Dollar, Dollar Burning Bright

The most adverse effect of expansionary US fiscal (see Stimulus Bill) and expansionary US monetary policies (see Federal Reserve balance sheet) in an economy with stable demand conditions is inflation. Simply put, more currency exists in circulation for the same basket of goods. In countries with similar patterns of inflation, one would expect nominal exchange rates to remain constant. If the US had higher inflationary expectations than the Euro zone, one would expect the US Dollar to fall in value against the Euro.

One of the most interesting outcomes of today's crisis is actually that the Dollar has risen against the Euro. Since the summer of 2008, the US Dollar has appreciated by 20%. This seems completely contradictory in the face of lower real interest rates in the US than in the Euro zone. Fortunately for US consumers, this "flight to quality" in the world currency market means that they can continue to run a trade deficit (import oil and Chinese manufactured goods) in the face of a domestic economic policy that would have sank any other country's currency.

This is the pattern of facts at the heart of China's current consternation. The Chinese central bank is the largest foreign holder of dollar denominated assets which they have built up over the years by reinvesting their trade surpluses in order to keep a fixed exchange rate. Any inflation in the Dollar will pose a risk to all of the financial assets held by the central bank, but any decrease in the real Yuan-Dollar exchange rate would sink China's export led economy. Hence in the current equilibrium, the Chinese central bank finds itself in the odd position of having to increase its own Dollar reserves in order to maintain the fixed exchange rate, despite the fact that these assets are losing value as they are being accumulated. China's proposal has the effect of creating a new standard for international reserves, which are the "special drawing rights" as set up by the IMF. The SDR was originally designed to replace gold in international transactions and consists of a basket of currencies. The Dollar only comprises 44% of this basket; the Euro, GBP, and Yen make up the remainder. It is the hope of the head of China's central bank that this will allow countries to maintain reserve currencies in such a way that will not make their financial systems as tied to the US. For China, the additional benefit is to offload much of its dollar reserves without accidentally triggering a devaluation.

China has come to realize that the US consumer-led world economy is unsustainable. The American government and American consumers have been allowed to increase their liabilities in an effort to maintain a standard of living not supported by real income growth. Interestingly, it is possible that the world returns to the status quo after this current recession has abated. Developing countries can subsidize the United States' domestic inflation as it slowly winds it way out a debt problem. The US once again becomes solvent and serves as the consumption center for China who has now dodged an unemployment problem. However, their reserves would then be worthless. What China really wants is to somehow maintain low levels of unemployment and decrease its dependence on the US economy, all while unwinding $2 trillion in reserve dollar assets.

Where does the future of the Dollar lie? It serves as the reserve currency for most of the developing and the undeveloped world. The US is also the world's largest economy and actor in international trade and thus its currency serves as the medium exchange for transactions in the financial and real sectors. Most of all, the power of the US Dollar lies in the faith of governments and private individulas around the world that it will hold its value because the US economy will always be stronger than those around it. True decoupling does not yet exist, and as the current crisis is proving, most other places are in worse shape than the US. If China does walk the tightrope, the US Dollar could start to lose its place of importance in international finance. When that happens, it will be harder for the US to borrow in its own currency, and all of us will have to accept a lower standard of living as a result.