The dollar’s Tinkerbell moment

By J Saft
July 7, 2009

James Saft (James Saft is a Reuters columnist. The opinions expressed are his own.)

Repeat after me: “I believe in a strong dollar as the primary global reserve currency, I believe in a strong dollar as the primary global reserve currency.”

Better hope it works, because the current debate over a far-in-the-future new monetary system may bring on a here-and-now dollar selloff and a whole new leg of the crisis.

Sadly, what worked when the children espoused their faith in Tinkerbell may not for a currency backed by the full faith and credit of a debtor nation which has socialised its banking system’s risk and needs to sell trillions in further debt to pay that and other bills.

Russia, India and, most significantly, China have all questioned the U.S. dollar’s central role in global trade and currency reserve management in the run-up to this week’s meeting of the Group of Eight industrialized nations in Italy. The future, it seems, is not greenback.

Russian President Dmitry Medvedev termed the system based on the dollar “flawed.” Suresh Tendulkar, a top Indian economic advisor said he was telling India to reduce the dollar’s weighting in setting the value of the rupee, comparing the situation to the classic “prisoner’s dilemma.”

It’s a good comparison, and as such makes his advice, and his choosing to make it public, puzzling. In the prisoner’s dilemma, two people are held for a crime and, being held apart, must decide whether to rat the other out. If both remain silent, they each get six months’ jail time, if one implicates the other he goes free and the other gets ten years, if both turn on one another they both get five years.

If holders of U.S. dollars can somehow maintain confidence in the currency, the value of their reserves will be protected, but the temptation to get a first mover’s advantage and get out while the getting is good may be overwhelming, though it will only work for that individual if everyone else more or less keeps faith.

Because, if they don’t the selloff could be so disorderly and damaging to the global economy that it will make concerns over the value of reserves look silly.

China, for its part, seems to be furiously paddling in both directions at the same time; saying that the dollar will retain its central status for “years to come” while also doing things like setting up a system to allow companies to settle cross border trades in yuan.

Writing in a newspaper published by the Chinese central bank, Li Ruogu, Chairman of the state-run Export-Import Bank of China said that Special Drawing Rights (SDRs), a unit of account used by the International Monetary Fund, could be molded to serve as a more representative global settlement unit, based on a basket of currencies. This echoes suggestions made by Chinese officials in March and can leave little doubt that the Chinese are preparing for a very different future.

“The financial crisis caused the global economy to suffer heavy losses and it also let us clearly see how unreasonable the current international monetary system is,” Li, a former central bank vice governor, said.

WHAT’S THE ALTERNATIVE?

He’s right, the old set up under which China kept its currency weak and U.S. borrowing rates lower than they otherwise would be made it too easy for the U.S. to load up on debt and almost surely was the fundamental underlying driver that led to the sub-prime mortgage crisis. It created conditions under which the huge risk management failure within banking was more likely. After all, when money is cheap and people are desperate for a bit extra yield, bad loans will begin to look safe.

Of course there are no credible current alternatives to the dollar at this point; not the euro, which might fracture or grow, or the yen or even the Chinese yuan.

And there is the danger: the very knowledge that the current dispensation is under review, and for extremely sound reasons, means that there is a small but dangerous chance that it unravels, that holders of dollars and buyers of U.S. debt lose faith leading to an uncontrolled fall in the dollar and in dollar-based assets.

It is all very similar to the banking crisis. A bank is only sound so long as we believe it to be, and the dollar, given the U.S’s weak fundamental position is only strong and worth holding so long as holders keep faith.

Really all we are observing is the continuation of the banking crisis on another plane. Last year the world lost faith in the U.S. banking system. The U.S., feeling it had no alternative, stepped up as effective guarantor of its banks and its financial system.

Well and good, and here’s hoping it works. It only will succeed however if faith in the U.S. and its dollar remain.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

30 comments

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Why are you omitting gold as a currency ??

Posted by baaa | Report as abusive

Have you been on holiday Mr Saft? some may call you a doomsday sayer, but the truth is that you are quite correct in most of your articles. The world economic system is unravelling, years of cheap credit and now the ballon has bust. Unfortunately all government can do is to paper over the leek and keep us afloat. The dollar like the market should be left to fall or rise naturally, no gain without pain.

Posted by P Iggy | Report as abusive

Suggest everyone go back and read what determines the “Value” of a nations currency AKA infrastructure, education, manufacturing, resources, income distributions, military to civilian spending, R&D, debt, etc, etc…

Time all the economic “wizards” and more so this nation on the backside of a dumb down curve, learn the subject matter. USA is failing in what makes the dollar the worthy dollar..and all the “Cheap imports”.. soon may not be so..

