In the Dollar We (and All Other Nations) Trust
By Laura D'Andrea Tyson
Early this year, the dollar began what many predicted would be a precipitous slide. After soaring by 50% relative to other currencies since 1995, its decline gained momentum during the spring as confidence in the American economy faltered in response to accounting scandals, weak profit forecasts, yawning budget deficits, and fears of another terrorist attack. But remarkably, the dollar began to strengthen during the summer despite the sharp fall in the U.S. equity market and growing speculation about a double-dip recession in the U.S. The NASDAQ is off more than 75% from its 2000 peak, the Standard & Poor's 500-stock index is off more than 40%, but the dollar's value remains about where it was at the beginning of this tumultuous year. Investors may have lost faith in U.S. equity markets, but they have apparently not lost faith in the dollar.
Unfortunately, the strength of the dollar is not a sign of strong fundamentals in the American economy. Rather, it is a sign of growing weakness in the rest of the global economy and its lopsided dependence on the U.S. as the engine of growth. The U.S. economy may be faring poorly, but the rest of the world is doing even worse. Growth in Europe is proceeding at a snail's pace, and progress in much-needed structural reforms is agonizingly slow. Japan is caught in a stranglehold of bad debt and deflation. Latin America is reeling from the loss of confidence and capital triggered by Argentina's default. And export-dependent Asia has been hard hit by dwindling demand in American markets. According to Stephen Roach of Morgan Stanley, the U.S. economy, which accounts for about 20% of global output, has contributed about 40% of global growth since 1995. As it slips, no other economy or region is able or willing to take its place as the primary source of global demand and the market of last resort.
Nor does there appear to be any appetite among the developed countries for coordinated macroeconomic policy action combining fiscal stimulus and monetary easing to prevent the global economy from falling further, perhaps into recession. The silence among the leaders of the developed countries on the dangers of a global recession--and its dire consequences for the world's poorer nations--is deafening.
In this uncertain economic climate, what have many investors around the world chosen to do? They have cut their holdings in U.S. equity markets and increased their purchases of other U.S. securities, especially safer government ones. Total net foreign purchases of U.S. securities during the first seven months of this year were about the same level as a year ago, but net foreign purchases of U.S. equities were down by more than half. In recent months, the level of net foreign purchases of U.S. securities has actually increased to nearly double the levels of last year, driven by purchases of U.S. Treasury notes and bonds.
The dollar's performance during this cyclical downturn provides evidence that the international financial system is operating on a de facto dollar standard. No asset since gold in the 19th century enjoys such broad acceptance as both a medium of exchange and a store of value as the dollar. It is the transaction currency for trade in primary commodities including oil as well as for trade in many industrial goods and services. The dollar is the vehicle currency in interbank and forward exchange markets and the main currency of denomination for most cross-border capital flows. Most governments outside of Europe use the dollar as their primary intervention currency, often loosely pegging their own currencies to it. Almost 50% of all U.S. Treasury bonds are held as reserves by foreign central banks and national governments that are reluctant to sell them for fear of undermining the competitiveness of their own currencies. As long as the U.S. inflation rate remains low, any run on the dollar by individuals is likely to be offset by foreign central banks accumulating dollars to prevent their own currencies from appreciating.
In a dollar-standard world, global growth fuels the demand for liquid dollar assets, and the U.S. can provide these assets, whether in the form of currency, government securities, or private securities, with no well-defined time frame for net repayment. As a result, the U.S. seems to enjoy a virtually unlimited line of credit denominated in its own currency with the rest of the world. This credit finances America's large and growing current-account deficit. The U.S. benefits from this arrangement because it can consume much more than it produces. But the rest of the world also benefits both because it gets the dollar holdings it requires and because the U.S. uses the credit to import goods and services and serve as the world's growth engine. Contrary to conventional economic wisdom, in a dollar-standard system there is little danger that America's current-account deficit will trigger a flight from the dollar, necessitating sharply higher U.S. interest rates. That's good news for both the American and world economy.
Laura D'Andrea Tyson is dean of London Business School.