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John Quiggin

Reserve status under threat

John Quiggin Australian Financial Review

3 July 2008

The news that the Australian dollar has once again approached parity with its US counterpart has been attributed to the strength of commodity prices and to expectations of higher interest rates. But, whatever might explain the latest news, the real story is not the rise of the $A but the decline of the $US.

In fact, measured against the euro, the Australian dollar has traded in a narrow band, from 56 to 66 euro cents ever since the currency was introduced in 1990. And until the recent decline associated with the financial crisis originating in US mortgage markets, the British pound displayed similar stability against the Australian dollar and euro.

Contrast this with the US dollar, which has halved in value from an all-time high of $A2.12 to its current value of $A1.04 in just seven years. This is the reverse of the usual way of quoting things, but it is more relevant in many ways. The convention of quoting exchange rates and commodity prices, such as the price of oil, in US dollars is one outcome of a global financial system in which the US dollar acts as the reserve currency.

The decline of the US dollar, and the trends that have contributed to that decline, raise real questions as to whether the dollar can continue to play the role of a reserve currency.

On the standard textbook account, money serves three main purposes. It is a medium of exchange, a store of value and a unit of account. In the international context, a reserve currency plays the same role.

It is as a store of value that the US dollar is proving unsatisfactory. Although currency values have fluctuated ever since the breakdown of the Bretton Woods system, the decline of the dollar appears likely to be sustained.

Even after steep depreciations against most currencies with market-determined exchange rates, and smaller, but still significant depreciations against managed currencies like the Chinese yuan, the US is still running a large trade deficit.

US inflation rates are higher than those of most of its major trading partners. Moreover, the US Federal Reserve has shown a much higher tolerance for inflation than other central banks. By focusing on measures of inflation that exclude energy prices, it has taken a bet that increased commodity prices will not feed into broader inflation. As a result, the the Federal Funds rate has been cut to 2 per cent (a negative real rate) at the same time as interest rates have risen elsewhere..

Finally, the crisis originating in the US subprime market casts doubt on the assumption that US financial assets represent a safe haven for investors concerned about financial instability. The downgrading of large numbers of AAA rated assets to junk status, and the rash of defaults that has followed must cast doubt on the safety of investments presented as virtually risk-free.

But if the $US no longer meets the requirements of a reserve currency, what can replace it, and how will this change come about? And does the concept of a reserve currency make sense any longer?

The obvious alternative to the $US is the euro. At current exchange rates, the eurozone is the world’s largest economy. And the euro share of reserves has been growing. Still, neither of these, in isolation, would be enough to allow the euro to achieve the kind of dominance that characterized the dollar in the early postwar period (or, before that, the pound sterling)

One possibility is the euro equivalent of dollarization, with the eurozone potentially expanding beyond the EU, along with a growing penumbra of currencies pegged to the euro or targeting a euro exchange rate.

Thus far, the eurozone authorities have shown no interest in such a development. Suggestions that Iceland might adopt the euro without joining the EU have received an appropriately chilly response from the European Central Bank.

Another alternative to a dollar-based financial system would be based on a basket of leading currencies, the most obvious candidate being the IMF Special Drawing Right. However, a shift of this kind would require the explicit consent of the US, and therefore seems unlikely.

So, the most likely outcome is that the reserve currency role of the US dollar will be eroded over the next decade or so, but that no single alternative will emerge for some time. The absence of a generally accepted reserve currency will make for interesting times.

John Quiggin is an Australian Research Council Federation Fellow in Economics and Political Science at the University of Queensland.

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