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How vulnerable is the dollar?

There are parallels with the decline of the pound sterling


There is no point dreaming about a new monetary order when the dollar remains dominant and is here to stay. At least, for all practical purposes.


That is the bottom line of most commentaries on proposals to reform the international monetary system, such as that advanced in The Money Trap.


Indeed, the very discussion of reform options irritates some people no end. “Oh, here we go again”, goes the refrain “Yet another doom-monger saying we are all going to hell in a hand-basket and what we need is a new global currency – what crap!”


When you reply, “Well, actually international monetary systems do not usually last long; the historical record shows quite frequent changes of regime; and such changes can be triggered by wars or revolutions but also sometimes by simple monetary mismanagement – as in the 1920s”, back comes the retort:


“But there is no world war, Robert, and no revolution in sight, and as for monetary mismanagement, we all know the cure.”


“Governments know it, economists know it, we just lack the political will to carry it out – we need more flexible exchange rates, more flexible markets , structural reforms, better regulation…..What we don’t need is a new international monetary system; the present one is just fine – especially if you can stop China manipulating its currency, but that’s a political matter”.


There simply is no alternative to the dollar and that’s it.


It reminds me of the horror with which, back in the 1960s, central bankers reacted to suggestions that exchange rates should be more flexible.


Everything is impossible until it happens, when it immediately becomes inevitable.


Like the Roman Empire, the rule of the dollar is likely to be brought down by internal decay – a progressive weakening of the foundations of its domain, enabling external challenges to succeed.


Demand for dollar as reserves is being eroded long-term by the policies of the US authorities. They have consistently pursued currency depreciation in the short-term interests of US exporters and as a means to stimulate the domestic economy. Deliberate depreciation undermines the trust of foreign investors. Apart from unwanted periods of dollar strength during the Reagan administration and again when it has been demanded as a safe haven – as in the Asian crisis and again in the global financial panic of 2007-09 – its trade-weighted real rate has been consistently downwards.


Moreover the chief frustration of successive US administrations is that the present arrangements do not let them devalue even more rapidly.


The value of the purchasing power of the dollar has fallen steeply, having halved since 1982. Against gold it has lost some 75% of its value since the start of the century.


There are other foundational weaknesses. There are doubts about whether the US will honour its debts – and if so in real, moral, terms or in worthless paper? This is a political, not an economic, question. Politically, the trend has been towards partisan gridlock. Economists have no special insight into the dynamics of such questions of political economy. There is no reason why anybody should pay attention to their views – as economists – on the question of whether the US will or will not default.


Setting aside US government policies, does the Federal Reserve offer a bastion of stability? Sadly, the Fed’s independence has proved an ineffective safeguard against partisan political pressures. Indeed, some would say its policies raise the risks of looming monetary anarchy. Under QE, there is no anchor to prices in the US. While the dollar remains the world’s currency, that means there is no anchor to world prices.


The private sector remains another source of weakness for the dollar. With many banks remaining too big to fail, easy monetary conditions make the temptations to excess risk-taking irresistible. Indeed, refusal to take such bets would be irrational. Such private sector policies can easily overwhelm the defences erected by regulators in the form of higher capital buffers and closer regulatory oversight.


Ironically, another financial crisis would trigger a panic flight to the dollar as a safe haven. But it would further erode the currency’s crumbling foundations.


Central banks elsewhere are led by teams that seem all too ready to do their masters’ bidding.


Above all, there is also an intellectual trap – a refusal to acknowledge the true causes of the crisis. As argued in The Money Trap and a few other recent works (such as Justin Lin’s Against the Consensus) there is a clear train of causation between international monetary anarchy and the Global Financial Crisis. The financial breakdown that caused the Great Recession fits into a pattern of recurring cross-border financial crises.


However, the patronage and self-interest of major parties involved – national politicians, central bankers and financiers – ensure that the media is filled with misleading stories about the origin of the crisis (Blame lax regulation! Blame China! Blame Europe!). Academics chase publicity and power. So we have the wrong remedies thrust down our throats: financial repression and nationalism. These are not only profoundly mistaken; they will themselves have far-reaching geo-political repercussions.


Finally, a future US administration might well decide the reserve currency game is not worth the candle. It is blamed for causing distortions to the US economy, lack of freedom for monetary policy, lack of ability to devalue (as others try to match it), and making US hostage to foreign powers.


Only people who lack historical perspective can be so blind as to insist “there is no alternative” to the dollar based system.


Another point: The dollar’s reign may already be past


Real power changes hands before you know it


That is another lesson of the past. In the 1950s, in the City of London, it was taken for granted that sterling was and would remain the leading international currency for markets. True, the City remained shackled by post-war controls. Yet 40% of world trade was denominated in sterling; and gold, not the dollar, was the dominant reserve asset. When controls were lifted, London and sterling would resume their normal central positions.


And to a surprisingly large extent – for a time – they did. American financiers and banks were the Johnny-come-lately’s of world finance. They had bags of money but no sense, no sophistication, no deep knowledge of foreign countries and markets. That was what bankers said, anyway.


The dollar was seen as an instrument of US power. It was not truly international. It was subject to a policy serving narrowly-defined national needs. US financial markets and banks served domestic customers; US banks only went abroad to follow US corporations and service FDI. New York did not welcome foreign banks. The US had a history of trade and financial protectionism.


The US works on the basis of reciprocity. That is not the way of the true world banker.


From the perspective of 2000s, it seems “obvious” that sterling was “bound” to be crushed. But at the time there was widespread scepticism in the markets of American qualifications, just as there are today about those of China or India. What really crushed sterling was the devaluation policy and the UK’s betrayal of the trust of creditors.


In the late 1960s, during a visit to Singapore, I had dinner with PM Lee Kuan Yew, Finance Minister Goh Keng Swee and the other founders of the modern state. They were shocked by Britain’s currency policies and saw them as a betrayal.


By that time, US financial power had of course long overtaken that of Britain. But financial market perceptions had not changed. There was enough life left in sterling area and the City to support such illusions.


Fast-forward 60 years, perceptions may again be lagging behind reality. Has not US political weakness already handed real control over the once Almighty dollar to East Asian creditors? Is it not already in effect a negotiated currency, just as sterling had become?