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Tom Palley makes this point:
Though the dollar is undergoing a correction, it is a healthy one
and the dollar is likely to stay on top for years to come. The real
matter for concern is the large U.S. trade deficit with the rest of the
world, which causes jobs and demand to leak out of the economy. As a
result, borrowing and spending that should create jobs in the United
States end up creating jobs offshore, while the U.S. economy is left
with a weakened manufacturing sector and burdened with the debts that
finance this spending.
More below (read more).
Don’t Bet Against the Dollar
Copyright Thomas Palley
The global economy runs on the dollar, and that isn’t about to change.
Today the world’s central banks hold about two thirds of their reserves
in U.S. dollars. Most commodities are priced in American currency, and
much of world’s trade is invoiced in dollars as well. The dollar is the
lifeblood of the international system.
Still, a growing number of observers, pointing to persistent
U.S. trade deficits and the dollar’s depreciation against the euro,
have begun to speculate that the dollar’s day is coming to an end. If
they were right, this would be a worrisome development. First, an exit
from the dollar would lead to its further depreciation, causing
increased import prices that might trigger higher inflation. Second, a
decline in demand for dollar assets would cause a fall in asset prices
and raise interest rates, which could cause a recession and permanently
slow U.S. economic growth.
Fortunately, these fears are misplaced. Though the dollar is
undergoing a correction, it is a healthy one and the dollar is likely
to stay on top for years to come. The real matter for concern is the
large U.S. trade deficit with the rest of the world, which causes jobs
and demand to leak out of the economy. As a result, borrowing and
spending that should create jobs in the United States end up creating
jobs offshore, while the U.S. economy is left with a weakened
manufacturing sector and burdened with the debts that finance this
spending.
So why is the dollar here to stay? Put simply, it’s still the
best option. The world needs a currency for international transactions
to facilitate pricing and payments, and what better than the dollar?
With an annual GDP of more than $13 trillion and with efficient, liquid
capital markets, the U.S. economy operates on a scale and with a
vitality that is unmatched. (It also helps that the dollar is backed by
the world’s sole superpower.)
Another, complementary explanation for the dollar’s preeminence is the
“buyer of last resort” theory. Countries hold dollar assets because
they want trade surpluses with the United States. According to this
theory, many countries can’t generate enough domestic consumption to
spur growth and full employment, forcing them to rely on exports.
As
the United States is the world’s largest consumer market, countries
therefore have an incentive to make their goods cheaper and more
competitive by undervaluing their currencies against the dollar. This
obliges them to buy and hold dollars to maintain their undervalued
exchange rates. The economic history of the past decade bears this
theory out. Since the late 1990s, American consumers have powered a
global boom, compensating for weak domestic demand in much of the
world. But their massive spending on goods imported from abroad has
also caused the U.S. trade deficit to balloon to $759 billion dollars
in 2006, equal to 5.8 percent of U.S. GDP.
East Asian countries such as China have been especially reliant
on exports, a policy that has earned them trade surpluses and a massive
storehouse of dollars. According to the U.S. Treasury Department, China
and Hong Kong have U.S. Treasury bond holdings of $455 billion, while
Japan has holdings of $582 billion. Now, there is talk that some East
Asian countries may diversify their foreign-exchange reserves by
reducing their dollar holdings. Their options are limited, however.
Because they want their exports to stay competitive, none of these
countries wants its currency to appreciate against either the dollar or
the currencies of its trading rivals. Nor do the two would-be
competitors to the dollar offer an appealing alternative. Yen
investments yield low returns. So do euro investments, and they may now
be risky given the euro’s large appreciation in recent years.
It’s highly unlikely that any countries will abandon the dollar.
Instead, some may choose to tweak the composition of their dollar
holdings by moving some funds out of U.S. Treasury bonds and into
commodities and U.S. equities. China has already said it plans to do
just that through its new sovereign wealth fund, the China Investment
Corporation. Moreover, now that the dollar has already depreciated
significantly against the euro, U.S. assets are starting to look
relatively more attractive. This suggests foreign capital worldwide
will be looking to buy dollar assets, which promises to put a floor
under the dollar and keep foreigners invested in the United States.
That said, there are two major scenarios under which the dollar
could fall out of favor. One is if U.S. inflation were to accelerate
sharply, thereby undermining the dollar’s attractiveness as a store of
value and unit of account. A second is if the United States alone
undergoes a deep recession that the rest of the global economy avoids,
thereby making investments denominated in other currencies more
attractive. However, this last possibility is unlikely: The global
economy is too closely intertwined, and a U.S. recession would likely
affect everyone.
In the next several decades, there will be a slow shift toward other
currencies as other economies catch up with the United States, but that
process will be gradual and will leave the current system essentially
intact. That does not mean there is nothing to worry about, but being
preoccupied with the dollar’s dominance is the wrong goal in the first
place. Indeed, the policy of a “strong dollar” contributed to creating
the overvalued dollar, and has always been misguided.
Instead, the target should be sustainable prosperity, one
requirement for which is exchange rates that prevent excessive trade
deficits. This will automatically deliver a “sound dollar,” which is a
better basis for a dollar standard that works. From this perspective,
far from being a strike against the dollar, the appreciation of the
euro is a welcome development. The Chinese yuan and Japanese yen should
be allowed to appreciate as well. The next step is for U.S.
policymakers to set up international arrangements to prevent future
damaging exchange rate misalignments—such as the ones now being
corrected. The bottom line is that the dollar is down, but it’s not out.
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