The Dollar Nosedive Why America's Currency Is the World's Problem

Part 3: The Center of the Postwar Global Economic Order


The dollar era began on a specific date. On July 22, 1944, 730 delegates from 44 countries met at a conference in Bretton Woods, a resort in the US state of New Hampshire. At the Mount Washington Hotel, the group decided what the world's monetary system would look like after the war. John Maynard Keynes, the great British economist, who led the British delegation at Bretton Woods, proposed the establishment of a sort of artificial currency that would be valid worldwide. It was a brilliant idea -- in theory. But the Americans, under the leadership of then-President Franklin D. Roosevelt, won out in the end.

Under the Bretton Woods agreement the dollar, tied to a fixed quantity of gold -- $35 per troy ounce -- would be at the center of the postwar global economic order, while other currencies would derive their value from the dollar. If an individual country's currency became too strong or too weak in relation to the US currency, its central bank would intervene by buying or selling US dollars.

That was how the system worked, until 1971, when President Richard Nixon cancelled the US guarantee to redeem dollars with gold. The problem was that by then the dollar had become too popular, so that the volume of US currency outside the United States exceeded the country's gold reserves. In March 1973, the world's central banks decided that they would no longer intervene, and the Bretton Woods system came to an end.

Many feared at the time that countries would simply continue to devalue their currencies, thereby improving their companies' export prospects. This had already happened once before, between the two world wars, when it drove the world economy into a fatal crisis.

But the new freedom between currencies was more effective than expected. The elimination of the central banks' controlling roles allowed the strength of an individual economy to determine which nation would assume monetary leadership in the world. And that country, thanks to its enormous economy, was clearly the United States.

Graphic: A double deficit
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Graphic: A double deficit

However, currencies did continue to fluctuate considerably, while politicians attempted to reduce the magnitude of these currency swings with words. Meeting in New York in 1985, the finance ministers of leading economies talked down the dollar in the Plaza Agreement. Only two years later they signed the Louvre Agreement to prevent the dollar from crashing. But from then on the US dollar, despite its highs and lows, was the measure of all things -- as it has remained to this day.

The dollar's dominance holds great appeal for Americans. They can continuously print green bills and sell them abroad without driving up inflation in their own country. They can go into debt to pay for things like the Iraq war or enjoy the benefits of tax cuts. This attitude has led to a record US national debt of $5 trillion.

At the same time, Americans have enjoyed the luxury of consuming more than they produce. The balance of trade deficit has been growing for years -- from roughly $80 billion in 1990 to a projected level of more than $700 billion in 2007. This is more than 5 percent of the country's GDP.

America paid for its economic boom in recent years by borrowing money. Its current double deficit is the monetary evidence that the world's biggest economy has been living beyond its means for years.

The whole thing only works because a special system of giving and taking has developed, a mechanism that flies in the face of every economic theory. For years, huge amounts of capital have been flowing from poorer emerging economies into the United States, the richest nation on earth. This influx of foreign capital, most of it coming from the Far East, amounts to roughly $2 billion a day.

Graphic: Currency reserves
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Graphic: Currency reserves

The central bank in Beijing, for example, has accumulated enormous hard currency reserves from the country's export business. China holds the astonishing sum of more than $1.4 trillion in its reserves. The Chinese have invested most of their money in US Treasury Bills, a low-risk but also relatively low-return investment. In doing so, they have kept the dollar high and their own currency low, ensuring that their exports remain competitive.

While Asia finances America's excessive consumer spending, the Americans buy Asia's cheap T-shirts, cars and flat-screen TVs. "Getting this much into debt while at the same time enjoying returns on long-term government bonds of less than 5 percent -- I'd call it the biggest free lunch in modern economic history," says Harvard historian Niall Ferguson, referring to the audacity with which the Americans take advantage of their privileges as holders of the world's reserve currency.

Rarely has the world economy been so out of whack or have global imbalances been greater. The Americans were the world's financiers for years. Today they are its biggest borrowers, while the Asians serve as America's bank.

It's obvious that this does not bode well for the long term. For years, economists and politicians have been warning against an impending crash. Now it seems that the time is ripe for this to happen.

The dollar's plunge in the last 10 weeks is a sign that America's pact with East Asia has become fragile. The Asians have become far less willing to buy dollars and Treasury bills. As the countries of the Far East become increasingly impatient with the United States, they have begun shifting their reserves to euros.

Hotel in Dubai: Oil producers are now distancing themselves from the US currency
REUTERS

Hotel in Dubai: Oil producers are now distancing themselves from the US currency

Lenders are unwilling to simply look on as the value of their US Treasury bills drops; they have already lost billions upon billions in recent weeks. The dollar's share of worldwide currency reserves has shrunk from 80 percent in the 1970s to about 65 percent today. China, Russia and Malaysia have already partially uncoupled their currencies from the dollar, and Kuwait plans to follow suit in May 2008. Many oil producers are now distancing themselves from the US currency, both for economic and ideological reasons.

Investment bank Morgan Stanley considers it unlikely that Saudi Arabia would abandon its peg to the dollar. But according to a recent study, smaller Gulf states could follow Kuwait's lead: "This could deal yet another psychological blow to the dollar" -- and to America, that once-proud economic power.

The nation is deeply uneasy, as the collective head scratching begins over the causes of the crisis. Many Americans feel by now -- and justifiably so -- that their future could be far gloomier than the present.

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