Paul Craig Roberts' op-ed piece is still timely and probably the best explanation as to why the U.S. dollar will inevitably get weaker with time. Mr. Roberts was a Cato Institute fellow and an assistant Treasury secretary in 1980 - 81.

The Inevitable Decline of a Reserve Currency

THE WALL STREET JOURNAL | THURSDAY, MARCH 16, 1995

The latest drop in the dollar is a reminder that not all is well with the inter-national monetary system. Things won't improve until a better understanding of the dollar's weakness is achieved.

For many years most U.S. economists and policy makers have blamed the trade deficit for the dollar's problem and expected a weaker dollar to bring the deficit into balance. Yet the trade deficit with Japan and Germany has persisted despite the dollar's long decline relative to the yen and mark. In 1994, a period of noteworthy dollar weakness when the dollar fell below 100 yen, the U.S. had a $65 billion trade deficit with Japan and a $12 billion deficit with Germany. Together the two countries accounted for slightly more than half of the $150 billion merchandise trade deficit.

Trade deficits do not help the dollar's exchange value, but a more fundamental factor is pushing the dollar down. Belgian economist Robert Triffin predicted the dollar's postwar weakness. He said it was the fate of a reserve currency to grow weak with time. As large stocks of dollars pile up around the world, any diversification into other currencies or gold puts the current exchange rate under pressure.

This persistent long-term pressure against the dollar has been periodically intensified when specific U.S. economic or political policies have caused a lack of confidence. Such an episode occurred during the first week of March when Fed Chair-man Alan Greenspan announced the probable end of tightening, the balanced-bud-get amendment failed in the Senate, and Majority Leader Bob Dole expressed doubts about reducing the capital gains tax rate. The expectation of billions of dollars more pouring out in support of the peso added to the sharp decline in the dollar against the mark and yen.

Unless there are no alternatives (even at the margin) to the reserve currency, the reserve currency country must be very prudent in its monetary and fiscal policies. It needs to be the low inflation country, and it needs to maintain an attractive domestic climate for capital investment.

In the 'postwar period, the U.S. has largely failed to meet these requirements.
Instead, the U.S. has added to the reserve currency pressure on the dollar by pursuing inflationary demand-management policies and subjecting capital income to multiple taxation. During President Reagan's first term, when these policies were replaced with tight money and reduced in-come-tax rates, the dollar soared (despite a large trade deficit), regaining much of the value it had lost since 1968. However,
U.S. policy makers did not understand the inherent tendency of a reserve currency to weakness, and they retreated from the policies that had allowed the dollar to re-cover from, and to cope with, the reserve currency problem.

By March 1995 the dollar had fallen to 1.4 marks and 90 yen from four marks and 360 yen in 1968-declines of 65 and 75, respectively. Part of the appreciation in the mark and yen is due to their growing role as reserve currencies. As people re-duce their dollar risks by diversifying into the mark and yen, their value rises. These portfolio shifts explain the extraordinary difference in dollar prices of goods and services in Japan, Germany and the U.S.
The U.S. dollar continues to be the primary reserve currency, because Japan and Germany are not large enough to take on more than partial roles. It is this lack of a full alternative to the dollar that could result in a breakdown of the international monetary system.

Consider the latest drop in the dollar and its effect on those who use it as a store of value and medium of exchange, such as the dollar-linked Pacific Rim countries. By using the dollar, they are losing wealth and incurring transaction risks and hedging costs that they could avoid by switching to yen. It seems logical that the use of the dollar for transacting and storing wealth will fall as the dollar falls, thus reducing the demand for dollars and adding to the down-ward , pressure. At some. point, dollar-linked countries, such as Hong Kong, may delink, and the Saudis may stop pricing oil in dollars. The resulting drop in demand for dollars would add more downward push to a dying reserve currency.

However, there is a limit to the extent to which the already overvalued mark and | yen can absorb flight from the dollar. Flight from the reserve currency when there is nowhere to go means a breakdown of the international monetary system.

When British sterling failed in its re-serve currency role, the dollar was there to assume the mantle. Unless the dollar can last until, for example, the 1.2 billion Chinese build a capitalist economy that can take on the role of reserve currency, a big crisis is somewhere in our future.

A reserve currency country has wide responsibilities. It can run a trade deficit, but it cannot have policies that reduce the demand for dollars as a store of value and a medium of exchange-such as inflation or policies that create an unattractive climate for capital.

A balanced budget might help to restore some confidence, but it would be self-defeating if it is achieved through taxes that fall on capital. The U.S. needs a thorough tax reform that ends the multiple taxation of capital; stable monetary policy that does not yo-yo interest rates by alternatively pumping up and then restricting demand; and a balanced budget that stops pumping out more dollar-denominated as-sets. These reforms would boost the demand for dollars and raise the currency's exchange value by curtailing the portfolio shifts that have caused the over-appreciation of the mark and yen.

The dollar's postwar decline was re-versed only by the supply-side policy of Mr. Reagan's first term. If this is not ac-knowledge, the only dollar policy will be continuing depreciation, leading ultimately to the breakdown of the international monetary system.

 

 

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