SPECIAL REPORT: The Decline and Fall of the Mighty US Dollar

The American dollar has been in free fall against the major currencies including the Euro, the British pound and even the Canadian dollar and there is a distinct possibility that it may cease to be the world’s reserve currency. What is behind this dramatic turn around for thre once almighty greenback and what are the implications for the global economy? The following articles examine these issues.

The Panic About the Dollar by The Economist

A full-blown dollar collapse would be disastrous. Thankfully, it need not happen

 

THE weather may be cold and wet, but in the rich world's financial markets it is beginning to feel like August all over again. Credit spreads have widened and shares are pitching from gloom to elation as investors look to the Federal Reserve for solace. The anxiety is unmistakable. But this time the scare is about more than bad mortgage loans and their baleful effect on the credit markets. America may be falling into recession. And a new fear now stalks the markets: that the dollar's slide could spin out of control (see article below).

 

A full-blown dollar crisis on top of a credit crunch and a weakening economy would be frightening. It would send financial markets reeling and tie the hands of the Fed, perhaps forcing it to raise interest rates even as recession looms. The sky-high euro would soar further, choking off Europe's growth. Political tensions would also rise. Already Airbus has called the dollar's decline “life-threatening” and France's president, Nicolas Sarkozy, has given warning of “economic war”.

 

At worst, the shadows could darken further. For half a century the dollar has been the hegemonic currency. A large slice of global trade is counted in dollars. Central banks hold most of their foreign-exchange reserves in dollars, a boon for America that has allowed it to issue debt more cheaply. That dominance has survived dollar slides before, as in the late 1970s and mid-1980s. But now, with the euro as an alternative, the fear is of a sudden shift in the global monetary system, with investors switching quickly from one currency to the other.

 

So far, this remains only a fear. Although the dollar has been falling at quite a lick—down 6% against a trade-weighted basket of currencies since August—it has seen no chaotic slump, but a slide interspersed, as this week, with brief rallies. Americans' expectations of future inflation have not yet risen much. Yields on government bonds have fallen: clearly, investors do not yet expect higher premiums for safe American assets. Whether disaster strikes depends on what exactly is driving the dollar down and on how policymakers react.

 

Headwinds and tailwinds 

 

Much of the dollar's weakness is driven by economic fundamentals. Since peaking in 2002, it has fallen by 24% against a trade-weighted basket of currencies. Given America's need to borrow from abroad to finance its consumption, that is neither surprising nor sinister. By inducing Americans to import less and export more, a weaker dollar helps cut the current-account deficit. For America, the medicine has been working—the deficit is down to 5.5% of GDP from a peak of almost 7%.

 

If the dollar's decline has accelerated of late, that is largely because of the cyclical divergence between America's economy and the rest of the world. America fears recession; the Fed has already cut interest rates by 0.75 percentage points and financial markets are convinced that it will cut another quarter point on December 11th, when it next meets. When America's growth prospects and interest rates fall relative to those elsewhere, a cheaper currency is inevitable.

 

But economic fundamentals are not all that is hurting the dollar. The currency is also suffering because the credit mess is concentrated in dollar assets. Investors' conviction that transparent markets and vigilant regulators make America a safe place to store money has taken a battering from the revelations of recent weeks. Net private capital inflows into America seem to have evaporated since the credit turmoil began. The subprime crisis has tarred the dollar as a subprime currency.

 

In recent years a fall in private inflows has usually been offset by central banks in emerging economies that link their currencies to the dollar. This system (often known as Bretton Woods II) has thus propped up the dollar. But this time these central banks have been less willing to take up the slack. Right on cue, the cracks in Bretton Woods are becoming clear. China is routinely attacked in America and Europe for linking its currency to the dollar. Squeezed between rising oil prices and the falling dollar, the Gulf states face rising inflation: speculation is rife that one or more of them will modify their currency pegs at a regional meeting on December 3rd.

 

Handle with care 

 

There you have it: the ingredients of a nasty crash. But self-interest and sensible policy can cut the odds of trouble. The first step is for American policymakers to pay more heed to their currency. For all their talk about a strong dollar, American officials have behaved as if they cared little about its worth. A reserve currency is supposed to be a store of value; by running a huge current-account deficit America has left the dollar vulnerable. At such a tricky time, benign neglect will no longer do. For the moment, this need mean little more than some carefully chosen words. If the slide becomes chaotic, it could demand currency-market intervention and a willingness to hold back interest-rate cuts for the sake of the dollar.

 

The other part of the solution lies elsewhere, particularly with those countries with dollar-pegging currencies. These economies need to allow their currencies to rise, both to curb inflation and encourage the rebalancing of the global economy. Appreciation would mean that these countries accumulated new dollar reserves at a slower pace. That in turn would lead to a loss of the dollar's pre-eminence and the emergence of other reserve currencies: there is no rule to say you can have only one reserve currency. But this need not—and in today's febrile environment must not—mean dumping existing dollar reserves. That would impose a far higher cost on everyone, including the dumpers.

