03/06/2011: Exorbitant privilege adieu?

Presently, international economic organizations are all doom and gloom regarding the future of the US. In April the International Monetary Fund reported that China would surpass the US as the largest economy in the World already by 2016 if measured by purchasing power parity. The World Bank came out soon after with a study “Multipolarity: The New Global Economy,” assessing that the US dollar will surrender its role as the major reserve currency by 2025, de facto ending what former French President Valéry Giscard d’Estaing once called the “exorbitant privilege” of the US currency.
The World Bank diplomatically sidesteps naming a successor to the dollar and instead states that by 2025, several currencies will be equally important in the world economy: the US dollar, the euro and an Asian currency, most likely the Chinese renminbi. Fifteen years is a long time, and it is likely that by 2025, no one will remember the World Bank study. This said, I have my doubts that it will be so easy to oust the old greenback.
Realizing such a scenario requires several assumptions, each of them likely, but not certain. First and foremost, the current erosion of confidence in the US dollar would have to continue for years. Considerable erosion of confidence has already occurred recently due to the current unorthodox US monetary policy (to use a euphemism). Surprisingly, though, the greenback still enjoys confidence as a storage of value in emerging market countries. For the Swiss, history shows the US dollar always on a weakening path, while for Brazilians, the dollar has been much better than the local currency over the last forty years.
Second, the Eurozone must solve its current problems to enhance its international position. But if a break-up scenario or one in which some European peripheral countries leave the common currency are to be excluded, then the only viable solutions for the present crisis lead through a default and restructuring of at least part of the European peripheral debt and/or monetization thereof. Clearly these are not alternatives which will boost confidence in the euro.
Finally, while many see the Chinese renminbi as the true challenger to the US dollar, its broader use as an international currency would require a much deeper financial market. This would mean availability of much more investable assets like stocks and bonds denominated in renminbi, and would thus imply free flows of capital and ultimately greater confidence in the rule of law in China than presently exists. There have indeed been many improvements over the last twenty years; the Chinese can move swiftly, but I think fifteen years is too short a period for such changes.Throughout history, only a handful of currencies have achieved leading currency status. It took two World Wars to establish US-dollar domination after the British pound had ruled over 150 years. Even the loss of confidence after the abandonment of the gold standard in the early 1970s didn’t seriously harm the status of the dollar. What many forget when proclaiming the dollar’s loss of privilege is that a currency need not be strong to hold this leading status as long as it does not have any serious challengers. In my view, a weak dollar will still be the currency of choice in 2025. That said, it is unlikely that anyone will remember my forecast then.