This article appears in the September issue of Prospect Magazine
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In the wake of Standard and Poor's downgrading of US government debt, it is tempting to write off the dollar's staying power as the global reserve currency. But before rushing to such a judgment, one needs to ask a fairly basic question. Do the outlooks for the Japanese and European economies really provide the basis for either the Japanese yen or the euro to supplant the US dollar any time soon as the world's leading international reserve currency?
Standard and Poor's was certainly right to downgrade the US's government debt. With a gross government debt of around 90 per cent of GDP and a primary budget deficit of 8.5 per cent of GDP, the US public finances are on an unsustainable path. Indeed, many observers suggest that, absent fundamental policy changes, within three years the US could be approaching Greek-like levels of national debt.
The recent sorry spectacle of the US congressional debate over raising the nation's debt ceiling offered little assurance that the country has the political will to address its budget deficit problem seriously. For rather than come up with the $4,000bn in budget deficit reduction measures over the next decade that were generally agreed upon as being essential for the restoration of US fiscal order, Congress came up with barely $2,500bn in cuts. And Congress decided to delay any serious attack on the budget deficit until after the 2012 presidential election.
Shaky as the US public finances might be, those in Japan are substantially more alarming. At over 180 per cent of GDP, Japan's public debt to GDP ratio is already by far the highest amongst the industrialised countries. Japan's population is also ageing at a considerably faster rate than any of its industrialised country peers, which raises the most fundamental of questions as to how it will be able to finance its persistently high budget deficit. An approaching train wreck in funding its government deficit hardly provides the basis for the Japanese yen to supplant the dollar.
Jean-Claude Trichet is fond of saying how much better Europe's public finances are than the US on an aggregate basis. However, this self-satisfied view glosses over the fact that it is almost inevitable that within a year or so there will be major sovereign debt defaults in Europe's over-indebted periphery. The European Central Bank itself acknowledges that should such defaults occur, Europe's core countries would experience a Lehman-like banking crisis. It is also more than likely that such defaults would pose a threat to the existence of the euro in its present form, which would hardly provide the basis for the currency to offer a serious challenge to the US dollar.
In the kingdom of the blind, the one-eyed man is king. In the global economy, it would seem that warts and all, the US dollar is not nearly in as bad shape as the Japanese yen or the euro. This makes it all too likely that, troubled as the US economy might be, the dollar is unlikely to relinquish its status as the world's primary international reserve currency any time soon.
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