The premature announcement of the dollar’s demise

It would be an understatement to say that the past few months have not been good for the dollar, which has lost around 10 percent of its value. But before jumping to the conclusion that the dollar’s recent swoon could be marking the beginning of its end as the world’s dominant international reserve currency, we should ask a basic question: Is the Eurozone economy really in such better shape than that of the United States to allow the euro to pose a real challenge to the dollar?  

At the start of the global COVID-19 pandemic, there was once again a flight to the safety of the U.S. dollar. Since then markets have become increasingly concerned about the U.S. twin health and economic crises as well as about its uncertain political outlook. As a result, investors started bailing out of the dollar, and in July alone the dollar lost 4 percent in value, its largest monthly loss since 2010.

To be sure, investors have a lot to worry about in the U.S. economic and political outlook. So soon after just having experienced its largest quarterly GDP decline on record, Federal Reserve Chairman Jerome Powell is now suggesting that the U.S. economy again appears be stalling. He is also warning that it might take a long time for the U.S. to regain its former vigor, especially if health experts’ warnings about a second wave of the pandemic materialize this fall.

The U.S. failure to get the pandemic under control now appears to be the major headwind to U.S. economic outlook. This is highlighted by the fact that the U.S. now accounts for around 25 percent of the world’s COVID-19 cases, even though it has only around 4 percent of the world’s population. Also weighing on investor and consumer confidence is heightened U.S. political uncertainty ahead of the November election as underlined by Congress’s current difficulty in extending the pandemic relief package.

Previously when observers fretted about the possible start of the dollar’s supposed long-run decline, the late Paul Volcker would remind us that for the dollar to decline it would need to do so against the world’s other major currencies. This begged the question as to whether the world’s other major economies were not without problems of their own. 

To date, the only currency that could possibly pose a real challenge to the dollar would be the euro. The Chinese currency could not do so due to its lack of convertibility and the very distorted nature of its economy. Similarly, the pound sterling could not do so especially were the UK to have a hard Brexit, while the Japanese yen could not do so especially at a time when Japan has a public finance problem that makes U.S. public finances look sound. 

It would be a stretch to think that the euro could pose a serious challenge to the dollar especially at a time when Italy and Spain, the Eurozone’s third and fourth largest economies respectively, look well on their way to banking sector and sovereign debt crises.  

The U.S. economy contracted 9.5 percent in the second quarter; meanwhile, the economies of Italy and Spain contracted by 12.5 percent and 18.5 percent, respectively. Such declines are bound to place inordinate pressure on those countries’ already weak banking systems and to see their budget deficit-to-GDP ratios balloon to double-digit levels. It is also more than likely that by year end Italy and Spain will see their public debt-to-GDP ratios skyrocket to 160 percent and 120 percent, respectively. As before, while stuck in a euro straitjacket, those two countries will have a hard time growing their way out of their debt problems.

In order to save the euro, the European Central Bank (ECB) will soon be forced to increase substantially its quantitative easing program to allow it to buy very large amounts of Italian and Spanish government bonds. It will also likely have to provide substantial support to bail out the Italian and Spanish banking systems. While those measures might allow the ECB to save the euro, they are bound to result in a large amount of ECB money printing that will tend to undermine confidence in the euro’s soundness. 

All of this is not to suggest that U.S. policymakers can afford to be complacent about the urgent need to address the country’s economic imbalances. Rather, it is to say that U.S. policymakers need not lose sleep over the prospect that anytime soon the U.S. will lose the exorbitant privilege that the dollar affords it.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.