U.S. dollar faces threats to its reign

War spending, trade deficits, and devaluation against foreign currencies weigh on the greenback.

By David R. Francis

from the June 2, 2008 edition

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The United States dollar has been the king currency in the world for decades. Could it now lose its throne?

It's "definitely a possibility," says Barry Eichengreen, an economist at the University of California, Berkeley.

The US has been spending hundreds of billions on the Iraq war, suffered massive trade deficits for many years ($708 billion in 2007), and now is paying about $1.2 billion a day for imported oil. Moreover, the dollar has been hugely devalued against the euro (the currency of 15 nations in the European Union), the British pound, and some other currencies.

Conventional wisdom among economists is that currency ascendancy gives a nation an economic advantage. The US, for instance, finances much of its international payments deficit by issuing Treasury bonds and other debt instruments denominated in dollars. So when the dollar loses value, as it has on foreign-exchange markets, the debts are paid in those same cheaper dollars.

Other nations cannot finance an international payments deficit in their own currency. So they can be more easily pressured by external forces to take unpopular domestic policy measures to restore an external balance. Those forces may include the International Monetary Fund (IMF) or a group of wealthy nations demanding repayment on loans.

In effect, the dominance of the dollar has enabled the US to live beyond its real means for decades. Charles de Gaulle, founder of France's fifth republic, complained in the 1960s about the "exorbitant privilege" the dollar gave the US. (It turns out that his finance minister, Valery Giscard d'Estaing, first used this famous phrase usually attributed to de Gaulle.) Loss of the privilege could lower US living standards a little.

Another piece of conventional wisdom is that loss of the key currency role can take many decades to happen. "This is not what history tells us," Professor Eichengreen says. It is usually thought that it took some 50 years, World War II, and the loss of the British Empire for the dollar to overtake the pound in 1945 with the creation of what is known as the Bretton Woods fixed exchange rate system. From that point, the value of most significant currencies were pegged to the dollar.

Eichengreen points out that in fact the dollar beat out the pound as the leading currency held by central banks in their official international monetary reserves in 1924. These reserves are held by nations to give them more time to manage an international financial crisis or a bad turn in their trade balance.

Further, Brazil switched in 1930 to pricing its coffee exports in dollars, rather than pounds.

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