We have noted in the past how an inability to apply objective analytical thought is a recurring theme in history, usually condemning the unfortunate subject to failure.
The weight of history is on us once again, with the slowly changing status of the US dollaras the world’s de facto reserve currency.
The importance of the dollar in the world economy is based on history.
When the Bretton-Woods exchange rate mechanism was devised in 1944, the US economy was the dominant force in the world and the US dollar the pre-eminent currency.
It naturally followed that the economic system the Allied powers set up at the end of the war would use the US dollar to back the fixed-rate regime.
But 20-odd years later, the US chose to pay for the cost of the Vietnam war on credit, and when the imbalances created by Bretton-Woods made continued backing with US dollars impossible, as the US economy wasn’t generating sufficient foreign exchange (FX) reserves, the system broke down and we moved, ultimately, to the floating-rate arrangement we have today.
The problem was, the rest of the economy didn’t move with it.
World trade is still priced in US dollars, everything from crude oil to gold to wheat.
While on the surface this doesn’t appear to present too much of a problem, it is when the US constitutes a steadily decreasing share of world economic output and world exports.
Is it efficient that when a Malaysian rubber exporter sells its product to a Korean car manufacturer, both parties have to transact in US dollars? As the value of the dollar depreciates steadily (for example, it has lost over 15 percent of its value against the euro in the last five years), it makes less and less sense to maintain pricing exclusively in this currency.
The export performance of the OPEC and Asia-Pacific currencies was a causal factor of the financial crisis.
The US dollar reserves of these countries were invested in the West, contributing to excess cheap liquidity which found its outlet in sub-prime and corporate lending.
The rest is, again, history.
The US dollar’s status as “reserve currency” means that the US economy in effect has a free lunch because it will always find buyers of its assets: the rest of the world.
The size of the US public sector deficit today is testament to this lack of fiscal discipline (when we are in trillions territory, the exact size becomes, as Stalin might have said, merely a statistic).
In this column a few weeks ago we discussed how investors will always seek risk-free assets, which is why the Federal Reserve can always print Treasury bills.
The current situation is not desirable from a number of viewpoints, whether one is a non-US exporter or a bank regulator trying to mitigate against the next financial crash.
So what is the solution? Bear in mind this is a long-term project, one cannot set up a reserve currency quickly.
An IMF-style special drawing right (SDR) we can dismiss out of hand, as lacking liquidity.
The euro is a genuine contender, but has to sort itself out first – it needs a centralized fiscal management system (some form of political union) as well as a review of whether economically weaker eurozone countries are viable long-term members.
That leaves the Chinese renminbi.
Although not a freely tradeable liquid currency, it is surely only a matter of time before it does become one.
The Chinese economy is only going to be growing over the next 20 years, and as its exports start to dominate world trade, it makes sense to transact more in its currency.
Fast forward 10 years.
If the world had three reserve currencies to pick from, for both its risk-free asset holdings and its global commerce, would this be a good thing? The answer is a definite “Yes.” In the first instance, the kind of global cash flow imbalances we experienced during 2001-2007, and which contributed to the financial crash, would not build up to the same extent.
This would contribute to economic stability.
Secondly, exporters would be less exposed to FX rate fluctuations, enabling companies around the world to save money on hedge costs.
And third, it would enforce an element of fiscal discipline on future US governments, which would be good for the US economy, and by extension the world, in the long run.
This is not to underestimate the importance of the US dollar.
It will still be the main currency for payments and risk-free assets in 10, and even 20 years’ time.
But the availability of the euro and renminbi on a similar basis – as freely tradeable, liquid currencies and with an open government bond market in China – will mean that central banks can diversify their currency holdings, and there would be less correlated risk with the entire world to the US economy.
This can only be a good thing.
DrMoorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland and Visiting Professor at London Metropolitan University