The End of Dollar Supremacy?

Given the current account deficit in the United States of more than five per cent and a negative net foreign investment position of over twenty per cent of its gross domestic product, it is the relative stability of the US dollar that needs explanation and not the fact that the effective exchange rate of the dollar has declined by twenty per cent since late 2002. It is even more remarkable that U.S. interest rates did not have to rise as might have been expected in order to attract foreign investment as a compensation for the deficit in the current account.

Balance of payments numbers such as those the United States currently has would have broken many other currencies and would have triggered severe financial crises in other countries much earlier. But the United States is different. It holds a privileged position within the international monetary system and its path to ruin may be longer and smoother than that for other nations. Nevertheless, even for the U.S. there is a limit and the country seems to be getting closer to it every day.

The relative strength of the US dollar despite the deteriorating external position results from the role of the dollar as the world's global reserve currency and because the pillars on which the dollar's supremacy rests do still seem intact. Furthermore, there is not yet a ready substitute for the dollar in sight which could replace it as a functioning global currency.

Compared to its potential rivals such as the euro or the yen, the US dollar has a historical and a quantitative advantage. For more than half a century, the world-wide use of the US dollar has been common practice. The dollar is the unrivalled global currency, a currency whose position as an international means of exchange rests on a prolonged experience. The dollar's origin as to its source of production is the visible power of the United States in terms of its national unity and its global military presence. Additionally, the dollar's predominance rests on the strength of the U.S. economy as there is no other economy of size which could match it in terms of productivity and innovation.

All these pillars have strengthened since the early 1990s. The use of the dollar has become more widespread on a global scale with the integration of the former Communist countries into the world economy; the position of the United States as the principal global political and military player has strengthened with the fall of the Soviet Union; and, particularly since the mid 1990s, the American economy has experienced a period of outstanding dynamism and resiliency.

So why the jitters about the imminent decline and fall of the US dollar that have emerged? Isn't there reason to believe that the dollar's supremacy will remain undisputed in the future as well?

Unfortunately, the outlook is more dramatic than the question may suggest at first glance. The dramatic statement says that?at least for a while?the dollar will not be replaced by another global means of exchange but that the dollar may lose its supreme role nevertheless. A fall in the dollar from its pedestal with no substitute to replace it would be the very disturbing outlook suggested by an interpretation of the current trends. The disastrous consequences of the demise of the dollar as the global currency with no other means of exchange to replace it refers to the outlook that we may enter a period of currency chaos and a global economic contraction.

Losing trust does not mean that there must be a ready substitute. On the contrary: when distrust will emerge towards the US dollar this would affect the attitude towards all paper currencies. In the final stages of the currency crisis, the dollar will most likely devalue not so much against the euro and the yen, but all of these currencies and most of the rest will devalue drastically against gold.

There is neither a theoretical nor an empirical reason to believe that the dollar should be different from the other fiat currencies that have emerged and disappeared in the past. Even more so, given the unique position of the dollar in the current monetary system, the temptation to abuse this privilege has been greater for the United States than that which inflicted other nations and led to their decline.

From early on, the United States has taken advantage from the privileged position of the dollar in the modern monetary system, but it has been essentially only since the early 1980s when the enjoyment of a privilege began to turn into an abuse; and it is only in the past couple of years or so when the abuse has turned into an almost complete lack of consideration. In due course, confidence of private investors has begun to erode.

In the past couple of years there has been a massive fall of foreign direct investment flowing into the United States and in 2002 the flow became negative (see table 1). In 2001 the basic balance turned negative and reached 218 billion US dollar in 2002. This signifies that there is less capital inflow to compensate for the expanding current account deficit.

United States. Current account and composition of capital account 2000?2002 (a)

(a) in billions of US dollars
(b) Current account plus net long-term capital
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table II.4

It has been mainly due to the buying of bonds by foreign central banks that a dollar crash has been averted so far. The massive buying of U.S. bonds by central banks in 2001 and 2002 has led to an increase in global US dollar reserves which surged by 219.8 billion in 2002 reaching a total of 1,751.4 by the end of that year (see table 2).

