economics dollar project

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VIVEK COLLEGE OF COMMERCE

HISTORY OF EMERGENCE OF DOLLAR AS INTERNATIONAL CURRENCY PAGE 1

CHAPTER1

INTRODUCTION

1.1INTRODUCTIONThe United States dollar(sign: $; code: USD; also abbreviated US$), also referred to

as the U.S. dollar or American dollar, is the official currency of the United States of

America and its overseas territories. It is divided into 100 smaller units called cents.

The U.S. dollar is the currency most used in international transactions and is one of

the world's dominant reserve currencies. Several countries use it as their official

currency, and in many others it is the de facto currency. It is also used as the sole

currency in two British Overseas Territories, the British Virgin Islands and the Turks

and Caicos islands.

1.2OVERVIEWThe Constitution of the United States of Americaprovides that the United States

Congress shall have the power "To coin money". Laws implementing this power are

currently codified in Section 5112 of Title 31 of the United States Code. Section 5112

prescribes the forms in which the United States dollars shall be issued. Those coins

are both designated in Section 5112 as "legal tender" in payment of debts.

The Sacagawea dollaris one example of the copper alloy dollar. The pure silver dollar

is known as the American Silver Eagle. Section 5112 also provides for the mintingand issuance of other coins, which have values ranging from one cent to fifty dollars.

These other coins are more fully described in Coins of the United States dollar.

The Constitution provides that "a regular Statement and Account of the Receipts and

Expenditures of all public Money shall be published from time to time". That

provision of the Constitution is made specific by Section 331 of Title 31 of the United

States Code.
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The sums of money reported in the "Statements" are currently being expressed in U.S.

dollars (for example, see the 2009 Financial Report of the United States

Government). The U.S. dollar may therefore be described as the unit of account of the

United States.

The word "dollar" is one of the words in the first paragraph ofSection 9 of Article 1

of the U.S. Constitution. In that context, "dollars" is a reference to the Spanish milled

dollar, a coin that had a monetary value of 8 Spanish units of currency, orreales. In

1792 the U.S. Congress adopted legislation titled An act establishing a mint, and

regulating the Coins of the United States. Section 9 of that act authorized the

production of various coins, including "DOLLARS OR UNITSeach to be of the

value of a Spanish milled dollar as the same is now current, and to contain three

hundred and seventy-one grains and four sixteenth parts of a grain of pure, or four

hundred and sixteen grains of standard silver". Section 20 of the act provided, "That

the money of account of the United States shall be expressed in dollars, or units... and

that all accounts in the public offices and all proceedings in the courts of the United

States shall be kept and had in conformity to this regulation". In other words, this act

designated the United States dollar as the unit of currency of the United States.

The U.S. dollar bill uses the decimal system, consisting of 100 equal cents (symbol ).

It is also officially divided into 1,000 mills(symbol) or ten dimes, while ten dollars

is equal to an eagle. However, only cents are in everyday use as divisions of the

dollar; "dime" is used solely as the name of the coin with the value of 10, while

"eagle" and "mill" are largely unknown to the general public, though mills are

sometimes used in matters of tax levies, and gasoline prices are usually in the form of

$X.XX9 per gallon, e.g., $3.599, sometimes written as $3.59910. When currently

issued in circulating form, denominations equal to or less than a dollar are emitted

asU.S. coins while denominations equal to or greater than a dollar are emitted

as Federal Reserve notes (with the exception of gold, silver and platinum coins valued

up to $100 as legal tender, but worth far more as bullion). Both one-dollar coins and

notes are produced today, although the note form is significantly more common. In

the past, "paper money" was occasionally issued in denominations less than a dollar

(fractional currency) and gold coins were issued forcirculation up to the value of $20(known as the "double eagle," discontinued in the 1930s).
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The term eagle was used in the Coinage Act of 1792 for the denomination of ten

dollars, and subsequently was used in naming gold coins. Paper currency less than

one dollar in denomination, known as "fractional currency," was also sometimes

pejoratively referred to as "shinplasters." In 1854, James Guthrie, then Secretary of

the Treasury, proposed creating $100, $50 and $25 gold coins, which were referred to

as a "Union," "Half Union," and "Quarter Union," thus implying a denomination of 1

Union = $100. Series of 1917 $1 United States bill

Today, USD notes are made from cotton fiber paper, unlike most common paper,

which is made of wood fiber. U.S. coins are produced by the United States Mint. U.S.

dollarbanknotes are printed by the Bureau of Engraving and Printing and, since 1914,

have been issued by the Federal Reserve. The "large-sized notes" issued before 1928measured 7.42 inches (188 mm) by 3.125 inches (79.4 mm); small-sized notes,

introduced that year, measure 6.14 inches (156 mm) by 2.61 inches (66 mm) by

0.0043 inches (0.11 mm). When the current, smaller sized U.S. currency was

introduced it was referred to as Philippine-sized currency because the Philippines had

previously adopted the same size for its legal currency.

1.3HISTORYThe first dollar coins issued by the United States Mint (founded 1792) were similar in

size and composition to the Spanish dollar. The Spanish, U.S. silver dollars, and

Mexican silver pesos circulated side by side in the United States, and the Spanish

dollar and Mexican peso remained legal tender until 1857. The coinage of various

English colonies also circulated. The lion dollarwas popular in the Dutch New

Netherland Colony (New York), but the lion dollar also circulated throughout the

English colonies during the 17th century and early 18th century. Examples circulating

in the colonies were usually worn so that the design was not fully distinguishable,

thus they were sometimes referred to as "dog dollars".

The U.S. dollar was created by the Constitution and defined by the Coinage Act of

1792. It specified a "dollar" to be based in the Spanish milled dollar and of 371 grains

and 4 sixteenths part of a grain of pure or 416 grains (27.0 g) of standard silver and an

"eagle" to be 247 and 4 eighths of a grain or 270 grains (17 g) of gold (again

depending on purity).
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The choice of the value 371 grains arose from Alexander Hamilton's decision to base

the new American unit on the average weight of a selection of worn Spanish dollars.

Hamilton got the treasury to weigh a sample of Spanish dollars and the average

weight came out to be 371 grains. A new Spanish dollar was usually about 377 grains

in weight, and so the new U.S. dollar was at a slight discount in relation to the

Spanish dollar.

The Coinage Act of 1792 set the value of an eagle at 10 dollars, and the dollar at 1/10

eagle. It called for 90% silver alloy coins in denominations of 1, 1/2, 1/4, 1/10, and

1/20 dollars; it called for 90% gold alloy coins in denominations of 1, 1/2, 1/4, and

1/10 eagles.

The value of gold or silver contained in the dollar was then converted into relative

value in the economy for the buying and selling of goods. This allowed the value of

things to remain fairly constant over time, except for the influx and out flux of gold

and silver in the nation's economy.

