[NYTr] As the dollar dwindles

[All the News That Doesn't Fit]

Financial Times - Dec 27, 2007
http://www.ft.com/cms/s/0/abfaa14c-b497-11dc-990a-0000779fd2ac.html


America faces a diplomatic penalty as the dollar dwindles

By Daniel Dombey

At the end of a year in which the dollar has endured a marked decline
against other currencies, an unsettling question is beginning to
be voiced: Can the troubles of the US currency be confined to the
financial world or are they set to undermine Washington's place on
the international stage?

"This is the neglected dimension of the dollar's decline," says
Flynt Leverett, a former senior National Security Council official
under President George W. Bush. "What has been said about the fall
of the dollar is almost all couched in economic terms. But currency
politics is very, very powerful and is part of what has made the
US a hegemon for so long, like Britain before it."

Along with some other commentators, Mr Leverett brackets the dollar's
recent fragility with related phenomena, such as the greater
international use of rival currencies. He argues that if such trends
continue, the result will be costly for the US. While a lower dollar
is associated with greater financing costs for America's twin current
account and budget deficits, he says, currency movements can be
determined by politics as well as economics -- and the US security
could be damaged if Americabs creditor nations move against the
dollar.

"Americans will certainly find global hegemony a lot more expensive
if the dollar falls off its perch," adds Kenneth Rogoff, former
chief economist of the International Monetary Fund, in an article
published this month.

He maintains that the US has been fortunate to be able to use the
huge low-interest dollar holdings of the central banks of China and
Japan to finance higher-return investments elsewhere, "but between
the sub-prime US mortgage crisis and the dollar's ongoing decline,
America's exorbitant privilege now looks a bit shaky. ... American
voters, who are famously loath to increase taxes, might start
thinking a lot harder about the real economic costs of their country's
superpower status."

The tumble of the greenback -- by more than 25 per cent against its
trading partners since February 2002 when adjusted for inflation
-- may lead other nations to turn away from using dollars for their
central bank reserves, international transactions or currency pegs,
with expensive results for the US.

Indeed, central banks have begun to move in such a direction. China,
which keeps the composition of its huge foreign exchange reserves
a state secret, has hinted that it plans gradually to reduce the
proportion held in dollars -- some analysts put the current level
at more than two-thirds. Yet while the dollar's role as the most
popular reserve currency is not under imminent threat, for cash it
is a different story: Last year the value of euro notes in circulation
overtook the value of circulating dollar notes.

"The US is extraordinarily fortunate in that its currency is also
the international standard of value. If that would disappear, US
leverage in many dimensions would also go," says Benn Steil, director
of international economics at the Council on Foreign Relations in
New York. He highlights the US's ability to further its influence
by bailing other countries out of financial crises. "What countries
need in a financial crisis is dollars and that gives the US enormous
leverage," he said.

Mr Steil adds that the dollar's all but indispensable role also
gives Washington an important tool against countries such as Iran
and North Korea, since by limiting their banks' access to dollar
financing -- a step Washington has taken several times over the
past year -- the US can damage such countries' financial systems
and make financing more expensive to obtain.

Mr Leverett says the US could relatively soon become vulnerable to
the kind of financial pressure that the strength of the dollar has
allowed it to exercise in the past. In the classic example, Washington
used the threat of a run on the pound to put pressure on the UK to
withdraw troops from Egypt during the Suez crisis in 1956.

In future, that kind of leverage may belong to China. "Right now
China wants to keep a close hold on how fast the renminbi appreciates,"
he says. "But it's increasingly likely that they decide their
strategic interest to constrain the US at some point outweighs the
economic considerations."

Mr Leverett also points to what he says has been a series of unwritten
but explicit understandings between the US and the oil producing
countries of the Gulf that underpin the dollar's role as the world's
leading currency by denominating oil contracts in dollars and linking
local currencies to dollars in return for security guarantees.

Many economists play down such agreements -- the dollar price of
oil should not be affected by what currency it is priced in,
determined as it is by supply and demand. But the way the US has
pursued and cultivated such understandings for decades -- Mr Leverett
says from the 1940s on -- highlights their significance for US
policymakers.

"The arguments now on economic grounds are overwhelming that the
Gulf Co-operation Council states, including Saudi Arabia, should
drop the dollar peg" because of the currency's decline, he says,
alluding to many Gulf states' worries that they are importing
inflation because of the link to the low dollar. "Saudi officials
will tell you it's a strategic decision, not an economic one, that
they are sticking with the dollar. That should be a real indicator
to American policymakers and citizens that this is a real
vulnerability."

Indeed, at an Opec summit last month, Saudi Arabia headed off a
push by Iran and Venezuela to price oil with reference to a basket
of currencies rather than the dollar. In television footage apparently
screened to reporters by mistake, Saud al-Faisal, Saudi Arabia's
foreign minister, argued that even mentioning the issue in the
summit communique would weaken the dollar still further.

After the summit ended, Hugo Chavez, Venezuela's president, declared
that the "empire of the dollar is crashing." Most economists and
foreign policy analysts disagree, arguing that economic and foreign
policy reasons mean that the dollar will maintain its pre-eminent
role for the medium term. Many countries view the US Navy's work
in protecting oil flows out of the Gulf as a public good, providing
a reason why the dollar-oil link is likely to persist.

Few economists expect a catastrophic collapse in the value of the
dollar and many expect it to remain the world's chief reserve
currency for years to come.

But, challenging the consensus view, Menzie Chinn and Jeffrey Frankel
of the US's National Bureau of Economic Research argued in a research
paper last year that, if the dollar's decline continued, the euro
could overtake it as the lead international reserve currency by
2022. Other economists have speculated that in the long term China
will establish the renminbi as the dominant currency in Asia.

The effect of either scenario would not be confined to currency
markets but could also have an impact on Washington's spending
patterns and financial clout -- the nuts and bolts of 21st-century
national security. The dollar might no longer be the source of the
US's power, but instead a factor in its decline.