Shifting World Image of the United States Not Depressing Dollar Yet

February 25, 2019

The dollar’s external value rarely makes news headlines except in times of extreme strength or, even more common, extreme weakness. Neither extreme characterizes current circumstances, but there it was this past Saturday. The lead left-column front-page story in the New York Times proclaimed, “Staying mighty, dollar fortifies Trump’s power to dictate foreign policy.” The dollar has been the unchallenged top global reserve currency since 1945 and, as the article by Peter Goodman, asserts, that “supremacy” has enhanced Mr. Trump’s ability to impose trade sanctions that are unpopular with other governments which nonetheless must conform lest they risk jeopardizing their “access to a global financial system dominated by dollars.”

Trumpism has charted a different course than the post-World War II foreign policies that established and cemented dollar hegemony in the international monetary system. Rule of law governance is under steady domestic attack in the U.S., and a slew of foreign treaties made by previous administrations under both Democrat and Republican presidents have been abandoned. Traditional foreign policy allies of the United States are routinely treated more rudely than historical enemies. If U.S. foreign policy in 1945 had resembled how it’s run now, the dollar-centric international monetary system likely would not have evolved as it did.

But instead, America until recently met the check-list of criteria around which to frame a reserve asset: liquid financial markets, a strong economy, geopolitical as well as economic leadership, and trustworthy institutions that made the dollar a favored unit of account and store of value as well as the dominant paper money in which to invoice transactions involving trade and capital flows. After three-quarters of a century with the dollar as king, there’s a lot of inertia against changing that system. Despite a widely held concern that changes under the Trump administration will outlive the Trump presidency, the dollar isn’t being abandoned; the dollar share of global foreign exchange reserves remains above 60% and has stayed very resilient in the Trump years. A significant deviation from the dollar’s role seems unlikely in the absence of two kinds of shocks: one eroding confidence in the dollar but another simultaneously assuaging current potentially existential concerns about the dollar’s potential rivals like the euro and yuan.

Within the next three years, the likelier blow to dollar hegemony seemingly will be homegrown, but I suspect not as a result of foreign policies but rather a deterioration in U.S. economic fundamentals. The last half of the 20th century revealed that adverse economic fundamentals were not a necessary factor for ending dollar hegemony. Comparatively high U.S. inflation and the emergence of chronically deficient U.S. domestic savings resulting in an uncomfortably large trade deficit made the initial post-WW2 system of fixed dollar rates unsustainable but did not dent the dollar’s heavy dominance among reserve currencies.

Sterling was the dominant reserve currency before being replaced by the dollar, and it was worth $4.03 at the end of World War II, $2.80 from 1949 to 1967 and an-alltime low of $1.0345 in February 1985. The Deutsche mark emerged as the dollar’s main rival by the 1960s. From 3.99 DEM per dollar at the end of 1969, the mark appreciated to DEM 3.223 after the first dollar devaluation in December 1971. Then following a second devaluation in February 1973 and subsequent ending to fixed dollar parities one month later, the mark strengthened to 1.703 per dollar by October 1978 and 1.3645 per dollar in April 1995. Back in the day, the mark acquired the term “hard currency” because it retained its value so well vis-a-vis the dollar and many other paper currencies. The yen also earned the hard currency label, strengthening from 360 per dollar prior to August 1971 to 308 per USD after December 1971, 176 in October 1978 and  75.55 per dollar in October 2011.

One sees, therefore, that whether the dollar appreciates or declines against other key currencies is decompartmentalized from whether it is able to retain hegemony among other reserve assets. And this is very important because whatever currency is king, that economy reaps enormous economic advantages year in and year out because of the currency’s global usage. The basis of the dollar’s reserve asset role was greatly enhanced after 1998, moreover, when Germany and many other European countries merged their currencies into the euro and exchanged independent national control over monetary policy for a single central bank and a one-size-fits-all monetary policy. This monetary union was not accompanied by political unification or even a unified EMU-wide fiscal policy, and that as time has revealed created an existential threat to the euro.

Even though the European Central Bank has achieved lower inflation than the Bundesbank was able to deliver, price stability hasn’t buoyed the euro. Partly this disconnection reflects the fact that U.S. inflation has been low, too. In mid-1980, the CPI inflation differential was 8.5 percentage points (ppts) between the United States and Germany and 6.1 ppts wide between the U.S. and Japan, compared to spreads now of 0.1 ppt and 1.3 ppts. The Deutsche mark inhaled its last breath at 1.6690 per dollar on the final trading day of 1998, and the DEM-translation value of the euro some twenty years later is now not far from that level at 1.723 per dollar.

Aside from the fact that U.S. inflation is now pretty indistinguishable from price stability in other economies, the U.S. current account deficit is sustainably manageable in contrast to the wider imbalances of yore. U.S. economic growth and its labor market are performing consistently and significantly better than counterparts in other advanced economies. U.S. interest rates are relatively high despite being historically low relative to U.S. norms. U.S. federal debt is on an unsustainable path, but a day of reckoning on that score is not a clear and present danger. All in all, the United States commands favorable economic fundamentals, and that should be good enough to preserve U.S. hegemony among reserve asset currencies, no matter what outrages the Trump administration commits during the next two years.

The next real test of the dollar’s reserve asset credentials will come when and if America’s erratic policy behavior is accompanied by clearly inferior U.S. economic fundamentals. In the long run, such a confluence doesn’t seem far-fetched. U.S. policies on immigration, energy-saving technologies, education, and taxation seem to herald weaker productivity growth in the future. But for now, the dollar is trading narrowly in a sweet spot. Against the euro, the dollar was confined over the first two months of 2019 to a 3.0%-wide trading range between 1.1571 and 1.1235. And on a trade-weighted basis against the euro, yen, sterling, Swiss franc, loonie, Aussie dollar and Swedish krona, the dollar climbed 8% over the last 11 months of 2018  but shows scant net changed thus far in 2019. By contrast, it fell 53% from February 1985 to April 2011 and remains 8% below its 1973 mean.

Copyright 2019, Larry Greenberg. All rights reserved. No secondary distribution without express permission.


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