The early currency of the USA did not exhibit faces of presidents, as is the custom

now. In fact, George Washington was against having his face on the currency, a

practice he compared to the policies of European monarchs. The currency as we know

it today did not get the faces they currently have until after the early 20th century;

before that "heads" side of coinage used profile faces and striding, seated, and

standing figures from Greek and Roman mythology and composite native Americans.

The last coins to be converted to profiles of historic Americans were the dime (1946)

and the Dollar (1971).

1.4ORIGINS OF THE DOLLAR SIGNThe sign is first attested in business correspondence in the 1770s as a scribal

abbreviation "ps", referring to the Spanish American peso, that is, the "Spanish dollar"

as it was known in British North America. These late eighteenth- and early

nineteenth-century manuscripts show that thes gradually came to be written over

thep developing a close equivalent to the "$" mark, and this new symbol was retained

to refer to the American dollar as well, once this currency was adopted in 1785 by the

United States.
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An alternative theory states that the dollar sign ($) is directly borrowed from the sign

used to represent the Spanish peso, which is in fact a "$", and is said to come from a

representation of one of the Pillars of Hercules with a motto-ribbon as depicted in the

Spanish Coat-of-Arms.

1.5ADOPTION BY THE UNITED STATESBy the American Revolution, Spanish dollars gained significance because they

backed paper money authorized by the individual colonies and the Continental

Congress. Common in the Thirteen Colonies, Spanish dollars were even legal

tenderin one colony, Virginia.

On April 2, 1792, U.S. Secretary of the Treasury Alexander Hamilton reported to

Congress the precise amount of silver found in Spanish milled dollarcoins in

common use in the States. As a result, the United States dollarwas defined as a unit

of weight equaling 371 4/16th grains (24.057 grams) of pure silver, or 416 grains of

standard silver (standard silver being defined as 1,485 parts fine silver to 179 parts

alloy). It was specified that the "money of account" of the United States should be

expressed in those same "dollars" or parts thereof. Additionally, all lesser-

denomination coins were defined as percentages of the dollar coin, such that a half-

dollar was to contain half as much silver as a dollar, quarter-dollars would contain

one-fourth as much, and so on.

In an act passed in January 1837, the dollar's alloy (amount of non-silver metal

present) was set at 15%. Subsequent coins would contain the same amount of pure

silver as previously, but were reduced in overall weight (to 412.25 grains). On

February 21, 1853, the quantity of silver in the lesser coins was reduced, with the

effect that their denominations no longer represented their silver content relative to

dollar coins.

Various acts have subsequently been passed affecting the amount and type of metal in

U.S. coins, so that today there is no legal definition of the term "dollar" to be found in

U.S. statute. Currently the closest thing to a definition is found in United States Code

Title 31, Section 5116, paragraph b, subsection 2: "The Secretary [of the
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Treasury] shall sell silver under conditions the Secretary considers appropriate for at

least $1.292929292 a fine troy ounce."

Silver was mostly removed from U.S. coinage by 1965 and the dollar became a free-

floating fiat currency without a commodity backing defined in terms of real gold or

silver. The US Mint continues to make silver $1-denomination coins, but these are not

intended for general circulation.

1.6USAGE IN GREAT BRITAINThere are many quotes in the plays ofWilliam Shakespeare referring to dollars as

money. Coins known as "Thistle dollars" were in use in Scotland during the 16th and

17th century, and use of the English word, and perhaps even the use of the coin, may

have begun at the University of St Andrews. This might be supported by a reference

to the sum of "ten thousand dollars" in Macbeth (Act I, Scene II)

(an anachronismbecause the real Macbeth, upon whom the play was based, lived in

the 11th century).

In 1804, a British five-shillingpiece, orcrown, was sometimes called "dollar". It was

an over struck Spanish 8 real coin (the famous 'piece of eight'), the original of which

was known as a Spanish dollar. Large numbers of these 8-real coins were captured

during the Napoleonic Wars, hence their re-use by the Bank of England. They

remained in use until 1811. During World War II, when the U.S. dollar was

(approximately) valued at 5 shillings, the half crown (2s 6d) became nicknamed a

"half dollar" by US personnel in the UK.

1.7USAGE ELSEWHEREChinese demand for silver in the 19th and early 20th centuries led several countries,

notably the United Kingdom, United States and Japan, to mint trade dollars, which

were often of slightly different weights from comparable domestic coinage. Silver

dollars reaching China (whether Spanish, Trade, or other) were often stamped with

Chinese characters known as "chop marks", which indicated that that particular coin

had been assayed by a well-known merchant and determined genuine.
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1.8OTHER NATIONAL CURRENCIES CALLED DOLLARPrior to 1873, the silver dollar circulated in many parts of the world, with a value in

relation to the British gold sovereign of roughly $1 = 4s 2d (21p approx). As a resultof the decision of the German Empire to stop minting silver thalercoins in 1871, in

the wake of the Franco-Prussian war, the worldwide price of silver began to fall. This

resulted in the US Coinage Act (1873) which put the United States on to a 'de facto'

gold standard. Canada and Newfoundland were already on the gold standard, and the

result was that the value of the dollar in North America increased in relation to silver

dollars being used elsewhere, particularly Latin America and the Far East. By 1900,

value of silver dollars had fallen to 50 percent of gold dollars. Following

abandonment of the gold standard by Canada in 1931, the Canadian dollarbegan to

drift away from parity with the U.S. dollar. It returned to parity a few times, but since

the end of the Bretton Woods system of fixed exchange rates that was agreed in 1944,

the Canadian dollarhas been floating against the US dollar. The silver dollars of Latin

America and South East Asiabegan to diverge from each other as well during the

course of the 20th century. The Straits dollaradopted a gold exchange standard in

1906 after it had been forced to rise in value against other silver dollars in the region.

Hence, by 1935, when China and Hong Kong came off the silver standard, the Straits

dollar was worth 2s 4d (11.5p approx) sterling, whereas the Hong Kong dollarwas

worth only 1s 3d sterling (6p approx).

The term "dollar" has also been adopted by other countries for currencies which do

not share a common history with other dollars. Many of these currencies adopted the

name after moving from a sd-based to a decimalized monetary system. Examples

include the Australian dollar, the New Zealand dollar, the Jamaican dollar,

the Cayman Islands dollar, the Fiji dollar, the Namibian dollar, the Rhodesian dollar,

the Zimbabwe dollar, and the Solomon Islands dollar.
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CHAPTER2

EMERGENCE OF DOLLAR AS INTERNATIONAL

CURRENCY

2.1 US DOLLAR BECAME WORLD CURRENCY 65 YEARS AGO

The historic conference in Bretton Woods ended on July 22, 65 years ago. The

members of the conference agreed to establish a system of payment based on the US

dollar and established the dollar peg with gold. The conference also resulted with the

establishment of the International Monetary Fund and the World Bank.

