The days of having a dominant world currency are coming to an end.
Listener: 9 February, 2008.
Keywords: Globalisation & Trade; Macroeconomics & Money;
When a barrel of oil rose to $US100, it also cost E69, $NZ130 and at least 200 million Zimbabwean dollars (at the unofficial exchange rate). There was some agitation among Americans, because they were paying 4.4 times the price of four years ago. In euros and New Zealand dollars it increased only about 2.7 times. (Zimbabweans can’t get their hands on the stuff.)
Here the US dollar value is functioning as a unit of account. A second function of money is as a medium of exchange. Oil trades are usually in US dollars, but some will happen in euros; if you are credible enough you may even transact in New Zealand dollars. (Zimbabwean ones are an international no-no.)
It is not necessary for the seller of the oil to hold the proceeds in US dollars. Many will diversify their financial portfolio into euros, sterling and yen (but rarely into New Zealand dollars, and certainly not Zimbabwean ones). Here the money is acting in its third role of a store of value.
These are the three basic functions of money. Other non-economic functions can be added. Commentators gets misty-eyed over a “strong” dollar (or whatever). They either come from the finance sector or they uncritically repeat anything the finance sector tells them.
Financiers like strong currencies because they encourage transactions that generate profits. But the productive sector may suffer from the “strength” when it weakens export performance and the economy.
This is a prelude to discussing one of the great structural changes that the world’s financial system seems to be facing, as the money it uses changes. Pre-globalisation, “money” was mainly gold and silver. (The UK’s “sterling” refers to a silver standard of 1000 years ago.) When the globalisation era began 200 years ago, the UK dominated the world economy and its sterling was the international currency. By the end of World War II, with the UK no longer such an important economy, and the US the “hegemon” (the dominant economy), the US dollar took over. It remains the international unit of account, transaction currency and reserve currency. But for how much longer?
The arrival of the euro introduces a viable alternative to the US dollar as a medium of exchange in many parts of the world. For a store of value, any sensible investor will have investments denominated in both US dollars and euros. The least important role, the unit of account, may change much more slowly.
This would have happened anyway, but in recent years the change has accelerated. The US Government deficit has poured out dollars since 2002. The expansion means its exchange rate has gone down, so the weaker currency is less attractive to investors as a store of value.
Moreover, awash with the currency of international preference, the financial sector introduced practices that are now euphemistically described as “extreme”. It may be that the sub-prime housing finance debacle is only the tip of an even more disastrous iceberg. No one knows its magnitude, but though financial institutions throughout the world are involved, the impression is that the US ones have been more culpable, and are likely to come out of any restructuring in a weaker state.
This column has to be a bit tentative, for we are entering unexplored territory. The US dollar will not be replaced by the euro but instead increasingly there will be two major international currencies. The same goes for the hegemon. The dominance by the US economy will not be replaced by another. Rather, there are going to be four (China, Europe, Japan and the US) or possibly five (India) economies, which will compete with one another, but none of which will be large enough to dominate the world.
If the experience of the UK losing its dominance is any indication, it will be particularly hard for the US to think about its diminishing relative power. But 200 years of being used to having a hegemon in a globalised world makes it hard for everyone to think about the future multi-polar one. We can start by not making a fetish of measuring the price of oil in US dollars.