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D. Sambandhan

IN TODAY'S world economy, the yellow metal is not international money officially, but just a commodity and, yet, it has begun to merit attention from international money and hedge fund managers as an attractive asset to stay in and get out, in view of the world's money — the US dollar — getting into deeper trouble. The historically given link between the dollar and gold refuses to die.

In the event of the euro and the yen refusing to absorb the pressures of the dollar's weakness, the yellow metal will give way and flare up. During the inflationary 1970s — the weak dollar days under Carter regime — the yellow metal touched the dizzy height of $800 per ounce in 1980. However, in today's deflationary world (2003 end), the recent spurt in gold price and the huge accumulation of dollar reserves (Asia alone sitting on more than $1.5 trillion) are indicative of the pressures on the US dollar. What is happening to the world's money?

A look at the evolution of the international monetary system in 20th century would reveal that after 1914 the US has called the shots all along as the producer of dominant world money, and influenced the world economy through its interest, inflation, exchange and growth rates. For more than two decades, even as it fuelled growth in the rest of the world, via its trade deficit, the US also caused havoc in the form of prolonged exchange and interest rate cycles — to the detriment of global macro stability. Result: The credibility of the dollar has become suspect now.

Like Britain from the mid-19th century until the First World War, the US, from the 1940s through the early 1970s, successfully played the role of key currency country by virtue of its sheer economic and financial supremacy. As explained by Robert Aliber, the British pound-sterling and the US dollar became "international currencies neither by Act of Congress (Parliament) nor by Act of God, but rather because they met various needs of foreign official institutions and foreign private parties more effectively than other financial assets could".

To perform the task of manufacturing and managing the world's money, the country must be economically robust, politically strong and stable and also be more sensible and responsible in conducting its monetary and fiscal policy, keeping in view the interest of global economy.

Since that country's national money serves as a transaction vehicle for traders and investors and reserve and intervention currency for central bankers, the country must also have a well-developed deep and broad money and capital markets (freed from any kind of inhibiting restrictions on capital flows) capable of providing a wide spectrum of financial assets to choose.

If it enjoys a strong current account surplus to facilitate a corresponding capital account deficit, that will enable the rest of the world to acquire the world money; this will preclude the economic super power from running into an overall BoP deficit.

The US dollar fulfilled all the criteria and the post-War Bretton Woods System (BWS) was built around the rigid gold-dollar link which served as the nominal anchor for other countries to fix their parities; even while the US ran a modest overall BoP deficit, it was welcomed as benign neglect as the rest of the world actually wanted it.

This beneficial disequilibrium in US BoP deficit was helping the world economy towards economic equilibrium. The gold-dollar link before 1971 was the official anchor to discipline the US from creating excess dollars and, thus, rein-in inflation; via fixed parity of the exchange rate, it was also supposed to restrain world inflation.

For others, it also served as an anchor for maintaining and defending fixed parities and keeping their monetary policy in line with the mainstream US policy. Virtually, the world was on the dollar exchange standard.

By virtue of its nth currency role/numeriare, and the gold-dollar link, the US could not alter its exchange rate; this lack of exchange rate autonomy was not a handicap, so long as its inflation rate was modest — far below than its trading partners.

Further, it was compensated by independence of its monetary policy, which it conducted with restraint until mid-1960s. It was only when the Vietnam war got financed not by taxes, its trade surplus began shrinking, and the technological superiority declining, problems arose. When the overall BoP deficit of the US exceeded all prudent limits leading to pumping of excess dollars into the world economy more than the world was willing to hold and their inflation rates getting threatened, the dollar's role as international money got dented. At that critical juncture, the US wisely and strategically extricated itself from the rigorous clutches of gold dollar-link, which the US found it to difficult to honour as foreign held dollar balances exceeded the official gold stock in US hands.

With the suspension of gold dollar link in August 1971 and the final collapse of BWS in March 1973, the expectation was that the fate of the dollar would be sealed and the exorbitant privilege of financing its external deficit issuing its own currency would end once and for all and that the US dollar would become another normal currency. That is, floating exchange rates would bring about a sort of socialism, among currencies and the monopoly power of dollar will be a thing of the past. But by a strange quirk of fate, the US dollar, inconvertible into gold, and also declining in its value continually, got ready acceptance and both central banking and international banking system had built up huge dollar holdings, in the absence of any viable alternative.

Thus, quite contrary to expectations, under the floating exchange rate regime, reserve accumulation by central banks have not declined but only increased; keeping in line with changing value of dollars, currency diversification has taken place and the share of the deutsche mark and yen did increase, but not much to dethrone dollar.