The Bretton Woods currency system, which set the dollar-based financial rules in the

post-war world, has proved to be justifiable. However, the system has changed a lot

since then and continues changing, Dmitry Pankin, an official with Russias Finance

Ministry believes.

The present world currency system is completely different. The USA unilaterally

terminated the convertibility of the dollar to gold during the 1960s. Secondly, all

countries practice the peg-free floating currency rate nowadays. As a matter of fact,

we are living in a different world, the official said in an interview with RIA

Novosti news agency.

There were no major collapses in the international payment system. The system was

working, the structure of international currency relations was clear to everyone, and

the countries were observing the rules of the game. The international payment system

works at this point, Pankin said.

On the other hand, the official added, the system is unable to prevent economic

difficulties. A crisis always lies in the beginning of any economy. A crisis may occur

in any system that man can create, he said.

The dollar will remain the international reserve currency, but the world will be aiming

towards the multi-currency system of payment.


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There has been no indication of the decline of the dollar in the international payment

system during the recent two decades. However, it is clear that the world will be

making steps towards the multi-currency international payment system, Dmitry

Pankin said.

For example, the influence of the European currency in the system has been growing

steadily. The Brazilian real and the Chinese yuan will most likely be strengthening

their positions too.

Yet, it is hard to say that the system of currencies will change drastically in 10 or 15

years, Pankin concluded.

2.2 THE INTERNATIONAL DOLLAR STANDARD

The world is on a de facto dollar standard, similar in some respects to the British

pound sterling standard of the 19th and early 20th century. When did the US dollar

become the international standard, and how likely is it to continue in that role?

Bretton Woods

In the aftermath of World War II, the relatively stable-valued US dollar was the only

major currency in which international exchange could freely take place. The dollar's

role was formalized under the Bretton Woods monetary agreement of 1944. Other

nations set official exchange rates against the dollar, while the US agreed to exchange

dollars for gold at a fixed price on demand by central banks.

This system functioned well for a brief period. However by about 1958 the initial

worldwide dollar shortage had turned into an overabundance. With the too rapid

growth of dollar credits around the world, gold backing of the dollar proved

unsustainable. The Bretton Woods agreement collapsed in 1973, but it enthroned the

dollar as the international medium of exchange. This unique role of the dollar

continues to the present day.


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How the Dollar Grew

The rapid growth of the industrialized economies after World War II created a

growing demand for dollar balances around the world. The more of its own currency

a central bank issued the more dollars it wanted as underpinning for its currency.

During the Bretton Woods period, the US ran large current account surpluses. That

would have drained dollars from abroad, but long-term capital outflows in the form of

grants and direct investments by the US were greater than its current surpluses. The

result was a buildup of dollar assets by foreign firms and central banks. In effect, the

US was lending long more than it was borrowing short, thereby satisfying the worlds

growing demand for dollar liquidity, even while it remained a net creditor.

The Dollar Today

Today over half of all dollar notes in circulation are held outside the borders of the

US. About half of US Treasury securities are owned by foreigners, mainly held as

reserves by foreign central banks. The dollar is the main currency in international

capital flows, as well as the currency of invoice for commodities and for many

manufactured goods and services. All countries that trade directly with the US

invoice both imports and exports in US dollars. Eurodollars often trade without any

involvement by US participants.

Advantages for the U.S.

With the dollar as the world standard, the US is free to conduct its monetary policy

independent of exchange rate fluctuations. In this respect, other countries operate at a

disadvantage. They are reluctant to see their own currencies depreciate against the

dollar because of the domestic inflationary threat that presents. They are also

reluctant to allow a substantial appreciation of their currency against the dollar for

fear of losing competitiveness in world markets. Consequently they sometimes

subordinate their domestic monetary policies in order to stabilize their currencies

against the dollar.
http://wfhummel.net/eurodollars.htmlhttp://wfhummel.net/eurodollars.html


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A Useful Analogy

The international dollar is analogous to the fiat money that a central bank issues

within its own monetary domain. Central banks do so by purchasing assets from

those who want to hold their currency as a store of value or for use in trade. There is

little or no need for a central bank to concern itself with redeeming its own currency.

Likewise the US can issue dollar-denominated claims to the rest of the world which

may never have to be redeemed so long as it maintains the domestic purchasing power

of the dollar. While this gives the US a unique advantage in terms of borrowing in its

own currency, the existence of a safe reserve asset is a great convenience to other

countries. Only a serious loss of confidence in the dollar could depose it as theprimary medium of international exchange, such as might be due to a prolonged major

inflation in the US.

2.3 DOLLARIZATIONDollarization means adopting the US dollar as the currency of choice in a foreign

country. Many countries today are already dollarized unofficially. Where the

purchasing power of the local currency has been volatile, as in Latin America and in

the former Soviet Union, people often hold dollars as a store of value. In those cases

the domestic currency is commonly used in small transactions, but the dollar is

preferred in large transactions and in savings.

Official Dollarization

In some countries, using the dollar in transactions is perfectly legal, in others it is not.

In a very few, the US dollar is the official currency, mostly in small or developing

countries. Panama has been officially dollarized since 1904. Other countries have on

occasion considered moving to an official dollarized system.

Under official dollarization the local currency is completely replaced by the dollar,

with the possible exception of coinage. That means domestic banks only accept dollar

checking accounts and issue dollar loans. Federal Reserve notes are legal tender and

the only form of paper money recognized by the government.


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Before its latest political and economic crisis, Argentina operated under a currency

boardsystem that maintained an exchange rate of 1:1 between the dollar and the peso.

That required holding sufficient dollar reserves to fully back the pesos in circulation.

The dollar was recognized as legal tender along with the peso. Argentina has since

abandoned the peg to the dollar and gone to a floating exchange rate for the peso.

In the wake of the Asian and Brazilian economic crisis, Ecuador was unable to avoid

a deep recession and banking crisis. In March 1999 the government froze deposits in

the entire banking system as the value of the sucre dropped. A year later, after much

political turmoil, and with the help of the IMF in structuring its financial system,

Ecuador adopted the US dollar as its official currency. This will be an important test

of dollarization under very difficult conditions.

The US Position

There is nothing to prevent a country from unilaterally moving to an official

dollarized currency, although the Fed has recommended that it be consulted in

advance. At the very least, the Fed would need advance notification of the extra notes

that it would have to make available.

