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Why hasn't the dollar plunged? Since the 2007-08 global financial crisis, the public debt of the US government has soared to $17.4 trillion, roughly equivalent to America's annual GDP (gross domestic product). The Federal Reserve has pumped more than $1 trillion into the economy in an attempt to spur lending - and, in effect, weaken the dollar. Uncle Sam's credit rating was downgraded, for the first time ever, in 2011. Round after round of fighting over the debt ceiling led to a government shutdown last October. Bitter gridlock has made it difficult for the US to get its fiscal house in order.
All of these circumstances would predict, under normal economic theory, a decline in both the value and the importance of the dollar. Strangely, this hasn't occurred - instead, quite the opposite. Over the last decade, experts have variously warned that the euro - or even the Chinese renminbi - might threaten the dominance of the dollar; almost no one seriously says that anymore.
Most international trade and financial deals are still transacted in dollars. Central banks around the world hold nearly two-thirds of their foreign-currency reserves in dollar-denominated assets, mostly Treasury securities. The dollar's roles as a unit of account (for denominating transactions across countries) and medium of exchange (for settling payments on those transactions) are likely to wane. Developments in financial markets and in technology are making it easier to conduct cross-border transactions using other pairs of currencies.
Oil and other commodities have for a long time been priced and traded almost exclusively in dollars because it was by far the most widely traded currency, but this is unlikely to persist. Technological advances will make it cheaper to settle commodity transactions using other currencies.
However, the dollar's position as the predominant store of value in the world is secure. The demand for American investments, especially Treasury securities, is not just a short-term, panic-driven phenomenon. Since the crisis, the long-term demand for safe and liquid financial assets - mostly advanced-economy government bonds - has gone up, while the supply has shrunk.
There are three principal reasons why investors continue to turn mainly to the dollar for safety: First, emerging market economies and even richer countries have a stronger incentive than ever to accumulate vast stores of foreign currency reserves. This protects their currencies from speculative attacks and insulates their economies from volatile capital flows.
Second, regulatory reforms agreed to by the major advanced and emerging-market economies have increased the demand for safe assets among financial institutions. New regulations require the biggest American and European banks to hold larger buffers of liquid and safe assets. Since the implosion of the market for mortgage-backed securities, private-sector investments are hardly seen as safe anymore.
Third, the supply of safe assets has shrunk. Bonds issued by most euro-zone countries look shaky in the aftermath of the Euro zone debt crisis, especially since many of these countries face weak growth prospects. The centrality of the dollar in global finance is frustrating to many foreign governments, but there is little they can do about it. Countries like China and Japan, each of which hold well over $1 trillion in Treasury securities (let alone other dollar-denominated assets), have nowhere else to turn.
The dollar - which decisively surpassed the British pound sterling as the world's main reserve currency by the 1950s - will remain dominant for a long time to come, mostly for want of a better alternative. This turns out to be a mixed blessing, both for the US and for the rest of the world. The dollar's dominance lets America borrow cheaply from the rest of the world to help finance its consumer spending and budget deficits. Foreign investors' eagerness to buy Treasury securities has kept American interest rates low, which translates into cheaper mortgages and consumer loans.
But low rates also lessen the pressure on Washington for fiscal discipline. And, the recent strength of the dollar against other currencies has held back American exports and job growth. The value of the dollar was in fact gradually declining. This trend is likely to resume once financial markets stabilise.
Economists see this depreciation as desirable and necessary to bring down America's trade deficits. But it means that foreign investors pay a high price when they come to the US financial markets for safety: They settle for very low yields on Treasury securities while accepting a fall in the value of their holdings as the dollar declines in value relative to their own currencies. This is a price they seem - so far - happy to pay.
Stranger still, when other currencies strengthen against the dollar, American households may have to pay more (for imported goods and for their vacations abroad) but America as a whole makes a profit: Its foreign investments are worth more (in dollars), while the dollar value of its liabilities to the rest of the world is unaffected. Yet another paradox: In 2008, when the Fed began what would be the first of three rounds of quantitative easing - flooding the financial system with dollars - capital flowed to emerging markets, fuelling inflation and asset bubbles. Indications of a gradual end to this policy have sucked money out of those markets in anticipation of rising United States interest rates. So foreign central banks have been storing money in American assets partly to protect themselves from the spillover effects of American policies themselves.
In fairness to the US, it has a winning combination that no other country comes close to matching: not just a large economy but also deep financial markets, robust public institutions including a trusted central bank, and an effective legal framework.
© 2014 The New York Times News Service
