The decline of the dollar

This Perspective column was first published in Monday’s edition of Fund Strategy.

The striking thing about the dollar is not that many see its pre-eminent position as under threat but that its dominance has lasted so long. In many respects the global monetary system is still shaped by the international settlement that followed the second world war.

To many people living in Britain this may seem a strange problem to raise. The more the War (usually designated with a capital “w”) recedes into history the more it becomes a cultural obsession. It is hard to escape copious references to it on television, in films, in books and on the school curriculum. But in monetary and economic terms it was a long time ago.

The dollar emerged as the overwhelmingly dominant global currency with the end of the War in 1945. Back then America accounted for about half of industrial production and trade outside the Soviet bloc. Today America accounts for 20-25% of global output, depending on which measure is used, and it is likely to fall further in the coming years.

Under such circumstances the dollar will inevitably lose its position as the pre-eminent global currency at some point. But the same claim was made, with considerable justification, back in the 1980s. The difficult questions are how the shift will pan out and the likely time scale.

Such points are addressed by Barry Eichengreen, a professor at the University of California, Berkeley, in a new paper published by the DWS Global Financial Institute.* A lot has happened since his book on the subject, Exorbitant Privilege (Oxford University Press 2011), was published almost two years ago. He uses the opportunity of the new work to update his arguments.

In his book Eichengreen argued that America should embrace a new world of multiple international currencies. The dollar would remain important but it should be prepared to share its role with the euro and the renminbi.

Deglobalisation could be the alternative: a dangerous fracturing of the global economy similar to that suffered in the 1930s. In this scenario the world could retreat into regional blocs with relatively weak ties between them.

Since Exorbitant Privilege was submitted to the publisher in mid-2010 the economies representing each of the main currencies have undergone significant developments.

America has fended off the effects of low economic growth by keeping interest rates close to zero and engaging in substantial monetary easing. As a result some of its competitors accused it of artificially depressing its currency to help bolster exports and depress imports. For example, Guido Mantagna, Brazil’s finance minister, has accused America of launching a “currency war”. Wolfgang Schäuble, his German counterpart, said America was “artificially depressing the dollar exchange rate by printing money”.

Vladimir Putin, then Russian prime minister, went even further. He said Americans were “living like parasites off the global economy and their monopoly of the dollar.”

At the same time the fortunes of the euro have dipped as the eurozone has suffered its well-publicised problems. It has become increasingly clear that it is not just facing turmoil in peripheral countries but fundamental structural weaknesses.

In contrast, the renminbi’s shift towards becoming an international currency has accelerated. An increasing number of firms involved in trade with China are invoicing and settling transactions in the Chinese currency. The authorities are also promoting a greater international role for the renminbi.

But although the Chinese currency is rising faster than previously assumed it is still a long way from becoming an international force. The government is likely to pursue this path cautiously as it is managing a difficult economic transformation towards more domestic consumption.

Eichengreen concludes in his paper that recent events have, paradoxically, strengthened the dollar’s role in the short-term. One of its main rivals, the euro, has seen its prospects dented although the renminbi is accelerating faster.

Overall though the trend is still towards a more multi-polar world. American policy will for Eichengreen be the main factor in determining how well this shift is handled.

Although it is hard to disagree with the thrust of Eichengreen’s argument some additional points from historical experience are worth highlighting. For example, the American economy surpassed the Britain in size in the 1860s but it took about 80 years, and two world wars, for the dollar to achieve dominance.

Indeed until the first world war the dollar played virtually no international role. It was only the war itself, along with the creation of the Federal Reserve system shortly before the conflict, which started the shift.

This is not to argue that the future will track the past. The world is a different place from a century ago in many ways. But it remains true that the shift from away from one dominant currency, even if it does not involve wars, can be a traumatic process.

It is also possible for changes to come about rapidly. The problems within the eurozone have already given some indication of how expected trends may not work themselves out in a straightforward way.

Politicians will play a key role in managing, or perhaps mismanaging, what is likely to be a difficult transition.

^{* “Is the Age of Dollar Dominance Coming to An End?” October 2012.}