The Fed has stated that under no conditions would it act as a lender of last resort to

foreign banks, nor would its monetary policy be contrary to the best interests of the

US. So far, US officials have taken a neutral position, neither encouraging nor

discouraging dollarization. However there are many issues, pro and con, for the US

and a dollarizing country that deserve careful consideration. Here are a few:

A Stabilizing Factor

A country with its own currency, typically issued by a central bank, can exercise its

own monetary policy. In theory this enables it to manage its money supply, interest

rates, and to some extent the exchange rates solely in its own self-interest. In practice

however many developing countries have experienced serious problems in their

monetary affairs, lacking the institutions and experience needed. It is likely that

official dollarization would significantly improve price stability in those countries

with a history of monetary problems.


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Loss of Independent Monetary Policy

On the other hand dollarization means that the country can no longer tailor its

monetary policy to suit its own needs. Unless its economy closely tracks the US

economy, that can be a serious limitation at times. Nevertheless the discipline

required might be worth the loss of flexibility. The added stability should offer a

better environment for planning business expansion and new enterprise. Under

dollarization the central bank would no longer be able to create money, but it would

still retain the important task of administering banking system regulations and

ensuring sound banking practices.

Seigniorage Effects

The US gains added seigniorage benefits as countries increase the use of dollar

currency. The annual cost to the US of creating and servicing its currency is now less

than 0.1% of the face value of currency outstanding. The notes however are sold at

face value. Thus notes that are purchased for use overseas are the equivalent of nearly

cost-free imports of goods and services to the US.

If the US wished to encourage certain countries to officially dollarize their economies,

it could easily afford to share some of the seigniorage benefits. That seems a

reasonable tradeoff, since dollarization would enhance trade with those countries, to

the advantage of both.

Political Considerations

An important political issue is the effect on national pride. Most people see their

currency as a symbol of national sovereignty. Losing their own currency could be

difficult for many to accept. It could foster the 'imperialist Yankee' reaction,

particularly when some incident strains relations. Also their politicians could find it

convenient to lay the blame for their own mismanagement and poor economic

conditions on US monetary policy. These, rather than purely monetary issues, appear

to be of primary concern to the US.


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2.4 DOLLAR OVERTAKES STERLING AS THE LEADING

INTERNATIONAL CURRENCY

The global economic and financial crisis has lent new impetus to discussions of the

future of the international monetary and financial system. Some advocate moving to a

multipolar system in which the US dollar shares its international currency role with

the euro, the Chinese renminbi and/or the IMFs Special Drawing Rights. At the

Cannes Summit of November 2011, G20 Leaders committed to taking concrete

steps to ensure that the international monetary system reflects the changing

equilibrium and the emergence of new international currencies.

Some observers expect this change to develop spontaneously, as a natural

consequence of the declining economic and financial dominance of the US and the

increasingly multipolar nature of the global economy, together with the advent of the

euro and gradual internationalisation of the renminbi. Sceptics object that the prospect

of a shift to a multipolar monetary and financial system is remote. If it occurs, they

insist, such a transition would take many decades to complete.

The view that a shift to a multipolar system is unlikely to occur rapidly is rooted in

theoretical models where international currency status is characterised by network

externalities (see for example Krugman 1980 and 1984; Matsuyama et al. 1993; Zhou

1997; Hartmann 1998; and Rey 2001). These give rise to lock-in and inertia effects,

which benefit the incumbent.

Such models rest, in turn, on a conventional historical narrative, epitomised by Triffin

(1960), according to which it took between 30 and 70 years, depending on the aspects

of economic and international currency status considered, from when the US overtook

Britain as the leading economic and commercial power and when the dollar overtook

sterling as the dominant international currency. Allegedly, sterling remained the

dominant international currency throughout the interwar years and even for a time

after the Second World War.

Recent studies (Eichengreen and Flandreau 2009 and 2010) have challenged this

conventional account, showing that the dollar in fact overtook sterling already in the

mid-1920s as lead currency for financing and settling trade and the leading form of


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international reserves. This new view, to paraphrase Frankel (2011), also challenges

broader implications of the conventional narrative. It suggests that inertia and the

advantages of incumbency are not all they are cracked up to be. It challenges the

notion that there is room for only one international currency in the global system, as

well as the presumption that dominance, once lost, is gone forever.

In a recent paper (Chiu et al. 2012), we reexamine the role of international currencies

as vehicles and currencies of denomination for foreign investment. Specifically, we

analyse the currency denomination of foreign public debt for 33 countries in the

period 1914-1946. The results lend further support to the new view.

First, while network externalities, first-mover advantages and inertia matter, they donot lock in international currency status to the extent previously thought. Abstracting

from the Commonwealth countries, whose allegiance to sterling was special, we show

that the dollar overtook sterling already in 1929, at least 15 years prior to the date

cited in previous accounts (see Figure 1). And even when the Commonwealth

countries are included, we find that the dollar was already within hailing distance of

sterling as a currency of denomination for international bonds by the late 1920s.

Second, our evidence challenges the presumption that monetary leadership once lost

is gone forever. Although sterling lost its leadership in the 1920s, it recovered after

1933 and was again running neck and neck with the dollar at the end of the decade.

Third, our findings challenge the presumption that there is room for only one

dominant international currency due to strong network externalities and economies of

scope. This is true even if one takes into account the Commonwealth countries, which

were heavily oriented towards sterling for institutional and political reasons.

A regression analysis of the determinants of vehicle currency choice points to the

development of American financial markets as the main factor that helped the dollar

overcome sterlings first-mover advantage. Financial deepening was the most

important contributor to the increase in the share of the dollar in global foreign public

debt between 1918 and 1932 (see Figure 2). In the case of the UK, economic

stagnation, i.e., declining relative economic size, was the most important factor

accounting for sterlings declining share over the period.


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These findings have important implications for the future of the international

monetary system. They suggest that a shift from a unipolar dollar-based system to a

multipolar system is entirely possible; that it could occur sooner than often believed;

and that further financial deepening and integration will be a key determinant of the

ability of currencies other than the dollar to strengthen their international currency

status.

The international status of a currency will only rest on solid foundations, however, if

financial deepening in the issuing country is sustainable, and not if financial

innovation and liberalisation simply cause a boom that eventually goes bust. The

impact of finance on international currency shares in global debt markets worked both

ways in the interwar period. Our findings underscore this point as well, insofar as the

collapse of the US banking system and subsequent financial retrenchment was the

most important factor contributing to the decline in the share of the dollar in global

foreign public debt between 1932 and 1939.

This underscores that the compass guiding the pace and scope of financial sector

reform should always point to the direction of medium-term sustainability. In turn,

this highlights the important role that macro-prudential policies and tools will play in

shaping the international status of currencies in the new millennium.