Way past time for our “education systems” to include college start to do their job and move on from entertainment and baby sitting so many practice now. Time to wake up and read a bit folks, China and rest of world is going to move on and leave us a “tourist mecca of the world”.. and little else. Time to start to learn what sets the value of currency and os far not to much posted anywhere..

Posted by Chuck | Report as abusive

The problem with the US dollar is the enormous effort being made to financially engineer an economic recovery in the US. So a company that buys US dollars or has a contract in US dollars for future delivery shoulders a greater risk of fluctuations. So from a functional standpoint, it is difficult for world markets to keep using the US dollar.

But people who regularly deal with the US will still do so in US dollars regardless of these talks. I would think that any changes would focus on the global pricing of commodities. Essentially these people at these meetings are a bunch of old men with nothing better to do with their time. Soon after they get home they will start screwing around with stuff and mess everything up. So keep them at the meeting as long as possible.

Posted by Don | Report as abusive

Actually Mr Iggy, I’ve moved back to the US, but will be writing regularly from here. Thanks for reading.
Doomsayer, Moi???

Posted by james saft | Report as abusive

Where you been jimmy? There has been no one to tell it like it is round here. All optimism and fanfare without the veritas.

Posted by James | Report as abusive

The dollar will succeed as the world’s reserve currency for a long time even if faith in its value (and the US government) is wavering. Simply put, there are not enough other-currency denominated assets to absorb global savings. From commodities to securities, global investors still view dollar assets as the safest, strongest investments. A lack of investment opportunities is one of the reasons why the Euro failed to become more prominent. It will also be the reason why the IMF’s special drawing rights (SDR) will fail. The Prisoners’ Dilemma applies to this situation, however, the author’s payoff structure is skewed. Collusion to withdraw is the best outcome in the short run because of long term inflationary pressures that will transfer wealth from debt holders to debt issuers (primarily the US Treasury). However, a lack of alternative investments compels global savers to continue purchasing dollar-denominated assets. This is a beauty contest of the uglies, and even a weak dollar is better looking than everything else.

Posted by Yun Wang | Report as abusive

“…by the full faith and credit of a debtor nation which has socialised its banking system’s risk and needs to sell trillions in further debt to pay that and other bills.”

I wish everyone making policy had been fortunate enough to be privy to your ingenious plan to otherwise offset the banking/credit crisis, as you must have had one as circumspect as that sentence was contemptuous. Odd that many of the above have been threatening to leave the dollar for quite a while, and are strategically unable to do so.

Posted by Justin | Report as abusive

My view is that the $ is heavily overvalued. It’s just a commodity bubble that has to burst.

Posted by J Fernandes | Report as abusive

Yun,
Exactly right! All the amateur economists listen to CNBC for a couple of months and suddenly speak at length about the impending failure of the dollar. The truth is that the fate of the entire system rests on the US economy and the dollar. China buys $ not just because it is the safest asset in the world today but because it helps them to force the yuan below the dollar. Without this artificially undervalued currency and U.S. demand there would be no Chinese economic miracle. There would only be a massive country with a billion people falling back into complete poverty. The Chinese know this, the world knows this and therefore wont move forward with any real plan for a change in dollar policy.

The current dibble being spouted by the G8 is nothing more than the expression of local politics. For all the goldbugs out there talking about taking the world back on the gold standard, you are all batsh*t crazy. Sorry guys there isnt enough gold in the world to accomplish what you are talking about without taking the global economy back to the 1900′s. There would be no way to maintain a global population of 6 billion without the velocity and expandability of a fiat currency. Are they all doomed to failure? Perhaps but there is currently no viable alternative.
So what is the moral of this story? Like Yun said its a contest of uglies and our contestant is the prettiest by far.

Posted by randy | Report as abusive

There have been talks of a different currency replacing the greenback, but no one says when or how. Diluting the intrinsic currency value of the $, by printing more of it could soon pave the way to its drastic devaluation.

There is also a lot of insight available on the book “Biography of the Dollar” by Craig Karmin.

Buckle up! Overall, it sounds like interesting times ahead.

It’s just another bubble waiting to pop. And like the rest over the past several years, once the run to the exit starts, the only \”winners\” are the ones who got out while the getting was good.

Problem with that is when you\’ve escaped the latest \”bigger idiot theory\” bubble, the only place to put wealth where it won\’t sink anyway is in the next bubble.

Fewer jobs, less hours and lower pay means the world economy that has gladly loaned the \”keeping up with the Jones\’\” style Americans more than they could ever repay is about to find out that to have a consumer economy, you can\’t artificially create them. The extremists on both sides are missing the one vital item: businesses need consumers, or they have no consumers, and consumers will have to return to purchasing goods on some criteria other than the cheap garbage from China is cheaper.

