Why the Dollar is Falling

When confronted with complaints about the falling value of the dollar, the U.S. official is said to have responded to his European visitors: "The dollar is our currency, but it's your problem." That was in 1971. The politician to whom this statement is attributed was John Connally, who at that time served as the secretary of the U.S. Treasury. His boss was Richard Nixon, the same President who used a word for the Italian lira which politeness prohibits repeating. Nevertheless, Connally and Nixon made clear how matters were.

In the meantime, the Italian lira no longer exists. It has merged into the euro, when the single European currency was established in 1999. The endeavors to create a common currency had begun in the early 1970s, when the Europeans began to construct their own currency systems based on stable exchange rates and off the dollar standard.

The Bretton Woods System (named after the resort where the conference took place in New Hampshire in 1944) bestowed a singular privilege to the U.S. when the dollar became the point of reference for the new currency system. With the other member countries fixing their currencies to the U.S. dollar, and the U.S. dollar officially fixed to gold at 35 dollars per troy fine ounce, it seemed as if an ideal combination had been found to avoid international monetary disruptions.

The gold anchor was meant to curb an excessive production of U.S. dollars. When foreign countries had a trade surplus, they theoretically could have used the excess dollars and asked the U.S. to exchange them for gold. With a fixed parity between dollar and gold, this would have restricted dollar creation. However, France was one of the only countries that took the agreement literally and demanded that the U.S. exchange the earned dollars for gold instead of accumulating them as international reserves like other countries did which had persistent current account surpluses such as Japan and Germany.

The system as it evolved in the 1960s provided a free ride for the United States, and it did not take long for the U.S. to abuse this privilege. Pursuing the goal of expanding the welfare state along with ever more active foreign military involvements, the U.S. could no longer fulfill the agreement of making foreign currencies exchangeable into gold. The gold shortage of the late 1940s and of the 1950s had turned into a dollar glut. World inflation began its rise.

Under the transformed system, the need for adaptation was unilaterally transferred to foreign currencies. The system, which had once foreseen the change of currency parities as the exemption rather than the rule, entered into a phase of high instability when fixing and re-fixing of foreign currencies to the dollar became increasingly necessary.

In 1971, with the so-called "Smithsonian agreement," a final attempt was made to save the old system when the U.S. devalued its currency against gold and a series of other currencies, but soon it became clear that the Bretton Woods System was no longer viable. In 1973, with the adoption of the new rule that each country could choose its own currency arrangement, the Bretton Woods System had come to an end.

Since then, the international monetary system is more like a "non-system" than a "system," or, more precisely, the international monetary system consists of a multitude of different currency arrangements ranging from currency unions and currency blocs to freely floating exchange rates with many other schemes in between such as unilateral fixed parities, managed floating or currency boards, and currency baskets.

As early as 1970, the members of the European Economic Community, which later transformed into an expanded European Union decided to prepare for the establishment of a common currency. In 1999, the euro as a common currency was instituted, first for banking transactions and then, on January 1, 2002, as the sole legal tender in the member countries of the euro area. Currently, twelve European countries take part in the European Monetary Union.

In terms of absolute valuation, the euro is not very much of a better currency than the U.S. dollar. In economic decision-making, however, things happen on the margin and decisions are taken based on relative valuations. Given similar degrees of liquidity and financial market sophistication, the euro has become increasingly attractive for currency diversification, particularly due to the favorable foreign investment position of the euro area compared to that of the United States.

After some initial weakness—probably due to fears that the new arrangement might fail—the euro has gained markedly in value against the U.S. dollar over the past three years. The American currency is facing a rival. An increasing number of central banks announced plans to shift part of their international reserves into the European currency. The dollar is still the currency of the U.S., but a sinking dollar is no longer just a problem for foreigners, it is also a problem for the United States.

In the past, the United States could count on having the monopoly of issuing the currency with the highest degree of liquidity and financial market integration. Although there were stronger currencies than the U.S. dollar, such as the Swiss currency or the Japanese yen and the German mark, these currencies could not rival the U.S. dollar because of their limited market share.

The existence of the euro has changed this constellation. As to its market size, the euro area is up to the U.S. dollar with the tendency of further augmenting this position when new members of the European Union will adopt the single currency, some non-EU countries will peg their exchange rates to that of the European monetary union or when oil producers will change to euros when pricing their exports.

For a while in the 1990s, it appeared as if the U.S. dollar could regain its unique position. The 1990s saw Japan—the apparent commercial threat to the U.S. in the 1980s—sink into a prolonged stagnation. Germany, the other major player in the international trade arena, began to entangle itself in the morass of a costly and economically ill-conceived unification process.

After the fall of the Soviet Union and the dissolution of the Soviet Empire, the United States had emerged as the sole global military might, and, so it seemed, also as the undisputed economic and political power with global influence and far-reaching dominance. On this basis, the role of the dollar as the major reserve currency and the main currency for international transactions experienced a second spring.

In the 1990s, the new global constellation could be interpreted as the replay of the endings of World War I and World War II with the United States emerging for a third time on top of the world. In the 1990s, the triad of global dominance seemed well in place of the United States: an unrivalled military might, a booming and innovative economy and the only issuer of a global currency.