By the same logic, intervention currency role of dollar also increased, as central banks accumulated huge inventory of dollars and other reserves to manage and stabilise exchange rates. The disruptive effect of floating exchange rates in the form of real exchange rate flexibility — both short-term volatility and medium-term misalignment — increased the overall vulnerability of all national economies under floating; it eventually increased both transactions and precautionary demand for dollar; the mobility of global finance and the currency crisis of 1990s gave additional strength to dollar, as the US was perceived as safe haven. The real sector performance of the US economy was also remarkable in the 1990s. Not withstanding its rise and fall, the dollar's role as international reference currency was very much evident through the 1990s. A passionate hug in the form of a strong dollar peg in pre and post-crisis Asia, including the robust China, dollarisation attempts and currency board arrangements in Latin America provided a fresh oxygen to dollar.

The US may have entered the 21st century as the greatest beneficiary of global finance and economic integration and also emerged as the leader of the unipolar world with unrivalled dominance and prosperity. And yet its unilateral domestic financial agendas have affected the credibility of the currency and, thus, adversely impacted on the soundness of international financial system.

The US today no longer fulfils the objective criteria of key currency country. The statement of Adam Smith that "there is a great deal of ruin in a nation" is very much true in the case of the US despite the longest period of economic expansion it experienced in the 1990s. The distinctive and definitive problems are huge current account and budget deficits.

Discussions on both the US economy and policy in the last two decades have invariably drawn attention to it, and the market too continually factors in these `twin deficits' while passing judgement on the dollar.

But unmindful of the debtor country status for nearly two decades, the dollar has been "performing a circus act", under the dominant, unpredictable and uncontrollable whim of foreign capital flows and "there is no net under it".

Thus far, the natural and normal death of dollar as international money has not taken place, precisely for the simple reason that no currency — not even the euro — is ripe and ready to take over the key currency role of dollar, as the latter did outsmart the British pound-sterling in the immediate post-War period and be willing to shoulder the responsibility, risks, and rewards of managing international money.

The cruel dilemma before the US is that the accumulated misalignment in exchange rate (read overvaluation of dollar) by its own unilateral economic and monetary misadventurism of the past is backfiring now. In the face of fear of floating, Asian surplus countries do not allow their exchange rate to appreciate (price adjustment) and instead their central banks intervene and accumulate reserves (quantity adjustment) as in the days of BWS.

The US is again back to square one; it lacks exchange rate autonomy. It cannot devalue its currency and the residual cosmic dance of yellow metal — the glittering of gold — is of no use to correct trade imbalances.

Quoting a nice analogy with the international use of the English language, Prof Jeffrey A. Frankel of the Kennedy School of Government, Cambridge, underplayed the exaggerated death of the dollar and thundered that no other currency could supplant the dollar as the world's premier currency even by 2020. "Nobody could claim that English is particularly well suited to be the world's lingua franca by virtue of its intrinsic beauty — simplicity or utility — yet it is certainly the language in which citizen of different countries most often converse and do business, and increasingly so. One chooses to use a lingua franca, as one chooses a currency in the belief that it is the one others are most likely to use.

"Similarly, it is not that the dollar is ideally suited for the leading role. It has some characteristics that mar its appeal. Most important, the US is a debtor country with a large deficit and few signs that it is getting its profligacy under control. But an international currency is one that people use because everyone else doing it." (Foreign Affairs, July/August, 1995 P.9). (Underlining ours)

The essence of Frankels' argument is very simple, that is, by virtue of the basic characteristics of money — General Acceptability — some currency must occupy a number one position and since there is no plausible alternative the US dollar can continue to go on because history, economic size, resilience of financial market — all support that role. The only snag is that if the Fed attempts to inflate away the debt value, then crisis of confidence will derail and that is unlikely to happen, he argued. Frankel knows the ailment, but he assumes that the patient need not bother.

Playing with the example of language will not help solve the predicament of dollar. It is virtually caught into a vortex of unknown. For long the dollar was US currency, but `problem' for others. The time has come now for treating this as US problem too, and a solution found by the US to tame current account deficit, by subjecting itself to a budget constraint and a cut in their real wage and standard of living. Will the US look inward and start bridging the gap between saving and investment and learn to live within the budget constraint before the rest of the world withdraws its support to US financial market? It is time the US resisted the temptation of again indulging in the rhetoric of singing the tune of strong dollar policy.

(The author is on the faculty of School of International Studies, Pondicherry University.)

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