Reserving Judgment

The U.S. dollar enjoys a privileged position in the world.

The federal government can print up the little slips of green paper and exchange them for barrels of oil or digital cameras. That trick is not unique to the United States; almost all countries print money and spend it at home.

The difference is that the dollar can be so easily spent abroad and that foreigners are so willing to hold on to large quantities of those little slips of papers, instead of trading them back in for American-made goods.

This raises the question: Is the dollar likely to be replaced as the world's reserve currency?

There have certainly been similar shifts in the past.

Some time in the first half of the last century, the dollar took over the exalted position long held by the British pound. Nor are the questions about the dollar's status as a reserve currency merely conservative fantasies aimed at stirring doubts about President Obama's leadership.

As with so many other things, this idea was made in China. Alarmed by his country's exposure to a potential slide in the dollar, the head of China's central bank floated the idea of a global currency to replace the dollar.

The Russians liked the idea.

The United Nations and the IMF were intrigued.

If we're to hold auditions for a new dominant global currency, we can start by considering the job description.

We're really looking for three things in an aspiring new currency:

▬It must be widely traded.

▬It must be linked to deep and open capital markets.

▬It must provide a stable store of value.

The dollar excels on the first two counts.

Given the size of the U.S. economy, the dollar has a broader reach than any other currency. U.S. capital markets (bonds, stocks) feature enormous trading volumes; that means that a government wishing to adjust its reserve position by selling Treasury bonds generally need not worry about whether it can unload them.

The dollar concerns stem from fears about U.S. fiscal incontinence. The Obama administration often deflects such concerns by arguing that it is necessary to run large deficits in a time of economic crisis. This conflates the short-term and long-term deficit problems. The administration declared early on that America's fiscal position was unsustainable because of burgeoning entitlement costs, especially in health care.

Yet the plans under consideration would likely increase overall health spending while raising the government's share of costs. Nor has the administration earned much credibility for its promises to offset costs.

The situation beyond health care does not look much brighter.

Runaway deficits can spiral out of control and have frequently ended in bouts of serious inflation, as governments print money to cover costs. That directly undermines the currency's role as a store of value. Inflation means that those green slips of paper buy less tomorrow than they do today.

Hence, the search for a successor to the dollar. But a review of the serious applicants suggests the dollar's position is secure, at least for a while.

At the front of the line is the euro.

It already accounts for almost 30 percent of global reserve holdings, compared to the dollar's roughly 60 percent. The euro zone certainly has the economic size to be a viable contender. But the recent crisis has shown up some serious weaknesses in the currency.

First, there was the question of how the euro zone would deal with bank failures, as in Ireland and Iceland. The European Central Bank does not have the full panoply of powers enjoyed by U.S. federal bank overseers. Europe also faces its own deficit problems, exacerbated by the fact that some members are more profligate than others.

In line behind the euro are the British pound and the Japanese yen. The economies are smaller, but still large enough to be contenders. Yet British debt problems are even more serious than those in the United States. Japan's fiscal problems are severe as well, offset only by that country's great propensity to save.

Beyond the yen and the pound, we come to the long shots, such as the Chinese yuan or the Brazilian real. For all its eagerness, China is disqualified because it does not have an open capital account (the opposite of deep capital markets; good luck unloading those RMB bonds). Brazil recently got a small taste of what it is like to be a favored currency and started running in the other direction. After the real appreciated 36 percent against the dollar this year, the Brazilians decided to start taxing investment flows.

So who's left? Just the imaginary currencies. These are artificial constructs like the IMF's SDR (special drawing rights). It's not widely traded; there are no deep SDR capital markets; nor are there any special guarantees about its prospects as a store of value. It has gained a following because it seems to offer an escape from all the failings of the other currencies. In fact, the SDR is nothing more than a basket of those very currencies.

So the dollar's reign looks likely to continue for a while. It's not a very resounding victory -- champion because everyone else fell over -- but a win is a win, as the cliché goes.

It does beg the question:

Is it a win? Has the U.S. benefited from the dollar's special role? More particularly, what do the dollar's role and value mean for U.S. foreign policy?