12-12-2007

IS IT TIME TO EULOGIZE THE DOLLAR?

Howard M. Wachtel is a professor of economics at American University. His most recent book is: "Street of Dreams -- Boulevard of Broken Hearts: Wall Street's First Century."

By Howard M. Wachtel

Washington, D.C. -- Has the tipping point arrived when the dollar ceases to be the pre-eminent reserve currency in the global economy -- a status it has held for 60 years? Such conjecture has been triggered by the recent dip in the dollar against the euro, following on the Federal Reserve’s three interest rate reductions -- the latest on Dec. 11 -- that reinforced a two-year slide in the dollar against the euro by 40 percent.

This bit of financial esoterica is not only of interest to financial markets, foreign-exchange speculators and the beleaguered American tourist in the euro zone.

Since World War II, the dollar has been held as reserves by other countries in their financial portfolios because of its universal acceptance in the world economy and its stable value.

For the country whose currency achieves this status, there are considerable advantages. The United States can run large trade deficits, buying more than it sells in the world, because the selling countries are eager to acquire dollars as reserves. Such trade deficits are in reality debts whose reconciliation can be postponed so long as countries seek dollars as reserves. Political power also derives from this financial reality, as countries become willing to accommodate the reserve currency country in order to gain access to that currency.

The euro’s introduction was not unmindful of these political and financial power configurations. Today Hugo Chavez of Venezuela and Mahmoud Ahmadinejad of Iran have joined a group of Europeans waiting and hoping for the dollar’s demise. In the not-for-public-consumption backrooms, where financial-political diplomacy is discussed, similar desiderata are expressed by some influential leaders in Russia, China and the oil-exporting countries of the Middle East.

Countries make decisions to hold their trade surpluses in a reserve currency based on several considerations: the rate of return, degree of risk, relative strength of economies competing for reserve status, and a more subjective determination of the confidence in a country’s decision making. Risk pertains to exchange rate stability. Holding dollars has made a country’s dollar reserves worth less by as much as 40 percent in the euro zone when the dollars are used to purchase services or commodities from euro zone countries.

Over the past several years, and especially in the past six months, these factors have turned against the dollar. Exchange rate risk has risen rapidly. The euro zone economies have started to grow faster to restore confidence in their near-term economic performance. The rate of return has turned against the dollar, with the three interest rate reductions in fall 2007 by the Federal Reserve. Finally, there is a general malaise out there about the solidity of policymaking in the U.S. that started after the Iraq war in 2003 and has deepened with each revelation of new problems raised about American governing competence.

Is it any wonder that there would be speculation about the future of the dollar as the dominant reserve currency? Seen from Asia, the Middle East or Russia, those in charge of reserve portfolios must be asking themselves: Is it prudent to place new surpluses in dollars at the same rate as in the past, or should we diversify further into euros? The rate of return is down on dollar assets because of lower interest rates and instability in American financial markets. While future risk rises with a gloomy exchange rate outlook for the dollar, why continue with our past portfolio strategy and why not place more of our new surpluses into euros? Indeed the question should be asked: Why haven’t major dollar reserve countries diversified more into euros than they have?

In 1999, when the euro was introduced, roughly 71 percent of all reserves were held in dollars; today it is about 65 percent (and 25 percent in euros), a modest decline that largely reflects a natural increase in euros held as reserves in the expanding euro zone among new entrants into the European Union and wannabe members who have started to take reserve positions in euros. While there are no clear movements out of dollars, anecdotal musings surface about diversions from the dollar.

For example, Cheng Siwei, vice chairman of the Standing Committee of the National People’s Congress caused financial markets to tremble when he said that China -- which currently holds $1.4 trillion in dollar reserves and is accumulating dollars at a rate that will add about $500 billion in 2007 -- would invest outside the dollar. Cheng’s comments were “clarified” a few days later by Chinese financial officials.

The explanation for apparent continuity in holding dollars as reserves can be found in the idea of sunk costs. It is costly to diversify out of the dollar. Any sharp movement will cause the dollar to fall even faster and further, hurting the dollar holders even more than the U.S. Cutting off one’s nose to spite one’s face is not a prudent financial policy. Some gradual portfolio adjustments at the margin with more of new dollar surpluses placed in euros will occur, but this will appear as a continuation of trends and foreshadow a soft landing for the dollar. It could be a hard landing if the Fed continues to cut interest rates, which lower returns on dollar-based assets and increase exchange rate risk.

The U.S. cannot be complacent about the sources of the dollar’s current weakness. Further interest rate reductions by the Fed will only hasten the dollar’s decline as a reserve currency; continuing trade deficits do the same. Restoring confidence in the United States as a 21st-century nation is of the highest priority and not just for global financial reasons. There is an inflection point, we know not where, when the cost of holding dollars exceeds the cost of jettisoning them.

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