Thursday, October 15, 2009

Why The U.S. Dollar Will Loose Its Eminence

Professional economists are a funny bunch. Most resemble a person who looks himself in the mirror and after walking away from it immediately forgets his appearance. Similarly, economists inspect their economic trade tool with diligence, but seem to forget them when it is of utmost important; that is, when abandoning them may lead to tenured positions or a high profiled political job. The issue of the U.S. Dollar’s eminence in international markets is no different. There are elaborate theories and abstruse statistical methods supporting this or that view of how the currency is supposed to behave. But there is an even simpler approach, a model which a scientist would say has parsimonious characteristics: it is called logic.

Since 1945 the U.S. Dollar has reigned supreme in world affairs. Many international prices and other market mechanisms are set in terms of the value of the greenback. Yet, this distinction comes with a (hidden) string attached. Simply, the Dollar status maintains a unique advantage vis-à-vis other currencies because, as long as foreigners allow it, the currency does not have to follow the standards which others are held to. In other words, the fact that the U.S. Treasury can merely print Dollars to pay its foreign claims, unlike other nations, provide America with special privileges. This is referred to as asymmetrical position. The reserve-emitting country (i.e. U.S.A) can fund many of its activities, and as long as the majority of foreign do not economically rebel, it will not suffer the consequences that another country would.

For example, a country with non-reserve currency can fund its day-to-day operations above it collects in taxes, but at a high cost: inflation and subsequent political upheaval. Inflation because the excess money printed exceeds currency demand. These excess funds chase a fixed amount of goods, or at least it is far more than the level of production. Prices will rise in this environment. High price inflation distorts prices and business decision plans.

On the contrary, the reserve currency country is not readily prone to such immediate consequences. Because of it’s prestige, traders and international investors have granted the greenback a tremendous standing. When economic worries sip into various countries, immediately you will see a sell-off in the said country. These investors pursue capital preservation. The U.S. Dollar has that perception. U.S. dollar assets are purchased, consequently providing support for the currency and the economy too. Over this decade, however, the growth in money printing has exceeded the growth in currency accumulation of foreigners. Said differently, had the U.S. dollar not have its unique status, it would have depreciated below what it is now a long time ago. An overvalue currency without due adjustment through the foreign exchange market would be price inflationary. However, in the case of the U.S., demand for dollars by foreigners has increased faster during the time the currency has had eminence, thereby transferring price inflation and other economic costs to foreign markets.

This arrangement cannot continue indefinitely. At some point it will come to an end. As to how it will unravel? I leave that thought to seers and soothsayers.

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