 

The history of international co-operation on currencies is patchy. But China and the oil-rich Gulf states have ample reason to play their part in an orderly decline of the dollar's dominance. Despite the opprobrium heaped on them, the Chinese do not want to see the Fed's hands tied by a dollar crisis; nor do they want to see the euro zone, one of their best markets, slow sharply; and they have little interest in the external value of their existing dollar reserves plunging. Beyond all that, China's leaders want to be taken seriously as responsible actors in the international system. Now is their chance.

 

From The Economist 

How Long Will the Dollar Remain the World's Premier Currency? By The Economist

THE long-run value of all paper currencies is zero. That is a fond saying of Bill Bonner, goldbug and publisher of the Daily Reckoning, a contrarian financial newsletter. So why should the dollar be any different? Mahmoud Ahmadinejad, Iran's president, seems to think the long run is now: two weeks ago he decried the dollar as a “worthless piece of paper”. And Jim Rogers, a famously shrewd investor, asks why anyone would buy dollars.

 

America's currency has been infected by the sense of crisis that bedevils its economy and financial markets. Speculative selling of the dollar is close to an all-time high, reckons Stephen Jen at Morgan Stanley. Many believe—and some evidently hope—that the greenback might be on its way out as an international currency. Worrying parallels are seen between the dollar's recent fall and the decline of sterling as a reserve currency half a century ago.

 

The dollar's value against the basket of leading currencies tracked by America's Federal Reserve has recently been at an all-time low. Against a broader range of currencies, the dollar has lost a quarter of its value in the past five years. Its decline has been especially marked against the euro. At one point in 2002 the euro was worth 86 cents; today it buys $1.48.

 

That currencies rise and fall and test records is hardly unusual. What lends the dollar's decline an air of crisis is that the world's bloated currency reserves are crammed with depreciating dollar assets. Foreign-exchange stockpiles have almost tripled to $5.7 trillion since the beginning of the decade. China alone has $1.4 trillion of reserves. Japan's $1 trillion or so make it the second-largest holder.

 

In this period of swelling reserves, the dollar has retained its pre-eminence. It still accounts for nearly 65% of identifiable currency-stockpiles, according to the latest IMF data. This is broadly in line with its historical share (see chart). Factor in the dollars hoarded by China and Middle Eastern oil exporters (not included in the IMF breakdown) and the dollar's share may be higher still.

 

Subprime currency 

 

The dollar's place as a reserve currency always seems to be questioned when it falls. Weakness in 1977-79, 1985-88 and 1993-95 was each time met with predictions that governments were about to switch their reserves into another currency. A burst of high inflation, which undermined the dollar in the late 1970s, made that slide as serious as today's scare is. Between 1978 and 1980 the Treasury sold $6.4 billion of “Carter bonds”, mostly denominated in Deutschmarks, to raise funds to defend the dollar. In January 1980 the gold price reached a record $835 (around $2,250 in today's prices) as investors sought an alternative store of value. And when the dollar fell to ¥81 in 1995, many—including this newspaper—saw it as the beginning of the end of its reserve-currency status.

 

The dollar has weathered these storms. But now it faces a nasty squall that combines both cyclical and structural blasts. Its decline in the past five years has imposed a huge capital loss on foreign-exchange reserves. If this becomes too painful, central banks may be tempted to cut their losses and dump their dollars, causing a slump in the currency's value. The lure of selling is made all the greater by the knowledge that other central banks are overloaded with dollars too. Those that get out first have more chance of saving their capital.

 

America's thirst for overseas funding is another reason to fret. For years it has spent more than it earns, running up large, persistent current-account deficits. Last year the shortfall in America was a whopping 6% of GDP. Bridging that gap requires foreigners to buy dollar assets—bonds, stocks or property. But the more overseas debt that America runs up, the greater the risk that it will partly default on its obligations, either through currency weakness or inflation.

 

These vulnerabilities are not new but they are made worse by an economy that is turning sour. Losses on subprime mortgages have intensified the housing downturn in America and poisoned its credit markets. The threat of recession has prompted two interest-rate cuts, and more reductions are likely. Faltering growth and falling interest rates make for a weak currency, particularly when growth prospects elsewhere seem rosier. And the downgrades to credit-related securities once deemed top-notch have hurt the reputation of America's capital markets.

 

America's downturn poses other problems too. The oil-rich Gulf states are thinking of ditching their currency pegs with the greenback. These links have obliged them to buy dollars, so as to prevent their own currencies from rising. The dollar peg has made it hard to curb inflation, especially in fast-growing oil economies, whereas a less rigid exchange-rate regime—say, a peg with a basket of currencies—may allow a more flexible interest-rate policy. Such a regime would also crimp the demand for dollars at a time when confidence in the currency is fragile. All this may not bode well for the dollar's status as the world's reserve currency.

 

However, even if this is an awkward time for the currency, it need not be a catastrophic one. The fear that the dollar could be swiftly supplanted as top dog is based on the idea that one currency will always have a near-monopoly: if everyone holds dollars chiefly because everyone else does, you could imagine how a falling share of global reserves might reach a point when central banks all suddenly switch to a new currency standard.

