Don’t Bet Against the Dollar

The global economy runs on the dollar, and that isn’t about to change. Today the world’s central banks hold about two thirds of their reserves in U.S. dollars. Most commodities are priced in American currency, and much of world’s trade is invoiced in dollars as well. The dollar is the lifeblood of the international system.

Still, a growing number of observers, pointing to persistent U.S. trade deficits and the dollar’s depreciation against the euro, have begun to speculate that the dollar’s day is coming to an end. If they were right, this would be a worrisome development. First, an exit from the dollar would lead to its further depreciation, causing increased import prices that might trigger higher inflation. Second, a decline in demand for dollar assets would cause a fall in asset prices and raise interest rates, which could cause a recession and permanently slow U.S. economic growth.

Fortunately, these fears are misplaced. Though the dollar is undergoing a correction, it is a healthy one and the dollar is likely to stay on top for years to come. The real matter for concern is the large U.S. trade deficit with the rest of the world, which causes jobs and demand to leak out of the economy. As a result, borrowing and spending that should create jobs in the United States end up creating jobs offshore, while the U.S. economy is left with a weakened manufacturing sector and burdened with the debts that finance this spending. So why is the dollar here to stay? Put simply, it’s still the best option. The world needs a currency for international transactions to facilitate pricing and payments, and what better than the dollar? With an annual GDP of more than $13 trillion and with efficient, liquid capital markets, the U.S. economy operates on a scale and with a vitality that is unmatched. (It also helps that the dollar is backed by the world’s sole superpower.)

Another, complementary explanation for the dollar’s preeminence is the “buyer of last resort” theory. Countries hold dollar assets because they want trade surpluses with the United States. According to this theory, many countries can’t generate enough domestic consumption to spur growth and full employment, forcing them to rely on exports. As the United States is the world’s largest consumer market, countries therefore have an incentive to make their goods cheaper and more competitive by undervaluing their currencies against the dollar. This obliges them to buy and hold dollars to maintain their undervalued exchange rates. The economic history of the past decade bears this theory out. Since the late 1990s, American consumers have powered a global boom, compensating for weak domestic demand in much of the world. But their massive spending on goods imported from abroad has also caused the U.S. trade deficit to balloon to $759 billion dollars in 2006, equal to 5.8 percent of U.S. GDP.

East Asian countries such as China have been especially reliant on exports, a policy that has earned them trade surpluses and a massive storehouse of dollars. According to the U.S. Treasury Department, China and Hong Kong have U.S. Treasury bond holdings of $455 billion, while Japan has holdings of $582 billion. Now, there is talk that some East Asian countries may diversify their foreign-exchange reserves by reducing their dollar holdings. Their options are limited, however. Because they want their exports to stay competitive, none of these countries wants its currency to appreciate against either the dollar or the currencies of its trading rivals. Nor do the two would-be competitors to the dollar offer an appealing alternative. Yen investments yield low returns. So do euro investments, and they may now be risky given the euro’s large appreciation in recent years.

It’s highly unlikely that any countries will abandon the dollar. Instead, some may choose to tweak the composition of their dollar holdings by moving some funds out of U.S. Treasury bonds and into commodities and U.S. equities. China has already said it plans to do just that through its new sovereign wealth fund, the China Investment Corporation. Moreover, now that the dollar has already depreciated significantly against the euro, U.S. assets are starting to look relatively more attractive. This suggests foreign capital worldwide will be looking to buy dollar assets, which promises to put a floor under the dollar and keep foreigners invested in the United States. In the next several decades, there will be a slow shift toward other currencies as other economies catch up with the United States, but that process will be gradual and will leave the current system essentially intact.

That hardly means there is nothing to worry about. It is quite possible for the United States to retain global monetary preeminence while simultaneously experiencing real economic stagnation. America could lead the global economy into a period of economic doldrums, yet the dollar’s status would be unaffected because all are dragged down together.

But being preoccupied with the dollar’s dominance is the wrong goal in the first place. Indeed, the policy of a “strong dollar” contributed to creating the overvalued dollar, and has always been misguided. Instead, the target should be sustainable prosperity, one requirement for which is exchange rates that prevent excessive trade deficits. This will automatically deliver a “sound dollar,” which is a better basis for a dollar standard that works. From this perspective, far from being a strike against the dollar, the appreciation of the euro is a welcome development. The Chinese yuan and Japanese yen should be allowed to appreciate as well. The next step is for U.S. policymakers to set up international arrangements to prevent future damaging exchange rate misalignments—such as the ones now being corrected. But that is for another day. In the meantime, people should relax: The dollar is down, but it’s not out.