The late run up of gold shows that even that\’s turned into a bubble of last resort.

In the end, it doesn\’t matter (years from now) what the reserve currency is. What matters is a new economic system not based on every nation loaning money to one to buy their exports, and hoping against reason that the insanity of such a doomed and insane model won\’t collapse. Free trade can\’t function on money loaned to \”consumers\” that are in reality nothing more than greedy and shortsighted children thinking Grandpa will live forever to give them more money to run to the candy store.

Posted by Brian Foulkrod | Report as abusive

Good article.

The problem will be compounded by the unemployment tidal wave now hitting the USA. This together with Alt A mortgages adjusting during the next few months will cause massive losses to the banks which have been kept afloat by the Fed. Already there are discussions about a new bailout package whilst only a few weeks ago Obamie was saying that there was no need and that unemployment had stabalised. Also, as unemployment rises and savings rates rise as well the GDP projections by the Govt will be shown to be the pipe dream they always were. As this happens Govt debt rises and this will undermine the Dollar as well.

The problem is that Obamie has not got a clue about economics. He believes that the world will continue to allow the printing of US Dollars:I do not think the world will allow it.I read the other day a phrase an American from Texas had written about Obamie and it was this ‘He is a cowboy with a hat but no cows’.Time will tell.

Posted by D Rumsfeld | Report as abusive

Gosh…how many western commentators does it take to change a light bulb? China’s “paddling in both directions” and India’s comments about “prisoner’s dilemma” is about posturing – telling the US that if they don’t take China and others seriously, they DO have the ability to talk to system into self-destruction just by talking about a far flung future. Geez…

Posted by P | Report as abusive

Until the USA fixes its core political and financial systems, the dollar will collapse. i.e. The USA cannot continue to spend 50% of every tax dollar on the military, every cent of which contributes to the deficit. People cannot be extended irresponsible credit card debt, and no-recourse on mortgage default. Education corrupted by big teacher unions and political correctness have crippled American science and technology leadership. Bonehead policy such as making bio-fuel from foodstocks, and bloated bureaucracies creating endless administration with oceans of “laws” has to stop. Why else do we need more lawyers per capita than any other country in the world? The system is broken, and borrowing money from China or Russia to fix it is a deeply flawed solution without having repaired core cancers in the American society — and that is what drives the rest of the world to look for another currency.

Posted by Milly O'Naire | Report as abusive

USA is gradually losing the vision that gave it the right of uncontested leadership, and this is a process that started in 1990 after the fall of the Communism.

To claim the EURO will break or fail require solid argumentation; so far, the EURO Zone led by a solid German economy and a low-leveraged financial system, seem to prove wrong all the doomsday advocates.

We will witness soon a drop of the USd in the international trade from 65 to less than 45%.

Posted by paul | Report as abusive

As there are major foreign policy differences between the U.S. and both Russia and the PRC, it would be prudent not to assume that an economic arrangement beneficial to the U.S. can rest on their goodwill forever. The U.S. has great natural resources and educated people. It can decouple its prosperity from the vagaries of the world economic system by what is usually derided as protectionism; the only price would be that the Americans who already do have jobs would be paying higher prices to buy things made by less-fortunate Americans rather than cheap imports.

no government will consider gold backed money because it kills the principle way all governments control populations – namely with paper money.

The idea that there is not enough gold in the world is ludicrous. Any amount of gold is enough because each subunit of gold (gram, microgram, etc) will keep buying the respective amounts of goods and services.

The main problem is that on country to country relativity, countries dont’want to be stiffed anymore by other countries (ie: dollars), but on a government to citizen relativity governments want to continue to stiff their citizens(subjects)with paper money. That’s how governments force their subjects to dance the government tune.

Until the idea of human allegiance to a country dies (and private property arises), humans will continue dying in devotion to a false god.

The real prisoner’s dilemma here is the prisoner has been in jail so long, the prisoner has fallen in love with jail and the warden!

Posted by earl | Report as abusive

“A lack of investment opportunities is one of the reasons why the Euro failed to become more prominent. It will also be the reason why the IMF’s special drawing rights (SDR) will fail.”

If there were no more dollars, no more euros and no more SDR, and everyone traded in one universal currency, then it would be possible to make investments anywhere, assumming they were not in contravention to local laws.

Posted by tom | Report as abusive

Don’t forget the Obama factor. Few Americans are incapable of seeing him for what he truly is, but non americans know what he’s about. They know he’s here to destroy America…..