 

The dollar's favoured position in international trade owes something to this kind of network effect. Global markets in commodities are priced and transacted almost exclusively in dollars, because it is convenient for buyers and sellers. But whatever Mr Ahmadinejad thinks, oil exporters would not get more income if commodities were priced in euros or pounds. The competing pressures of supply and demand set the oil price: the dollar is just an easy way of keeping score. The convention of quoting in dollars is often employed when the currency of one or more trading partners is not used. Once such a standard is set, there are costs to shifting to a new one. But the benefits to America of issuing the world's favoured transaction currency are easily exaggerated. Advances in financial technology mean that a given volume of trade requires a much smaller dollar-float than in the past.

 

The confidence factor

The role for the dollar as an international means of exchange is entirely different from its role as a reserve currency. Reserves are held to buttress confidence in a country's own currency, not as a float for global trading. As a backstop, reserves need to be easily convertible (so they can be used as an emergency source of liquidity) and a good store of value. The dollar, with its large and liquid capital markets, meets the first criterion even if it has failed the second—at least, recently.

 

Barry Eichengreen, a professor of economics at the University of California, Berkeley, argues that there is no reason why a single currency should dominate reserves as the dollar has. Before the era of the dollar standard, he points out, reserves were in a handful of currencies. On the eve of the first world war, when Britain was the greatest trading power, the pound's share in official currency reserves was all but matched by the combined share of the French franc and German mark. After the war a three-way split was maintained, with the dollar replacing the mark.

 

If the dollar's dominance is to end, two or more currencies are likely to share the crown. Those who take a grand sweep of history are backing China's yuan as a big reserve currency of the future. The dollar's immediate rival, however, is the euro. In several important respects—the euro area's size, the depth of its capital markets and its share of world trade—it has the attributes of an ideal reserve currency (see table below). Unlike America, the euro area has the added attraction of a broadly balanced current account.

 

The euro has already made inroads into the dollar's territory. At its launch in 1999, its constituent currencies—the mark, franc, lira, etc—accounted for less than a fifth of the world's official reserves. Its share has since increased to around a quarter, even as total currency reserves have swollen. The euro area is less dependent on oil imports than America is and it sells more to oil exporters as well as to fast-growing economies such as China and Brazil.

 

The euro's attractions may be somewhat superficially enhanced at the moment. It has risen sharply in value, flattered by cyclical forces that have favoured it over the dollar. But only a year ago Italy's sluggish economy and fiscal problems inspired talk about a break up of the euro. Just five years ago the euro was considered irredeemably weak.

 

But although the near-term outlook may be favourable to the euro, its prospects in the medium-term may not be so bright. The euro's appreciation is already causing strains within the currency zone. In the coming decades the euro zone's workforce is set to age faster than America's, which will hamper its economy and add to its fiscal pressures. There is also the question of how much trust investors will put in a currency with no central fiscal authority to stand behind it.

 

Since the title of reserve currency can be split, the dollar's share in global currency reserves is probably too big—whatever happens to foreign-exchange rates. Many of the countries that have built large stocks of dollar assets by pegging their currencies to the greenback are now battling with inflation. Sticking with the peg would mean importing the policies of recession-threatened America and feeding inflation still more. Yet abandoning the peg only adds to the pressure on the dollar.

 

A compromise is to be weaned off the dollar, with a peg made up of a basket of rich-world currencies, including the greenback. This would give dollar-peggers more freedom over their monetary policy—they would no longer have to mimic the Fed slavishly—while allowing them gradually to slow their purchases of dollars.

 

Is a dollar rout avoidable? An optimist would say that central banks, having spurned the chance to diversify out of dollars when a euro could be bought for 86 cents, are unlikely to want to switch now when the price is close to $1.50. Against conventional benchmarks like purchasing-power parity, the euro looks dear against the dollar. So it could be a bad time to swap from one horse to another. To the extent that dollar-holders act like an informal cartel, then the biggest dollar-holders will set an example. Japan seems unlikely to start selling its huge dollar reserves—if anything it might intervene to prevent the dollar falling further against the yen. A crash might be averted if China holds fast too, because it recognises how self-defeating dumping dollars would be to such a large owner of American assets.

 

Yet a pessimist would counter that a revaluation of emerging-market currencies against the dollar could easily turn disorderly. Although economic logic may argue against selling dollars at a cyclical low point, central banks have sometimes been hopeless portfolio managers: witness their shift out of gold just as its price hit a low. Yes, the dollar looks cheap, but currencies often overshoot. So it would be foolish to say where its decline should stop.

 

Averting a crash

Despite the anxiety and gloom, some straws in the wind suggest that the dollar's decline may soon slow. In the past few weeks it has regained ground against a handful of important currencies, including the pound and the Australian dollar. America's trade balance is narrowing, despite the effects of expensive oil imports, suggesting that a weaker currency is already working to correct imbalances.

 

As a rule, central banks cannot intervene to determine exchange rates, but as Morgan Stanley's Mr Jen suggests, some sort of official action has often preceded turning points in the world's foreign-exchange markets. If he is right, then a change in rhetoric or even co-ordinated intervention may be the signal the markets need before they stop believing that the dollar is destined to fall further.

