Exclusive Role of Dollar Under Pressure Amid Market Instability

Today's Wall Street Journal argues that that U.S. dollar's facing increasing downward pressure, a trend that's rekindled questions about the greenback's historic role as the world's reserve currency (here and here):

Beaten down by fears of a U.S. recession, the dollar is falling with new speed -- creating severe challenges not just for the U.S., but also for sugar traders in Brazil, central bankers in the Persian Gulf and a host of others.

On Thursday, the dollar sank to a new record low against the euro, deepening a six-year slide in which it has fallen more than 40% versus the European currency and more than 20% against a broader basket of currencies. In late trading in New York, one euro fetched about $1.52, just two days after it surged through the symbolically important level of $1.50.

The latest impetus: economic data in the past three days showing a softening U.S. labor market, deepening turmoil in housing, and growth in 2007 slowing to the worst pace in five years. Federal Reserve Chairman Ben Bernanke put more pressure on the dollar during testimony before Congress yesterday, emphasizing gloomy prospects for the economy while pointing to the weak dollar as a rare bright spot helping exports, jobs and the trade deficit.

The greenback's biggest detractors -- a small but growing group -- say the currency is in danger of eventually losing its place as the world's dominant currency. Jim Rogers, a well-known commodity investor and a former partner of famed currency trader George Soros, has a particularly bleak assessment: "The dollar is a terribly flawed currency and its days are numbered," he said in a recent interview. He cited the U.S.'s huge foreign-held debt as the biggest cause.

Yet for all of the gloom, the world is unready to let go of America's unloved dollar. Akin to the way Microsoft's often-criticized Windows operating system remains indispensable to the majority of computer users, the dollar remains the common language of finance, the medium of exchange in everything from sugar to wheat to oil.

Shaking the dollar loose from that place would require a vast reworking of the global financial system that few parties seem prepared to confront. It is far from certain that the dollar will continue to decline. But if it does, businesses and policy makers around the world could be wrestling with the problems created by their dependence on it for many years.

Keep in mind that U.S. world monetary leadership's been threatened many times in the post-World War II era.

As Robert Gilpin, whose The Political Economy of International Relations is the standard textbook in the field, noted with reference to earlier "dollar crises":

With the dollar providing the base of the monetary system, the United States has been able to fight foreign wars, to maintain troops abroad, and to finance its hegemonic position without placing substantial economic costs on the American taxpayer and thereby lowering the American standard of living. The crucial role of the dollar and the "extravagant privileges," to use the term of Charles de Gaulle, that it has conferred on the United States has required a foreign partner to help support the dollar. In the contemporary era [1980s], this task has fallen to the Japanese and their immense capital outflows to the United States. U.S. financial dependence on Japan and the growing interdependence of the Nichibei economy is a major theme of this book.

Gilpin's a realist, so his concern is how the U.S. can maintain its status as global hegemon and continue providing the international public goods of economic stability, market access, military security.

Are we in a new era, with the collapsing dollar, in which our major creditor nations will abandon dollar holdings, pushing a new currency as a new standard of international monetary exchange?

I doubt it.

China's holding roughly a trillion in U.S. dollars, and critics of the American economy (especially leftists) routinely talk of the "Chinese stranglehold on America," the collapse of the U.S. standard of living, and the sellout of the American worker to Beijing. That's hyperbole (and a little America-bashing). We're not at risk of losing our dominant position, even amid current world financial volatility. Are the world's traders ready to stake their national economies on the renminbi?

As Daniel Drezner noted recently:

American consumer and capital markets are still the primary engine of global economic growth....

Two decades ago international-relations scholars were enmeshed in a debate about American decline. Replace China with Japan, and the current gnashing of teeth sounds like a replay of debates from the 1980s. Over the long term, however, the demographic and economic vitality of the American economy is difficult to dispute compared with possible peer competitors. For decades to come, the United States will be first among equals. So don't believe the hype. By most measures, the United States is still the hegemon.

This is not to say we don't have problems, or that global market jitters are insignificant. Rather, until the deep cultural and institutional affinities to the dollar give way at the central banks around the world, we're not likely to witness an end of America's "extravagant privilege" any time soon.