Part 12 (1/2)

The Decline of the Dollar

In the late 1950s the United States was at the peak of its power It ran a current account surplus, and the dollar served as the international reserve currency Under the faned shortly before the end of World War II, other nations made their currencies convertible into dollars at certain fixed rates, and the United States pledged to convert those saold

Most econoht Bretton Woods was a good idea, but Robert Triffin, a Belgian-born econoainst the idea of having one nation's currency simultaneously serve as an international reserve currency Such an arrangement, he warned, contained the seeds of its own destruction Triffin observed that nations that issue reserve currencies-Britain in the nineteenth century, the United States in the twentieth-generally maintain current account surpluses In the case of the United States, that meant that more dollars flowed into the country than flowed out

So far, so good But other countries, Triffin pointed out, would need to hold the reserve currency The resulting de dollars to flow out of the United States Those pressures, Triffin argued, would eventually create a current account deficit, which would eventually undercut the econo of the United States and, by extension, the dollar In effect, Triffin pointed out that the needs of the United States would collide with the needs of the rest of the world, paving the way for the decline of the dollar That was precisely what happened in 1971, when President Nixon reneged on the pledge to convert dollars into gold

Triffin's Dileer convertible into gold, but it remains the world's de facto reserve currency, even as that delobal iement-the so-called ”Bretton Woods II” system-can persist for the foreseeable future, as dollars flow out of the United States and pile up in the vaults of central banks in Asia and the Middle East

In fact, this uneasy arrangens of strain Back in 2001 dollars made up a little over 70 percent of the currency reserves held overseas Over the succeeding decade, as the fiscal deficits and current account deficit of the United States spiraled out of control, that percentage declined, reaching 63 percent in 2008 In the second half of 2009 foreign central banks displayed a pronounced aversion to the dollar and a strong preference for the euro and the yen; in the third quarter of 2009, dollars constituted only 37 percent of newly acquired reserves-a far cry froe 67 percent a decade earlier Gold and even soe of these reserves

The ongoing effort to diversify away fron wealth funds These state-owned investanizations like the China Investment Corporation-have started to avoid the US Treasury debt that has long been a staple of central bank reserves, focusing instead on higher-yield investhts

That trend is likely to continue in the coradual process, not a sudden, disorderly collapse Possibly the United States may follow in the footsteps of Britain, whose power-and currency-ebbed over h the United States surpassed Britain as the world's biggest econo reenerations Only after World War I, when Britain went fro seriously slip, and other countries began diversifying their currency holdings, though as late as 1928 the world's currency reserves still contained twice as old standard in 1931, the dollar did displace the pound The Bretton Woods agreeh only with the Suez Crisis of 1956-and the further collapse of the pound sterling-did the dollar become the world's unrivaled reserve currency

The fall of the pound took three-quarters of a century, and we may reasonably hope that the dollar's decline will also proceed at such a leisurely pace But this sort of historical analogy shouldn't be taken too far China, which occupies roughly the sao, is clilobal economic ladder far more quickly than any other nation in history It will likely surpass japan as the world's second-largest economy in 2010 or 2011, and it may dethrone the United States from the top spot sooner rather than later All of this has happened with astonishi+ng speed While the United States took a century to rise to power, China has lobal power in only twenty years

That raises the unnerving prospect that the dollar's days may be numbered in years rather than decades How such an abrupt and disorderly decline ht play out is difficult to know Historically, currencies had soold or silver; only in the 1970s was this connection severed entirely The world's old but on a fiat currency-a currency that has no intrinsic value, is not backed by precious metals, and is in no way fixed in value In a way, the dollar occupies the role that gold once did, and its collapse would be no less calaents and bankers of centuries past had opened their vaults one day to find that their precious piles of coin had turned to dust

Thatspiraling deficits While China will likely continue to purchase debt, other, se toward the exit That may eventually prompt a stampede that even China would be tees of the present systeh the benefits

