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How Safe Are Your Dollars?

CAMBRIDGE – Chinese officials and private investors around the world have been worrying aloud about whether their dollar investments are safe. Since the Chinese government holds a large part of its $2 trillion of foreign exchange in dollars, they have good reason to focus on the future value of the greenback. And investors with smaller dollar holdings, who can shift to other currencies much more easily than the Chinese, are right to ask themselves whether they should be diversifying into non-dollar assets – or even shunning the dollar completely.

The fear about the dollar’s future is driven by several different but related concerns. Will the value of the dollar continue its long-term downward trend relative to other currencies? Will the enormous rise of United States government debt that is projected for the coming decade and beyond lead to inflation or even to default? Will the explosive growth of commercial banks’ excess reserves cause rapid inflation as the economy recovers?

But, while there is much to worry about, the bottom line is that these fears are exaggerated. Let’s start with the most likely of the negative developments: a falling exchange rate relative to other currencies. Even after the dollar’s recent rally relative to the euro, the trade-weighted value of the dollar is now 15% lower against a broad basket of major currencies than it was a decade ago, and 30% lower than it was 25 years ago.

Although occasional bouts of nervousness in global financial markets cause the dollar to rise, I expect that the dollar will continue to fall relative to the euro, the Japanese yen, and even the Chinese yuan. That decline in the dollar exchange rate is necessary to shrink the very large trade deficit that the US has with the rest of the world.