The Future of the Dollar

And the Recent Rise of the Euro

Peter Ferrandi 11/27/2010

Examining a brief, summarized rise of the dollar to the recent financial collapse and the problems the dollar and U.S. economic system face; as well as the recent rise of the euro and its' place on the world currency market.

Peter Ferrandi ECO4713 Dr. Ky Yuhn 11-27-10

I. Introduction The study of economics is enormously complex, tedious and often overwhelming. The further I delve into the subject, the more knowledge I gain, yet the more I realize that there is far more to know. The topic of the economy of the United States is certainly not an exception. If anything, trying to understand the vast complexity of the United States economy; its rise, its current standing, and how it has created a global economic atmosphere; can prove tiresome. The U.S. economy now lays partially lifeless, perhaps traumatized after narrowly escaping an elephantine blunder of the financial sector; rivaled only by the Great Depression. This financial catastrophe has seeped deep into the roots of our economic system, or maybe it has simply exposed the root rot that has been there for quite a while. The U.S. economy is now left with serious challenges and lingering questions: What is our economic future nationally and what is our economic future relative to other leaders in the global economy? What is the future of the dollar and will it always be the key currency of the global economy? This paper attempts to shed perhaps a glimmer of light on the topic, with use of both fact and opinion respectively. Currency is at the root of a discussion concerning the notion of a global economy. International finance has intertwined many world nations due to their relative holdings of each other's assets and currency reserves. For a substantial period of history, the U.K. pound sterling held the title of key currency on the international level. As stated in the
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topic handout, it wasn't until post-WWII that the U.S. dollar replaced the pound sterling as the new international key currency. Since that period, the United States has remained at the top in regards to global economic standing and therefore its' respective currency has also continued to be used for most international financial transaction. Of course, the future does not seem as bright for the dollar due to the economic conditions as of recent. Adding to the dollars' uncertain future, the euro has risen on a global scale since its inception. Undoubtedly, the euro has climbed in strength against the dollar. Which leaves many asking questions concerning the future standing of the dollar, especially in comparison the euro, or perhaps even the yuan. In order to fully understand the current landscape, one must have at the very least a basic understanding of the dollars path to its' current position in the world. Therefore, the first section of this paper will be in regards to such. II. The Dollar Many before me have discussed the rise of the dollar in numerous articles and even books. Having read a few of them, one thing I can gather is that reports vary in regards to the exact time that the U.S. dollar supplanted the pound sterling as the key international currency. The handout has stated that this replacement happened shortly after WWII. This seems to be relatively common consensus on the subject matter. However, various economists have written on the subject and have expressed time periods as early as the 1920s as to when the U.S. dollar first supplanted the pound sterling
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on the international scale. An article by Barry Eichengreen and Marc Flandreau of the economics department of Berkley, seems to highlight these varying beliefs. The article is entitled "The Rise and Fall of the Dollar", and it is interesting as they hold that the dollar initially supplanted the pound sterling not in the 1930s or 1940s, but in the mid 1920s. Of course this is up for debate, however they make valid arguments for the claim. The difficulty in identifying when the dollar actually supplanted the sterling is due to the fact that the early 20th century seems to be extremely cloudy concerning the topic of currency composition of reserves. The Federal Reserve as gone on record as stating that "as much as $1,000,000,000 of the operating reserves of foreign banks" was held in dollar balances, bills and bonds.1 This is good evidence to support that the U.S. dollar had already mostly replaced the sterling. In this article stated above, they have uncovered new data that does show significant support in favor of the notion that the U.S. dollar had supplanted the pound sterling by the mid 1920s and simply widened the gap between the two by the halfway point of the century. There was a brief period of time where the sterling regained its' spot as the key currency, specifically 1933 when the U.S. dollar devalued. However, as stated before, by the better half of the decade the dollar had emerged as the major reserve currency of the global economy.

