US dollar to remain dominant despite its economic travails

The relat ive economic decline of the US has led many economists and policymakers to question the US dollar’s position as the world’s anchor currency. Suggested alternatives range from a global reserve system to even a return to gold. While recent efforts to internationalise the Chinese yuan have only added to the expectation of a shift in the international monetary system, we believe the US dollar will remain t he dominant global currency for a long time to come.

History shows that the global economic s yst em has often been based on an asymmetric relationship of an anchor economy - currently the US - that runs persistent current account deficits even as it provides liquidity to 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

Spain was the world’s dominant power in the 16th century but expensive wars caused it to run continuous deficits and eventually default. Yet, Spanish silver coins continued to be the key currency used in world trade right up to the American Revolution. In fact, they remained legal tender in the US till 1857 - long after Spain itself had ceased to be a

major power

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 system by Robert Triffin and has since become known as Triffin’s Dilemma.

During the Roman times, the world economic system was underpinned by booming trade between the Roman Empire and India. The problem with Indo-roman trade, however, was that India ran a large trade surplus with the empire. This deficit meant that there was a continuous drain in gold and silver coins that, in turn, created shortages of these metals in Rome (in modern terms, this was a monetary squeeze).

The Romans unsuccessfully tried to impose restrictions on imports but eventually resorted to reducing the gold/silver content of imperial coins (the ancient equivalent of printing money). Yet, frequent findings of Roman coins in India suggest that Roman coinage continued to be accepted for a long time after it was obvious that the gold/silver content had fallen.

Spain was the world’s dominant power in the 16th century but expensive wars caused it to run continuous deficits and eventually default. Yet, Spanish silver coins continued to be the key currency used in world trade right up to the American Revolution. In fact, they remained legal tender in the US till 1857 - long after Spain itself had ceased to be a major power.

In fact, the only clear historical solution to Triffin’s dilemma can be seen with the ‘triangular trade’ system between Britain, India and China in the 19th century. Under this arrangement, the British sold manufactured goods to the Indians and purchased opium. The opium was then sold to the Chinese in exchange for goods that were then sold back in Europe.

Britain did not bleed gold in order to keep the system flowing. This system was stable in the sense that it did not suffer from Triffin’s Dilemma but functioned because the East India Company was militarily able to impose its will. Chinese attempts to close down the opium trade resulted in the Opium Wars of 1839-42 and 1856- 60. In other words, Triffin’s dilemma was circumvented through war, colonisation and drug-running.

By the 1870s, the world had shifted to a gold standard underpinned by the Bank of England’s willingness to convert sterling into gold on demand. However, Britain’s economy was surpassed by the US in 1890 and the Gold Standard was abandoned due to the shocks of WW1 and the Great Depression. The pound sterling however, continued to be a world currency till after WW2. Even in 1950, 55% of foreign exchange reserves were held in sterling and many countries continued to peg their currencies to it.

Under the Bretton Woods system after WW2, the US dollar became the anchor currency with an explicit gold peg. Yet again, the need to run deficits to supply the Europe with liquidity undermined the gold peg and the Bretton Woods system collapsed in 1971. Or did it? Over the next few decades, Asian currencies pegged themselves to the dollar and pursued exported-oriented growth strategies.

The system allowed the peripheral economy (say, China) to grow rapidly even as the anchor economy (US) enjoyed cheap financing. Note how the relative rise of China did not diminish the role of the US dollar and may even have enhanced it. Indeed, like the Japanese during their period of high growth, the Chinese resisted the internationalisation of the Chinese yuan till recently and even now are proceeding very cautiously.

So, should we expect the demise of the US dollar? The best sign of the resilience of the dollar-based system is that its trade-weighted index has been stable since the crisis began - hardly a sign that it is being abandoned. Far from it, the world appears to be willing to finance the US at very low interest rates.

History shows that once an anchor currency has established itself, it can be very resilient and often outlasts the economic and geo-political dominance of the country of origin. It is possible (albeit not certain) that China will replace the US as the world’s largest economy within a decade, but we feel that the US dollar will remain the dominant global currency for a long time afterwards. (The author is Global Strategist,

Deutsche Bank) (Courtesy Economic Times)