The Future of Reserve Currencies

• Author: Benjamin J. Cohen
• Position: Professor of International Political Economy at the University of California, Santa Barbara
• Pages: 26-29

Page 26

For nearly a century, the u.s. dollar has reigned supreme, but are those days over?

THE global economic crisis has again raised the question of the future of reserve currencies. For nearly a century, the U.S. dollar has reigned supreme as the world’s top international money. In recent decades, however, confidence in the greenback has been undermined by the United States’ persistent current account deficits and growing foreign debt. Increasingly, observers have predicted an end to the dollar’s dominance. For many, the dollar’s fate seemed sealed following the collapse of the U.S. housing market in mid-2007, which triggered the greatest upheaval in U.S. financial markets since the Great Depression.

As it turned out, the crisis proved to be anything but fatal for the dollar. Not even the troubles of the U.S. financial sector, which required massive government interventions, sufficed to tip preferences decisively. Instead, ironically, the crisis temporarily reinforced the greenback’s global standing, as investors fled to the dollar for safety. Late last year, global demand for U.S. treasury bills was so intense that yields fell to zero or below. Nonetheless, the dollar’s future continues to be hotly debated (Helleiner and Kirshner, 2009). Over the longer term, it is widely held, the decline of the greenback will undoubtedly resume, ending the currency’s reign once and for all.

But that begs a critical question: What would replace the dollar? Some say it will be the euro; others, perhaps the Japanese yen or China’s renminbi. And some call for a new world reserve currency, possibly based on the IMF’s Special Drawing Right or SDR, a reserve asset. None of these candidates, however, is without flaws. In fact there is no obvious alternative to the dollar lurking in the wings, just waiting to take center stage. To paraphrase Winston Churchill’s famous remark about democracy, the dollar may turn out to be the worst choice—except for all the others.

The most probable outcome is apt to be more ambiguous—more like the interregnum between the two World Wars, when Britain’s pound sterling was in decline and the dollar on the rise but neither was dominant. Coming years, I submit, will see the emergence of something similar, with several monies in contention and none as clearly in the lead as in the recent past. The economic and political impacts of a more fragmented currency system could be considerable.

When economics and politics intersect

In the absence of a world currency backed by an effective global government, foreign trade and investment must rely on acceptable national currencies to play international roles. A disconnect therefore exists between the jurisdictions that are the source of international monies and the domains of the markets in which they operate, which introduces a political dimension that is often overlooked in purely economic analyses.

The conventional framework for the study of international currencies separates out the three standard functions of money—medium of exchange, unit of account, and store of value—at two levels of analysis: the private market and government policy. In markets, an international currency plays a role in foreign exchange trading, trade invoicing, and financial investments. For governments, the functions of international money are as an exchange rate anchor and as a reserve currency. At the market level, economic considerations typically dominate in determining preferences. At the government level, the additional ingredient of politics is unavoidable.

Politics enters because an international currency offers unique advantages for the nation that issues it—political as well as economic. Economists naturally tend to focus on the economic benefits involved, such as...