As of June 1927. Federal Reserve Bulletin (1928)

Peter Ferrandi ECO4713 Dr. Ky Yuhn 11-27-10

Although I do believe the article has much merit in proving the dollars rising superiority by as early as the 1920s, if this were false, most all can still agree that the dollar was key by post-WWII period. I feel this history is important in attempting to understand the future of the dollar, in that it helps illustrate the reasons for the rise of the dollar originally. Understanding why the dollar rose to prominence allows one to understand conditions as to why it could fall. Looking at the time period of the first half of the 20th century up until post-WWII, we see the U.S. as a growing, industrializing nation. A nation with attractive investment opportunities due to our government structure which stood for freedom of industry and sound property rights. A stable, growing nation is most certainly going to attract foreign investment. The Great Depression of course proved to be a large speed bump in the progression of the U.S. But, it was overcome and by the end of WWII, the U.S. had emerged as a strong political power. It is after the Great Depression that the U.S. began to abandon the notion of a pure gold standard. But, this is not exclusive to the United States. Almost all world power nations felt the strain of the Great Depression, subsequently abandoning the gold standard system one by one. For reference, it wasn't until 1971 that the gold standard was "officially" abolished, however gold had not been redeemed by the Fed since 1933. Since this period of time, most countries monetary unit has been defined as its' paper currency. A good example of how the U.S. dollar had taken full control as the key international reserve currency is that of the Bretton Woods System near the end of WWII

Peter Ferrandi ECO4713 Dr. Ky Yuhn 11-27-10

in 1944. This was a system to replace the gold standard, in which the U.S. dollar was used as the reference point of the system. At the time, Europe was in ruin. The U.S. was the only "strong" nation left. All other countries set the values of their currencies in terms of the dollar. In doing such, these counties' central banks had to hold large reserve of dollars. This proved to be too much of an advantage for the U.S. as it could simply just print more of its own money while other countries had to keep a keen eye on dollar reserves. Ultimately, the Bretton Woods system ended, but this wasn't until 1973. This is a great illustration as to the standing of the dollar on the world stage throughout very recent history. Considering how important the dollar still is as a global reserve currency, we are in some ways using what I like to call Bretton Woods 2.0. In the 1970s and 1980s, currencies like the yen began to rise in the international market. This did mellow by the 1990s. However, the euro was introduced in 1999 which seemed to come just at the right time to grow. The euro has up to this point become the currency of almost all of Europe. Now that the United States is on the back end of the worst recession faced since that of the Great Depression, it seems it is opportune time for the euro to now supplant the dollar as the dollar once did to the pound sterling. It seems that the rise of the U.S. dollar has now leveled off, perhaps even fallen in respect to other currencies. The foundation

Peter Ferrandi ECO4713 Dr. Ky Yuhn 11-27-10

of the euros' success is that of the entire European Monetary Union. This includes just about every industrialized nation of Europe. As stated before, the history of the dollars' rise is important in that now we can recognize conditions that facilitate the type of atmosphere conducive to a currencies success on the world market. With the European Union stretching approximately as large as the United States and with similar democratic/capitalist ideals, perhaps the euro mirrors the conditions that allowed for the dollar to rise. III. The Rise of the Euro The euro is a baby of a currency in terms of years in existence. It was put into action in 1999 by the European Union. The euro is now used by the majority of Europe's nations. There hasn't been too much opposition as many European nations benefit from a shared currency like the Euro. Sure, without the ability of countries within the union to have their own monetary policy, may create disparities favoring one country over another. However, the smaller nations who's currency would not be too reliable or respected independently, now are experiencing monetary stability. Respectively, countries with a history of inflation like that of Germany benefit a great deal by the euro. This is due to Germany being an export nation. In recent years, it has surely grown as a world currency. Nations now hold euro reserves, and the euro bond market has grown. It is of interest to look at how the euro came to be, particularly in this modern era. Although the groundwork for the euro was in the making in certain ways throughout the
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1980s, policies that really brought about the notion of a European Union currency started in the 1990s. This can be summarized into three separate stages of development, leading us to the present euro. This three stage plan began on July 1, 1990, when restrictions on movement of capital between member states of the European Union were abolished in principle. The development of a working program to implement the changes to be made in the future had begun. The second stage began on January 1, 1994 which marked the establishment of the European Monetary Institute, or EMI. This agency was responsible for coordinating the monetary policy as well as strengthening all of the central banks of the union. Preparations were beginning to be made for a European System of Central Banks. This was in preparation for a single monetary policy and single currency. It was in December of 1995 that the European Council decided on the name "euro" for this single currency. Stage three began on January 1,1999, which established "irrevocably fixed exchange rates" of the currency of the then 11 member nations. At this stage, the euro became the official currency of these nations. The amount of nations using the euro has now grown presently to 16. Since this point, the euro has truly found a place on the world market. Some would and have said that the euro is now starting to rival the dollar. In fact, since its' inception it has been the second most widely held international reserve currency. This is due to certain factors, one being the stability of the European Union and therefore the stability of the euro itself (currently). The euro also serves a rapidly expanding area of

