The one thing that could jeopardise the dollar’s dominance would be significant economic mismanagement in the US. And significant economic mismanagement is not something that can be ruled out.
The Congress and Administration have shown no willingness to take the hard decisions needed to close the budget gap. The Republicans have made themselves the party of no new taxes and mythical spending cuts. The Democrats are unable to articulate an alternative. 2011 will see another $1 trillion deficit. It is hard to imagine that 2012, an election year, will be any different. And the situation only deteriorates after that as the baby boomers retire and health care and pension costs explode.
We know just how these kind of fiscal crises play out, Europe having graciously reminded us. Previously sanguine investors wake up one morning to the fact that holding dollars is risky. They fear that the US government, unable to square the budgetary circle, will impose a withholding tax on treasury bond interest – on treasury bond interest to foreigners in particular. Bond spreads will shoot up. The dollar will tank with the rush out of the greenback.
The impact on the international system would not be pretty. The Canadian and Australian dollar exchange rates would shoot through the roof. A suddenly strong euro would nip Europe’s recovery in the bid and plunge its economy back into turmoil. Emerging markets like China, reluctant to see their exchange rates move, would see a sharp acceleration of inflation and respond with even more distortionary controls.
With exorbitant privilege comes exorbitant responsibility. Responsibility for preventing the international monetary and financial system from descending into chaos rests with the US. How much time does it have? Currency crises generally occur right before or after elections. Can you say November 2012?
More by Barry Eichengreen here. He argues that until the next currency crises arises (and an alternative currency found), dollar will remain the dominant currency at the global level because of capital controls in India and Brazil; relatively small scale of Canadian loonie and Australian dollar; and China’s capital control plus worry among investors about its opening of financial markets, enhancing their liquidity, and strengthening the rule of law. But, the dollar will be in crisis due to political economy ups and downs in the US. Eichengreen hints that it could be in November 2012, after the US presidential election.