The Decline ofthe Dollar Age

With the escalation of the financial crisis, America has encountered its most serious economic problem since the Great Depression. In the days following the onset of the crisis, the US Treasury Department and the Federal Reserve adopted a series of measures to prevent the collapse of the financial system. Within a short period, these measures rallied market confidence against the prospect of a free-fall. But, Congressional debate on the Treasury plan sent the market into panic once again.

The first consideration for a Capitol Hill politician is, of course, the problems of their own district. Interestingly, among members of Congress up for re-election, the vast majority voted against the rescue proposal. Using taxpayer dollars to clean up the non-performing assets of greedy banking institutions has no public support. Finally, politicians recognized that if they did not confront the issue this time, the fall could take down not only the banks, but the economy and the financial system as a whole; hence, Congress finally acted to quickly pass the rescue package. But, the markets were apparently already convinced that all of the rescue measures combined were still not enough to resolve the present financial crisis. So, asset prices continue to plummet.

No matter how America’s circumstances may change over the coming months, it is safe to say that America’s financial landscape will be completely rebuilt; America’s hegemony within the global economy must begin to weaken as well. Since World War Two, the American economy and financial system have been the models for the rest of the world, especially for developing countries. But the current crisis has fully exposed the grave problems of America’s economic growth and financial system; its growth model, excessively reliant on current account deficits, will be forced to change; global investors’ confidence in the dollar and the US market will continue to drop, thus ending the post-1944 era of the American dollar.

The history of global economic development shows that no country can maintain its economic dominance indefinitely. Since the 15th century, the dominant economic powers of the world have held their positions for roughly 100 years: from Portugal (1450-1520), Spain (1530-1640), the Netherlands (1640-1720), France (1720-1815) to England ((1815-1920), there have been almost no exceptions. America’s global economic dominance began in 1920, and if it follows the pattern of the past several hundred years, then the days of American economic hegemony are numbered. Of course, there is a general lag between an economy’s loss of status and the decline of its currency. In the early 20th century, America was already overtaking Britain as the world’s number one economic system, but British sterling still accounted for two-thirds of countries’ foreign exchange reserves.

Since the 1980s, the American economic growth model was already showing signs of trouble. Despite steady increases in consumption and investment, the savings rate fell close to zero. Consequently, the current account, initially running a small surplus, has now fallen into massive deficit, accounting for up to 6% of GDP in the last few years. In other words, America’s economic growth is in fact made possible by using debt as a source of constant support.

For a long time, this economic growth model functioned without apparent distress. The reasons are complicated: on the one hand, the dollar served as the world’s currency, earning the favor of global investors; on the other hand, in the midst of massive development, the country’s current account surplus did not constantly increase. To guarantee high growth, Asian countries accumulated foreign exchange reserves and implemented conservative exchange rate policies, driving up their current account surpluses substantially. Changes came even faster for oil-exporting countries in the Middle East and elsewhere, as rising oil prices led to constant current account surpluses. Over the past ten years, Asian and Middle Eastern countries have contributed at least two-thirds of America’s additional current account deficit.

But, relying on constant injections of foreign capital to support a growth model is obviously utterly unsustainable. Along with its economic growth, America needs to expand its capital stock every year, but the rest of the world has grown less and less willing to put up the funding. Many developing countries have launched efforts to stimulate domestic demand, reducing their current account surpluses. Meanwhile, over the past few years, the dollar has depreciated and the ratio of dollars in nations’ foreign currency reserves has tended to fall. Given these trends, America has only three paths to choose from: increase domestic savings, allow GDP growth to drop, or accept a large depreciation of the dollar. No matter which path America takes, the international influence of the American economy will decline.

With the onset of the financial crisis, the efficiency of the American financial system has been called into question. Many experts believe that the root cause of the crisis (and the asset bubble which caused it) comes down to excess liquidity, an error for which Alan Greenspan is now widely held to be responsible. There is nothing wrong with the logic of this analysis, of course, but the current crisis further shows that the risk controls and regulatory agencies failed to work properly, and that the financial sector promoted risk in addition to innovation. Consequently, dealing with the crisis calls not only for adjustments in asset prices, but also for the enactment of major reforms within the financial system. The crisis will also further depress investors’ interest in dollar assets.

These are all structural factors in the expected long-term decline of the dollar. At the beginning of this century, America already bid farewell to its “strong dollar” policy of previous decades. For over six years, the dollar has continued to fall relative to the world’s other major currencies, leading to a 30% drop in the US real exchange rate. Recently, US government officials have asserted that they will insist on a strong dollar policy. Such statements are only declarations; the fundamentals of the US economy will prove such a policy to be an illusion. Moreover, American authorities also lack the means to efficiently support such a policy. In the past two months, US exchange rates experienced a short-term rebound, reflecting not the strength of the dollar, but the fatigue of the euro and other currencies.

Once the financial crisis has passed, the structure of the world economy will experience great change: apart from the obvious fall of America’s economic position and the decline of the dollar, global economic inequality will decline, excess liquidity will disappear and commodity prices will begin to decline. It is important to note that these shifts will occur as America undergoes transition, a transition with great implications for China. For the past decade, China has been America’s inverted image: America’s deficit is China’s surplus, America’s growing consumption fuels China’s booming exports.

Without a doubt, the era of the US dollar is already ending. But it is still unclear how long the dollar’s curtain call will last. This will to a large degree depend on how quickly a new world currency is established. More importantly, what currency will replace the dollar? The euro is perhaps the most likely replacement. Between 1999 and 2007, the dollar fell from 70% of world currency reserves to 63.9%, whereas the euro-denominated reserves rose from 17.9% to 26.5%. The economic performance and monetary policies of the Euro Zone are major obstacles to the euro’s ascendancy, however.

The Chinese renminbi (RMB) could also become an important potential currency. Within 20 years, China could catch up with America, becoming the world’s largest economic system. But the RMB’s biggest drawback is that it is still not really a freely convertible currency. Even if China sped up the opening of its capital accounts, the RMB’s prospects as an international currency (let alone a global currency) still depend on a series of factors, including the health of its financial system, the power of its regulatory structures, and issues of transparency. Obviously, if the RMB is to be the world’s currency, it still has a long way to go.

In the 20th century, developing an international currency system and a world currency were even more difficult. Before the dollar, the Spanish peso, the Portuguese lira and the English pound were all once the acknowledged reserve currency, linked at the time to fixed amounts of precious metals (for example, silver in the peso era and gold in early dollar era). Following the establishment of the dollar as the core of the Bretton Woods system, the value of the dollar remained tied to gold. After Nixon removed the gold standard in 1971, the functioning of the world’s monetary system hinged upon the credibility of the Federal Reserve. For other countries to develop such a reputation is no easy task.

On the one hand, the dollar age is coming to a close; on the other hand, a new currency to replace the dollar has yet to emerge. In the context of the international financial system, the most likely outcome is that several currencies will jointly play the role of world currency. The euro will no doubt play a bigger role in international financial transactions, investments and foreign reserve holdings, but the euro cannot completely replace the dollar. If China succeeds in its economic growth and financial reforms, then perhaps the position of the RMB will strengthen substantially; thus could emerge a three-legged world currency structure based on the dollar, euro and RMB. In short, the dollar age has entered its final phase, but it will continue to function as the world currency for a long time to come.