 

From The Economist 

 

 

The Global US Dollar Showdown By William (Bill) Buckler

The October 19 meeting of the G-7 Finance Ministers and Central Bankers in Washington which takes place in the wings of the IMF/World Bank meetings stands as one of the pivotal post WW II meetings. The European Union appears to have had its fill of false American protestations to the effect that the US has a "strong Dollar policy". The US has had no such policy for a long time. The US Dollar has been falling since early 2002 and the Bush Administration has done nothing to support it.

 

The Word from Europe is "Extreme":

On October 15, the President of the European Central Bank came out and said that he was paying "great attention" to American statements in support of a "strong US Dollar". The previous week he had said that he was paying "extreme attention". This is not so "coded" speech to the effect that the US Dollar is in danger of losing EU support.

 

A Matter of Balance - A Matter of Scale:

Over the past six years, Europe has added jobs at a faster rate than has the US. It has had a much lower budget deficit than the United States and is now posting higher productivity gains and a $US 3 Billion annual trade surplus as well as a global current account surplus. The US stands with a current account deficit of $US 860 Billion annually, about 6 percent of GDP. It is the US which is out of balance with the world, not Europe.

 

The Bernanke Fed's recent interest rates cuts while the US Dollar hovered near all time historical lows shows that the international value of the US Dollar is today only being held up by the courtesy of others - mainly Europe. Japan is not helping while it holds it official interest rates at 0.5 percent and fosters the "carry trade". China is holding down its currency.

 

The Importance of True Global Scaling:

The European Union (EU) stands with a $US 16 TRILLION plus economy and is the largest trading bloc in the world accounting for nearly a third of the global economy. The $US 13.8 TRILLION US economy accounts for 27 percent, Japan 9 percent and China less than 6 percent. Europe is the creditor nation, the US is the debtor nation. Unless this fact is kept firmly in mind, the events surrounding the G-7 meeting which starts on October 19 will, on the surface, not make any sense at all. The US, of course, will maintain the facade that it is still the number one in the world, at least for internal consumption. The Europeans will see straight through this as empty and hollow blustering. What the EU wants to see is direct and concrete US actions to rein in its ongoing internal credit expansion.

 

The US wants to reaccelerate that same credit expansion. There is a huge collision ahead.

 

Listen to the US Dollar - TIC, T-I-C:

August was the turn of the tide. The latest US monthly net TIC (Treasury International Capital) flows include all non-market flows, short-term securities and changes in banks' US Dollar holdings. This measure of US net foreign capital outflow(!) was $US 163 Billion in August compared with an inflow of $US 94.3 Billion in July. This is a net turnaround in the money flows across US borders of $US 257 Billion! This is what The Privateer has analysed and forecast would happen if the US continued on its present course. The fact that this outflow is now happening is, of course, to be seen by the huge fall in the international value of the US Dollar as well as the global increases in US Dollar commodity prices. The US Dollar is now falling against most currencies, against most global commodities and against Gold.

 

The Data of this US Turn is Drastic:

The August US TIC flow compares with the $US 57.59 Billion trade deficit during the month as reported last week by the Commerce Department. Foreign official institutions such as Central Banks sold a net $US 29.7 Billion of Treasuries, up from net sales of $US 6.9 Billion during the previous month.

 

For US equities, net foreign sales totalled $US 40.6 Billion in August, compared with purchases of $US 21.2 Billion the previous month. For US corporate bonds, net foreign sales were $US 1.2 Billion in August versus purchases totalling $US 4.5 Billion in the previous month. Net foreign sales of long maturity securities accelerated to $US 85.5 Billion in August, following sales of $US 2.7 Billion in July, according to the US Treasury Department report. Foreign official holdings of US Treasury bills, notes and bonds fell to $US 1.428 TRILLION in August from $US 1.453 TRILLION in July.

 

Japan remained the largest holder of US Treasury securities, though its holdings fell to $US 585.6 Billion in August from $US 610.4 Billion. China was still the second largest world holder of US Treasuries. Its holdings declined to $US 400.2 Billion from $US 409.0 Billion. Great Britain remained in third place, with holdings increasing to $US 244.0 Billion from $US 210.6 Billion. The US has to borrow $US 2.1 Billion a day to finance its huge trade gap. But the money outflows from the US have begun. The US cannot even gain the funds internationally to cover for its own monthly trade deficits. Something has to give. The main item which is "giving" and will "give" more is the international value of the US Dollar.

 

Washington - October 19, 2007:

As he prepares to host the G-7 Finance Ministers and Central Bankers in Washington on October 19, US Treasury Secretary Paulson has had his ability to fight back undermined. He cannot point to a strong US economy as mortgage defaults and foreclosures roll like a threshing machine across the US economy. He cannot point to a "strong US Dollar" as its fall in the 12 months through September has caused US import prices to increased by 5.2 percent. Over the past year, US producer prices rose 4.4 percent, compared with a 2.2 percent rise in the 12 months through August. He cannot point towards US corporate earnings, as S&P 500 earnings estimates have dropped significantly since the beginning of the quarter. In the aggregate, US corporate earnings are now expected to have increased only 0.7 percent during the third quarter. He had also better not call attention to either the Dow or the S&P 500 as good places to invest. The US "price to book ratio" of the S&P 500 index is now at 4.04 - compared with 1.73 in 1987.

