Most commentators thought the dollar would fall this year. Instead, it has risen. Two experts explain what's driven the greenback's unexpected revival, and tell us why it can't last.
The five pillars propping up the dollar
The last year has not been kind to the dollar bears. Instead of diving, as they thought it should, the dollar's risen. And despite the pessimism and diversification talk of recent years, IMF figures show dollars still make up roughly two-thirds of the world's foreign exchange holdings. So why is the dollar so popular? What gives America free rein to settle debts in its own currency, print more of it at will, and impose its fiscal whims on the rest of the world? There are five elements currently supporting the dollar as world reserve currency. We will discuss each in turn.
The first is security, provided in the form of military and economic dominance. Charles and Louis-Vincent Gave, of research house GaveKal, theorise that the world's reserve currency is primarily held as a form of insurance in the event of crisis, so the nation that issues the reserve currency must be dominant militarily, technologically, and agriculturally so that in case of a random crisis, "reserves can be morphed into food to feed local populations". By this reckoning, the dollar is more than just a paper liability of the US government; it is backed by the physical strength of the US military and the financial strength of the US economy. This provides a sense of security to smaller countries facing greater exposure to the dangers of political unrest, military conflict or economic shock.
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The second element underpinning the dollar as world reserve currency is universal acceptance. Whether you are a tax accountant in Togo or a spice merchant in the Maldives, you probably accept American money. In effect, the dollar acts as a go-between for less liquid currencies, greasing the wheels of world trade.
Similarly (and this is the third element), the dollar's dominance is supported by the network effect, where the value of something increases in proportion to the number of users. The more widely circulated dollars become, the more people are willing to use them, reinforcing their competitive advantage as a medium of exchange.
Fourth in the dollar hit parade is America's willingness to act as spender of last resort. Issuing the world's reserve currency gives America huge privileges, chief among them fiscal autonomy, and with those privileges come responsibilities. In times of gloom, the leader is expected to step up, running deficits if necessary, until global growth gets back on track. Those who see America's current-account deficit as benign argue that this is exactly what the United States has been doing of late: spending more to make up for anaemic demand elsewhere.
Last but not least, a significant element propping up King Dollar's throne is plain old inertia. When things have been done the same way for a very long time, it is hard to introduce change. An example that immediately comes to mind is the popular engineering anecdote that says "standards last forever", in which specifications for the space shuttle are traced back to the wheel spacing on a Roman war chariot. So many essential goods and services are priced in dollars today, and so many transactions are conducted in dollars by tradition, that it would be nearly impossible to coordinate a mass switchover.
But might the king be toppled? There's little to work with in terms of past example. The Economist observes the last regime change: "The pound was king during the era of the gold standard. But in the years after 1914, Britain switched from net creditor to net debtor, and by the 1920s, the dollar was the only currency convertible to gold (although the pound returned to gold in 1925). Two costly wars and two episodes of currency devaluation in Britain later, the dollar was unchallenged as the world's chief reserve currency." It arguably took two world wars and a global depression to dislodge the pound. That is a tall order; no wonder the consensus is that the dollar will prevail.
But for all the elements working in its favour, the reign of America's world-beating currency has a big strike against it the profligate policies of America itself. While it took a series of extraordinary events over the space of decades to dislodge the pound, Britain never spent others' money as the US has. US consumers are happily in hock up to their eyeballs, betting on further housing appreciation to bail them out, while the accelerating pace of US government spending makes the mind boggle.
The result is an extraordinary situation. The status quo is unsustainable, but no one is clear what will happen next. America seems bent on destroying its own hegemony through unprecedented spending, yet the world is hard up for alternatives. And here is where things get interesting. For if no other fiat currency can stand up to King Dollar there just don't seem to be any particularly good candidates about then perhaps a metal can. Perhaps gold will make a comeback and reclaim its throne from the paper pretender. If so, the recent bull market in gold is just the beginning of its run.
