At the end of a year in which the dollar has endured a marked decline against other currencies, an unsettling question is beginning to be voiced: can the troubles of the US currency be confined to the financial world or are they set to undermine Washington’s place on the international stage?
“This is the neglected dimension of the dollar’s decline,” says Flynt Leverett, a former senior National Security Council official under President George W. Bush. “What has been said about the fall of the dollar is almost all couched in economic terms. But currency politics is very, very powerful and is part of what has made the US a hegemon for so long, like Britain before it.”
Along with some other commentators, Mr Leverett brackets the dollar’s recent fragility with related phenomena, such as the greater international use of rival currencies. He argues that if such trends continue, the result will be costly for the US. While a lower dollar is associated with greater financing costs for America’s twin current account and budget deficits, he says, currency movements can be determined by politics as well as economics – and the US security could be damaged if America’s creditor nations move against the dollar.
“Americans will certainly find global hegemony a lot more expensive if the dollar falls off its perch,” adds Kenneth Rogoff, former chief economist of the International Monetary Fund, in an article published this month.
He maintains that the US has been fortunate to be able to use the huge low-interest dollar holdings of the central banks of China and Japan to finance higher return investments elsewhere, “but between the sub-prime US mortgage crisis and the dollar’s ongoing decline, America’s exorbitant privilege now looks a bit shaky . . . American voters, who are famously loath to increase taxes, might start thinking a lot harder about the real economic costs of their country’s superpower status.”
The tumble of the greenback – by more than 25 per cent against its trading partners since February 2002 when adjusted for inflation – may lead other nations to turn away from using dollars for their central bank reserves, international transactions or currency pegs, with expensive results for the US.
Indeed, central banks have begun to move in such a direction. China, which keeps the composition of its huge foreign exchange reserves a state secret, has hinted that it plans gradually to reduce the proportion held in dollars – some analysts put the current level at more than two-thirds. Yet while the dollar’s role as the most popular reserve currency is not under imminent threat, for cash it is a different story: last year, the value of euro notes in circulation overtook the value of circulating dollar notes.
“The US is extraordinarily fortunate in that its currency is also the international standard of value – if that would disappear, US leverage in many dimensions would also go,” says Benn Steil, director of international economics at the Council on Foreign Relations in New York. He highlights the US’s ability to further its influence by bailing other countries out of financial crises. “What countries need in a financial crisis is dollars and that gives the US enormous leverage.”
Mr Steil adds that the dollar’s all but indispensable role also gives Washington an important tool against countries such as Iran and North Korea, since by limiting their banks’ access to dollar financing – a step Washington has taken several times over the past year – the US can damage such countries’ financial systems and make financing more expensive to obtain.
Mr Leverett says the US could relatively soon become vulnerable to the kind of financial pressure that the strength of the dollar has allowed it to exercise in the past. In the classic example, Washington used the threat of a run on the pound to put pressure on the UK to withdraw troops from Egypt during the Suez crisis in 1956.
In future, that kind of leverage may belong to China. “Right now China wants to keep a close hold on how fast the renminbi appreciates,” he says. “But it’s increasingly likely that they decide their strategic interest to constrain the US at some point outweighs the economic considerations.”
Mr Leverett also points to what he says has been a series of unwritten but explicit understandings between the US and the oil producing countries of the Gulf that underpin the dollar’s role as the world’s leading currency by denominating oil contracts in dollars and linking local currencies to dollars in return for security guarantees.
Many economists play down such agreements – the dollar price of oil should not be affected by what currency it is priced in, determined as it is by supply and demand. But the way the US has pursued and cultivated such understandings for decades – Mr Leverett says from the 1940s on – highlights their significance for US policymakers.
“The arguments now on economic grounds are overwhelming that the Gulf Co-operation Council states, including Saudi Arabia, should drop the dollar peg” because of the currency’s decline, he says, alluding to many Gulf states’ worries that they are importing inflation because of the link to the low dollar. “Saudi officials will tell you it’s a strategic decision, not an economic one, that they are sticking with the dollar. That should be a real indicator to American policymakers and citizens that this is a real vulnerability.”
Indeed, at an Opec summit last month, Saudi Arabia headed off a push by Iran and Venezuela to price oil with reference to a basket of currencies rather than the dollar. In television footage apparently screened to reporters by mistake, Saud al-Faisal, Saudi Arabia’s foreign minister, argued that even mentioning the issue in the summit communiqué would weaken the dollar still further.
After the summit ended, Hugo Chávez, Venezuela’s president, declared that the “empire of the dollar is crashing”. Most economists and foreign policy analysts disagree, arguing that economic and foreign policy reasons mean that the dollar will maintain its pre-eminent role for the medium term. Many countries view the US Navy’s work in protecting oil flows out of the Gulf as a public good, providing a reason why the dollar-oil link is likely to persist.
Few economists expect a catastrophic collapse in the value of the dollar and many expect it to remain the world’s chief reserve currency for years to come.
But, challenging the consensus view, Menzie Chinn and Jeffrey Frankel of the US’s National Bureau of Economic Research argued in a research paper last year that, if the dollar’s decline continued, the euro could overtake it as the lead international reserve currency by 2022. Other economists have speculated that in the long term China will establish the renminbi as the dominant currency in Asia.
The effect of either scenario would not be confined to currency markets but could also have an impact on Washington’s spending patterns and financial clout – the nuts and bolts of 21st-century national security. The dollar might no longer be the source of the US’s power, but instead a factor in its decline.