The Dollar Is Still Central To The Global Economy. That May Not Last.

Aug 12, 2011

The U.S. economy is spooking investors. But every day, all around the world, foreign businesses are still eager to use U.S. dollars — even when their business has nothing to do with the U.S.

When South Koreans buy Chilean wine, they convert their Korean won to U.S. dollars, and send those dollars to the winery in Chile. The winery then converts the dollars into Chilean pesos. This kind of thing is routine in global trade, according to Barry Eichengreen, an economist at U.C. Berkeley.

Why not just go from won to pesos?

"It's easier for them to do two foreign exchange trades, both of which involve the dollar, both of which are standardized, both of which involve a very low fee or transaction cost," Eichengreen says. "Everybody else is doing the same transactions."

It's like how so many Delta Airlines flights get routed through Atlanta. The dollar is the hub of world trade.

This helps U.S. businesses, which often don't have to go through the hassle or expense of changing currencies. And the central role of the dollar means that foreign governments have to hold massive amounts of U.S. currency — which they tend to park in U.S. Treasury bonds.

"U.S. interest rates are lower than they would be otherwise because foreign central banks and governments find it convenient to hold our treasury bonds," Eichengreen says. "They lend to us more freely than they would otherwise."

This ends up being worth hundreds of billions of dollars a year to the US economy. But it probably won't last forever.

A hundred years ago, the British pound was the center of the financial world. The U.S. dollar's rise started after World War I, and continued after World War II. Today, the dollar is still the world's only viable reserve currency.

Safe-haven currencies like the Swiss Franc are too small to play that role. The Japanese yen is tied to an economy that's been stagnant for decades.

The only two contenders — the euro and the Chinese renminbi — have big problems of their own.

But Eichengreen argues that the euro is likely to survive the current crisis. And he expects China to liberalize its economy and allow the renminbi to become a more widely used international currency.

"Once upon a time it may have been true that there was only room in the world for one true global currency," Eichengreen says. "But ... everyone now can look at their smart phone and figure out what the price of a euro or a chinese renminbi is in terms of dollars."

In the long run, Eichengreen sees a world of multiple reserve currencies, where the U.S. dollar plays a diminished role.

The U.S. would wind up paying higher interest rates, and U.S. businesses would have to use other currencies more often. But as long as the change is gradual, it shouldn't entail too much pain for the U.S.

But there's another, more worrisome possibility. Eichengreen describes it like this:

...one can imagine a real crisis of confidence in the dollar that at some point in time down the road, foreign central banks and governments and private investors throw up their hands and say: "This is not a serious country. We better look harder for other places to put our money." And at that point in time, if those other places exist, there could be flight away from the dollar and the dollar crash that people worry about. And that could be in fact be seriously disruptive to the operation of financial markets and to the stability of the economy. That's the thing to worry about.

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