Justice Litle is editor of Outstanding Investments, the commodity and energy advisory service. Justice has also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall)
Irrational exuberance and the dollar
Almost the entire edifice of neo-classical economics and modern financial theory is predicated on the assumption that investors act rationally. After all, why would anyone wield their hard-earned funds in an irresponsibly unhinged way? More to the point, surely anyone who did so would quickly lose their shirt and be unceremoniously removed from the game? The thing is that, although investors are, on the whole, rational, markets can take their time to come to their senses. Remember the dotcom bubble? Sure, none of the valuations made any sense. Absolutely, it was all going to end in tears. But it took its own time to run full circle.
The dotcom bubble may be an ever-diminishing memory in the rear-view mirror of the past, but markets are again doing the "wrong thing". They're not being rational, and once again Warren Buffett, who famously missed out on the whole tech-market rally, appears to have got it wrong. His Berkshire Hathaway group had a "very long-term" bet against the US dollar that by June totalled $21.5bn. However, after the first six months of this year, the dollar had risen more than 10% and Buffett was down $926m. He has subsequently been forced to cut his exposure back. This was not supposed to happen. Buffett, and he was not alone, predicted that the dollar would weaken because of the huge US trade deficit. As the US sucked in more and more goods from around the world, the sellers of those goods would be receiving dollars and (since they weren't spending them on US-made goods) exchanging them into their own domestic currency. Wouldn't they?
Apparently not. It turns out that the countries with the biggest trading surpluses Japan, Korea and, increasingly, China haven't been selling their hard-earned dollars. Instead, they've been buying US government bonds with them; effectively lending the money back to Americans to spend on yet more imports. Today, America receives three-quarters of the rest of the world's savings. So attractive and cheap and free-flowing is this supply of credit that the US household savings rate is now below zero for the first time since 1933. This makes sense to the Asians. They are having a tough time encouraging consumption at home, so their economies rely on the export industries for growth. It would be cutting off their noses to spite their face to push the dollar down, as that would push their export prices up. So far this year the US is the only major economy with rising short-term rates, so it's no wonder the dollar has been on the up.
But there is a reason for America's deficits, according to Fed chairman-in-waiting, Ben Bernanke. "There's a glut of global savings," he says. Roughly translated, his point is that it's everyone else's fault that the Americans are all up to their eyebrows in debt, because they shouldn't have been lent the money in the first place. Technically speaking, he is correct, in that one county's deficit must be another's surplus, but by that measure it's just tautological nonsense to say that it's a glut of global savings that is causing the US to go mad with its credit cards and that this won't have nasty consequences. While the world hasn't seen a major economy run deficits of this size in modern times (so we can't be sure), it makes sense to think that anyone, or indeed any nation, that spends money now that it doesn't have, will have to forgo that money later.
The Americans can't live beyond their means forever. So what will this mean? When the US gradually ran down its current account deficit between 1987 and 1991, the dollar fell about a third, even though interest rates rose, unemployment went up and the economy slowed sharply (see graph). Such periods usually see inflation rising too, because a weaker currency means import prices rise. It's not happening yet, I grant you, but when you've got people such as Warren Buffett betting $20bn that it could be soon, it'd be foolish to suppose that America can continue partying on with impunity forever. If building up deficits means strong, inflation-free, full-employment growth with low rates and strong asset markets, it rather suggests that unwinding them will give you the opposite. There is also a concern that the world's "savings glut" will find a new home for its money, in effect forcing the Americans to stop living beyond their means.
With an inheritance like that, no wonder Bernanke would like to have us all believe this is a sustainable position, but I think we all know that it's not. Likewise, even if his timing has been a bit out, you can see where Buffett's mind is going. America has all the debt and everyone else holds all the IOUs, but it's still Bernanke who controls the printing presses, so it'll be awfully tempting for him to inflate his way out of trouble simply by expanding the money supply at speed. That would make the dollar collapse, for certain. But the pain would all be with creditors (read foreigners') and the gain with the spendthrift debtors (read US voters'). I don't know about you, but I wouldn't want a job abroad right now that paid in US dollars.
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