 

Have NO doubts whatsoever. The other G-7 Finance Ministers and Central Bankers have already looked at all the numbers that you have read on this page. They all know that the US cannot handle this.

 

The other G-7 Finance Ministers and Central Bankers know that the US cannot keep doing what it has done over recent decades. A continuation will inescapably lead to a massive fall in the US Dollar.

 

That is why THIS G-7 meeting in Washington on October 19 is of true world changing importance.

 

Resetting - A Subprime US or a US Foreclosure:

Geo-monetarily as well as geo-financially, the US is now, in principle, in the same position as any American who has had a subprime loan at low teaser interest rates for some years. In the case of the US, the "subprime" loan goes back decades during which the ever climbing debts owed were easy to carry because of the very low interest rates. But now, these low international interest rates which the US has had to pay are going to be reset at much higher rates. Either that, or as the economic inverse of same, the US Dollar is set to fall massively if the international interest rates the US pays are not raised drastically.

 

There is only one alternative to this. It is that the US as the borrower, and the other G-7 members as the lenders, sit down at their Washington meeting and jointly agree to a bail-out plan for the US. This will in the first instance require a real currency swap from the EU, Japan and others (perhaps with China participating) of gargantuan proportions. A currency swap at this level, the Central Bank level, is essentially a swap of two currencies with the US Treasury getting a huge sum of Euros from the ECB and other Central Banks and the ECB (and the other Central Banks) getting a matching sum of US Dollars. The US Treasury signs up for its side of this swap, in effect a huge international Euro loan, and uses the borrowed money to support the international value of the US Dollar.

 

It does this with conditions. While supporting its Dollar, the US also acts to bring its federal budget into balance with revenues and then into a real fiscal surplus. This US surplus is then used to pay down the Euro currency swap. Inherently such a US currency swap with the EU has to be long-term, taking into account the enormous US debts owed. Meanwhile, the US Dollar maintains its value against the Euro.

 

Also inherent in such a huge Euro currency swap is the dire necessity for the EU (and the other participants) NOT to sell any of the enormous amounts of US Dollars received in the swap. After that, it is incumbent on the US Treasury that these US Dollars now held by "foreigners" will NOT lose their international purchasing power. Otherwise, a situation arises where the US once again defaults on its international debts through a currency depreciation. But such a gigantic bail-out of the US has some chance to work IF the US does its part. With the stabilisation of the international value of the US Dollar, other nations will have less incentive to sell it into oblivion in a US Dollar global panic. Of course, the US doing its part would make necessary a global geo-strategic pullback from all its 760 odd military bases around the world. This would include those now in Iraq, in Afghanistan, in Europe, in Japan, in South Korea and in many other nations. This is by no means historically unique. It is precisely what happened to Great Britain after its failed attack on Egypt in 1956. President Eisenhower simply moved to end the US credit line to Great Britain. Since Britain was then in a position where it could no longer borrow from the US, it could also no longer funds its own empire. Great Britain spent the next decade folding its former global empire up and withdrawing its armed forces.

 

Regrettably, with President Bush in charge of the US, the chances of THIS currency swap are next to nil.

 

The Alternative is Foreclosure USA:

Nothing better demonstrates the vehement denial of plain facts by the US Political Establishment than its recent moves to raise the official US debt ceiling by $US 850 Billion to almost $US 10 TRILLION as well as cutting US official interest rates by 0.50 percent! To follow that by going out and borrowing more is absurd. But that is what the US Political Establishment intends to do. That points the US and the rest of the world which has to lend the US the money towards an international version of foreclosure.

 

Foreclosing on the US not only means that the rest of the world stops lending more of its money to the US but also that the rest of the world starts showing up in the US and demanding repayment of all the past loans! This has now started happening as shown by the "TIC" data already reported. The US financial system will not be able to handle a situation where the world demands that they begins to repay debts. US market interest rates would soar, as would US Treasury rates. An instant US recession follows.

 

The Growing Spectre of US Foreign Exchange Controls:

If an accelerating outflow of funds now held by foreigners inside the US were to start, it is a near certainty that at some point in this accelerating outflow, the US would act to institute a version of FOREIGN EXCHANGE CONTROLS. In effect, these would prohibit funds owned by foreigners from leaving the US. For all those who had lent to the US, that would be a global catastrophe.

 

The recent freeze-up in the global interbank payments system would be small potatoes in comparison because the flow of money across the world's borders would also start to freeze up. Many smaller nations in this bind would promptly institute their own national versions of foreign exchange controls and some of them would simply seize American assets inside their borders and sell them in their own local markets, using the proceeds from the sale to compensate their nationals from the losses they had suffered from having their money blocked by the US. International trade and air travel would come to a shuddering halt. Factories beyond number would be standing still because required foreign components would not be arriving. Economically, most nations would be thrown backwards to function upon the productive means presently existing inside their own borders. Deep recessions and outright depressions would follow.

