The use of the US dollar as the world’s ‘reserve’ currency is based on history. When the Bretton-Woods exchange rate mechanism was devised in 1944, the US economy was the dominant force in the world and the US dollar the pre-eminent currency. It followed that the economic system the Allied powers set up at the end of the war would use the US dollar to back the fixed exchange rate currency regime. But 27 years later, with the US having chosen to pay for the cost of the Vietnam War on credit, the imbalances created by Bretton-Woods made continued backing of US dollars with gold impossible because the US economy wasn’t generating sufficient FX reserves. The system broke down and we moved, ultimately, to the floating-rate arrangement we have today.
The problem was, the rest of the economy didn’t move with it. World trade is still priced in US dollars – everything from crude oil to gold to wheat. While on the surface this might not be an issue, it is a problem when the US constitutes a steadily decreasing share of world economic output and trade. Is it efficient, economically speaking, that when a Malaysian rubber exporter sells its product to a Korean car manufacturer, both parties have to transact in US dollars? As the value of the dollar depreciates steadily (for example, it has lost over 15% of its value against the euro in the past five years), it makes less and less sense to maintain pricing exclusively in this currency.
The US dollar’s status as reserve currency means that the US economy has something of a free lunch because it will always find buyers of its assets: the rest of the world. The size of the US public sector deficit today is testament to this lack of fiscal discipline. Investors will always seek risk-free assets, which is why the Federal Reserve can always print treasury bills.
The current situation, then, is not desirable from a number of viewpoints. Is there a solution?
One cannot simply set up a reserve currency. We can dismiss an International Monetary Fund-style ‘special drawing right’ as lacking liquidity. The euro is a genuine contender, but has to sort out its structural problems first – it needs a centralised fiscal management system before it can be deemed viable in the long term.
That leaves the Chinese renminbi. Although not a freely tradeable liquid currency, it is surely only a matter of time before it does become one. The Chinese economy will be growing over the next 20 years, and as its exports start to dominate world trade, it makes sense to transact more in its currency. If the world had two or three reserve currencies to pick from, for both its risk-free asset holdings and its global commerce, would this be a good thing?
The answer is a definite ‘yes’. Firstly, the kind of global cash flow imbalances we experienced during 2001-2007, and which contributed to the financial crash, would not occur. This would contribute to global economic stability. Secondly, exporters would be less exposed to FX rate fluctuations, enabling companies around the world to save money on hedging costs. Thirdly, it would enforce an element of fiscal discipline on future US governments, which would be good for the US economy, and by extension the world, in the long run.
Moorad Choudhry is visiting professor at the department of mathematical sciences, Brunel University, and a member of ACT’s education advisory board. He is author of The Principles of Banking (published by John Wiley & Sons)