Dollar slips, euro gains credibility as viable rival
But to take the place as banker to the world, the euro may still need to prove itself.
For over half a century, the US dollar has been the preeminent form of legal tender in the world. Much of today's global trade is priced in dollars, even if the item in question isn't being sold or bought by a US firm. Most of the foreign exchange held by national central banks is dollars – not British pounds, Chinese renminbi, or Japanese yen.
But in recent months, the king of currencies has taken it on the chin. Since August the dollar has shrunk about 6 percent in value, measured against an assortment of its fellows. Perhaps more important, it may be losing cachet overseas: Tourists can no longer pay in dollars to enter the Taj Mahal and other Indian national landmarks, for instance.
Is the dollar set to lose its top status and the national financial advantages that entails? It has swooned and recovered before, most notably in the 1970s and late 1980s.
But there's a difference this time. The dollar has a credible rival: the euro.
"We are vulnerable. But it is not going to happen overnight, and we really have to see the euro establish itself as a safe haven currency," says William Silber, a professor of finance at New York University and author of a book on America's monetary supremacy.
Financial professionals call the world's leading monetary unit the "global reserve currency." It's a currency that bankers and industries around the world are willing to take in return for other currencies, or products.
In essence, foreigners are content to use dollars as the primary means to store their wealth. They're willing to do so because they're pretty sure the United States isn't going away, and because (for now) they have faith that the Federal Reserve will keep a lid on domestic inflation, which devalues dollar holdings.
"A lot of people hold dollars just because it's handy. Everybody is willing to take them in return for other currencies, or for stuff," says Russell Roberts, an economist at George Mason University, in Fairfax, Va.
The status of the currency can be seen in this: The European aircraft maker Airbus prices its planes in dollars, per industry custom. About 85 percent of South Korea's exports are priced in dollars, even though only about 21 percent of them are sold to the US. Overall, about 65 percent of known foreign currency reserves around the world are in dollars, according to International Monetary Fund figures.
The United States gains geopolitical power and prestige from the dollar's position, as the British did when the pound sterling reigned. It means convenience for US exporters and travelers and more business for US banks. It also makes it easier – some might say too easy – for the US to run up huge debts with the rest of the world, denominated in its own currency at low interest rates.
Those debts would be the US trade deficit, which is currently running at a pace of $533 billion a year.
"The willingness of Asians and others to continue financing the US current account deficit in the future is certainly related to the dollar's continued role as premier international reserve currency," concludes a National Bureau of Economics Research paper by economists Menzie Chinn of the University of Wisconsin and Jeffrey Frankel of Harvard University.
Lately, however, the dollar hasn't been looking so luxe. It's been gradually declining in value against other strong currencies for some five years; in the past few weeks, that slide has threatened to become a plummet. Since August, the dollar has slid about 6.6 percent against the euro. It has declined some 4.7 percent against the yen.
Kuwait used to peg its currency to the dollar but unhitched it in July. Other Gulf region petrostates are talking about loosening currency ties to the greenback. At recent Organization of the Petroleum Exporting Countries (OPEC) meetings, Venezuela and Iran unsuccessfully tried to persuade the cartel to price oil in a basket of currencies instead of dollars.
The dollar is a "worthless piece of paper," Iranian President Mahmoud Ahmadinejad jeered.
This drop is partly caused by international concern about the mortgage mess in the US and what it may mean for US and world economies. But the dollar's past success and the huge US trade deficit are also part of the problem.
There is a vast trove of dollars stored in vaults around the world. If, say, China tires of watching its dollars become less valuable by the day and decides to trade a large amount for euros, the flood of currency into the market could depress the dollar's value further. This might lead to more dollar dumping and price decline, leading to ... well, you get the idea.
The fact that the US "is running current account deficits and incurring a large net foreign debt threatens to undermine its position as banker to the world," according to Barry Eichengreen, an economist at the University of California at Berkeley.
Thus the dollar's future as world reserve currency crucially depends on the performance of the US economy and America's own policies.
In the short run, the greenback's status is unlikely to be threatened. Too much of the financial world is accustomed to dealing in dollars. Too many computer systems are set to deal with dollar pricing. Too many professionals have invested their careers in following it.
"There is a tremendous amount of inertia when it comes to what we use as medium of exchange," says Mr. Silber.
In the medium term, if the US continues to run huge trade deficits by buying up OPEC oil and Chinese manufactured goods without increasing exports in return, world bankers may think seriously about their options. Enter the euro.
Though not yet a decade old, the euro now accounts for about 20 percent of known world foreign-exchange reserves. Eurozone nations, lumped together, form an economy close in size to the US.
What's missing for the euro is history. It has yet to weather an economic crisis without damage. There's still a small question as to whether all the countries in the euro's zone can keep their economic policies in step.
But it's possible that within 10 years or so the euro will have edged into the dollar's spotlight.
"There is no reason why, several decades from now, two or three reserve currencies cannot share the market," concludes UC Berkeley's Mr. Eichengreen.