The United States stands at a crossroads If it doesn't get its fiscal house in order and increase its private savings, such a seismic event will only becoine a scenario where this plays out, particularly if a political stalemate develops: Republicans veto tax increases, De the deficits-printinginflation will erode the dollar value of the public and private debt held around the world Faced with such an ”inflation tax,” investors around the world du them into the currency of a country with a far better reputation for fiscal responsibility

Should that take place, the United States would pay the price Up to noe have been able to issue debt in our own currency rather than a foreign one, shi+fting the losses of a fall in the value of the dollar to our creditors If other countries effectively revoked this ”exorbitant privilege,” the burden would fall back on us, and our borrowing costs would shoot upward, dragging down consurowth The price of i from cheap plastic toys from China to barrels of oil fro that Aht In the process, the dollar would become just another currency in the crowd

But that invites a question: ould take its place?

The Allance, the Chinese currency-the renminbi or the yuan-seems the obvious candidate to follow in the footsteps of the American dollar Few other currencies pose serious competition The British pound, the japanese yen, and the Swiss franc ree fro dollar, but they're the currencies of countries in decline The saer scale, of the euro, whose continued survival depends on the unity of a fractious group of countries,populations, and growing co old For all its recent luster, the idea of old the basis of the htly called a ”barbarous relic” While itdollar, its rising value is largely a function of fear and anxiety about the future Gold is a place to hide, not a foundation for a new monetary order It has few practical uses, is difficult to store, and exists in lobal econoood candidate for a reserve currency

That said, if governher inflation, gold could rise sharply in price But should that happen, central banks would probably not try to corner scarce supplies of gold More likely they would invest ainst inflation In other words, they would rush into real assets as they fled fiat currencies like the dollar

That leaves the ren-term alternative to the dollar China looks much like the United States did when it cae current account surpluses, has becoet deficit, and carries much less debt relative to other countries It has already taken subtle steps to challenge the dollar For exa to issue Chinese public debt denoional market in the debt and, by extension, the currency The Chinese finance ly described thiscountries and improve the yuan's international status”

China has taken other steps to bolster its monetary power It has set up currency sith several countries, including Argentina, Brazil, Belarus, and Indonesia It has also pushed so partners to use the yuan to settle accounts-that is, to denominate their invoices in yuan This may seem like a s in international trade uses the dollar as the ”unit of account,” even when the trade doesn't involve the United States This deference-sio-reflects the dollar's real and symbolic status as the international reserve currency If the yuan gains widespread acceptance in the world's account books, the dollar will see its reserve-currency status usurped

For noever, the renminbi faces an uphill battle to become the world's premier currency Even the Chinese e rate would have to beco the ren China's exports less affordable to other countries In addition, China would need to i restrictions onthe country, for exa its currency fully convertible for such capital transactions China would also need to accelerate doreater quantities of yuan-denoreater role for the rener for it to become the world's reserve currency anytiovernor of the People's Bank of China, proposed son currency that would coested a revision of the Special Drawing Rights (SDR), a quasi-currency created in 1969 under the auspices of the IMF, that can't pass from hand to hand the way a paper dollar or euro does but is purely a unit of account used by the IMF It derives its value frohted in different ways: the dollar is the predoredient, followed by the euro, the yen, and the pound Anyone holding SDRs has a clai ”basket” The instru debts owed to the IMF

The relative quantities of the currencies in the basket get recalculated every five years, and Zhou's broadside made it clear that China expects its currency will be included But wanting to sit at the table is not the sa to run the show In fact, Zhou cited Triffin's Dile for the creation of ”an international reserve currency that is disconnected fro run, thus re credit-based national currencies”

In fra this proposal, Zhou looked back to the Bretton Woods Conference of 1944 That year John Maynard Keynes pushed the attendees to contelobal supercurrency, called the ”bancor,” that would derive its value fro commodities The Americans rejected the idea and pushed for the dollar to become the world's reserve currency Zhou criticized that fateful step as hted,” and the SDRhis ideas

For now, the idea of turning the SDR into a global reserve currency renificant number of private and public parties would have to use it as a unit of account, and so far there's no sign of that happening; the SDR re interest in expanding its role highlights the degree to which China anda bit more stable and resistant to crisis and collapse

