Cyrillic Partners

An essay came across my desk today that I thought worth passing on.  Professor Andrew Clare argues that despite the dollar’s downturn, there are significant costs associated with moving off the currency. He also points out that the world’s previous currency for global commerce was the British Pound, which succumbed due to the loss of power its underlying economy went through when it disposed of its colonies. The U.S. has not undergone such a dramatic fundamental economic change (despite credit crunches and national debt).

The full essay is continued after the jump.

The Death of the Dollar
By Andrew Clare

Andrew Clare is a professor of finance at London’s Cass Business School and a former economist with the Bank of England.

With oil prices hovering just below the totemic $100 per barrel level you could be forgiven for thinking that the world’s major oil exporters would be happy. But the mood at a recent OPEC summit was more sour than sweet.

“They get our oil and give us a worthless piece of paper,” complained Iran’s Mahmoud Ahmadinejad.

The “worthless piece of paper” was essentially the “mighty” green back. Oil like most other commodities is priced in dollars so a fall in the price of the dollar hits the bottom line of the producers of these commodities. Since 2002, the US dollar has lost nearly a third of its real value on a trade-weighted basis. Adjusting the price of oil for the dollar’s decline since 2002, oil prices have only tripled rather than risen five-fold over that time. And so Mr Ahmadinejad had a point, though only a small one.

The view that OPEC might in the not too distant future announce a move towards pricing their precious commodity using a basket of currencies, rather than just in the dollar, is gaining ground. So too is the idea that we are approaching the end of the dollar’s hegemony as the world’s reserve currency of choice.

The pound sterling was the dollar’s predecessor as the global currency. Once upon a time Britain’s position as the hub of much of the world’s trade flows and demand for finished goods, afforded it a privileged position as the world’s reserve currency. At the start of the 20th century 60% of world trade was invoiced in sterling and some 64% of the world’s reserves were held in sterling. By the end of the century, it was around 4%. The cost of fighting two world wars and a succession of sterling crises, the biggest of which was in the 1930s, eventually eroded confidence in sterling as a reserve currency.

Today the dollar commands around 70% of both trade flows and reserves. But nothing lasts forever, so could the dollar now be headed down the path previously trodden by the great British pound? There are two obvious contenders for the dollar’s crown: the euro and the Chinese yuan. The yuan is a story for the future. Yes, China’s role in the global trading system is becoming increasingly important, but the yuan currently does not have the other necessary attributes of a global reserve currency. Such a currency requires a well-developed financial system; a significant degree of external confidence in the currency as a store of value; and finally, political stability – who knows what China’s political future might be.

A better bet might be the euro. Its share of foreign exchange transactions has risen from around 16% at its launch to just over 25% today, and it clearly does satisfy most of the other conditions for reserve currency status that the yuan currently fails. The mere thought that the euro might one day replace the dollar in the global trading system is enough to make many European politicians go weak at knees. But in reality there are few obvious advantages to the euro over the US dollar.

Economic theory suggests that a multiplicity of international currencies can coexist at any one time. However, if we consider the Microsoft Windows operating system as an example, once market dominance is achieved it is very difficult to dislodge the dominant player because of the high costs of switching. In the context of currency denomination, an individual trader would have very little incentive to leave the dollar regime unless every other trader decided to do so at the same time. Hence, there exists a strong inertial bias to keep the incumbent currency as the vehicle, even if another currency should come along that can play the role just as well, just as there is a bias towards keeping Microsoft Windows.

Trade-weighted exchange rates

Perhaps the more compelling argument for the Euro is its attraction as a store of value. As noted above, the dollar has lost over a quarter of its real value in the past half-decade, while the euro has gained by a similar amount, as this week’s chart shows. But this is only a necessary condition for regicide. It is not sufficient. The dollar eventually replaced sterling not because sterling’s value kept falling, but because the fundamentals underpinning sterling’s value weakened, namely Britain’s Empire and the strength of its underlying economy. As Britain’s importance in the global system waned so too did the demand for its currency. So unless the fundamentals underpinning the US economy weaken markedly – its higher rate of productivity growth, its pre-eminent financial system and the liquidity of the dollar-based system, will mean that it is very likely to remain as the world’s reserve currency.

Finally, would you sell an asset that has already fallen for five straight years in order to buy one that has already reached a record high? If not, then we can conclude by misquoting Mark Twain: “Rumours of the dollar’s death seem greatly exaggerated.”

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