 

Source 

 

 

Farewell to the U.S. Dollar? By Gwynne Dyer

 

It's just straws in the wind so far. India's Ministry of Culture announces that foreign tourists can no longer pay in dollars when visiting the Taj Mahal and other heritage sites; they have to pay in good, hard rupees. Iran and Venezuela call for a joint OPEC statement on the weak U.S. dollar, and Saudi Arabian Foreign Affairs Minister Saud Al-Faisal warns that any public reference to the U.S. dollar's problems could cause the troubled currency to "collapse." Rap star Jay-Z's latest video shows our hero flashing a wad of euros, not dollars.

 

Only straws in the wind, but all in the past couple of weeks. For the majority of Americans who do not travel abroad, the only visible effect so far of the dollar's steep fall has been higher fuel prices at the pump. The Chinese imports that fill the big-box stores still cost the same, because the Chinese yuan is still pegged to the American dollar. But that may be about to change, along with many other things.

 

At the beginning of 2003, one euro bought one U.S. dollar. Eighteen months ago, it bought $1.20. Now it is pushing $1.50, and there is no reason to think that it will stop there. Three of the world's biggest oil exporters, Iran, Venezuela and Russia, are demanding payment in euros rather than U.S. dollars. Last week a Chinese central bank vice-director, Xu Jian, gave voice to the suspicion of many others, saying that the U.S. dollar was "losing its status as the world currency."

 

If that happens, then America loses a great deal. Other countries have to maintain large reserves of foreign currencies–most of which they keep in U.S. dollars–to cover their foreign debts, but the United States can pay its huge foreign debts in its own money. If necessary, it can just print more dollars. Having their own money as the world's reserve currency confers advantages that Americans would miss if they lost them.

 

The main reason for the collapse of the U.S. dollar is President George W. Bush's attempt to fight expensive foreign wars while cutting taxes at home. This involved deficit financing on a very large scale, and inevitably the value of the dollar began to fall–slowly at first, but with increasing speed as it became clear that the White House did not care. "Ronald Reagan proved that deficits don't matter," as U.S. Vice-President Dick Cheney told then-treasury secretary Paul O'Neill.

 

But they do matter to foreigners. As the U.S. dollar fell in value, the price of oil (which is usually calculated in dollars) rose to compensate for it, but there was no comparable adjustment for foreign central banks that had huge amounts of U.S. dollars in their reserves. China, which was sitting on about a trillion U.S. dollars, simply lost several hundred billion as the currency's value fell. So various central banks started wondering if they should diversify their reserves, and some acted on it.

 

The downward pressure on the dollar will continue, because the United States is currently borrowing six per cent of its Gross Domestic Product from foreigners each year to cover its trade deficit. Foreign banks were happy to go on lending so long as they had faith in the integrity of U.S. financial institutions, but that has been hit hard by the sub-prime mortgage crisis. Besides, other markets, notably China and India, now offer a better return–and Congress's resistance to foreign takeover bids, combined with tighter visa restrictions, make the U.S. a less welcoming place for foreign investors.

 

Above all, there are now alternatives to the U.S. dollar. The last time it faced a comparable crisis was in 1971, when a different Republican president was trying to run another unpopular war without raising taxes. Richard Nixon devalued the U.S. dollar and demolished the Bretton Woods system that had fixed all other currencies in relation to the dollar, inaugurating the current era of floating exchange rates.

 

There was no other candidate then for the role of global reserve currency, so the dollar stayed at the centre of the system despite all the turbulence. This time, by contrast, there is the euro, the currency of an economic zone just as big as the United States, with the Chinese currency as a possible long-term rival. But nothing is likely to happen very fast.

 

The last time the world went through a change like this, it took over 40 years to complete. Before the First World War, the British pound reigned supreme, accounting for 64 per cent of the world's currency reserves and 60 per cent of all international trade. Britain then impoverished itself in two world wars, but the U.S. dollar did not fully replace the pound until the 1950s.

 

Today the U.S. dollar accounts for 70 per cent of both international trade and currency reserves, but it is probably starting down the same road. Many countries are replacing part of their dollar reserves with a basket of other currencies, and those who have pegged their currency to the dollar are starting to cut loose from it: Kuwait has already done so, and the United Arab Emirates is actively considering it. If China unpegs, things will move a lot faster, but in any case the long farewell of the U.S. dollar has begun.

 

From Embassy Canada’s Foreign Policy Newsletter

The Rise and Fall of the US dollar By Socialism Today

 

THE US DOLLAR appears to be on the verge of a sharp decline. Officially, the Bush administration continues to support the strong-dollar policy associated with the 1990s bubble economy. "I favour a strong dollar", announced the new US Treasury secretary, John Snow: "It’s in the national interest". (International Herald Tribune, 29 January)

 

In reality, however, the Treasury and the Federal Reserve have adopted a policy of ‘benign neglect’ towards the dollar’s recent decline. As of 12 May, the dollar was 9.1% down against the euro for the year, and 27.5% down from its July 2001 peak. Against a ‘broad basket’ of 37 currencies (of all the US’s main trading partners), however, the dollar was down only 3.7% on the year and only 6.4% since July 2001. Without publicly acknowledging it, the US government appears to be encouraging a steady decline of the dollar in the hope that this will boost US exports and reduce the ballooning trade deficit (and the growing overseas debt resulting from the deficit).

