Future of the Dollar dollar ("dollar")

is the world's reserve currency of choice, but at various points in its history, critics have pointed to other currencies as potential vehicle currencies of choice. While in the 1970s or 80s it might have been the yen or the deutschmark, the creation of the euro in 1999 brought a new competitor onto the scene. In its first few years, the euro became increasingly popular. With the Eurozone having an economy nearly as large and robust as the American economy to back it, the 'common currency' began to make inroads as the world's vehicle currency. Nations with closer ties to Europe than to the United States were among the first to make the switch, but many major nations have some operations (debt issues, for example) in euros. Today, there is also some speculation that the yuan could take over as a vehicle currency, or that a basket currency could be created using a number of different currencies (Fisk, 2009).

This paper will analyze the future of the dollar. The first step in understanding the future of the dollar is understanding how the dollar came to be the world's reserve currency. It is also important to understand what a reserve or vehicle currency is, and how the dollar is currently playing this role. In addition, the new currencies that might threaten the dollar need to be analyzed -- their relative strengths and weaknesses are important to the future course of the dollar. Consider that the dollar overtook the pound sterling as a reserve currency through its own strength, not necessarily because Britain actively removed its currency from this role. Lastly, the analysis will conclude with a determination of the likely future course of the dollar.

Modern Monetary System and the Rise of the Dollar

The modern monetary system had its antecedents at Bretton Woods. In brief, the outcome of this meeting was that the price of dollars was fixed in local currencies, both replacing the gold standard and establishing the dollar as the leading currency in the capitalist world (Urban, 2009). The latter was essential at the time -- Europe was rebuilding from the war and once-dominant Britain had been superseded by the United States for economic supremacy in the world. While other currencies had their rates pegged to the dollar and were allowed some minor adjustments, the dollar was pegged to the value of gold.

In 1971, Bretton Woods was replaced by a system of free-floating currencies. This effectively reinforced the division between the world's "hard" currencies -- USD, GBP, DEM, HKD, CAD, CHF, etc. -- and the other currencies. Many of the latter either floated freely but were volatile, or became fixed to hard currency exchange rates. The hard currencies would become traded on global foreign exchange markets. This shift removed gold from the international currency system, placing more emphasis on the dollar.

Currencies under a free floating system are fiat currencies in that they are not underwritten by any specific asset. Prior to 1971, the international currency system was either directly (prior to Bretton Woods) or indirectly underwritten by the value of gold reserves. The shift was more psychological than practical -- gold is essentially a fiat store of value itself, often trading far above its intrinsic value precisely because of its traditional role as a store of value (Indiviglio, 2011). The underlying asset in the modern monetary system is the economy of the nation or group of nations that backs the currency. The United States being the world's dominant economy at the time and the only capitalist superpower, the dollar naturally became a reserve currency of choice, following on its Bretton Woods-era role. The currencies of other nations would sometimes play a small regional reserve role, but the dollar came to dominate. Other strong currencies such as the deutschmark and the yen were touted as potential successors to the dollar in this role, but for that to occur, the U.S. would have to have lost its status as the world's dominant economy. Both Germany and Japan are much smaller than is the United States, so unless the U.S. economy completely collapsed, neither of those currencies represented much more than a regional threat.

The dollar's role as reserve currency is manifested in a number of ways. Foreign trade is often conducted in dollars. Even between two non-dollar nations, trade is often conducted in dollars. This is done in order to mitigate foreign exchange rate risk, to provide trade terms that are familiar to all counterparties and to take advantage...

As a result of this usage of the dollar, 85% of foreign currency trades worldwide are trades of other currencies for dollars (Eichengreen, 2011). Flowing from this dollar-centric activity is that 60% of the world's foreign reserves in central banks and governments are held in dollars (Ibid).
The dollar's dominance is supported by a number of competitive advantages. It has economies of scale. The sheer volume of dollar trading means that the liquidity of dollar-based exchange is better than for any other currency pairing. Spreads are lower, and this lowers the cost of foreign exchange for companies doing business internationally. The dollar is relatively stable as well, and this means that dollar-based transactions have lower risk for the counterparties than would transactions in any other currency.

The dollar is the unit of currency for global commodity transactions. With the world's most critical resources being traded in dollars, there is constant demand for dollars. This situation also creates significant liquidity. No other currency can match dollar liquidity in part because the dollar is used to trade for all major commodities. And liquidity is critical. The reason that the dollar is considered by investors to be a safe haven from economic distress, even when that distress is centered on the U.S. economy, is that the dollar has the greatest liquidity of any currency by far (Eichengreen, 2011).

The global use of the dollar, while easy to take for granted, is still underpinned by the strength of the U.S. economy. The United States has the world's largest economy. It is fractionally smaller than the European Union, but the Eurozone does not include the United Kingdom, leaving the U.S. As the largest economy in the world that backs a single currency (CIA World Factbook, 2011). The economy is diverse, backed by a massive population, a high level of average wealth, immense natural resources, robust capital markets and a culture of entrepreneurship that allows the U.S. To produce many of the world's leading companies. The United States also has a perfect track record of paying its debts (U.S. Treasuries), and has traditionally been understood to have the capacity for paying for these.

Decline of the Dollar?

Eichengreen (2011) argues that the dollar's decline is possible, for a few reasons. The first is that the underlying strength of the dollar -- the U.S. economy -- is called into question. The government of the United States is a fractious, dysfunctional system with politicians who are foolish, obstructionist, ignorant and generally unable to deal with the major problems facing the country. The markets do not currently feel that the U.S. is at any real risk of default, as evidenced by bond rates, but there is enough concern about the toxic state of American politics to downgrade U.S. debt for the first time since the international monetary system was developed (Paletta & Phillips, 2011). Of particular note is the country's inability to come up with credible solutions to the long-run budget problem, or in the case of health care reform the inability of some members of the political system to accept credible solutions when they are introduced. Fiscal austerity combined with tax cuts for the rich will not solve the problem, the markets know this. This calls into question the ability of the U.S. To ensure its solvency in the long-run.

It is worth pointing out that the current state of politics is not necessarily indicative of the country's long-run ability to manage its debt and make payments on its Treasuries, and the entire debate could be much ado about nothing, but for the first time questions are being raised. There are stronger economies in the world with better rates of stability but these -- such as Switzerland or Canada -- are not nearly large enough to have anything even close to the dollar's liquidity (Eichengreen, 2011). This leave the future of the dollar in the hands of the American government and in the currencies that some feel are potential competitors -- the euro and the yuan.

Another potential competitor lies in the concept of a basket of currencies. The idea was floated in 2010 that a basket of currencies including the yen, yuan, euro, a common Gulf state currency and gold could be used to set the price of oil (Fisk, 2010). This would represent a serious challenge to the dollar if it was replaced as the medium of exchange for one of the world's most important commodities. The constituents of any such basket would immediately gain a sharp…