The US Dollar

Since about 1999, media pundits have been predicting the imminence of two things: breakdown of the US economy and the end of dollar hegemony. The

first has more or less happened now. I have argued earlier in previous articles in this column that, in the long run, demographics will largely determine the economic/political shifts which normally follow major episodes of global recession.

The recent meeting of the G20 called to discuss measures to tackle the current global meltdown, made all the necessary Keynesian noises and, most important, established the need for a continuing multilateral dialogue for economic cooperation.

The second issue regarding the role of the dollar as the principal reserve currency also came in for some discussion with suggestions about the need for a second Bretton Woods conference to reform the global financial architecture. As in the 1940s, the discussion has centred around world liquidity and the dollar’s hegemony.

Joseph Stiglitz is also reported to have made noises about the need to end the primacy of the dollar. While some of these suggestions are certainly politically motivated, it is useful to discuss the economic fundamentals of such issues. After all, even political discussions must be backed by at least some modicum of economic rationality. This is what we will take up in this article.

What determines the dominance of a currency in world trade? Here it is useful to first begin with elementary undergraduate economics. Any currency, domestic or international, must satisfy three criteria: it must serve as a unit of account, medium of exchange and a store of value.

The first implies that people accept valuation in that currency, the second that they should be willing to accept that currency in return for sale of goods and services and the third that people should be willing to hold savings (future demand) valued in units of that currency. What has been the actual experience?

The problem of a unit of account other than gold vexed financial planners after the setting up of the Bretton Woods institutions in the late forties. If currencies were convertible to gold on demand then the world supply of currency would depend entirely on discoveries of new gold deposits.

Since global liquidity could not be allowed to depend on such fortuitous circumstances, the dollar came to be the principal reserve currency (convertible to gold) under the so called ‘gold exchange’ standard. The dominance of the dollar followed the decline of the pound sterling as the dominant currency after the Second World War.

The main circumstance that led to this was the Marshall Plan under which the US became the main supplier of goods and services to reconstruct war ravaged European countries. Since the demand was mainly for US commodities, it was natural that the dollar would best serve as the medium of exchange in international transactions.

Yet, this did not imply that the dollar need also be the unit of account. In fact, as Robert Triffin pointed out, increasing world supply of money depended on increasing US trade deficits and hence something new was needed. This came in the 1960s in the form of the IMF created Special Drawing Rights (SDRs) which became a unit of account in which reserves could be valued.

But, as we have noted, the SDR could never become a real currency as it could not serve as a medium of exchange: barring IMF quota transactions, all other world transactions were dominated by demand for US goods and hence dollars. In addition, the US was the only country willing to become the banker to the world by keeping the value of the dollar fixed in relation to gold (at least till 1971) and hence limiting its flexibility in domestic monetary polices.

That then is the bottom line. As long as countries value the independence of their monetary and fiscal policies the international reserve currency will follow the law of the market: any currency which satisfies the three properties we have noted will be the reserve currency irrespective of political preferences.

The primacy of the dollar comes from the dominance of the US in world production and hence supply of goods and services. Between 1980 and 2007, the US accounted for around 30% of world production (GDP). Since most transactions would thus involve the use of the dollar it makes sense for traders to reduce transaction costs by holding dollars. What about store of value? It is a telling fact that most countries hold dollar-denominated debt indicating their continuing faith in the dollar as a store of value.

When would the dollar’s primacy end? When world production shifts away from the US subcontinent and some other country exhibits the same degree of political stability. Who are the candidates? The euro is one but the share of EU27 in world production has fallen continuously since 1980 and is now around 25%. China? In 2007, China accounted for 6% of world GDP!

However unfortunate it may seem, the dollar is going to be around for some time to come. I am sure Stiglitz knows this.

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