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Figure 1. Global foreign public debt Selected currency shares (As a % of total; at

current exchange rates)

Figure 2. Estimated contributions to the change in the share of the US dollar in global

foreign public debt between 1918 and 1932 (in percentage points)


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2.5 THE DOLLAR WILL REMAIN THE GLOBAL CURRENCY

People's Bank of China governor Zhou Xiaochuan recently sparked a new round of

debate regarding the international monetary regime with his call for a new

international reserve currency. While the dollar was not specifically mentioned, it is

clear that the proposed new international currency is meant to replace the role that the

US currency currently plays. When a senior official of a government that holds about

10% of the US government's marketable debt makes such a statement, people take

notice. There also appears to be some international support for governor Zhou's idea,

although the U.S. is understandably less enthusiastic. So will we see the U.S. dollarlose its international preeminence anytime soon?

An evaluation of this question must begin with an understanding of why the U.S.

dollar is so well regarded globally in the first place. There are four main reasons for

this. One, it has, at least until now, been a reliable store of value. Two, it is the most

widely accepted means of international payment for goods and services. Third, large,

deep, and liquid dollar financial markets exist for savers to invest their money in. And

finally, a long period of dominance has allowed the currency to become a part of the

international financial trading infrastructure.

The U.S. dollar is the most frequently used currency in international trade today. The

fact that the U.S. is the world's largest trading nation is only part of the reason. The

value of international trade that is invoiced in dollars is much larger than the total

trade conducted by the U.S. and countries with currencies linked to the greenback.

This is particularly true in Asia, where many countries bill more than 80% of their

exports in dollars.

Large international savers such as the Persian Gulf states and East Asian exporters

also find U.S. financial markets most attractive. Partly, this is because Gulf oil exports

are paid for in dollars and because it is the most convenient currency with which to

intervene in foreign exchange markets for Asian central banks. But more importantly,

the U.S. financial markets remain the most efficient place to intermediate globalfunds. In these markets, particularly the U.S. Treasury market, large amounts of


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financial assets can be bought and sold without causing large movements in market

price. Moreover, due to the narrow differences between buying and selling prices, the

costs of transacting in these assets are lower than in any other market. Investing in

U.S. financial markets, and also through the dollar in other financial markets,

therefore, lowers costs and increases the flexibility of portfolio decisions.

The previous two reasons also give rise to a third factor that keeps the U.S. dollar as

the world's currency. The dollar has become an integral part of international financial

and commodity markets because it is so frequently used in international trade and

investment. In quoting exchange rates, the value of a currency is most commonly

stated in terms of the U.S. dollar. Even in actual exchange, the dollar's role is

important. A company wishing to exchange Thai baht for New Zealand dollars

typically buys U.S. dollars first, before converting them into New Zealand dollars. As

a result, the U.S. dollar is involved in one leg in close to 90% of all foreign exchange

transactions, compared with less than 40% for the euro and 16% for the Japanese yen.

Similarly, commodities, such as oil and copper, usually have their quotes and their

trades executed in U.S. dollars. This prevalence also means that the dollar derivative

markets are the most developed for anyone wishing to hedge currency and commodity

price risks.

The common factor crucial for the continued validity of the above support for the

dollar's international status is confidence in the stability of its purchasing power and

confidence in the government to honor its debts. Whether one is a trader or an

investor, there is a need to hold the currency on an ongoing basis. People have to

believe that it is a good store of value, in that the real effective exchange rate of thedollar is not expected to see large declines over the short to medium term. This belief

rests on the strength of the U.S. economy, the independence and checks inherent in

key institutions, as well as the prudence and coherence of its policies. If even a

significant minority of external creditors has doubts that these factors are no longer

true, then the U.S. dollar money and capital markets will become unstable. Real

interest rates and equity premiums will rise sharply and the dollar will fall

precipitously against other major currencies.


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The reason for governor Zhou's proposal is that recent developments have the

potential to weaken confidence in the dollar. As the U.S. has the largest trade deficit

in dollar terms, its vibrant economy as well as responsible fiscal and monetary

policies have supported the value of its currency. These conditions make investments

in U.S.-based companies attractive and the government's debt a safe asset to hold. As

a result, the U.S. has managed to attract international capital to help maintain its

international balance of payments.

This foundation is looking shaky now that the economy has suffered serious damage,

budget deficits are expected to rise sharply, and the Federal Reserve is pursuing

quantitative easing. Not only have growth prospects dimmed, but inflation risk over

the medium term has risen. U.S. policymakers pursuing measures that deal with

domestic problems, however, have affected confidence over the longer-term

attractiveness of the dollar. But it is still too early to call the end of the pole position

of the dollar. And even if it isn't, it is not clear that Zhou's proposed use of the

Standard Drawing Rights (SDR) is the right answer anytime in the next few years.

The SDR is an accounting unit that represents a basket of currencies: U.S. dollars

(44%), euros (34%), yen and sterling (both 11%). It is neither used in physical nor

financial trading, only in the internal accounting of the International Monetary Fund.

There is no economic need and, therefore, demand for the unit. It will be difficult to

persuade major financial institutions to make expensive investments to change their

systems for such trading. It will also be of little use to international savers since it will

take a long time, if at all, for SDR financial markets to grow to a reasonable size.

Finally, companies involved in international trade will find it difficult to hedge the

SDR against the domestic currencies that determine their costs of production.

A more natural alternative to the U.S. dollar is a currency that is already widely used

today. Perhaps this is the reason China has signed currency swap agreements with a

number of countries recently. However, the yuan is hardly ready for a major

international role anytime soon. China's strict capital controls and restrictions on

currency convertibility currently prevent such a development. And in the next few

years, it is unlikely that policy makers will have sufficient confidence in the Chinese


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banks to subject them to the large international currency flows that come with an

internationalized yuan.

The most likely candidates for an alternative international currency are the euro and

Japanese yen. In recent years, however, the growth in the use of the euro has slowed

significantly. In terms of use in international trade and international debt issuance, the

share of the euro has stabilized. While its use in Europe is naturally widespread, the

currency's influence outside the region has remained small. The Japanese

government's push to internationalize its currency in the late 1990s met with no

success. Also, while the U.S. economy has weakened recently, the European and

Japanese economies hardly seem in better shape.

Even more than the U.S., both Europe and Japan face serious demographic challenges

that are likely to bring down their medium- to long-term growth. Over a longer

horizon, as long as fundamental U.S. economic policies are not changed, the U.S. will

continue to have better growth prospects. The truth is that, in the near term, there

appears to be no good alternative to the U.S. dollar as an international currency.

It's also far from certain that current conditions in the U.S. economy are sufficientlyserious for the world to doubt the stability of the worth of its currency. Even counting

a few years of exceptionally large fiscal deficits, it is unlikely that the U.S.

government debt will reach that of the Japanese government in relation to their

respective GDP. Yet, domestic confidence in the Japanese government's

creditworthiness is so strong that it can continue to borrow long term at among the

lowest interest rates in the world. These rates are achieved despite maintaining an

open capital account that has enabled the Japanese private sector to become one of theworld's largest external creditors. Meanwhile, the U.S. government experienced a far

higher debt burden than it has now, just after the Second World War. Yet, the dollar

continued to grow in international importance at that time.

