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September 2004 • Vol 4, No. 8•

The Crisis of the Dollar

By Niall Ferguson

“The convention whereby the dollar is given a transcendent value as an international currency no longer rests on its initial base…. The fact that many states accept dollars in order to make up for the deficits of the American balance of payments has enabled the U.S. to be indebted to foreign countries free of charge. Indeed, what they owe those countries, they pay in dollars that they themselves issue as they wish.… This unilateral facility attributed to America has helped spread the idea that the dollar is an impartial, international means of exchange, whereas it is a means of credit appropriated to one state.”

Thus spoke Charles De Gaulle in 1965, from a press conference often cited by historians as the beginning of the end of postwar international monetary stability. De Gaulle’s argument was that the U.S. was deriving unfair advantages from being the principal international reserve currency. To be precise, it was financing its own balance of payments deficit by selling foreigners dollars that were likely to depreciate in value.

The striking thing about De Gaulle’s analysis is how very aptly it describes the role of the dollar in 2004. That is itself ironic, since the general’s intention was, if possible, to topple the dollar from its role as the world’s number one currency. True, pressure on the dollar grew steadily in the wake of De Gaulle’s remarks. By 1973, if not before, the system of more or less fixed exchange rates, devised at Bretton Woods in 1944, was dead, and the world entered an era of floating exchange rates and high inflation. Yet, even in the darkest days of the 1970s, the dollar did not come close to losing its status as a reserve currency. Indeed, so successfully has it continued to perform this role that in the past decade some economists have begun speaking of Bretton Woods II—with the dollar, once again, as the key currency. The question is: how long can this new dollar standard last?

The existence of a dollar standard may come as a surprise to any American who has been considering a summer holiday in Europe. With the euro at $1.18 (compared with 90 cents two years ago), talk of a new era of fixed exchange rates seems far-fetched. But “son of Bretton Woods” is not a global system (nor, in fact, was Bretton Woods senior). It is primarily an Asian system. Pegged to the dollar are the currencies of China, Hong Kong and Malaysia. Also linked, less rigidly, are the currencies of India, Indonesia, Japan, Singapore, South Korea, Taiwan and Thailand.

As in the 1960s, it is not difficult to make the case that this system is highly beneficial to the U.S. Over the past decade or so, the American current account deficit with the rest of the world for goods, services and loans has grown dramatically. Add together the deficits of the past 12 years and you arrive at a total external debt of $2.9 trillion. At the end of 2002, according to the department of commerce, the net international indebtedness of the U.S. was equivalent to around a quarter of GDP. Yet as recently as 1988 the U.S. was still a global net creditor.

This rapid role reversal—from world’s banker to world’s biggest debtor—has had two advantages for Americans. First, it has allowed U.S. business to invest substantially (notably in information technology) without requiring Americans to reduce their consumption. Between 10 and 20 per cent of all investment in the U.S. economy in the past decade has been financed out of the savings of foreigners, allowing Americans to spend and spend. The personal savings rate is less than half of what it was in the 1980s.

The second payoff, however, has taken the form of tax cuts rather than private sector investment. The dramatic shift in the finances of the federal government from surplus to deficit since 2000—a deterioration unprecedented in peacetime, according to the IMF—has been substantially funded from abroad. Had that not been the case, the combination of tax cuts, increased spending and reduced revenue that has characterized President Bush’s fiscal policy would have led to much more severe increases in long-term U.S. interest rates. Veterans of the Nixon and Reagan years can only shake their heads enviously at the way the present Republican administration has escaped punishment for its profligacy. To run deficits on this scale while enjoying long-term bond yields of under 5 per cent looks like the biggest free lunch in modern economic history. The cost of servicing the federal debt has actually fallen under Bush, even as the total debt itself has risen.

The reason is simply that foreigners are willing to buy the new bonds issued by the U.S. treasury at remarkably high prices. In the past ten years, the share of the privately held federal debt in foreign hands has risen from 20 to nearly 45 per cent. Just who is buying up all these dollar-denominated bonds, apparently oblivious to the possibility that, if past performance is anything to go by, their value could quite suddenly drop? The answer is that the purchases are being made not by private investors but by public institutions—the central banks of Asia.

Between January 2002 and December 2003, the Bank of Japan’s foreign exchange reserves increased by $266 billion. Those of China, Hong Kong and Malaysia rose by $224 billionn. Taiwan acquired more than $80 billion. Nearly all of this increase took the form of purchases of U.S. dollars and dollar-denominated bonds. In the first three months of this year alone, the Japanese bought another $142billion. The Asian central banks’ motivation for doing so is simple: to prevent their own currencies from appreciating relative to the dollar—because a weak dollar would hurt their own exports to the mighty American market. Were it not for these interventions, the dollar would certainly have depreciated relative to the Asian currencies, as it has against the euro. But the Asian authorities are willing to spend whatever it takes of their own currency to keep the dollar exchange rate steady.

