The dollar crash risk

As Jacob (“Jack”) Lew, the ex Citibank man who has succeeded Tim Geithner as US Treasury Secretary, surveys his inheritance, one thing he will probably not be worrying about is the dollar. Perhaps he should. True, prospects for the US currency have brightened recently. This reflects the new spring in the step of the American economy, and the poor prospects for the euro and the yen – not to mention a bouyant Wall Street, which always makes people euphoric. When people start to see the world through rose-tinted gasses, it is time to put on tin hats. All this is short-term froth. The longer-term threats to the dollar remain ominous. And the stakes are high.

For many decades, the US currency has performed indispensable services to the world economy. So any weakening of its ability to perform them – above all to provide the international monetary system with safe, liquid assets – will pose a serious threat. In any event, governments must be ready to manage the transition to a better system – such as that outlined in  “The Money Trap” – in an orderly fashion.

So what is the case for viewing the dollar as a crash risk?

• The United States accounts for a declining proportion of world output.
• Its military power, which provided geo-political stability for the dollar area, is in relative decline. China is set to expand its presence big time in the Pacific.
• US monetary policy has been erratic and its fiscal policy undisciplined.
• As a result the United States has run huge payments deficits for many years.
• It is the world’s biggest debtor.
• It has short-term liquid liabilities and long-term illiquid assets.
• Periodic spells of ultra-low interest rates have unleashed large capital outflows, causing global monetary instability.
• The Fed’s artificial manipulation of interest rates, long as well as short, have eroded confidence in the long-term Treasury bond, which has long been the benchmark for all financial assets everywhere. Without such a benchmark, all financial asset prices will become more volatile.
• The US banking system came close to collapse in 2008. The collapse in trust was if anything even greater.
• Yet a credit currency depends totally on trust.
• There is less than full confidence that banking and regulatory reforms now being instituted will prevent a recurrence.
• Meanwhile, the US Congress has failed to get to grips with the nation’s daunting fiscal challenges.
• This in turn eats away at another pillar of the dollar – confidence in the American political system.
• No currency can retain the confidence of holders if its government and central bank follow policies calculated to drive down its real value over a prolonged period.
• A future financial and currency crash could spark rumours that the US might impose controls on convertibility. This would spark panic.
• People will ask: How safe are my US assets? Remember President Roosevelt stole gold from US citizens.
• Except for a few periods,  the US has not cared to have the dollar as international currency (see Allan Meltzer’s History of the Federal Reserve).
• Leading economists such as James Tobin favoured letting the dollar go.  He advocated monetary fragmentation. He wanted “greater financial segmentation between nations or currency areas, permitting their central banks and governments greater autonomy in policies tailored to their specific economic institutions and objectives.” James Tobin . “A Proposal for International Monetary Reform”. Eastern Economic Journal (Eastern Economic Association) July 1978,153–159. Milton Friedman favoured floating, which George Shultz (Treasury Secretary 1972-74) implemented.  President Nixon and Arthur Burns didn’t care. Nor have their successors.
• Paul Volcker was the only Fed chairman with any interest in the outside world. Even he couldn’t get it to lift its horizons.
• US policy since 1965 (48 years) has mostly trashed the dollar.
• There is no reason to expect this careless attitude to change.  What has changed is the system’s resilience.  When underlying conditions were more favourable, the dollar could perform its vital services despite regular assaults by its so-called guardians. But it has grown weary of such abuse.

The trend in the Real Dollar Exchange rate from 1970 is clear enough. It is likely to persist.

Of course there are alternatives

It is often said that, in contrast with the position of sterling in the 1960s, when the dollar was waiting in the wings, the dollar’s position now is secure as there is no credible alternative. This is to misunderstand how markets work. Given the demand, markets will evolve alternatives. Several other currencies offer attractive opportunities for investment. We are already in a “multi-reserve currency, multi-polar world” . There is also gold – and central banks last year bought more than at any time since the glory days of de Gaulle.

The real question is rather: once it starts, how brutal and abrupt could the dollar’s decline as a reserve currency be?

Triggers of change

I do not see China playing the main lead any time soon, but its policies could act as a trigger for seismic change. As the world’s leading creditor, it clearly holds a strong hand. While it is true that China’s underdeveloped financial markets appear to rule out the RMB from becoming a true reserve currency any time soon, the demand for RMB -denominated assets from the rest of the world will remain strong.

Again, demand is likely to produce a response.

Europe also could use its clout to press for reform of the system to exert more discipline – hopefully both on surplus and debtor countries.

Then some arrangements would have to be made for the vast outstanding short-term liabilities of the United States.

But the cost of avoiding the risk of the world breaking up into blocs, which would bring about a collapse in living standards, will be nothing less than a voluntary sharing of national sovereignty over financial and regulatory policies.

That is the lesson of The Money Trap.

For another assessment of the prospects for the dollar as a reserve currency, see my article in the latest issue of Quantum magazine  and here.