The Dollar Isn't Dead Yet

China is demanding a new reserve currency – not much chance of that. But a basic cause of the crisis can be found in the global currency system. The G20 needs to address that.

The dollar is ailing, a reflection of the financial crisis. Its value has been fluctuating for months now. China has been agitating for a new reserve currency to replace the greenback. It would consist of a basket of currencies, an artificially created accounting unit the value of which would be less dependent on the dollar. The determining currencies would include the euro, the British pound, the Japanese yen and, according to media rumors, also the Chinese yuan.

This isn’t just evidence of Peking’s growing economic strength, it’s an economic turning point. A strong dollar has traditionally been part of the world economic order that has fueled growth for many nations. Because of the dollar’s strength, it allowed Americans to import a great many of the items it consumes. At the same time, it permitted Asian nations to offer their goods to America at bargain basement prices. They put their trade surpluses into dollar-based investments that, in turn, kept the dollar exchange rate high while Asian prices remained low. It was a win-win situation for both sides.

But it has been clear since the time of last fall’s economic crisis, brought on so suddenly by the Lehman Brothers bankruptcy, that the old division of labor was no longer working: a new balance was needed. Seen in that light, the Chinese suggestion is plausible. As Rolf Langhammer, Vice-President of the Kiel Institute for World Economics (IfW) said, “The reserve currency question is at the core of international financial architecture, so it must be discussed at the G20 summit.”

But there’s a problem with that: no other currency is currently in a position to take over reserve currency status from the dollar. Not the euro, not the yen, not the pound. The same goes for the Chinese-suggested, artificial “special drawing unit” consisting of four currencies and created by the International Monetary Fund (IMF) for bookkeeping purposes. Matthias Busse, head of the research program World Economy at the Hamburg Institute of International Economics (HWWI) asks, “Why should the United States and Europe voluntarily assume “special drawing unit” debt? They would be taking on additional risks they’ve never had before.” IfW economist Langhammer also expressed skepticism of the suggestion saying, “Discussing the special drawing unit would be like discussing whether we should try riding a dead horse.”

There has been speculation for some time that the euro could perhaps replace the dollar. But the greenback has always had a stabile basis for being reserve currency. It is the currency of a large, well-integrated domestic market where it functions as a very liquid currency. It draws its strength overseas from the political, economic and military strength of its homeland – and the United States is still the most powerful nation on earth despite its current crisis problems.

“Whether the dollar should be replaced as the reserve currency, however, isn’t the right question to ask. It didn’t become reserve currency by law or decree, it developed into that over many years,” says Busse. “The important question is: are we prepared in the eventuality the dollar collapses?”

Everyone fears that scenario: Americans fear the loss of their economic and political leadership role and the economic fallout that would cause. Their fear is that the Chinese could dump their considerable currency reserves, over $1 trillion to date, onto world markets thereby provoking the ultimate demise of the dollar. But in so doing, the Chinese would be hurting themselves as well. “The Chinese have no interest in doing that,” says Busse.

Other nations that have put their surpluses into dollar-based investments, other Asian or Arab countries, for example, would also suffer huge losses if the dollar rate collapsed. Exporting nations such as Germany or Japan would have greater problems than they now have in selling their goods overseas.

Far more important than whether and when the world should adopt a new reserve currency is how we can go about stabilizing exchange rates, because that’s the key to the entire international economy – business as well as financial markets. If rates fluctuate too wildly, commodities and financial markets would be in greater danger than they are now. “The United States can no longer guarantee stability,” says IfW economist Langhammer. “Unstable currencies are a menace to international financial currents.” Therefore, everything must be done in this crisis to stabilize exchange rates, he says, similar to what was done by the Bretton-Woods system following the Second World War.

The problem there is, fixed exchange rates can also be destructive as can currently be seen in Europe. Despite Europe’s single currency, the individual countries have never pursued common economic or fiscal policies. Tensions caused by the current economic crisis are such that pessimists have begun to fear a collapse of the monetary union.

Argentina presents an even more impressive example of the problems inherent in fixed exchange rates. It pegged its currency, the peso, to the dollar in a move many economists hailed as the ultimate solution to Argentina’s persistent inflation problem. But its economy developed independent of the United States’ economy. When Argentina slid into a deep recession, the American economy was flourishing. The strong peso put the brakes on Argentina’s exports and the high dollar exchange rate suppressed economic activity. The country slid into a downward spiral that culminated in national bankruptcy.

An interim solution must be found. Exchange rates must be stabilized without overly restricting them. It’s a delicate balance. In order to achieve it, the participating governments and reserve banks must be in close agreement. How to do that would be a worthy theme for discussion at the G20 summit.

The dollar may continue to lose significance in the medium run. “It’s conceivable that China could slowly and quietly begin putting its reserves into other currencies, and other nations could follow suit,” HWWI’s Busse says. That would be the preferred scenario: the dollar falls further, but slowly and under control, so no great damage would be done. In a world that is tumbling from one crisis to the next, that would be a dream scenario.