I have a few hundred Euros in cash, which I joke with myself will make me rich in a few years, when the dollar crashes. The International Herald Tribune is trying hard to dash my hopes with an article, “Reports of dollar’s death greatly exaggerated.”
But currency experts say that this turn away from the dollar is not likely to do any long-term damage to the currency’s value for a number of reasons. First, the motives of central banks that are adding other currencies to their reserves do not appear to be driven by the belief that the euro will eventually supplant the dollar as the world’s key currency. Rather, these central banks are doing what investors typically do to minimize risk: diversifying their portfolios.
Further, the lasting impact on the dollar’s value when foreign central banks invest in other currencies is far from certain, analysts said.
“Most people think it does not influence exchange rates for any long period of time,” said Edwin Truman, senior fellow at the Petersen Institute for International Economics who served for more than two decades as the director of international finance for the Federal Reserve. “It has some day-to-day effects, but not any big effects.”
News of the United Arab Emirates decision was part of the reason the dollar fell against the euro, the British pound and the Japanese yen last week. Last year, the euro appreciated more than 11 percent against the dollar, and the British pound rose nearly 14 percent against the dollar.
But those trends seem to be driven by other forces, including varying prospects for growth around the world and changes in interest rates in the United States and elsewhere.
The above description minimizes some of the trends that are causing the dollar to fall. First, France and Germany’s economic growth used to be anemic, but in the last year and a half have grown very quickly; since late 2005, the Eurozone’s economic growth has outpaced the USA’s. I have no idea if this will sustain itself in the future, but for what it’s worth, France is slated to engage in growth-improving economic restructuring after the election.
Second, deficits tend to hurt the currency. The warnings of liberal economists like Krugman about spiraling deficits probably created an expectation of deficit reduction after the Democratic victory. Now that even Krugman is running away from his earlier deficit-hawkish rhetoric, it’s becoming decreasingly likely that the Democrats will get the US closer to a balanced budget. After another unbalanced budget or two, it’s probable people will resume dumping dollars.
Third, the mere fact that countries are diversifying their portfolios is bad omen for the dollar’s value. The dollar used to be the unchallenged world currency. Everything else was the equivalent of company town vouchers, only on a somewhat larger scale. That there’s another world currency is enough to weaken the dollar. It’s going to get even more marked once China lets the yuan float.
Fourth, the Euro is a stabler currency than the dollar. The European Central Bank’s charter is very German, in the sense that it declares price stability to be the bank’s primary goal. In contrast, the Federal Reserve determines interest rates based on a balance of price stability and full employment. The United States’ rapid growth in the late 1990s was fueled partly by Greenspan’s choice to care more about unemployment than about inflation for a few years.
And fifth, if it’s in China’s vested interest to keep the dollar strong, it hasn’t acted on this interest yet. It’s good for China to be able to export to the US propped by an artificially weak currency, but if the Eurozone keeps growing at its current rate, it’ll become even better for China to export to Europe more. Europe’s lack of overriding overseas military interests already makes it a more attractive target insofar as it won’t start a cold war with China for global domination.
China has somewhat acted towards keeping the dollar stronger – Chinese banks hold a lot of US bonds – thus loaning money to the US, and keeping the dollar stronger.
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