And the dollar has survived other serious tests as well. In the early 1970s, there was a

significant loss of confidence in the U.S. currency, which eventually led to the dollar

floating freely against gold. Stagflation in the 1970s also called into question the

preeminence of the U.S. economy and the role of the dollar. In both episodes,


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however, the innovation and flexibility of the country's open economy helped it to

return to strong growth, which sparked renewed confidence in the dollar as well.

What could prevent a similar revival are policy mistakes by the U.S. government. The

economic position of the U.S. will not emerge unscathed from this financial turmoil.

In the near to medium term, we believe some weakening of the dollar's dominance is

likely. Only a permanently less-vibrant U.S. economy, however, will ensure a trend

decline in the dollar's international importance. If that happens, it will most likely

come from a structural shift in U.S. economic policy, for example, if we were to see a

much more protectionist international trade regime or excessive regulation of

businesses.

These risks could materialize. The rise of unemployment in the country, coupled with

the government's weakened finances, has led to rising pressures to put American firms

and workers first. The recent U.S. stimulus package, for instance, came with a "Buy

American" clause. Meanwhile, public discontent with executive compensation and

increased state control over the economy could lead to restrictive policies that could

ultimately introduce excessive risk-aversion in firms. Policy mistakes could lead to a

period of price instability. Factors such as these could diminish America's growth

prospects and the long-term international status of the dollar. But if that day arrives,

we believe it will likely stem from developments in the U.S. rather than from efforts

abroad.

.


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CHAPTER3

THE INTERNATIONAL ROLE AND DECLINING

STATUS OF THE DOLLAR

3.1 INTRODUCTION

The U.S. dollar is always in the news. This is not surprising, given the role of the

United States in the world economy and the role of the dollar in transactions around

the world. During the Great Recession, the strong dollar funding reliance of banks in

some markets outside the United States was not viewed as particularly noteworthy

until balance sheet funding was disrupted. Some of the news articles speculated on

pending changes to the global financial system. As one example, an article in the

Financial Times (June 28, 2011) discussed a likely shift from the dollar as the

dominant reserve currency to a portfolio of currencies, based on a survey of over 80

central bank reserve managers, sovereign wealth funds, and multinational

institutions. There is an expectation that there will be an associated evolution of the

international financial architecture. Of course, it is already the case that the U.S.

dollar is not the only international currency. The euro also is extensively used, andthere are international roles for other currencies including the pound sterling, the

Swiss franc, and the Japanese yen.

For a currency, its international roles include serving as: a store of value and a unit of

exchange; a medium of exchange; an anchor currency in exchange rate regimes; a

primary currency in official foreign exchange reserves; a transaction currency in

foreign exchange and international capital markets; and an invoicing and settlement

currency in international trade. As a preview of main findings on currency status, we

show that the dollar maintains a dominant role in all key functions. However, there

also are some areas where dollar dominance has declined.

The discussion of an evolving role of the dollar is not new. For example, in the past

decade there had been ample discussion of the euro overtaking the dollar as the key

international currency, or at least having a more balanced allocation of international

activity across these two currencies.


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Much of the discussion, even from the academic side, focused on the role of the dollar

in the international reserve holdings of central banks. Chinn and Frankel (2008) is one

example of the reasoning behind evolving roles. They project that the dollar status has

been based mainly on the growth trajectories of different regions and argue that, in the

next decade, the euro could potentially rival or surpass the dollar. Likewise,

Eichengreen (2011) forcefully argues that the world is evolving toward a

multicurrency regime, without the continuing dominance of the U.S. dollar.

Most discussions of an expanding role of the euro have paused in the aftermath of the

Great Recession and during the period of European sovereign debt stresses. Instead,

more recent discussions have turned towards speculating about some the future roles

for Chinas currency, the renminbi. In part, and following on the Chinn and Frankel

arguments about country size, this potential is due to because of the spectacular

economic growth of China over the past two decades. The argument holds that

Chinas historic rise as a global economic and trading power will continue to

profoundly reshape the global economic system. Chinas promotion of RMB

internationalization in recent a time is viewed as having the potential to accelerate the

removal of Chinas restrictions on international capital flows. I will not take a stand

on projections for the role of the dollar, euro, RMB, or any other currency. And,throughout this chapter, the views are my own, and not those of the Federal Reserve

Bank of New York or the Federal Reserve System.

In this article I focus on a few main themes. I begin with a brief review of the main

international roles of currencies, and then present data on the status of the dollar in

these roles, updating Goldberg (2010). I next turn to three questions. First, from the

vantage point of the United States, what are the potential consequences of a change in

the international role of the dollar? Second, I note how my own research agenda

addresses related questions. And finally, I discuss what types of research questions are

open and beckoning economic researchers in this area of analysis.

As I turn specifically to the question of whether a potential decline in the international

role of the dollar or a rise in the roles of other currencies would be a concern, a key

caveat prevails: the contexts surrounding such changes are important. International

currency usage is a market-driven decision. The roles of currencies are not

exclusively defined by the relative size of countries and their country s presence in


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international markets. Indeed, in the early part of the 20th century, the United States

had surpassed the United Kingdom in size, but size alone was not enough to unseat

the pound sterling. Official and private sector agents have strong financial incentives

to vote with their feet and use currencies that satisfy high standards of liquidity and

convertibility. Many dimensions influence such currency choice outcomes, including

country size, openness in international trade and international capital flows,

creditworthiness, and institutional and policy soundness and stability. The dollars

primacy in international economic transactions is a historical artifact that reflects the

fact that the United States satisfied these criteria following the ravages of World War

II. Its status was institutionalized within the Bretton Woods system and has been

retained even as other economies, including the euro area and China, have grown in

strength. Size, openness, creditworthiness, and institutions and policies have

reinforced the status during this period.

Whether the rise of other currencies presents more negative or positive consequences

for the United States is closely linked to conditions within the United States. If the

United States maintains the strong economic fundamentals and the types of

institutional strengths that have supported the dollars international roles, the

consequences of a reduced dollar role may not be a large concern. Indeed, theemergence of plausible alternatives to the dollar could signal strength in other

economies and serve as a positive source of discipline on U.S. decisions. A decline

of dollars international primacy in such an environment is not to be regarded as a

significant threat to U.S. economic well-being when this decline arises in the context

of strong U.S. growth and institutional fundamentals.

However, if poor U.S. policy decisions undermine U.S. economic fundamentals and

institutional strengths, the reduced international role of the dollar could be one

component of a broader decline. The changes described below could have more

adverse effects if the reduced dollar role is associated with less auspicious U.S. policy

and institutions.

