The decline of the U.S. dollar over the past six months is reviving concerns about its status as the world’s reserve currency.
A reserve currency is held in significant quantities by many governments as part of their foreign-exchange reserves. This permits the United States to borrow trillions of dollars at low interest costs.
The recent weakness in the dollar has several explanations.
First, our government has encouraged a weak dollar in order to help our exports. The trade figures for June showed that the dollar value of total exports was running at a pace 19.2 percent higher than it was last year.
Second, as the world economy recovers, investors feel comfortable holding other asset classes, such as gold, oil and non-U.S. currencies.
In the fiscal year that ended Sept. 30, the Treasury held at least daily auctions and raised $7 trillion of new and maturing debt. Moreover, Treasury yields are low. The 10-year Treasury is about 3.4 percent — a very low rate in relationship to its yield since the mid-1960s.
The country borrowed trillions of dollars and the Federal Reserve lowered its federal funds level to almost zero since August 2008 to prevent another depression. Despite massive borrowing, our interest costs are no higher than the prevalent level in August 2008.
On March 21, Moody’s said that if the United States doesn’t reduce its deficit spending to manageable levels in the next three to four years, it could lose its top AAA rating.
Recently, the greenback hit a 13-month low against a basket of major currencies. Gold recently rose to record highs, and oil rose above $80 because of investor fear about the dollar.
Policymakers historically seek to balance two goals: growth and stable prices. That is, unless the economy has unused capacity, growth tends to drive up prices. Policymakers currently wish to err on the side of growth.
In the long run, we need to develop policies that assure reasonable growth and stable prices. If America tries to reduce our debt burden with inflationary policies, this would accelerate a movement away from the dollar.
In March, the Fed bought $300 billion in Treasury bonds. Such purchases amount to printing money. This created concerns that the United States was more interested in financing our deficit than fighting inflation.
Most observers feel that the greenback’s importance should decline over time because of our staggering budget and trade deficits. The IMF predicts that the federal deficit will reach 100 percent of our GDP by 2019. Including the deficits of our states, the deficit numbers are even more ominous.
The on-going relevance of the dollar is dependent partially on China, our largest creditor, which raises three questions:
Will China continue to hold $1 trillion of American bond obligations?
Will China purchase additional American debt to help us finance our prospective ongoing deficits?
Will China leverage the American financial distress to replace the United States as the world’s leading superpower?
In recent months, China has expressed concerns about America’s growing fiscal and trade deficits. China has indicated a preference to replace the dollar with a basket of currencies for foreign reserve purposes. Alternatively, China’s yuan, which is pegged to the dollar, is possibly 50 percent undervalued. China’s artificially low currency value reflects a desire to keep its exports strong in order to augment its domestic demand. The World Bank estimates the Chinese growth rate at 7.2 percent.
Since World War II, the U.S. dollar has been the world’s reserve currency because of our wealth, our commitment to stable prices and our strong democratic traditions. In essence, savers trusted us to repay our debts.
We cannot continue to spend and borrow wantonly without running the risk of prompting a dollar rout.
Originally published in the Sarasota Herald-Tribune
