The Discreet Charm of the Dollar

Or perhaps a better title would be “The Charm of Reserve Currencies,” since I will not be speaking of the fashionable spread of the dollar, but of the global strengthening of the dollar during times of worldwide uncertainty — uncertainty partially linked to problems in the United States itself.

Here we have in one line the empirical definition of a reserve currency: It is the one that goes up when everything else goes down.

The dollar is not a panacea, but it is the best we have. To understand this, it is necessary to review the basic requirements a financial asset should meet in order to be a storehouse of value during times of panic.

Number one is size. If the asset’s market is small and illiquid, it will be overwhelmed by the tsunami of fleeing capital and will suffer from sudden appreciations with each piece of bad news — and equally sudden falls with each piece of hopeful news — creating volatility that is incompatible with the stability of a reserve asset. Even worse, since this volatility has a negative effect on the issuer’s health, it will generate strong anti-bodies. For example, the appreciation of the Swiss franc reduced economic growth projections, and forced the authorities to undertake a drastic intervention. Result: The value of the franc rose from $1.18 in early July to $1.37 at the height of the buying frenzy, and later collapsed to $1.14 after the Swiss National Bank’s intervention. If size matters, the contenders are few: the U.S. and EU (which comprise 25 percent and 20 percent of the world economy, and falling) and China (7 percent, but gaining ground quickly).

A second requirement has to do with institutions: The reliability and predictability of economic policy, and the economy’s capacity to respond to stressful situations, are essential for the asset to maintain its value. On this front, the race is tighter. No one doubts (for now) the solvency of the U.S. or Europe, but the Treasury debt crisis, and the growing federalization of the peripheral European countries’ debt, suggests the possibility that the value of their assets may be punished by an inflationary dilution — for some, the natural solution in order to avoid a decade of stagnation or “Japanification”. In comparison, China, with less monetary and fiscal experience, evens things up with its greater financial solvency.

The third requirement for a reserve currency is political. As Tomasso Padoa-Schioppa, one of the founding fathers of the euro, has often said, a currency is more than a trustworthy central bank (something which the European labyrinth clearly illustrates): It requires the unity of the issuing countries, and the political will to act as a reserve currency.

The fact is, having a reserve currency can be both a blessing and a curse. As global demand permits the U.S. Treasury to issue debt at low rates, it does so at the cost of a structural appreciation of its currency (a pattern that economists call the Triffin dilemma).

The world’s dollar savings (which is simply the purchase of U.S. bonds of various maturities) generates a continuous inflow of capital to the U.S., which finances interest payments and a chronic trade deficit.

China is the classic example of the opposite case: It has the requisite size and fiscal and monetary solvency, but it does not (yet) have the desire to be the recipient of the fears of the West, at the expense of its competitiveness and trade surplus. This is why its currency is not convertible internationally; it cannot be purchased outside of China, which disqualifies it as a reserve asset.

Therefore, with Europe resisting centralization and in danger of implosion, China shut away behind its wall, and the rest of the candidates too small for the job, one can understand the paradox of why slowing growth and fiscal cutbacks in the U.S. can cause the dollar to appreciate, or why a downgrade can cause the value of Treasury bonds to go up.

The impact of all this on our peso is, as always, somewhat idiosyncratic. A global appreciation of the dollar should be reflected in a higher exchange rate, but in the short term, the opposite has occurred. The absence of peso-denominated assets which protect against inflation keeps the demand for dollars alive, and yesterday’s depreciation feeds today’s purchases, in a spiral that can easily lead to unwarranted stampedes, with no small cost to the economy (and to those with small savings accounts, who tend to be the last to buy and the last to sell). Thus, the need for intervention by the Federal Reserve, which has been selling the dollar against the current of the global market. And thus we see the paradox of a peso which appreciates against world currencies (by 2 percent nominally in the first 10 days of September), at the same time that the local demand for dollars accelerates.

However, the status of the dollar as the global reserve currency is rather unstable. There is something of a self-fulfilling prophecy in the preference for the greenback; people expect it to appreciate in a crisis, so they buy dollars when they see a crisis approaching — thus confirming the expectation that it will appreciate. It would only take one crisis in which the dollar fell to cast doubt on the safety of a currency besieged by debt.

Moreover, capital is no longer fleeing the emerging markets as quickly as it did in 2009; after all, a diversified portfolio of emerging economies (and some more developed peripheral economies such as Australia or Sweden) is not a bad alternative to a fragile dollar, which barely pays interest. An expensive dollar is even worse; if its demand as a storehouse of value is what keeps it at these levels, then a diversification of this demand towards other currencies would cause it to depreciate to more reasonable levels.

It remains to be seen if with the passage of time emerging markets (including our own) will evolve into storehouses of value in a multipolar world, thus avoiding exposure to the changing moods of global investors. In the interim, to paraphrase Peron, one could say that it is not that the dollar is particularly good, but that the other candidates are even worse. With a foreseeable future of low growth and high volatility and a timid and fragmented opposition, it would seem that the much-promised decline of the dollar will have to wait.