A second caveat also applies to the discussion. While the exposition has a focus on

the roles of currencies, this is a somewhat distinct issue from a focus on the exchange

value of currencies. Exchange rates can move substantially, without immediately

having bearing on the international roles of currencies.


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3.2 THE CURRENT STATUS OF THE DOLLAR IN ITS

INTERNATIONAL ROLES

In policy discussions, two of the most frequently discussed roles of the dollar are as a

central currency in the exchange rate arrangements of many countries and in country

international reserves. While a historical perspective is provided in Goldberg (2010),

up-to-date information on the status of the dollar in these roles is provided.

Currency arrangements are grouped according to whether countries have dollarized or

have formed currency boards using the dollar, have a pegged exchange rate against

the dollar, or maintain managed floats with the dollar as a reference currency. The

table shows statistics of 1995, 2000, 2005, and 2010. The statistics show numbers ofcountries with each exchange rate regime status out of a total of 207 reporters. There

also are statistics presented on the share of GDP of all of these countries in the dollar-

linked regime. As of 2010, eight countries are dollarized or have currency boards

using the dollar, and ninety have a pegged exchange rate against the dollar. There is

little evidence here that the dollar role as an anchor has changed to date. Indeed, the

share of global GDP for countries with exchange rate regimes tied to the dollar has

increased over time.

Country foreign currency reserves are another focal point of analyses and policy

discussions. Cross country data show that foreign exchange reserve holdings grew

sharply over the recent decade. While reserves dipped during the great recession, they

have since resumed their climb, nearing $10trillion in the beginning of 2011. In

particular, reserves growth is dominated by, but not limited to, developing countries.

Within foreign exchange reserve portfolios, the dollars denominated assets continue

to account for the majority of reserves held by both industrialized and developingcountries, whether these assets are valued at current exchange rates or at constant

exchange rates. This distinction is useful as it abstracts from changes in portfolio

shares that might be passive and due to evolving currency values. These charts show

that there appears to have been some recent diversification away from dollars by

developing countries. Yet, overall and despite recent years of market turbulence,

various crises, and including movements toward greater internationalization of the

RMB by China, the dollar has not declined in prominence either as a central currencyfor exchange rate arrangements or as an international reserve currency.


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The next international currency role is as a transaction currency. A range of evidence

shows that the dollar continues to be the leading transaction currency in the foreign

exchange markets and a key invoicing currency in international trade. With an 85

percent share of foreign exchange transaction volume--more than twice the share of

next leading currency, the euro--the dollar dominates these markets. Yet, this

dominance has declined somewhat in the past decade, even as volumes of currency

transactions have more than doubled.

The dollars leading role in foreign exchange transactions also is reinforced by this

currencys widespread use in the invoicing of international trade. Cross-country

evidence in Goldberg and Tille (2008), and the extended evidence in Kamps (2006),

present some of the more comprehensive views based on data at the level of country

exports and imports. More recently, the ECB report on The International Role of the

Euro details currency use in imports and exports of European Union countries. In

general, the euros role rose in the years following the advent of the euro, before

stabilizing. More recent evidence on direction of changes in euro and dollar shares is

mixed across counties. In other recent work using Canadian Customs data (Goldberg

and Tille 2010), I document relatively stable use of the dollar, euro, and other key

currencies in invoicing international trade over the past decade.

International debt and loan markets are yet another area in which currency roles can

be compared. The ECB has compiled comprehensive data which show the shares of

euros, dollars, yen and other currencies in all outstanding debt securities, issued

anywhere in the world. The growth of debt issuance within European economies,

including internal markets of the euro area, has been associated with a declining dollar

share in all debt securities. Another key gauge of presence in international finance is

the dollar-denominated share of all securities sold outside the issuing country and in a

currency different from that of the issuers country. Within this narrower type of debt

issuance -- termed international debt securities -- the dollar role continues to

expand. Currently, dollars account for nearly half of all debt when borrowers turn to

external markets and foreign currency financing. It also is the dominant currency in

liabilities extended to both nonbank and bank counterparties. The dollar share in loans

to bank and non-bank customers has remained around 60 percent. The dollar also

plays an important role in the growing volumes of cross-border loans of banks.


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3.3 CONSEQUENCES OF THE U.S. DUE TO DECLINING

DOLLAR STATUS

It is sometimes argued that the United States extracts large benefits from the

privileged international status of the dollar. It is less frequently asked what could be

the consequences of a decline in this status. We examine the potential consequences

in five areas: seignorage returns, funding costs, transaction costs, U.S. insulation to

foreign shocks, dollar valuation, and U.S. global influence. These consequences are

summarized discussed in more detail below:

Seignorage revenues:Seignorage gains on currency outstanding can be approximated by the difference

between interest earned on securities acquired in exchange for bank notes and the

costs of producing and distributing those notes. Total seignorage returns to the United

States are estimated to be moderate, despite roughly $1 trillion in cash dollars in

circulation. In a low interest rate environment seignorage gains can be relatively

small, with an upper bound of around $2.5 billion per year if calculated at 25 basis

points, or $20 billion if calculated at an interest rate of 2 percent. By some estimates,

in excess of 60 percent of U.S. dollar notes are outside of the United States. Clearly,

changes in volumes of dollar cash holdings that are outside of the United States would

alter these gains proportionately.

Funding costs:It sometimes argued that one reflection of the exorbitant privilege afforded the

United States due to the dollars international status is evidenced in the lower funding

costs facing U.S. borrowers on dollar liabilities. This point has been at the center ofheated debate. While U.S. entities have had higher rates of return on outward

investments compared with what is paid to foreign investors on U.S. inward capitalflows, the evidence for exorbitant privilege per se is disputed. Careful empirical

investigation by Curcuru, Thomas and Warnock (CTW 2011) shows that most of the

differential in funding costs on U.S. borrowing roles versus those on U.S. investments

is attributable to the different composition of outward and inward capital flows. In


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Particular, U.S. outward investment is more heavily focused on higher return foreign

direct investment. While there remains a small advantage on average for the United

States compared to other countries in official and bond financing, this is not relative

to all countries. Also, recent studies attribute the lower rates charged the United States

on its debt to country risk premia, differences in tax rates, and the relative stability of

investment returns across nationalities, rather than to the dollars international role per

se. There is a conceptual counter argument provided by Gourinchas and Rey (2011),

in which there is effectively an insurance premium paid by the rest of the world to the

United States for its exorbitant duty in giving the world a stable anchor and for

providing other countries lender of last resort resources. This argument does not

refute the CTW evidence, but does raise interesting questions about the role of

currencies and volumes of flows Vis a Vis the United States during crises.

