The world relies on a universally accepted currency to be able to transact business on a global scale smoothly. In the 19th century, the British pound sterling served the purpose. After World War ii, since the U.S. was the world’s biggest economy and the only major power whose industrial base was not damaged by the war, its dollar gradually replaced the pound as the currency of choice. The world’s central banks still hold most of their reserves in U.S. dollars—that’s why the greenback is known as the world’s reserve currency. But that is starting to change.
According to a survey of 65 central banks conducted by Central Banking Publications from September to December of 2004, an obvious change in attitude toward the dollar occurred since the last time the survey was made, in November 2002.
During the past two years, about 70 percent of central banks increased their euro holdings, while almost half cut back on dollar reserves. The majority of bank managers polled feel that investing in eurozone debt and money markets is just as attractive as investing in the U.S. Consequently, not a single one intends to increase his or her proportion of dollar reserves.
This means it will become increasingly difficult for the U.S. to finance its growing current account deficit—the difference between the amounts of money going out of the country and that coming in (mostly due to trade imbalances).
One reason the U.S. has been able to carry such a large current account deficit is that it owns the world’s reserve currency and nations have been eager to hold it in their vaults. But look for world events to nudge central bank managers toward the euro even more than they already have, and for the euro to increasingly rival the dollar as the world’s reserve currency.
As that status shifts, so too will strategic power in the global markets. That in turn will weaken the power of the U.S., which will no longer enjoy the many advantages of owning the world’s reserve currency.
It happened to Great Britain. It’s going to happen to the U.S. too. It’s just a matter of time.