Every time the dollar slides in the international currency markets, people predict the death of the mighty dollar. No one, they say, will want to go on investing in a depreciating currency. The age of the dollar has come to an end. Its successor will be a multi-polar currency system, with the dollar, the euro, and possibly the yen as the three competitive poles of attraction. How likely is this?
Take a look at the chart below. Since 1970, the US $ has appreciated by X per cent against a trade-weighted basket of currencies. In this light, its recent fall by 15% is little more than a ‘blip’, which reverses its appreciation since 2000. What the chart shows is that short-term fluctuations in exchange-rates are useless as predictors of international currency status.
Moreover, the factors which have made the dollar so strong are still in place. The US economy remains the world’s largest in terms of output and trade. EU enlargement will bring a rough equality between the USA and the euro zone in both respects. However, the USA is the only economy whose invoice share of world trade (over 50%) far surpasses its share of world exports (15%). As long as commodities, particularly oil, continue to be invoiced in dollars, this situation will not change.
The use of a currency is also governed by the size, depth, and liquidity of its financial markets. These determine the transactions costs of using it. New York is the world’s leading financial market, followed by London. Commodity exchanges are based in countries which have a comparative advantage as financial centres.
Trade and financial links largely determine countries’ exchange rate policies. Small countries peg to their largest trading partners and sources of capital. In 1975, 52 members of the IMF (41%) pegged their currencies to the dollar. Fixed pegs are no longer so popular, but in 2000, 43 countries, including Russia, either pegged to the dollar or limited the movement of their currencies relative to the dollar, as against to 24 countries tied to the euro –which included 13 former African colonies of France.
The currencies in which imports of goods and capital are invoiced are also the main determinant of the composition of reserves. The dollar remains the most favoured reserve currency. In 1973 it accounted for 76 per cent of official reserves held by IMF members. At present it is 68 per cent, having been 72 per cent in 1999. Over time, the dollar fraction of reserves has remained fairly stable, though the percentage of reserves held in euros is likely to grow slowly.
These facts point to the underlying strength of the US economy. Its competitiveness comes, uniquely, from entrepreneurship and high tech, not from its exchange rate. So it sucks in capital. As long as international demand for US assets is greater than American demand for foreign goods and services, America is bound to run a current account deficit, and this pattern of unbalanced trade will be sustainable. China, Japan, and the smaller economies of East Asia will have no choice but to keep their currencies cheap; and the EU will be driven to limit the euro’s rise against the dollar. The United States alone has the freedom not to manage its currency.
So before you decide to switch from dollars to euros look at the chart –and think ahead.
Robert Skidelsky 