James Saft

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

HUNTSVILLE, Ala. — While the U.S. will fight it kicking and screaming, the dollar’s upcoming fall from its central global role will be a blessing all round.

The World Bank on Tuesday predicted that the dollar will lose its place by 2025 as the principle global reserve currency, to be supplanted by a multipolar world where it, the euro and the yuan will share top billing.

First off, things have come to a sorry pass when the dollar is going to lose out to two currencies of which one, the euro, many people worry may cease to exist, and the other, the yuan, isn’t even properly convertible.

But beneath the ignominy lies a simple truth: being the world’s main reserve currency is a bit like being a pop star; there are lots of fringe benefits but it is very easy to end up in financial rehab.

There are several supposed central benefits to being the world’s principal reserve currency; lower funding costs, a home-field advantage in financial intermediation and better control over one’s own monetary policy. All three have been a mixed blessing, at best, for the U.S. and may yet turn out to be mostly malign.

“Countries whose currencies are key in the international monetary system benefit from domestic macroeconomic policy autonomy, seigniorage revenues, relatively low borrowing costs, a competitive edge in financial markets, and little pressure to adjust their external accounts. It has also produced a potentially destabilizing situation in which (a) the world’s leading economy, the United States, is also the largest debtor, and (b) the world’s largest creditor, China, assumes massive currency mismatch risk in the process of financing U.S. debt,” according to the World Bank’s report titled “Multipolarity: The New Global Economy.”

“Another shortcoming of the current system is that global liquidity is created primarily as the result of the monetary policy decisions that best suit the country issuing the predominant international currency, the United States, rather than with the intention of fully accommodating global demand for liquidity,” it added.

Because people must buy dollars to make many financial transactions, and central banks choose to hold dollars as a store of value, the dollar is too strong, borrowing in dollars is too cheap and there are inadequate controls on unsustainable behavior such as running current account deficits.

IT’S BAD TO BE KING

The U.S., both as a nation and a collection of individuals, would surely have borrowed less and arguably would have invested more if lower demand for the dollar had made real interest rates higher. It has been all the easier to believe fictions like the idea that we can all grow rich by buying each other’s houses when money was so cheap. There is then a direct line between dollar supremacy and the serial bubbles.

That brings us to monetary policy and the supposedly huge benefits of being free to run it the way you see fit. This of course has not always been true, Chinese buying of dollars and Treasuries has meaningfully impaired the Federal Reserve’s ability to control the economy.

Even beyond that, being able to run unimpaired monetary policy is akin to allowing small children to decide exactly what they will eat; they are going to tend to overindulge in sweets and get sick. Now part of that is due to the “heads,  asset holders win, tails, they get bailed out” policies of the Fed, which has concentrated wealth and rewarded people for taking on too much risk. It is impossible to know how the Fed would have acted if the dollar were not king of the hill, but it’s a fair guess to say they would have placed less faith in the benign powers of debt and consumption.

As for having a competitive edge in financial markets, this perhaps has been the real disaster, as America has financialized itself into a place with greater structural risks (think too big to fail), greater income and asset inequality and a hollowed-out manufacturing base.

Now, if you want to know why the world will become financially multipolar you simply need to look at the growth projections the World Bank made for developed markets between now and 2025 — 2.3 percent annually — and the same figure for the emerging world — 4.7 percent. Power and centrality will follow the money.

The new world will not be perfect either. If China opens its economy fully we will see a huge bubble as capital floods in to make money. And if you are not in one of the main currency areas you will face new and complicated issues of volatility and risk.

The key point is that this transition must happen gradually. If the dollar’s reign does end the hard way, all of a sudden in a currency crisis, it will be in large part because of temptations inherent in being number one.

(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.)

We’ve entered a new era in global financial markets: the U.S. is intentionally devaluing the dollar.

For the U.S., which has long espoused a strong dollar but in reality had a policy of benign neglect, this is the equivalent of pushing the big red eject button in the jet cockpit: something big is going to happen and we will have to see how it will work out.
The Federal Reserve on Wednesday moved to open a second round of quantitative easing, pledging to purchase a total of $600 billion of longer-dated Treasuries between now and the end of the second quarter of next year. As well, the Fed will reinvest $250-300 billion in the same period, meaning that the central bank will be buying up $110 billion a month in Treasuries and creating a like amount of new money out of the ether.

Perhaps the principal way QE will boost the economy, the Fed hopes, is by lowering effective interest rates, enticing investors to move into riskier assets, some of which may generate inflation and jobs. As well there is the wealth effect; the old canard of spending more because your retirement account and house have gone up in nominal terms.

The bald fact, though, is that by turning on the printing presses the Fed will drive down the value of the dollar absent a similar move in another currency. Much of the new investment created by QE will be made not in the U.S. but will be money borrowed in the U.S., exchanged into a foreign currency, probably an emerging markets one, and invested overseas. That will drive the dollar down, which will help to make U.S. industry more competitive.

There you have it; competitive devaluation, a beggar-thy-neighbor policy. It is not much of a lever, but it is one of the few which the Fed has left to pull.

Don’t expect anyone from the Fed or the Treasury to tell you this in simple declarative sentences, but it’s true nonetheless.

“Devaluation is the intention, and devaluation is what is going to happen,” Avinash Persaud, Chairman of Elara Capital told the Forex Forum conference in New York on Tuesday.

We can surely expect the U.S. to deny this, as Treasury Secretary Timothy Geithner did in October, but the truth will be seen in the foreign exchange markets, where the dollar has been falling and will fall further as the year winds down.

GETTING THE GENIE BACK INTO THE BOTTLE

It is most certainly in the power of the U.S. to begin a period of competitive devaluation. The U.S. dollar is a global reserve currency and the marginal cost to Bernanke of printing more is very low indeed. Less certain are the reactions of the rest of the world.

While the U.S. will surely have prepared the way for QE2 with its major trading partners (and in fact may be deliberately ticking off the Chinese) there remains a strong chance that a falling dollar sets off a range of tit-for-tat reactions. Already Korea and Brazil are moving to stem the appreciation of their own currency. Look too for the possibility of other countries joining in to QE, in part so that the Japanese yen, to name just one, does not rise too much against the dollar.

A currency war blossoming into a trade war has to be one of the outside but significant risks of 2011. If global growth can recover significantly this may be averted, but this is far from promised.

The second and maybe more important risk is that the U.S., having lost control over its own monetary policy many years ago due to recycling of capital by the Chinese, now loses control of its currency. Like going broke, this can happen little by little and then all of a sudden.

On the Fed’s reckoning it will go like this; QE2 and very low rates go on for an extended period, but almost as a matter of mechanics, when the Fed begins to tighten, the dollar recovers. The Fed has used the dollar lever to ease and then uses it to help to tighten. The dollar remains the principal global reserve currency and investors respond to the Fed’s incentives.

The alternative is that QE is not terribly successful in improving U.S. growth but does touch off a round of speculative investment elsewhere, investments that make returns in a shrinking dollar look worse day by day. When the time comes that the Fed, perhaps hurrying to prove its control, decides to stop QE2, bond investors want compensation for holding U.S. debt — a lot of compensation. U.S. equities, which have been held aloft by QE, duly fall sharply, as does the dollar, while yields spike. This is not a central case, but it is a possibility, and as it would be a disaster, one that needs to be watched closely.

Extraordinary times surely call for extraordinary measures, but those measures sometimes bring extraordinary results, and not always the ones we hope for.

(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.