 

It is far from certain, however, that the US can engineer a smooth, controlled decline of the dollar. A number of states which rely on exports to the US market, notably China and Japan, are working to counteract the dollar’s decline by buying US government bonds. (In other words, they are investing some of their trade surpluses in dollar assets rather than converting all their export earnings into their domestic currencies.) At the same time, there is an increasing flow of private capital out of the US, which is undermining the dollar’s value internationally. Much of the capital outflow from the US has moved into the euro, now the world’s second main trading currency. This is why the euro has risen sharply against the dollar while the majority of broad-basket currencies have risen only marginally (6.4%) since 2001. If this US outflow gathers momentum, however, the dollar could plunge relative to a broad range of currencies – bringing about a sharp contraction in the US economy.

 

The dollar bubble

THE OVERVALUED DOLLAR was a major component of the bubble economy of the late 1990s. The dollar was pushed up by the massive inflow of capital into the US from the rest of the world. Foreign investors saw the US as a ‘safe haven’ in a turbulent world, while corporations and wealthy investors were attracted by the prospect of the high profits apparently available in the US. Between 1995 and 2001 the real value of the dollar rose 34% against a basket of major industrial country currencies and 41% against a broader range of currencies that included all the US’s major trading partners. This took place in spite of the USA’s growing trade deficit. According to textbook bourgeois economics, a large and growing trade deficit should lead to a weaker currency, tending to correct the deficit through cheapening exports and making imports more expensive. Instead, the ever rising dollar exacerbated the US trade deficit, which rose from around $200 billion in the mid-1990s to over $500 billion in 2002. The trend growth of US imports (in constant prices) between 1980-2002 was 7.6% a year, compared to 3.1% growth for GDP. In contrast, the trend growth for exports between 1997-2002 was 2.2% a year.

 

The high dollar allowed US companies and consumers to buy imported goods at a massive discount, a kind of subsidy for US consumers at the expense of the rest of the world. The high consumption of imports, however, hit US manufacturing hard. At the height of the boom, between 1998 and 2001, around 1.2 million manufacturing jobs were lost. The 1990s boom was the first US expansion in which there was a decline of manufacturing jobs. The elimination of relatively highly paid jobs in the manufacturing sector, replaced by relatively lower paid service-sector jobs, contributed to the growth of inequality.

 

In the world economy, the US demand for imports acted as a powerful stimulus, providing a ‘market of last resort’ for European, Asian, and other exporters. The effects of a high dollar, however, were not all positive. Dollar-denominated debts and raw materials (like oil) priced in dollars became more expensive. Some of the countries which pegged their currencies to the dollar were plunged into crisis by its soaring value (South East Asia in 1997, Argentina more recently). Moreover, the flood of capital into the US, which lifted the dollar, at the same time depressed capital investment in other countries (some of the EU states, many underdeveloped countries).

 

Under Clinton, the ‘strong dollar’ was promoted as a symbol of a pre-eminent US capitalism. The strong dollar was good, in particular, for US international financial operations. The price, however, was a growing trade and payments deficit. (The trade deficit is the balance of imports and exports of goods and services; the payments deficit is the trade deficit plus the balance of currency transfers, profits, dividends, etc.)

 

Despite the recession, the payments deficit rose to $500 billion between 2001-02 or 5% of GDP, a post-war record. As the payments deficit has to be financed by an inflow of capital, this gave rise to an increasing US debt to the rest of the world – over $2.5 trillion or 25% of GDP. This trend is unsustainable.

 

US capitalism now needs a net capital inflow of around $1.9 billion a day to cover its deficit. Over the last year, however, the flow of foreign direct investment (corporate investment within multinationals) and portfolio investment (private investment in shares, bonds, etc) has declined sharply. Foreign direct investment fell from $308 billion in 2000 to $14 billion in 2002. Foreign private purchases of US shares, bonds, etc, fell from $978 billion to $560 billion. (Martin Wolf, The Rake’s Progress, Financial Times, 8 January 2003) Inward investment has continued to decline in the first quarter of 2003.

 

This trend has been counteracted, to some extent, by a number of central banks, such as those of Japan and China, buying US government bonds. Japan, China, Taiwan, Hong Kong and Singapore together have accumulated official reserves worth more than $1,100 billion, mostly invested in US government bonds. The biggest investor is Japan, which is desperate to minimise the appreciation of the yen that would make its exports more expensive. At the same time, a number of central governments are increasingly fearful that a sharp fall in the value of the dollar will substantially devalue their reserves, and both China and Russia have begun to shift some of their reserves from the dollar to the euro.

 

No longer a ‘safe haven’

US CAPITALISM NO longer has the magnetic attraction for international capital that it exercised during the late 1990s. "The US has, since the bursting of the stock market bubble, become a relatively unattractive destination for foreign private capital. Interest rates are low, the dollar is weak and the US economy will advance this year at less than its underlying trend growth rate". (John Plender, The Sinews of War, Financial Times, 21 March)

 

"Last month, according to a report by Morgan Stanley, foreign investors’ demand for treasury securities suddenly slackened. And well before the possibility of a war in Iraq began to concern investors, corporate scandals pushed foreigners to shift their portfolios away from American securities, said a senior executive of a major European bank. In addition to changes in portfolios, the pace of foreigners’ direct investment in the US has slowed". (Daniel Altman, International Herald Tribune, 4 April) There is an increasing trend for international investors to lend US corporations the money they need (through bonds, etc) rather than investing in assets or shares. Such borrowing, commented John Rathbone, a European financial analyst, is evidence that the US is "taking on the financial characteristics of a banana republic". (International Herald Tribune, 8 March)

 

The US invasion of Iraq has undoubtedly exacerbated this trend. "What the rest of the world is being asked to fund is very different from what they were being asked to fund three years ago", said David Bowers, chief global investment strategist of Merrill Lynch: "Three years ago they were being asked to fund a private-sector miracle. Now they are being asked to fund Bush’s tax cuts and the war on Iraq".

