U.S. dollar faces threats to its reign

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

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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.

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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.

Today oil and most other commodities are priced in international trade in dollars. A few nations, including El Salvador, Panama, and Ecuador, have adopted the dollar as their national currency. They thereby lost the benefit of seigniorage, the free money governments receive when they issue new money. More than 100 nations do not allow foreign exchange markets to set the value of their currency, pegging its value to the dollar or euro by buying or selling that currency in those markets.

But with the jump in the price of oil and the tumble in the dollar, the psychology of world financial markets and perhaps central bankers is changing.

For one thing, the dollar has a serious competitor now – the euro, says Robert Hormats, vice chairman of Goldman Sachs (International). Euro member nations had a combined output of goods and services of about $12.7 trillion last year, not too far from that of the US. It also has a major financial market, even though it doesn't include that of London. Britain has stayed outside the euro area.

Already, central banks hold close to 30 percent of their international foreign exchange reserves in euros (about $1 trillion), a currency created in 1999, notes Mr. Hormats. Bankers are hedging against further drops in the dollar.

Another trend is for nations to peg their currency to the euro or a basket of currencies, which may include the dollar. In effect, both governments and private investors are seeking to diversify their international investment portfolios.

An IMF Working Paper (not official policy) released last week noted that "a sudden decrease in the willingness of nonresidents to continue funding ongoing trade deficits" [such as that of the US] could lead to a "currency crisis" with "a critical number" of nations switching their currency pegs or letting foreign exchange markets decide the value of their currencies.

Investors "are in the middle of hedging their bets," says Hormats, buying oil and other commodities on the futures markets. Such moves reflect concerns about US budget deficits, its dependence on imported oil, and a lack of consumer savings.

Some US hedge funds are now betting that certain Middle East nations will drop their dollar pegs and let their currencies soar. Last year Kuwait pegged its currency to a basket of currencies. Qatar has talked about doing the same. Ukraine last week altered its peg against the dollar to make its hryvnia more valuable.

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