Reuters on the Fate of the Dollar

A few days ago I responded to a Reuters Blogs posting by writer Agnes Crane regarding the ongoing bull market for U.S. stocks. Crane's perspective was ultimately optimistic - she argued that, while American stocks would face volatility, the rally would continue.

I definitely took notice today when I cruised over to Reuters Blogs and saw a post by the same author entitled 'Getting ready for the dollar's fall.'

I'd like to respond to that article here.

It just won’t go away, this needling worry about the U.S. dollar losing its coveted top-dog status.

No matter that there are plenty of reasonable arguments to support the dollar as the world reserve currency — namely there’s just no alternative — for perhaps decades to come.

Yet, in a world where once-rock-solid assumptions quickly turn to dust, investors should keep an eye on the dollar since changing perceptions are chipping away at its cherished status as currency to world.

Much of the debate so far this year has centered on creating an alternative to the U.S. dollar, championed by China and Russia as a way to wean the world off its dependence on the U.S. as well as buffer individual nations against the missteps of those in developed world. Most recognize creating a new currency will take years and the chances of an existing currency, like the yuan, usurping the dollar anytime soon are remote.

I would argue that Crane needs to reflect a little bit more on her own writings as she answers some of her own questions.

Why won't worries about the dollar go away? Maybe its precisely because we live in a world "where once-rock-solid assumptions quickly turn to dust." We're living in historic times, as some would say. We have already seen a variety of banks, corporations and institutions that were all dubbed "too big to fail", well, fail. Now we have the financial media essentially telling us that the dollar is "too big to fail." And the public is supposed to believe that without question?

Crane also states that there is no alternative to the dollar. A few paragraphs down though, she points out that China and Russia are already contemplating alternatives. Her new argument is that such a large-scale implementation of a new currency would take a long time, years in fact. No doubt that is true. But if Russia and China were to announce their intent to create a new supra-national currency (more on that below) and begin reducing their dollar investments, that alone would destroy much of the value of the dollar before any actual implementation began.

In fact, I would argue with the very premise of this article. The dollar doesn't have to lose its reserve-status. Foreign countries, especially China, could simply begin investing in baskets of other currencies and move away from dollar holdings. That alone would provide a pretty big blow to the American economy in this economic climate.

But that doesn’t mean big money isn’t starting to prepare for world in which the buck isn’t the currency of choice.

Curtis Mewbourne, a portfolio manager at PIMCO, has suggested that investors diversify away from the dollar and to move into other currencies, especially those in emerging markets.

“And while we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the U.S. dollar as a store of value even in the absence of a single viable alternative,” he wrote in an article published on PIMCO’s website.

Indeed, Bloomberg news has an article on PIMCO's report. Ms. Crane argues that implementation of a new supra-national currency would take a long time. Well, how about this: Bloomberg mentions that Russian President Dmitry Medvedev presented a sample coin for a new supra-national currency at a recent international summit. No doubt its a bit of political side-show but you're definitely not hearing news like that on the economic report of your eleven o'clock newscast.

The financial crisis, however, woke the world up to just how vulnerable those squirreling away dollars — like China and Russia — were to the fortunes of the United States. The bulk of the world’s currency reserves are in dollars, with the euro still a distant second. Foreign central banks, however, could hardly start selling dollar-denominated assets to limit their exposure because such sales would cause prices on their remaining holdings to fall further.

Here, Crane finally makes a good point in favor of her argument, one she should have made at the beginning. This is the critical dillema facing countries like China right now. Its something of a Catch-22. However, if the dollar's value keeps declining China loses either way, so eventually the cost-benefit analysis might tip and make reform the best option for China anyway.

That’s because the loss of reserve status means, among other things, that the United States would lose a crucial crutch that has allowed it to borrow its way into prosperity as well as out of depression with relative impunity. Foreign investment in dollar assets have helped keep a cap on interest rates even though the government’s borrowing binge in recent years has brought new meaning to the word stimulus.

Yes, a dollar dive would be pretty disastrous for the U.S. We would likely see the standard of living of the average American decline (further). The really scary question is ... if the dollar does take a dive where does the American economy go from there? 70% of our economy is consumption and that consumption would be severely impacted by a large decline in value for the dollar. This is why you have so many ultra-bears predicting Doomsday - the effects of hyperinflation would pretty much be ruinous. Of course, some are actually predicing massive deflation as I point out in a previous post.

In an op-ed published in the New York Times today, Warren Buffett railed against the flowing red ink that will push the nation’s debt to roughly 56 percent of GDP from 41 percent in this fiscal year.

Presumably this is something that has also caught the eye of foreign investors.

While the greenback is likely to stay on top for some years, persistent concerns about its reserve status and moves to diversify away from it could usher in a new era for U.S. borrowers, public and private alike — a more painful one where debt costs can no longer be offset by the kindness of foreign investment.

Indeed.

Although I've criticized this article and Agnes Crane, I actually find it quite refreshing that Reuters is tackling this topic. Its quite timely and quite serious but it seems like a lot of mainstream media outlets don't want to touch the topic, either because its too complex for the average American or because the implications are too scary. Overall I would say that this was a decent blog post.