Regardless of ones stance in this exorbitant privilege debate, it is certainly possible

that funding costs could rise on U.S. government borrowing if the assets of other

countries emerge as stronger alternative investment vehicles to U.S. Treasuries, or if

the safe haven role of the dollar is perceived as eroded. This could potentially reduce

the demand for U.S. government debt relative to the non dollar denominated assets

purchased by private and official sector investors. A reduced demand for U.S. officialsector debts could increase the debt financing costs for the United States, having as a

consequence a higher fiscal burden of U.S. debt and perhaps an increasing crowding

out of domestic public and private sector spending. A reduced demand for the U.S.

assets also could lead to U.S. dollar depreciation.

US insulation from foreign shocks:The dollars role in invoicing international trade and its predominance in international

borrowing and lending activity have traditionally provided the United States with a

degree of insulation from shocks that originate in foreign markets. This type of

insulation is discussed in Goldberg and Tille (2006). The relatively low sensitivity of

U.S. import prices to exchange rate changes results in less expenditure switching

between home and foreign goods when the dollar value changes. The low import price

sensitivity is partially attributable to the use of dollars in trade invoicing. With

increased use of other currencies in invoicing trade and in borrowing and lending

activity, the insulation could decline. In particular, reduced dollar invoicing of


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international trade and use of dollars in international borrowing and lending activity

could raise exchange rate pass-through into domestic import prices, and ultimately

make U.S. prices more sensitive to foreign fluctuations. Thus, when the dollar

exchange rate moves, more of the expenditure switching burden is felt in the United

States and less by our foreign trading partners. Greater invoicing in other currencies

could shift the adjustment burden more to the United States. On the financial side, the

global predominance of the dollar has enabled U.S. entities to issue their debt in U.S.

dollars, helping the U.S. government and private entities avoid the original sin of

large currency mismatch risks on their balance sheets.

Overall, the increased use of other currencies in place of the dollar in international

roles such as trade invoicing and lending and borrowing activity could lead to a

directional rebalancing of international transmission of shocks and stimuli. The

United States could be influenced more by the policy decisions and economic cycles

of foreign markets, and increasingly take these into account in a range of policy

decisions made in the domestic economy.

Dollar valuation:

A currencys value is supported by its status as the primary global reserve currency tothe extent that U.S. dollar assets are demanded by public and private sector entities

worldwide. If, for example, there was a withdrawal of foreign exchange reserve

demand for U.S. dollars, this occurrence could be associated with a depreciated U.S.

dollar relative to whichever currency gets an enhanced role. The potential economic

consequences of a weaker dollar are mixed. The U.S. debt burden does not increase in

dollar terms since U.S. liabilities are denominated in dollars, regardless of the size of

external debt of the United States. However, higher costs of carrying the debt could

arise if further dollar depreciation is expected and compensation for that risk is

required by investors. Changes in the value of the dollar also are associated with

well-established facts on competitiveness of U.S. exporters and importers. Countries

that use the dollar on their international trade with other (non-U.S.) counterpartiesalso may be affected (Goldberg and Tille 2009).


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US global influence:Less quantifiable but potentially more significant could be a loss of global prestige

and policy influence for the United States resulting from a shift towards a multi-polar

currency world. One key channel of U.S. global influence in the modern economic

system has been its influence on the institutions, such as the IMF and World Bank that

undergird the current international economic and financial order. A second avenue

by which U.S. influence may be impacted by growing international use of other

currencies in international negotiations and transactions. This could further strengthen

the reach of other countries in ways that could differ from U.S. preferences and

interests.

3.4 THE WORLD'S CURRENCY: THE U.S. DOLLAR AND ITS

FUTURE STRUGGLE FOR SUPREMACY

The US dollar is used at the reserve currency for the rest of the world, but much like

the English Pounds Sterling, that dominance might not last forever. With the dollar as

the world's reserve currency, the US is insulated from foreign supply shocks, reduces

transaction costs in trade, and contributes to the international transmission of US

monetary policies. The dollar is likely to continue its global dominance of the

currency markets in the near term; however, there are significantpointing towards a

reduction in the dollar's world market share.

The transition in the computer industry from one dominant operating system to a few

dominant operating systems is comparable to what is occurring in the currency

markets today. 10 years ago when you purchased a computer you did not have the

option of an operating system, you only got Windows. Now a person buying a new

computer has many options to choose from. Like the computer industry in the past,

advances in foreign technology and portability have set the stage for three major

currencies to duke it out over the next ten years. The Chinese renminbi, the euro and

the US dollar are all trying to dominate the global currency market.
https://www.carnegiecouncil.org/resources/transcripts/0345.html/_res/id=sa_File1/Exorbitant_Privilege_Eichengreen.pdfhttps://www.carnegiecouncil.org/resources/transcripts/0345.html/_res/id=sa_File1/Exorbitant_Privilege_Eichengreen.pdf


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The dollar has to overcome a few fiscal challenges if it wants to stay the major

currency in the markets. As you can see from the graph ofUUP, a fund which tracks

the dollar's value, there has been a significant decline recently. US debt is

approaching 75% of the national income, which is significant given that the US only

raises approximately 19% of national income from taxes.

If this debt continues to increase, foreign users of the dollar will conclude that the

US's only way out of debt is by inflating the debt away. If this conclusion is reached

by foreign leaders, bankers, businesses and investors then a major collapse in the

value of the dollar would occur. Based upon current US fiscal trends, some experts

have warned this collapse could occur within the next 3 years.

The Chinese government is currently working very hard to make the renminbi an

international currency. A recent and public display of these actions can be observed

by the Bank of China offering foreign exchange services to American citizens. The

Chinese have many more significant steps to accomplish before the renminbi is truly
http://seekingalpha.com/symbol/uuphttp://seekingalpha.com/symbol/uup


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an international currency, but the Chinese government has shown a strong will to

accomplish their fiscal goals.

Simply because the US government ignores the national debt does not mean that the

rest of the world will also turn a blind eye. If the US debt continues to increase, therewill reach a point when foreign investors, both public and private, will turn their

backs on the dollar. Foreigners will conclude that massive inflation is coming, and

they will sell the dollar in droves. When the smoke clears, the dollar will have lost the

trust of the world, and the exorbitant privilege which comes with being the world's

currency.

3.5 US DOLLAR TO REMAIN DOMINANT GLOBAL

CURRENCY DESPITE ITS ECONOMIC TRAVAILS

History shows that the global economic system has often been based on an

asymmetric relationship of an anchor economy - currently the US - that runs

persistent current account deficits even as it providesliquidityto the rest of the world.

This leads to a symbiotic relationship where the anchor country gets cheap financing

and the rest of the world gets the monetary liquidity needed to lubricate economic

activity.

Unfortunately, history shows this system eventually breaks down because the anchor

country needs to run continuous current account deficits in order to provide more and

more liquidity needed by an expanding world economy, making it increasingly

indebted over time. In turn, this undermines the very credibility on which the

monetary system is based. This scenario was first described in the 1950s in relation to

the Bretton Woods

economics dollar project

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