The Implications of a Weakened Dollar
Remember that two likely side effects of the sliding dollar for the U.S. are higher interest rates and climbing prices, especially on imports—not the least of which is oil. The Middle East oil-producing countries sell oil in dollars, but they import much of their goods and services from the European Union and must pay for them in euros. As the dollar loses ground against the euro, their purchasing power deteriorates. They can either raise prices (as Americans have already experienced at the gas pumps) or start pricing oil contracts in euros as Iraq did in 1999.
Russia also sells oil in dollars but imports many of its goods from the EU. So it is losing purchasing power too. According to
www.gateway2russia.com, the deputy chairman of the Russian Central Bank has recently suggested abandoning the policy of pegging the Russian ruble to the dollar only, replacing it with both the dollar
and the euro (March 1).
The unstable dollar is putting pressure on central banks around the world to move away from dollar reserves. In fact, several have
already reduced their dollar reserves to stop further losses. “A new analysis by Lehman Brothers estimates that in the last half of last year as much as $133 billion of foreign exchange reserves in non-Japan Asia left the dollar for stronger, higher-yielding currencies such as the euro” (
Observer, February 22).
What this indicates is that the U.S. dollar—as a result of its weakening—is losing some of its status as a reserve currency. This has
far-reaching implications. In order to be able to transact business on a global scale in a smooth manner that promotes growth, the world relies on a universally accepted currency—the reserve currency. In the 19th century, the British pound sterling served the purpose. After World War ii, the U.S. dollar gradually replaced it.
“A national currency becomes an international reserve currency for other countries when it is established as the currency of choice in global finance and trade, owing to its overwhelming relative economic and financial power. Countries are eager to hold that currency as a reserve. It is a cherished asset that can be deployed anywhere, in any nation with which it has international economic relations, because it knows that every other country also wants this currency as a reserve for the same reasons it desires the currency” (
Le Monde Diplomatique, op. cit.).
The U.S. has a big advantage for this reason. It is the only nation that can simply print dollars and easily exchange them for other currencies to buy products without increasing the domestic money supply and risking inflation. It’s like getting an interest-free loan, and it is one reason the U.S. economy has been able to run trade deficits.
The real danger of a weakening dollar is that it cools the demand for dollars as a reserve currency! If the dollar continues to fall over time (which some analysts say it must), and if demand wanes and the supply of foreign capital starts to dry up, we face the prospect of strategic power shifts in global markets that would weaken the power of the U.S.—the same thing that happened to Britain not so long ago.
The Euro Challenge
In 2002, 12 nations of the EU adopted the euro as their common currency. It was not just for domestic economic reasons. “[P]lanners hoped that the importance of the euro would lead individuals throughout the world to hold their assets in euros rather than in dollars” (David C. Colander,
Economics). Recent U.S. aggressiveness, as Europe sees it, and the meteoric rise of the euro against the dollar have rekindled that aspiration. There is renewed speculation about whether the euro can become an alternative reserve currency to the dollar.
Admittedly, there are structural problems that hinder such a development. For example, the practices of the European banking system are cumbersome in handling transactions between countries compared to U.S. banking practices. And there are policy roadblocks such as the stability and growth pact that the European Central Bank interprets very narrowly and that unduly constrains national fiscal policy, especially in the economies of Germany and France.
While there are reasons to doubt the emergence of the euro as a reserve currency, remember that the U.S. dollar also has three enormous vulnerabilities: persistent trade deficits now running at about a half trillion dollars a year, budget deficits that are perceived to be out of control, and a lack of confidence in Washington’s foreign policy decisions (whether justified or not).
Meanwhile, the weaker dollar is indeed hurting European exports to the U.S. and undercutting the growth of the EU economy. This is placing “unexpected and growing pressures on the euro zone governments to advance structural reforms to make their economies more competitive” (Stratfor Global Market Brief, February 16). If the EU advances these reforms faster than the U.S. can put its financial house in order, watch for the euro to increasingly edge out the dollar as a preferred reserve currency. This would especially occur if more terrorist attacks on U.S. soil further undermined confidence in the U.S. dollar as a safe haven.
“Britain’s 200 years of global supremacy were based on a
strong currency, a large trade surplus and growing foreign investments. Trade decline in the late 19th and early 20th century gave a clear sign that Britain’s empire was on the wane. Today’s trade and payments deficits, and
the falling dollar, may point in the very same direction for the global order based on U.S. dominance” (Global Policy Forum, op. cit.).
