Is the dollar doomed?

Even after the slide of the last two years it still looks over-valued: that's bad news for all of us.

December 19, 2006 03:06 PM

There are plenty of big economic questions that will be answered in 2007. Will there be a global trade deal? Can the German economy shrug off the impact of higher taxes? Can China continue to grow at 10% a year? Will oil prices stay high or come crashing down? But they are all sideshows to the main event. The really crucial question for 2007 is whether it is the year when there is a run on the dollar. There are plenty of people out there - me included - who think the US currency is going to take a beating over the next 12 months.

Here's why. Over the past decade, the dollar has had two big strengths. Firstly, it has been the world's only reserve currency: secondly, its economy has grown far faster than its two big rivals in the developed world - Europe and Japan. Neither of these factors is now as powerful as it was even a couple of years ago, the last time the dollar had a real wobble on the foreign exchanges.
The advent of the euro has meant foreign investors now have a choice of currencies in which to hold their reserves. To be sure, they will still continue to stash away plenty of greenbacks, but the balance is likely to change over the year. Iran's announcement that it was diversifying its portfolio was clearly a political shot across Washington's bows, but it was significant nontheless. Central banks around the world no longer have to load up on dollars simply because there is no alternative; the euro is one, the Chinese yuan will soon become another.

As far as the economy is concerned, the strong dollar has allowed the US to live beyond its means for far longer than has been healthy either for America or the global economy as a whole. A high dollar meant exports into the US were cheap, and that kept both inflation and interest rates low. Easy credit terms meant that the US has had not one but two speculative booms over the past decade, the first in dot com shares, the second in the housing market. Growth has been artificially boosted and the trade deficit has exploded.

Now, though, things have started to change. The US economy has slowed down markedly during 2006 as the housing bubble has collapsed and the eurozone has put in a decent performance for a change. The move from dollars to euros is perfectly rational when looked at on economic grounds.

A word of caution here. Those who write off the US economy do so at their peril; it is resilient and has had more comebacks than Frank Sinatra. It could well be that the world's biggest economy does rather better in 2007 than the pundits think.

What is worrying, though, is that even after falling by around 30% in the last two years the dollar still looks over-valued. The hope is that there is a controlled depreciation of the US currency that leads to a rebalancing of the economy and a lower trade deficit. But financial markets don't always work in that way. Financial markets are skittish. They get jittery. They are prone to bouts of panic. And if the dollar's fall turns into a crash - as it might well - the outcome would be higher interest rates and a collapse of consumer demand in the US, the end of export-led growth in Europe and Asia, and a world economy on the brink of the precipice.

Larry Elliott

Larry Elliott has been at the Guardian for 17 and a bit years, and the newspaper’s economics editor for the past 11. He coauthored the Age of Insecurity with Dan Atkinson in 1998.

His areas of particular interest are globalisation, trade, Europe, development and the interface between economics and the environment. Outside of the Guardian, he is on the editorial board of Catalyst, a council member of the Overseas Development Institute and a visiting fellow at the University of Hertfordshire.