But that's not going to happen without international cooperation So one of the other institutions that eed from that fateful 1944 conference will have to be reformed: the IMF

Global Governance

The swift rise of the economically powerful BRICs-Brazil, Russia, India, and China-and other elobal econoinal G-7-the United States, japan, Gerdom, Canada, and Italy-cannot possibly clailobal imbalances, other players must sit at the table To some extent they already are: in the past few years, the G-20 has started to supplant itsBrazil, Indonesia, South Africa, Saudi Arabia, and other countries into the fold

While more es in the global economy and the internationalthat;the number of members may make it i and i policy-and most of the world's economies would still have no voice

The IMF may be more representative, but it has its own proble takes place via its executive board, which has twenty-four directors, each of wholobal constituency Unfortunately, European nations are overrepresented, while e economies in Asia and Africa are underrepresented A similar problem bedevils the way the IMF calculates ”shares”-the votes each country receives by virtue of its contributions to the IMF One recent study found that in 2000 and 2001, the collective voting power of China, India, and Brazil was 19 percent less than that of Belgium, Italy, and the Netherlands, despite the fact that by one measure the former cluster of countries had a GDP four times the size-and a population twenty-nine times the size-of the latter

So far the Europeans have been unwilling to cede power That's foolish: if the IMF is to have any credibility in the co years, its allocation of chairs and shares will have to reflect the interests and input of the e-anization too An informal precedent dictates that an American heads the World Bank while a European leads the IMF So far, calls to dump this antiquated practice have fallen on deaf ears, further threatening the organization's legitimacy

The IMF needs to be refore over itstimes of crisis, and only to s payments on their debt China, japan, and Germany, nations that act as creditors to the rest of the world, can ignore the IMF So can the United States, which runs current account deficits but gets to borrow in its own currency In effect, the IMF can do nothing to force China, Europe, and the United States to change their ways Worse, it has been reluctant to use the bully pulpit, failing to name and shalobal economy

That doesn't mean the IMF should be abandoned Even with its limited resources, it can tackle one problem in particular: current account i economies came away fro current account deficits, and an currencies in anticipation of an international liquidity crunch These strategies paid off during the recent crisis: countries in Asia and Latin An currency reserves aggressively intervened to prop up their own currencies, reassuring foreign investors that they could deal with a liquidity crisis without having to beg for support from the IMF

However commendable, independence from the IMF has coies contribute to unsustainable balances, but the real cost of such self-insurance-trillions of dollars stuck in low-yield assets-is high Moreover, if left unattended, these reserves can help fuel asset bubbles in the countries that aovernovernment bonds to soak up or ”sterilize” the surplus cash, they end up paying high rates of interest on these new obligations-yet another cost to bear

The IMF can address these proble more liquidity in tis attached: countries that accepted theree to undertake economic reforms that the IMF deemed necessary But not every country that suffers fro the recent crisis, the IMF offered a so-called Flexible Credit Line to qualifying countries This is a good start In the future, precautionary lines of credit should be ns of a crisis appear

The IMF can also expand its issue of SDRs, particularly in tiht to issue 250 billion worth of SDRs, sorah the issuance of international bonds denominated in SDRs Central banks could purchase the to the potential instability that conventional currency purchases cause (because the SDRs effectively spread the burden ale one) Here the IMF should attach sos: any recipients of SDRs should be forced to reduce their current account surpluses and otherwise reduce their accun currency reserves

These lobal economy off the kinds of imbalances that played a role in the recent crisis But if the world is going to move away fro dollar, reater reliance on SDRs is a good first step but only a ses will require a level of international cooperation that has been noticeably absent in recent years Whether the world's ood is an open question If the United States and China continue to focus on short-term national interests, iile international monetary system may fall victim to accumulated strain and stress

In fact, the historical record would suggest that we live at a particularly vulnerable mo crises like the recent one have often been a prelude to waves of sovereign debt defaults and currency crashes Econoone bust and the consequent banking crisesfor a little while, but many will ultioing to be especially likely if the sorts of current account balances that preceded the recent crisis continue to spiral out of control If they unravel, what happened to Iceland e

The Road Ahead