Since the turn to the 21stcentury, however, these factors of dominance have increasingly come under challenge. The mania of the New Economy has ended. The U.S. economy still registers high growth rates due to unrelenting consumption spending, but regarding its productive capacity, it is in a precarious state, as it is indicated by the persistence of high trade deficits. The military power of the United States in its present form is largely inefficient with respect to the relation between financial costs and political outcome. Finally, and probably most important, the dollar no longer holds the monopoly of being the only available international reserve currency.

While after 1919 and after 1945, the United States emerged as the largest international creditor, the U.S. became the world's largest debtor nation in the course of the 1990s. Also in contrast to the earlier world wars, the economies of Russia, Western Europe, and South East Asia were not devastated when the Cold War ended. As to their productive capacity and financial resources, these regions are on an even footing with the United States or even are superior—at least concerning their foreign investment position.

The performance of the U.S. economy in the past century owes much to the role of the U.S. dollar in the international monetary system, and a large part of attaining this role was the result of the political and military supremacy that the United States had gained since 1919. In the 20th century, the position of the U.S. dollar in the world represented a major underpinning of the prosperity at home, which in turn fed back positively on the dollar's foreign role.

As long as fiat money rules, currencies, particularly the standing of the dollar and the euro, also reflect their value as a "political currency." They represent the degree of global political and financial power and in turn they provide the basis for attaining supremacy. They are tools in the hands of governments in the struggle for dominance.

With the dollar privilege passing, the U.S. confronts a radically different situation than in the past, and a tormenting process of changing the accustomed world-view is on the horizon. However, even as of now, the role of the euro as a rival to the U.S. dollar is rarely a subject of concern in the United States. It is the same with additional power shifts that are going on, all of them potentially reducing or even eliminating the dominant role of the U.S. currency in the world economy.

New alliances are emerging that neither politically nor militarily may be benign to the United States. Also, older powers have maintained their might. The Soviet Union has disappeared, but Russia remains a military power matching the nuclear overkill capacity of the United States. China is beyond any immediate control or persuasion by the United States.

The current U.S. President identified an "axis of evil", composed of countries with relatively modest economic, financial, and military clout—and situated far away from the shores of North America. But how about the other axis that is being formed, right at the U.S. border and stretching down the South American continent. The alliance between Fidel Castro of Cuba, Hugo Chavez of Venezuela, and Lula da Silva of Brazil? What about the constant rumors that Brazil strives to become a nuclear power? What about the deals that are being made between Latin American countries and China with the perspective of forming an economic symbiosis between China's need for food and oil, and this region's abundance of natural resources?

Then there is another axis that has come into existence in the past few years: the fraternization between the leaders of France, Germany and Russia. This entente covers the Euro-Asian continent, the geo-strategic heart of the world. It represents an alliance that is ready and capable of challenging U.S. influence in almost any aspect. What do these constellations imply for the role of the U.S. dollar?

Anytime soon one may expect that countries like Russia or Venezuela and other oil producers will turn to the euro as the currency for their oil exports. The move to the euro as a currency for international transactions and reserves during the past couple of years may represent only the initial stage of long-lasting process. Currency shifts of such proportions start slowly but over time they will gain more momentum. By now, the euro may have passed the threshold that had limited its global use. Once a means of payment is widely accepted, it becomes increasingly more attractive for a wider use.

There is a consensus currently among the major players in international finance, particularly among the relevant governments and central banks, that an abrupt fall of the dollar should be avoided. Japan, the largest foreign holder of U.S. assets, depends on U.S. protection in the face of the growing muscle of China in its region. China itself most likely would also like to avoid a dollar crash at least as long as it has not yet spent a considerable part of its dollar reserves in the effort to secure future supplies of food and oil around the world. The Europeans do not want a much weaker dollar because as of now it is mainly exports that are booming in the major economies of this region.

In contrast to the wishes, however, the fundamental geo-strategic trends call for a reduced global role of the dollar. While the temporary interests of the major global players are directed at maintaining dollar stability and thus avoiding a rapid demise of the dollar's role as a global currency, these desires are not congruent with the longer-term aspirations of the foreign players themselves.

The international monetary system has entered a stage when it becomes more difficult to manage a conflict that is getting out of control the longer it lasts. Inexorably, the constellation moves to a point where the potential loss will outweigh perceived benefits—not only for the holders of U.S. dollar reserves, but also for the United States itself.

Under such conditions, economic and financial decisions in the private sector are prone to be made under false premises. One must not forget that three of the most essential prices in the modern monetary economy are politically determined or manipulated prices: the oil price, interest rates, and the exchange rates. Taking away the interventions, the price that the U.S. pays for imported oil, and the price for money and credit should already be much higher than they currently are. At their present levels, they reflect a position of the U.S. dollar in the global system that can hardly be maintained.

Given the importance of these three prices for the economy and their potential direction, it is not difficult to assess the prospect for asset prices, particularly those of stocks, bonds, and real estate which all must come down when the fall of the dollar continues.

8 March 2005

Antony Mueller teaches economics at the University of Caxias do Sul (UCS) in Brazil. He is an adjunct scholar of the Ludwig von Mises Institute and serves at the program "International Political Economy" of the Universidad Francisco Marroquin (UFM).This paper is an expanded version of the presentation by the author at the recent Austrian Economics and Financial Markets conference in Las Vegas on February 18, 2005. You may listen to the MP3 audio version of this lecturehere. He will also be presenting at the upcoming Austrian Scholars Conference in Auburn. Email: [email protected]. Discuss this article on the Mises.org Blog.