The Future of the Dollar

Felipe Larrain | Apr 29, 2008

Nowadays few things come up in economics discussions as often as the subject of dollar weakness, something that affects investors, exporters, importers and many other people that don’t even realize it. To analyze the issue, a bit of historical context is useful.

The gold standard was the way in which the international monetary system maintained parities until the 1930’s (with a notable interruption during WWI and the years that followed it). Later, at the end of WWII, more than 40 countries signed on to the Bretton Woods agreement, which established a fixed exchange rate system between most of the major world economies. The accord stipulated that the undersigned fixed the value of their currencies in relation to the US Dollar (USD), and that the dollar would be convertible to gold at the fixed price of U$35/ozt. The Bretton Woods lasted until 1971, when President Richard Nixon suspended the USD convertibility to gold and unilaterally changed the USD parity with other international currencies.

From 1973 to 1999, the USD, the Japanese Yen and the European currencies operated a “dirty float” exchange system, that is to say the currencies were allowed to move in accordance with market forces but the central bank of each country would intervene to move the exchange rate in one or another direction. In general, exchange rates between the European currencies stayed inside a tight band from 1973. For example the German Mark and the French Franc freely floated with respect to the USD, though they stayed within a tight band between each other most of the time by virtue of an agreement known as the European Monetary System. In January 1999, eleven countries adopted the same currency, the Euro, issued and administered by the European Central Bank (ECB), which floats against the dollar in the same way as the various European currencies did up to 1999. Today, thirteen countries have adopted the Euro, with two more due to join in 2008.

After Bretton Woods fell apart, the USD remained the focus of the international monetary system, and evidence to support that abounds. In 2000, more than 70% of international reserves were in USD. However, that proportion has fallen every year, reaching a bit under 65% in 2007. It is the Euro which has gained from the reduction of dollar holdings: Euro assets have gone from a little over 18% of world reserves to nearly 26% in 2007. The British Pound has also gained, to 4.7% of total reserves in 2007.

Considering the announcements that various countries (including China) have made about diversifying their reserves to lower the proportion held in USD, the question we should consider is whether we are (or not) at an inflexion point in the international monetary system. Could the USD lose its role as the world’s reserve currency? Which currency would replace it? The Euro?

The USD could effectively lose its protagonist’s role in the international monetary system. And the probability of that happening has certainly increased with signs of weakness in the US economic scenario, with a current account deficit of around 6% of GDP and with several years of deficits of similar magnitudes already behind it. Also, added to this is an inactive government that cannot make the needed reforms due to its low popularity, the lame duck syndrome and its concentration in the Iraq war.

The challenge of the new US administration is no small one. It must bring strength back to the USD, putting it back to the position it has held. To do this, it will need to push through the reforms needed to reverse the current account deficit and face the retirement of the baby boomers. This is clearly not a minor challenge.

The situation facing the USD is not irreversible. Although macroeconomic indicators are weak and there is much uncertainty, the USA shows more strength and microeconomic dynamism than many countries. It remains one of the most competitive economies in the world and there are no signals that this is about to change. Because of this, although today´s scenario is not favorable for the USD, the world economy has not yet passed its definitive sentence. The USD can take back its stronger position of the recent past years if the US authorities are prepared to implement the needed reforms. Given the position of the current administration, we will have to wait for the next one to sort this out.