This, then, is Bretton Woods junior: an Asian system of pegged exchange rates which keeps the Asian economies’ exports competitive in the U.S. while at the same time giving Americans a seemingly limitless low interest credit facility to run up huge private and public sector debts.

In one respect, at least, the claim that the world has unwittingly reinvented Bretton Woods is convincing. Taking a long view, the real trade-weighted exchange rate of the dollar has proved remarkably stable. It experienced bouts of appreciation in the early 1980s and the late 1990s, but then reverted to something like a mean value. Right now it is less than 10 per cent below where it was in 1973. And where the new system differs from the old is to the advantage of the former. The original Bretton Woods was premised on a fixed link between the dollar and gold. Remember the plot of Goldfinger? The prosperity of the cold war era supposedly rested on the foundation of the Fort Knox gold reserve. But that made the system vulnerable to speculation by foreigners who, like De Gaulle, decided they would rather hold gold than dollars. This time around there is only the dollar. The world’s monetary system is built on paper.

But here’s the catch. The proponents of the new Bretton Woods seem to see it as a system with a boundless, rosy future. The Asians, so the argument goes, will keep on buying dollars and U.S. treasury bonds because they so desperately need to avoid a dollar slide, and because there is no theoretical limit on how much of their own currency they can print purely in order to make their dollar purchases. In any case, why should foreigners not want to invest in the U.S.? It is, as numerous Wall Street practitioners have told me over the past few months, the place to invest now that recovery is under way. “Where else are they going to go?” one Wall Street banker asked me last month, with a rather superior sneer. “Europe?”

But this optimistic conventional wisdom overlooks a number of big differences between the 1960s and the present. American deficits under the old Bretton Woods system were insignificant; the U.S. was running current account surpluses throughout the decade. People then were worried about the fact that Americans were investing quite substantially abroad, though that was counterbalanced by inflows of foreign capital. But mainly they were worried that overseas dollar holdings were outstripping the Federal Reserve’s stock of gold. Today the U.S. is running up huge deficits, while international capital flows are much larger. So, consequently, are the potential strains on a system of fixed exchange rates.

Whatever its virtues, the Bretton Woods system did not last long. If you count only the period when the dollar and the major European currencies were truly convertible into gold at the agreed rates, it lasted ten years (1958-68). There are reasons to think that this Asian son of Bretton Woods could prove equally ephemeral. And the aftermath of its breakdown could be as painful as the crisis of the mid-1970s.

For all the mystical appeal of the dollar bill, it is not a piece of gold. Since the end of gold convertibility, a dollar has been little more than a flimsy piece of printed paper that costs around three cents to manufacture. The design with which we are familiar dates back to 1957, since then, as a result of inflation, it has lost 84 per cent of its purchasing power. Tell the Japanese that they are the lucky members of a “dollar standard” and they will laugh. In 1971 a dollar was worth more than 350 yen; today it hovers around 100.

Until very recently, the frailty of the dollar has not really mattered. We have forgiven it the periodic bouts of depreciation for the simple reason that there has been no alternative. The sheer scale of American trade (the prices of so many commodities from oil to gold are quoted in dollars) means the dollar has remained the world’s favorite currency and the first choice for settling international balances.

Yet no monetary system lasts forever. A hundred years ago, sterling was the world’s number one currency. Yet Britain’s soaring indebtedness during and after the first world war created an opportunity for the dollar to stake a claim first to equality and then to superiority. This pattern could repeat itself, for there is a new kid on the international monetary block. And few Americans have grasped that this new kid, despite the flaws of his parents, is a plausible contender for the top job.

Whatever you may think about the EU as a political entity, there is no denying that the currency it has spawned has what it takes to rival the dollar as the international reserve currency. First, eurozone GDP is not so very much less than that of the U.S.—16 per cent of world output in 2002, compared with 21 per cent for the U.S. Second, unlike the U.S., the eurozone runs current account surpluses; there is plenty of slack in European demand. Third, and in my view most important, since the creation of the euro, more international bonds have been issued in euros than dollars. Before 1999, around 30 per cent of total international bonds were issued in the euro’s predecessor currencies, compared with more than 50 per cent in dollars. In the past five years, the euro has accounted for 47 per cent to the dollar’s 44 per cent.

Could this mark a turning point? Last month, at a dinner held in London by one of the biggest U.S. banks for around 18 clients at other major City institutions, I posed the question: who thought the euro could plausibly replace the dollar as the principal international reserve currency? No fewer than six thought it could—and were prepared to admit it before their American hosts. When I asked a smaller group of Wall Street bankers the same question, they were more doubtful—though one observed that the euro is already the preferred currency of organized crime because, unlike the Fed, which no longer issues bills with a value above $100, the European Central Bank issues a high-denomination E500 note. That makes it possible to cram around E7m into a briefcase—which can come in useful in some parts of Colombia. Maybe on Wall Street too.