Posted by Cyn | Report as abusive

to Mr. Wang
….the alternative currencies are tangibles today, raw resources, oil, natgas, precious metals, semi precious metals, agricultural foodstuffs, and etc a large list. One has to stop thinking in terms of pseudo wealth and think in terms of actual wealth. Real wealth is grown, mioned or extracted, and then manufactured or given value added from the previous two. Aqll else is wealth rearrangment, wealth skimming, wealth punditry, wealth “governance” and so on.

The smart ones are trading their soon to be worth-less digital electronic promises to pay to the less smart ones for long term access to real wealth, like in the case of china, buying up or contracting for most of productive Africa,(swapping their depreciating in value digits for the “real stuff” to the local stupid warlords) or just stockpiling what they can get now, such as the huge warehouses full of copper ingots they are stashing away by the shipload.

Tangibles rule. That’s the main lesson to be learned from man’s history.

Debt and snakeoil lie based casino bankster fraud “instruments” are such a con and a scam, including the fraudulent private Federal Reserve “note” or labor IOU, that millions of thinking people, rich and not so rich, are sliding away as fast as they can from storing their wealth in such dubious “products”.

Until there is a commodity based currency, something akin to Keynes “bancor”, not just gold backed but backed by a basket of useful commodities, which are real wealth, all these central bank notes from here or there remain suspect.

These big bankster frauds are just panicking that their old congame is being exposed for what it is.

Posted by zogg r mann | Report as abusive

The U.S. became the reserve currency by cornering the gold market when we were on a gold standard. What will be the next reserve when no currency is reliably on a gold standard?

Posted by Arthur O. | Report as abusive

I agree – we have lived in a false balloon -created by false profits – for so long we have forgotten what real wealth is … it is tangible stuff, land, gold, and houses are OK.

My grandfather had a saying that went like this, ” if you don’t have the money in your pocket to buy it you don’t need it,” never buy on credit. He kept his cash rolled up, and held together with rubber bands in old cigar boxes – he did not trust banks – I now know why.

Land was his value, and we (government) is selling it right out from under our feet. Other countries probably own more of this country than many realize, and country is only on loan to us, till we die, because we will never be able to pay-off our debts. Our founders would be ashamed of us right about now – don’t you think?

Posted by Tim | Report as abusive

The transition to a Single Global Currency can be as smooth and trustworthy as the transition in Europe from the legacy currencies, e.g. franc, mark, lira, to the euro. Preparing for such a transition will take a lot of planning and research. At some point, holders of dollars must be reassured that they will receive the equivalent value in the new currency, just as holders of the preeminent pre-euro European currency, the mark, received the correct value for those marks.

WHAT’S THE ALTERNATIVE? What about trading whitout any money involved! Iran traded oil for Thai rice for instance. A very large, very underestimated proportion of world trade is done this way. Countries who have this possibillity and don’t want to stick their necks into the “dollar guillotine” are going to increase this way of trading. But I have to agree that not every country has this possibillity but still, it’s an alternative for some countries.

Posted by Youri Carma | Report as abusive

The U.S. Dollar: created over two hundred years ago, kinda like the Earth, but only took a generation or so to turn to radioactive dust.

Faith-based economics… gotta love it!

Posted by The Bell | Report as abusive

What will the effect be of a successful Ron Paul inspired revelation of how the Fed works have on the trade-ability of the mighty dollar? It seems Ron has cobbled together a coalition of American lawmakers sick of being out-bid by the lobby-groups Obama was going to consign to history (ha-ha-ha) in Fed decision making!
Perhaps a return to the gold-standard makes more sense now than at anytime since Nixon ditched it… including when Nixon ditched it… unless of course you are the guy sitting next to the printing press!
Good to read a James Saft article, it been a while. I guess there hasn’t been much worth writing about recently?

Posted by Peter H | Report as abusive

Dear,Mr.James,
You have created lot of interests to me go thorough of your article.
I have been watching American and English economy since so many years.
Today, i firmly believed that,so many developing nations American education system and started for applying by their own set of formulas.
That works,produces good returns by standard of living,more jobs in I.T.Sectors,coonstruction activities,and very concrete methodology in financial sectors.
As on today,even world recessions gave only cautious signals to India,China,Brazil and Russia.
But America,England,Germany,Japan and some western countries had not come out from bad economic stages.
Please see the reasoning on modern terms than seeing only historical ways.
All your writings had some valuable answers from G8and from G5 summits.

Everyone get ready for a Super-Depression.
Its coming.
We will return to the age of local economies and local food supplies.
Some of it will be good, some will be bad.
Either way, its coming.

RLS

Posted by Ron S. | Report as abusive