(a) in billions US dollars at constant exchange rates
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table V.1

The major buyers of U.S. debt among the central banks are now located in Asia, and here particularly in China, Hong Kong and Taiwan (see table 3). This trend?that central banks substitute private investors and thus stabilize the dollar?will hardly be sustainable.

(a) in billions US dollars at current exchange rates
(b) mainly China, Hong Kong SAR, and Taiwan
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table V.1

A situation like this which has emerged over the past few years implies an increasing financial vulnerability of the United States. If the buying spree by foreign central banks should stop or even reverse, the impact would affect the dollar exchange rate, the treasury market and the domestic price level with the consequences of a sinking dollar, a sharp rise of domestic interest rates and an increased inflation rate. It is highly unlikely that the American economy would prove resilient enough to withstand such a triple blow.

The coming of a dollar crisis would expose the internal fragilities of the U.S. economy which currently are largely hidden. Along with the end of the favors for consumers to indulge in spending and for private and public debtors to have their investment and budget deficits financed by foreigners, a decline of the dollar would expose the lack of a balanced industrial structure in the United States. More than twenty years of persistently high trade deficits have led to an industrial structure which has made the United States highly dependent on foreign imports with a lack of domestic suppliers that could readily substitute dearer imports.

What would happen if the dollar should surpass the threshold and a crisis of confidence emerges? The consequences would not be confined to the United States itself. The dollar crisis would affect the rest of the world and it would put the current international monetary system at stake with the potential of bringing it down. While the pillars on which the dollar stands may still seem to be intact today?the statue itself may come down. But when the dollar should fall, the pillars on which it has stood, will crumble too.

Given the trend that the U.S. foreign debt position will continue to deteriorate, a severe dollar crisis seems almost inevitable. But this is only half of the story. The dramatic part of the enfolding scenario is that there is no ready substitute for the dollar as a global currency and that the dollar crisis will put the overall economic and political position of the United States at risk. With the loss of the privileged position of the dollar the economy would weaken and this in turn would undermine the political role that the Unted States plays presently as the world's hegemon.

International finance is closely intertwined with international politics. While a predominant role in international finance does not come without the basis provided by politics, it is sound finance on which the continuation of the dominant global role will depend later on. Both of these, however, have a more profound basis: it is basically the ethical attitude to the matters of money and finance, the deeply rooted sense for prudence and rectitude, which is required to be maintained in order to keep the privileged position.

Near the end of the Hapsburg Empire, before the outbreak of World War I, Eugen von Böhm-Bawerk wrote in his essay "Our passive trade balance"[i] that all those theories brought forth to explain the persistently negative trade balance of the Austro-Hungarian Empire?such as a surge in industrial strength and its attractiveness for foreign investment?do not stand a more profound analysis. These argument would imply that the "passivity" would be transitory. The persistency of the trade deficits requires that the situation be analyzed beginning with the capital balance, and this way, Böhm-Bawerk pointed out, the negative trade balance had its roots in a lack of domestic savings, the unproductive use of resources and "wasteful consumption" (pp. 509).

A "change of mind" had occurred, said Böhm-Bawerk, and the accumulation of massive deficits reflected a "lack of morality" (p. 511): "We slithered from surpluses into a phase of easy-hearted and willing expenditures, and we continued to slither even after the surpluses were long gone."[ii]

[i]Eugen von Böhm-Bawerk: Unsere passive Handelsbilanz (1914), in: F. X. Weiss (ed.): Gesammelte Werke von Böhm-Bawerk, Vienna and Leipzig, 1926, pp. 449?515.

Antony Mueller is a professor of economics at the Universidade Caxias do Sul in Brazil and a member of the Institut für Wirtschaftswissenschaft of the University of Erlangen-Nuremberg in Germany. He is also an adjunct Scholar of the Mises Institute. Antonypmueller@aol.com

The dollar is where it is because it is backed up by nothing..., not even a promise to pay. Return us the the gold standard and watch the world become our plaything. FDR and his ungodly socialists/democrat minions have all but destroyed this nation.

"Return us the the gold standard and watch the world become our plaything."

Return us the the gold standard and watch the world clean out Fort Knox in a week.