The future of the Asian Bretton Woods system—and indeed of this year’s U.S. recovery—depends on the willingness of Asian institutions to go on (and on and on) buying dollars and dollar-denominated bonds. But why should they, if the Japanese economy is—as now seems to be the case—finally coming out of its deflationary slump? In any case, Japan’s intervention has not been wholly successful in stemming the dollar’s slide: over the past two years, the yen has gone from 135 to 110 against the dollar. In yen terms, the returns on the Bank of Japan’s dollar portfolio have been decidedly negative.

Moreover, reliance on exports to the U.S. may not be a long-term option for Asia. In a recent lecture in Washington, Larry Summers, the former U.S. treasury secretary, argued that the U.S. has no alternative but to increase its savings rates if it is to extricate itself from “the most serious problem of low national saving, resulting in dependence on foreign capital, and fiscal unsustainability, that we have faced in the last 50 years.” His conclusion is that the world can no longer count on the U.S. to be the consumer of first resort, which means in turn that “the growth plans of others that rely on export-led growth will need to be adjusted in the years ahead.”

The Asian dollar dilemma is the euro’s opportunity, both economically and politically. First, if the U.S. does cease to be the only functioning engine of global demand, it is imperative that the eurozone step up to the plate, and soon. For too long the European Central Bank [ECB] has made price stability the “magnetic north” of its policy compass. It has not spent enough time thinking about growth in Europe and the world. For too long ECB interest rates have been about a percentage point above the Fed’s, despite the fact that deflation is a bigger threat to the core German economy than it ever has been to the U.S.

The president of the ECB is now a Frenchman. Maybe Jean-Claude Trichet should remind himself of some history. Thirty-nine years ago, the dollar was coming under pressure as U.S. entanglement in a messy postcolonial war began to grow. It was Charles De Gaulle who called time on the Bretton Woods system, which, he alleged, obliged European economies to import American inflation. This is the moment for someone to call time on Bretton Woods junior. Asians and Europeans alike need to sell their goods somewhere other than to profligate America. And they need to recognize that the emergence of the euro as an alternative reserve currency to the dollar creates a chance to fundamentally shift the center of gravity of the international economy.

If the Europeans seize their chance, Americans could face the end of half a century of dollar domination. Does it matter? You bet it does. For if Asian institutions start rebalancing their portfolios by switching from dollars to euros, it will become harder than it has been for many years for the U.S. to fund its private and public sector consumption at what are, in terms of the returns to foreign lenders, low or negative real interest rates. (Do the math: the return on a U.S. ten-year treasury bond a year ago was around 4 per cent, but the dollar has declined relative to the Japanese currency by 9 per cent in the same period.)

Losing that subsidy—in effect, the premium foreigners are willing to pay for the sake of holding the world’s favorite currency—could be costly. For a rise in U.S. long-term interest rates to the levels recently predicted by the economist Paul Krugman (a ten-year bond rate of 7 per cent, a mortgage rate of 8.5 per cent) would have two devastating economic consequences. Not for big U.S. corporations—they are hedged (more than five eighths of all derivative contracts are based on interest rates). But a 3 percentage point jump in long-term rates would whack first the federal government and then U.S. homeowners with considerable force. For neither the U.S. treasury nor the average U.S. household is even a little bit hedged. The term structure of the federal debt is amazingly short: 35 per cent of it has a maturity of less than one year, meaning that higher rates would feed through almost instantly into debt service costs (and into the deficit). Meanwhile, even as rates have been nudging upwards, the proportion of new American mortgages that are adjustable-rate rather than fixed has risen from around 12 per cent in late 2002 to 32 per cent.

The geopolitical implications of this are worth pondering. A rise in American interest rates has the potential not just to slow down the U.S. recovery; it could also cause the federal fiscal deficit to leap even higher. Under the circumstances, the pressure will increase to reduce discretionary spending, and that usually turns out to mean defense spending. It will get steadily harder to sell an expensive occupation of Iraq to a population groaning under rising debt service payments and alarmed by spiraling fiscal deficits. Meanwhile the Europeans will have added another string to their internationalist bow: not only will they be bigger contributors to aid and peace-keeping than the U.S.; they will also be the supplier of the world’s favorite money.

Such historical turning points are hard to identify. It is not clear when exactly the dollar usurped the pound. But once it did, the turnaround was rapid. If the euro has already nudged in front, it may not be long before oil producers club together to price their black gold in the European currency (an idea that must surely appeal to anti-American producers like Venezuela and Malaysia). World money does not mean world power: the EU is still very far from being able to match the U.S. when it comes to hard military power. But losing the position of number one currency would without question weaken the economic foundations of that hard power.

As the ghastly implications of the demise of the dollar sink in across the U.S., the specter of General De Gaulle will savor his belated vindication.

Niall Ferguson’s latest book is Colossus: The Price of America’s Empire (Penguin). He is professor of history at the Stern School of Business, New York University.

Prospect Magazine, June 7, 2004





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