Are We Witnessing the End of the US Dollar's Hegemony?

11/19/2010 12:01 am EST

Focus: FOREX

By: Rosanne Lim

When politicians and policy makers see an economic problem, especially one with the scale of the financial crisis today, they feel obliged to solve it. Unfortunately, the measures they've implemented have not worked so far. In fact, their policies have the opposite effect because it reinforces imbalances. The monetary stimulus just whetted the appetites of consumers to purchase even more imports. Meanwhile, the second round of quantitative easing might only make it worse.

So investors, analysts, politicians, and policy makers all over the world are looking for a solution ― and found the culprit: the dollar. Because it is used as a reserve currency, Americans enjoy almost boundless spending.

At the very start of the financial crisis, it was already clear to many that the dollar's hegemony would be in question. Along with this is the fear that America's dominance will go right down with it. This process may take time, possibly more than a decade, but the process has been set in motion. And there is no doubt that countries including China, Brazil, and possibly even France will insist that it continues.

It is important to look back at the credit crunch and the reasons behind it to understand how the dollar has reached this crucial point. Huge trade and capital imbalances have already existed for 20 years. The world is divided into surplus and deficit countries. The giant gap between the two is very dangerous. Basically, there are countries that manufacture products and save money (surplus nations) and there are countries that borrow the former's savings to buy goods and services.

To put it simply, the richest economies are actually borrowing money from the poorest nations to pay for goods ― which are the same products that are beyond the reach of people producing them. If you take it at face value without looking at the structures supporting it ― this set-up is very strange indeed. But this is exactly what happened between the United States and China. The credit-fueled glut that resulted was bound to end in a corrective global recession. This was bound to happen even without the real estate bubble that excess savings (from surplus countries) produced. The global recession is still being felt in the present.

In the short-term USD chart below, the dollar rallied against most expectations after the news of the $600 billion QE2 was announced.


Click to Enlarge

There is a theory that other major currencies will follow the dollar's lead and a currency war will gain intensity. Another belief is that the markets have already expected this move, so it has already reacted, even before the official announcement. Though the USD decline is over for now, further effects of the QE2 may be seen in the coming weeks.

Last Monday, Robert Zoellick, the president of the World Bank, revealed that gold should be considered as a yardstick. This surprised everyone because it goes against 40 years of reliance on paper currencies. During the last two months alone, the dollar has already declined by 6% against other major currencies while gold jumped to 17%. The latest surge in gold prices, ironically, came from Washington.

As the Fed prints more money, more dollars will go after the same supply of commodities ― driving its prices higher. With the interest rates kept at a minimum (short-term rates closing in on zero), investors have little to lose and much to gain if they hold gold. But as a sign of gold's volatility, its price quickly lowered to $1,392.90 on the same day as it reached $1,424 an ounce. This was prompted by comments from Mark Camey, the governor of the Bank of Canada, stating that this precious metal has "no role to play in the international monetary system". Not yet ― he might have added.
Gold is a perfect example of investor worries about inflation. But the prices of other commodities, including cotton, wheat, and copper, also rose drastically on Tuesday. The rush to gold is not driven to the hedge fund market either. Individual investors are scooping up as much physical gold as they can. In printing more money, the Fed is not only stoking fears of inflation, it is also lowering the cost of holding this metal.

NEXT: Ending the Dollar's Hegemony

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Ending the Dollar's Hegemony

There is no doubt that surplus nations will defend their mercantilist economic models. Exporting to the rich world has benefited them greatly and they would not be willing to change the status quo for the rest of the world. China, for instance, won't accept currency appreciation because it will undermine their export industry. But even if they do let it appreciate, it probably won't be enough to solve the problem. In addition, surplus countries have an uncanny knack to maintain their competitiveness in the midst of appreciating currency.

Since currency reform seems impossible at this point, the United States has turned to monitoring countries' current accounts directly in an effort to limit imbalances. The proposal was welcome by the G20. Sighs of relief can also be heard from US politicians and policy makers because this measure will cool hot-heads in the meantime. Engaging in a trade war would benefit no one. China, in particular, also championed the proposal with obvious relief.

Such measures can only go so far, though, because underlying problems need to be addressed. Parallel rules can be seen within the Eurozone. Let's be realistic. If the EU has failed to maintain fiscal discipline in its member countries, the possibility of this kind of set-up working on a global scale is remote. Even if there are sanctions involved, rules will be manipulated by everyone who strives to seek an advantage. In addition, the 4% cap on deficits and surpluses would place a burden on smaller countries, while only marginally affecting big economies. For example, for a country like the US, a trade gap of 4% GDP still involves a massive amount ― which is capable of contributing to surplus savings.

With that, global imposed regulation isn't likely to work. It might stop the problem from getting worse, but it won't solve the issue at its core. The next alternative is to stop using the dollar as the world's reserve currency. As everyone already discovered, the dollar's hegemony was, in itself, already dangerous. It allowed for almost boundless borrowing by the US at very affordable rates.

If the United States remained as the world's dominant economy, and the country represented a major percentage of the global economy, using the dollar would still make sense. However, America has already squandered their advantage through credit-fueled spending. The developing world will also represent over half the world's economy in just five years. Thus, the dollar hegemony would not be appropriate.

Countries from Germany to Russia are already questioning the merit of using the dollar as a reserve currency. These concerns are legitimate because the dollar is indeed being governed by the domestic needs in America. There are also questions about the country's ability to pay debts.

Alternatives to the dollar are being proposed. But many countries don't want to wait for these alternatives. Instead, central banks around the world are diversifying their reserves, including gold. The shift to other currencies and gold will exert a certain level of discipline on the US.

Rosanne Lim is a contributor to SunshineProfits.com.

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