Earlier this year, I sketched out a fairly nasty potential scenario where the falling dollar (and stable Euro) might cause the world to drop the dollar as its reserve currency, followed by all hell breaking loose. The rhetoric is heating up:
You know that nerves are taut when a couple of stray comments set off a flurry of selling. The dollar fell sharply on November 7th after mid-ranking Chinese officials, not actually responsible for foreign-exchange policy, made remarks that were seized upon by already jittery markets. A Chinese parliamentarian called for his country to diversify its reserves out of “weak” currencies like the dollar and another official suggested that the dollar’s status as a reserve currency was “shaky”. The greenback reached $2.10 against the pound and a new record of $1.47 against the euro, before recovering slightly (see chart). A widely traded index, which tracks the dollar’s value against six major currencies, also fell to a new low.
A true dollar crisis has long been one of the more frightening possibilities for the world economy. If foreign investors suddenly abandon America’s currency and the dollar collapses, financial markets could crash while the plunging currency constrains the Federal Reserve’s ability to cut interest rates. That fear is exacerbated by rising concerns about higher crude oil and food prices.
As I’ve pointed out in the past, the dollar’s status as a reserve currency has largely allowed America to inflate with very little visible burden on our own citizens. We create worthless money, use it to buy durable goods from other countries, and watch as they hold that money or reinvest it in the sinkhole that are Treasury bonds. It’s a credit card on the world, and we can print whatever we need to pay it off…
…as long as they don’t wise up. If they do, suddenly that money might come back to us, and we’ll feel the results of the inflation we’ve engaged upon.
Thankfully, The Economist doesn’t think the nightmare scenario is quite upon us yet:
For now, the dollar nightmare is still unlikely. The currency’s decline is neither surprising nor, at least until this week, alarmingly rapid. The gaping current-account deficit and interest-rate differentials between America and other big economies point to a weaker currency.
If cyclical considerations point to a weaker dollar, the most recent nervousness seems to be driven more by structural worries. Judging by the dollar’s slump in the wake of the Chinese officials’ comments, investors are fretting that central banks in emerging economies will abandon the ailing greenback. In the short term at least, that fear is easily exaggerated. The share of global foreign-exchange reserves held in dollars has fallen in recent years, but only gradually. Central banks are unlikely to accelerate a dollar rout by making dramatic changes in their reserve portfolios.
They’re right, that destabilizing the world economy through rash actions is likely to hurt the country dropping the dollar as much or more than it would hurt us. But with the emergence of the Euro, I think other nations are currently eyeing an exit strategy from the dollar. The writing’s on the wall, and unless our politicians grow a spine, I really don’t think we’re going to see the situation change.
How does that old adage go? “May you live in interesting times, and buy some gold while you’re at it.”