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The End of the Dollar?

Not yet.

12:00 AM, May 28, 2011 • By IRWIN M. STELZER
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The fuss about a possible default if our warring politicians fail to agree on an increase in the debt ceiling is good fun for reporters: the president removed himself from the negotiations in favor of a visit to the Palace and says he won’t agree to cut spending unless the Republicans agree to raise taxes on the rich, variously defined as families earning more than $250,000 per year and “millionaires and billionaires.” Some Republicans say they don’t fear default because keeping the ceiling on spending will reassure financial markets and prevent a downgrade of U.S. Treasuries even if there is a brief and well managed default. And all parties to the dispute are enjoying the sense of importance that comes with being key players in the “crisis”—politicians relish the spotlight. And all know that the crisis will be resolved by a last-minute deal that allows everyone to claim victory but postpones meaningful decisions until after the 2012 elections. All the negotiators, but not all investors. The gross value of contracts insuring against a U.S. default, although still small relative to the size of the Treasury debt market, has doubled from a year ago.

The negotiations make for good theater, but are a diversion from the real issue—whether the dollar remains the world’s reserve currency, which carries substantial advantages. Some 62 percent of foreign exchange reserve holdings are in dollars, down from 71 percent in 2000 but still above the 1995 level of 59 percent. Those dollars are a fiat currency—backed not by gold, or silver, but only by the government’s implicit word that a dollar today will be worth a dollar tomorrow. That’s why holders of dollars view with alarm the Federal Reserve Board’s policy (soon to end, we are told) of printing more and more dollars, and of holding down interest rates. History suggests those policies will drive down the value of the dollar. That worries holders of America’s IOUs more than the possibility of default, despite the increased prominence given to that possibility since a rating agency mused publicly about the possibility of downgrading U.S. sovereign debt. It is fears of such a dollar devaluation, plus a desire to diversify risk, that accounts for the increased role of the euro in world finance: from 18 percent of foreign reserve holdings in 2000 to about 28 percent by 2009 (the latest year for which the World Bank reports these data). And for China’s decision to handle more and more international transactions in renminbi—several countries now buy renminbi to pay for their imports from China, rather than purchasing dollars.

But now things get interesting. To economists, exchange rates, the rise and fall of one currency or another, are what matters. There is some reason for that, the main one being that a rise in interest rates demanded by international lenders can slow domestic growth, as Greece, an admittedly extreme example, has painfully discovered. Right now, that is of crucial importance in America, where the recovery seems to be faltering, and job creation is insufficient to put a serious dent in the unemployment rate. With government spending heading down, the added headwind of a rise in interest rates is the last thing the economy needs.

But economics is not the only driver of policy. The relative rise of the renminbi and the euro in international trade is taken as still another indication of the relative decline of the U.S. as an economic and military power. And if the World Bank is to be believed, some time between 2011 and 2025 the now-dominant dollar will “be replaced by a global system with three roughly equally important currencies: the dollar, the euro, and an Asian currency,” most likely the renminbi.

Whether this forecast is the result of dispassionate analysis, or an expression of the wish of World Bank economists, internationalists naturally craving a multipolar world in which America loses its pole position, is impossible to determine. It might be a bit of both. But it is a forecast best viewed with a healthy skepticism.

For one thing, it is risky indeed to assume that the Chinese economy, which has a long way to go to produce American-level living standards, will continue to grow in the future as it has in the past. Inflationary pressures have built up so rapidly that the authorities have been forced to hit the brakes, not with complete success. Meanwhile, increasingly restive workers are forcing wage rates up—a revolt of the new proletariat class that the regime is unwilling to squelch with its usual ruthlessness lest existing social unrest increase.

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