Peter Ferrandi ECO4713 Dr. Ky Yuhn 11-27-10

approximately 320 million people, a bigger population than the U.S. The eurozones financial markets have been growing rapidly and therefore prove to be attractive to foreign nations. The euro

is now starting to become the currency of choice for companies around the world looking to issue international bonds and equities. By 2003, the euro had become the most popular currency for international bond issues. As the liquidity of the euro financial markets has began to increase, so has the euro gained ground as a reserve currency. Since 2003, the euro has had over a 25% share of reserves globally. Of course, the only country ahead of the euro in respect to global reserves is the United States, which is now close to 60% of global reserves. With facts like these it is very hard to deny the possibility of a possible supplant of the U.S. dollar by the euro, or at least a situation in which both currencies share an equal footing in the global economy. IV. Current Currency Problems and Possible Future This takes us to the reality of the global economic landscape, and what I consider the truth of the U.S. currency and most other currencies in the industrialized world. It is in my opinion that the fragility of the currency of the U.S. dollar and that of the currencies of other nations, increased when the gold standard began to be abandoned. We now have a currency system that is built almost entirely on perception and
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confidence, on a national and international scale. I do not expect to go back to a gold standard entirely, but I do believe that the fragile and volatile nature of our system has been exposed since the recent financial meltdown. The U.S. is now a nation of enormous capital account debt; with a currency that seems to be prodded along and propped up by an over-zealous and possibly harmful Federal Reserve. Making statements like this comes at the expense of sounding harsh or perhaps extreme. However, there is compelling evidence and proof that this system is as fragile as pointed out to be. The Federal Reserve has had a long history of dramatically influencing and shaping the U.S. economic atmosphere. It is understood that before the Fed was conceived, many banks were collapsing regularly. American confidence in the banking system was low; due to this, the Federal Reserve was created. The goal of the Fed has been to organize, standardize and stabilize the U.S. monetary system. It sought out to make the money supply more liquid in the United States so that banks could honor withdrawals from customers. Also, the Fed has attempted to create a more "elastic currency". This alludes to the fact that the Federal Reserve has the ability to influence and control prices, thereby keeping a hand on inflation. The questions are: Has the Federal Reserve been more or less successful in its' goals? Has the Fed done more good for the U.S. (and perhaps the world economy as a whole) or has it done more overall harm? I believe the answers to these questions demand a greater attention to the true nature of our economic and financial system. If
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one looks at just the surface of the situation, it may appear that the Federal Reserve has done a great job, and helped far more than it has harmed. It is in my opinion, and the opinion of many economic experts that this is not the case. The Federal Reserve has been artificially propping up the U.S. currency for years now. In recent years, the Fed has been pumping ridiculous sums of currency into the market. Last month, the Fed announced that it would be printing another 600 billion USD. This means approximately 2.3 trillion dollars have been added in about 24 months time. I'm in awe as to how one could look at these statements, these facts, and not think that this behavior could be possibly destructive to the economic system of the U.S. as well as to the international system. The notion of a fiat system has been accepted and used all across the globe. But at what point is it reality and at what point is it illusion? The subject of currency is extremely cloudy. It's very sensitive. But this can't be kept up for too much longer. The Fed will not be able to get away with shuttling more and more "hot" currency into the market. It won't be able to continue to artificially reduce interest rates, nor continue to transfer large sums of money to the U.S. Treasury. At some point, the illusion will begin to unravel. In fact, it has began to unravel. It is

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clear that foreigners do not like the current situation. Why would they? Flooding the market creates bubbles, it distorts the market and it can lead to busts and bankruptcies, perhaps even hyper-inflation. It is simply a fact the Americans have less real net wealth than they did when this millennium began. I personally believe that the Fed is attempting to create asset bubbles so that citizens will feel they have more money. By the Feds' reasoning, this would lead to more actual spending, thereby actually making more money. This is risky for obvious reasons. I believe the euro has gained significant standing on the global scale, but it too suffers from similar problems. However, I do not feel it is crazy or off the mark to suspect a greater collapse here in the U.S. and a dethroning as the world economic leader. Could the euro then supplant the dollar? Possibly. But, one thing is for certain; the U.S. economic system cannot go on in this way for an infinite period of time. At some point, as "they" say, we will have to "pay the piper".

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