 

"The US is prepared to act unilaterally", said Bowers. "The bottom line is that if you are a net debtor to the rest of the world, ultimately you have to be multilateral". (David Altman, Paying the Cost of Unilateralism, International Herald Tribune, 2 May)

 

A dream scenario for the US?

CAN THE US find a way out through devaluation of the dollar? The dream scenario, envisaged by such economists as Fred Bergsten (a former US Treasury assistant secretary), is for a steady, continuous descent of the dollar which would gradually reduce the US payments deficit to around 2% to 2.5% of GDP, considered a ‘sustainable’ level. This would require a devaluation of at least 25%. (Let the Dollar Fall, Financial Times, 18 July 2002) Under capitalism, however, complex economic forces rarely unfold in a coordinated, balanced way, especially in a period of world economic stagnation.

 

Managing a decline of the dollar against the yen, the Chinese renminbi, and the currencies of other states which depend decisively on exports to the US market, will not be easy. Major exporters to the US will strive to counter a higher dollar price of their goods for US consumers by cutting their production costs even further and also through accepting smaller profit margins (which they are already doing to some extent). Such a reaction would accentuate the deflationary pressures in the world economy.

 

For as long as it is effective, big exporting countries to the US will try to use part of their trade surplus to invest in dollar assets in order to prevent a big fall in the value of the dollar against their own currencies. However, if such a tactic becomes unsustainable, and the dollar begins to plunge anyway, they are likely at a certain point to resort to a policy of devaluation, most likely leading to another wave of competitive devaluations (as in the 1997 Asian currency crisis). This could again provoke a regional downturn in Asia or even internationally.

 

In theory, a weaker dollar should mean lower prices for US exports on the world market. However, worldwide overcapacity and stagnant growth will make it difficult for the US to massively boost its exports. Even with the advantage of a dollar devaluation, US big business would have to drive down wage levels and intensify the exploitation of workers even more to compete against low-cost producers in China and elsewhere.

 

The recent decline of the dollar in relation to the euro is already demonstrating the contradictory effects on the world economy of shifts in currency alignments. Higher eurozone export prices, resulting from the strengthening of the euro, have already hit eurozone exports, helping to depress growth. The high euro will intensify the growing internal tensions within the eurozone, which are aggravated by the restrictive fiscal policy (under the ‘growth and stability’ pact) and the European Central Bank’s (ECB) reluctance to follow the US Federal Reserve with interest rate cuts. Stagnation in Europe, Japan, and elsewhere will restrict the market for US exports.

 

The US also faces the danger that a relatively gentle decline of the dollar may, at a certain point, turn into a plunge as overseas governments and investors rush to withdraw their capital in order to avoid a massive devaluation of their dollar-denominated assets. The US’s massive overseas debt, accumulated through recurrent deficits, would then become absolutely unsustainable. The US government would be forced to take drastic short-term measures to curb the demand for imports, which would induce a slump in the US economy.

 

One possible policy to curb imports would obviously be protectionist measures, either through tariffs or quotas. Bush has already imposed a 30% tariff on steel imports, ruled illegal by the WTO. There is growing pressure from US big business for protection for a wider range of manufactured goods. Protective measures by the US would have a devastating effect on the world economy, especially on economies that currently have big trade surpluses with the US. Protectionism, however, would not provide a way out for US capitalism: big business, relieved of international pressure to invest in the most productive technology, would attempt to boost its profits through raising domestic prices (pushing up the cost of living) while intensifying the work-place exploitation of US workers (further restricting the consumer market).

 

If, as is likely, the dream scenario does not work out, and US capitalism fails to massively reduce its payments deficit through increased exports and reduced imports, the correction will take place through a massive reduction in US consumption on a scale that would most likely provoke a major downturn in the economy. US workers would suffer devastating cuts in jobs, wages and social conditions as the capitalist class attempted to force the working class to pay off the external debts accumulated during the 1990s bubble economy.

 

The complexities of the factors involved in the world currency and financial system make it extremely difficult to predict the exact course of events in the next period. One thing is clear, however. Every period of major currency realignment (as when the post-war Bretton Woods system disintegrated after 1970, or when the European Exchange Rate Mechanism collapsed in 1992) has been accompanied by convulsions in the world economy. The contradictions currently facing the world economy are far deeper than any time since the Great Depression of the 1930s. The slide of the dollar, which could become a precipitous collapse under certain conditions, will have incalculable consequences for the world capitalist economy.

 

From Socialism Today (June 2003)