WHAT !

watch the world clean out Fort Knox in a week

Not if $50,000 equals an ounce of gold ! There's you devalue the dollar in spades !

"Not if $50,000 equals an ounce of gold ! There's you devalue the dollar in spades !"

... and just how does the U.S. government do this ?
A 50 K price while the rest of the world is at $400 simply means that you don't exchange gold for dollars - same as now.

In the final stages of the currency crisis, the dollar will most likely devalue not so much against the euro and the yen, but all of these currencies and most of the rest will devalue drastically against gold.

In other words runaway inflation. But weren't we just being warned that the big threat was looming defaltion? If there is anybody more fickle in predictions of gloom and doom than envirometnalists it's gotta be economists.

"So you think that there IS gold in Fort Knox?"

Didn't you see Bond keep Goldfinger from getting it ?

... seriously - do you think there is NOT gold there ?
... where did it go ?

In other words runaway inflation. But weren't we just being warned that the big threat was looming defaltion?

What a head fake. I for one am outraged by the falling prices of medical care, housing, education, energy, copper, soy beans, lumber, etc. etc.

means that you don't exchange gold for dollars

You got it. And it anchors the value in stone, if you will. Every one else has worthless fiat money. Especially those holding old dollars and other currencies not backed by gold.

Course this action would probably mean war but it points out there are ways to politically get around debt, if you're a government. It's also too late to put in this type of fix but it is a better one than printing more dollars and letting the dollar devalue as a means to negate debt. Because in the end you have something stable not more of your own worth less dollars.

Gotta keep everyone on their toes, spinning that is. If every body came up with the same conclusion we'd have had a crash months ago.

That's why we now have Snow and the good guy/bad guy game being played.

Saw the Lincoln SUV commercial this weekend where it's 0% interest and $4,000 rebate. And quess what, small businesses can buy these things and write them off up until Dec with Bush's tax program.

Sign up now fo mo hellichoppeter moola. It's also patriotic, me first, the American.

"You got it. And it anchors the value in stone, if you will. Every one else has worthless fiat money. Especially those holding old dollars and other currencies not backed by gold."

It dosen't anchor squat... There is enough gold floating around that the noone in there right mind will pay the 50 K for it - It effectively takes US holdings off the market ... just as they are now.

"OLD dollars" ??? so your idea is just to revalue our money DOWN ? and that's supposed to make other money worthless ????

You mention the falling price of copper. I read where nickel is becoming fairly pricy. How far is the price of nickel from driving nickels from common usage? And what does one use to debase a nickel?

You mention the falling price of copper.

I was being sarcastic. All the items named are inflating like mad.

How far is the price of nickel from driving nickels from common usage?

No idea.

The supremacy of the Dollar is a function of the USA's world power. It is why europe united to form the euro. They want to take over the US dollar's supremacy.

Here is something to really ponder regarding stability. Every US dollar made this century is still usable. Even though we have new versions of our paper money, the old money is still valid and will still be valid.

In europe, they have a nasty habit of issuing new versions of their money and making the old versions worthless. How long before the EU needs to issue new versions and makes the old versions worthless? They have done it before, they will do it again.

Whose money do ou want long term?

Nickels aren't made of nickel anymore, and pennies aren't made of copper. Both are mostly zinc these days with a small amount of the real metal for color.

Every US dollar made this century is still usable.

Yes, but they've lost more than 90% of their value.

20 posted on 10/20/2003 8:32:56 PM PDT by Tauzero (Avoid loose hair styles. When government offices burn, long hair sometimes catches on fire.)

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	2000	2001	2002
	Current Account	-410	-393	-503
Net long-term capital hereof:	422	335	285
Direct Investment		129	3	-93
Equities	90	15	35
Bonds	203	317	343
Basic Balance (b)	12	-58	-218

	2000	2001	2002	Total end-2002
Dollar reserves	115.5	82.9	219.8	1,751.4
Other currencies	75.2	58.1	48.6	643.8
Total reserves	190.7	141.0	268.4	2,395.2

	2000	2001	2002	Total end-2002
Euro Area	-9.4	-10.8	8.0	215.8
Japan	69.5	40.5	63.7	451.5
Asia (b)	52.5	76.0	173.3	943.8