Dog Days For The Super Dollar

Kenneth Rogoff

CAMBRIDGE -- Is the United States’ position as the world’s dominant superpower at risk if the dollar loses its super-currency status? Maybe not, but Americans will certainly find global hegemony a lot more expensive if the dollar falls off its perch.

Until now, Americans have been raking in profits by borrowing cheaply from pliant foreigners and investing the money in high-yield foreign equities, land, and bonds. Counting capital gains, Americans have profited to the tune of $300 billion to $400 billion annually in many recent years – an amount roughly equivalent to the entire US military budget.

Former French president Valéry Giscard d’Estaing once famously complained about America’s “exorbitant privilege.” D’Estaing was incensed that the US seemed to be able to flood the world with dollar currency and debt without ever seeming to pay a price in terms of higher inflation or interest rates.

At least half the $800 billion US currency supply is held abroad, mainly in the world’s underground economy. But the really big bucks come from the fact that places like the People’s Bank of China and the Bank of Japan passively hold enormous volumes of low-interest US debt, while Americans romp around the world with venture capital, private equity, and investment banks, reaping huge gains.

It has been a great ride for the US, and America’s financial supremacy has certainly eased the burden of being a superpower. But, between the sub-prime US mortgage crisis and the dollar’s ongoing decline, America’s exorbitant privilege now looks a bit shaky.

The dollar is already down 25% over the past five years, and if the US tips into recession – a 50/50 chance right now -- the dollar is going to drop a lot more. Foreign investors are already reshuffling their portfolios, moving into euros, pounds, and even emerging-market currencies like the Brazilian real and the South African rand. Controversial “sovereign wealth funds,” which invest funds for governments in the Middle East, Asia, Russia, and elsewhere, are just one manifestation of the search for alternatives to low-yielding, rapidly depreciating, dollar bonds.

Even without any portfolio shift, Americans shouldn’t expect their recent luck to hold up in the future. If there is a global downturn, any region that is long stocks and short bonds is going to get burned.

Unfortunately, faced with the growing risks to the dollar’s status, American policymakers, rather than nursing the country’s premier export, seem to be more interested in milking it. The US government itself has taken advantage by running vast deficits. The Federal Reserve appears to care about exchange rates only to the extent that they affect growth and inflation, and right now the weak dollar is helping US exports. Last but not least, US tax policy hardly encourages private-sector savings, especially giving the preferential tax treatment of real estate.

Professor Maury Obstfeld of the University of California at Berkeley and I have been warning for some time that without pro-active policy adjustments, the dollar is vulnerable to a sharp collapse, with many attendant risks. Unfortunately, that scenario now seems to be unfolding.

This year alone, the dollar’s value has fallen by another 10% in purchasing power terms against America’s major trading partners, and it could fall at the same rate in 2008 – or faster if global investors decide to cut and run. When the Chinese premier, OPEC heads of state, and the world’s richest supermodel all express concern about the dollar, you can be sure we are in for a bumpy ride.

The good news for Americans is that there is enormous inertia in the world trading and financial system. It took many decades and two world wars before the British pound lost its super-currency status. Nor is there any obvious successor to the dollar yet.

Indeed, the sub-prime crisis has made the European financial system look just as vulnerable as that of the US. Likewise, while the Chinese Yuan might be king in 50 years, China’s moribund financial system will prevent it from being crowned anytime soon. A huge share of world trade is denominated in dollars, even if some OPEC presidents, such as Venezuela’s Hugo Chávez, openly preach mutiny. Central banks still hold more than 50% of their foreign exchange reserves in dollars.

But danger signs abound. Unless the US gets its act together soon, it may find the value of its super-currency franchise much diminished. American voters, who are famously loathe to increase taxes, might start thinking a lot harder about the real economic costs of their country’s superpower status.