manufactured goods,' Paul Craig Roberts, chairman of the Institute for Political Economy in Falls Village, Connecticut, wrote in a recent column.
Part of the explanation for the dollar's continuous run as the world's dominant currency is habit. Sterling, for instance, continued to be regarded as the main reserve currency long after the UK ceased to be the world's superpower.
Inertia is a very thin reed on which to hang dollar dominance. Meanwhile, the currency's slide isn't winning any friends. -- Bloomberg
Michael Sesit is a Bloomberg News columnist. The opinions expressed are his own.