When the monetary history of the year coming to an end is written decades from now, the headlines of European debt crisis and Federal Reserve's adoption of QE2 may turn out to be mere footnotes to the bigger story: 2010 could be a watershed marking the beginning of the end of the dollar-based, Western-centric monetary system.
To be sure, suggestions that the system dubbed Bretton Woods II should be supplanted by a new regime began in 2009. China proposed the creation of a new, multinational currency for international transactions and as a reserve asset.
This year, the idea of reform was advanced by World Bank President Robert Zoellick, who proposed in a widely read and commented-upon Financial Times op-ed piece "a cooperative monetary system that reflects emerging economic conditions." That would include the dollar, the euro, the yen, the pound and the renminbi -- plus gold "as an international reference point of market expectations about inflation, deflation and future currency values."
Zoellick's November commentary followed the outbreak of the so-called "currency wars," as Brazil's finance minster dubbed the tensions in the foreign-exchange markets resulting from Fed's liquidity expansion through the purchase of $600 billion of Treasury securities, dubbed QE2, for the second phase of quantitative easing. The downward pressure on the dollar from the surfeit of greenbacks was viewed by finance officials abroad from Asia to Europe as well as Latin America as tantamount to a competitive devaluation to boost the U.S. economy while beggaring its neighbors.
The ire aroused internationally by QE2 has been compounded by events that demonstrate there really is no ready substitute for the dollar as an international reserve currency. The hope had been for the euro to provide a viable alternative to the dollar, and for a time the single currency seemed to growing into that role. Prior to the financial crisis of 2008-2009, for a time more global bonds were issued in euros than dollars.
But the European sovereign debt crisis has resulted in what German Chancellor Angela Merkel called "serial bailouts" of first Greece last spring and now Ireland. The current crisis lays bare the contradictions that have beset the euro from the start: monetary union without fiscal union, not to mention nationalistic animosities going back decades, even centuries. How long the serial bailouts can paper over these things remains to be seen.
Dissatisfied with the options of the dollar or the euro, the ascendant economic powers are essentially cutting out these middlemen. Just Wednesday, Micex, Russia's largest securities exchange, began trading in the ruble vs. the Chinese renminbi. It was largely symbolic given the volume traded was equal to about $700,000. More importantly, Russia and China have agreed to settle their bilateral trade of about $50 billion in their respective currencies.
That means Chinese importers don't need to obtain dollars to buy oil from Russia. Nor does Russia need greenbacks to buy Chinese goods. The vast majority of international trade has been, and continues to be, conducted in dollars.
Financial markets also are dominated by dollar instruments, even if they trade in London or Singapore or any number of financial centers around the world. But less so than before.
It used to be that if an emerging market such as Brazil wanted to borrow, it would have to issue dollar-denominated bonds because of lack of international confidence in its currency, which had been devalued and replaced numerous times over the year. Now, Brazilian government bonds denominated in the real are so sought after by international investors for their double-digit yields in an appreciating currency that the government has put a tax on foreigners wanting to buy the securities.
But the biggest development has been in the burgeoning in so-called dim-sum bonds -- securities denominated in renminbi by non-Chinese borrowers. Issuers include blue-chip U.S. corporations such as Caterpillar (ticker: CAT) and McDonald's (MCD.)
That's a huge, but largely under-appreciated development. Because the rest of the world uses the dollar for transactions and a store of value, the U.S. has been able to take advantage of that. Indeed, the greenback is America's most successful export.
So, Americans get the goods, allowing us to consume more than we produce, simply because the rest of the world wants our paper. That fuels the U.S. credit expansion that covers the gap between Americans' savings and U.S. investment, including for residential real estate. Without money from abroad, there would not have been the housing bubble. American ingenuity produced triple-A mortgage-backed out of subprime loans, which dollar holders around the globe eagerly scooped up.
These foreign dollar holders are funneling their funds into Treasury securities, effectively funding the U.S. budget deficit. But they're not doing it as willingly as before. The Financial Times reports that some Chinese have taken to calling the renminbi the "redback," in contrast to the American greenback, which gives some idea about the competition between the currencies is playing out.
None of this suggests that the dollar is about to be toppled from its perch as the premier global currency in 2011. Strains in the original Bretton Woods system were evident long before President Nixon abrogated the promise to redeem dollars for gold at $35 an ounce for foreign monetary authorities on Aug. 15, 1971. Even then, the floating exchange-rate system didn't come into being fully until 1973.
China is keeping a tight rein on the renminbi. Its exchange rate is held down by China's policy of buying dollars to keep the RMB in check. Those dollars eventually are recycled into U.S. assets.
How long this process goes on depends on the availability of alternatives to the dollar. Direct settlement of trade in the currencies of trading partners cuts into demand for dollars, as does the availability of investments such as renminbi-denominated dim-sum bonds.
When the tide changes, the shift is almost imperceptible. The tides of history are by nature very long term. The last great sea change came when the dollar replaced the pound-sterling as the world's main reserve currency. The dollar's role was cemented under the Bretton Woods Agreement following World War II, when other currencies' exchange rates were fixed in terms of the dollar and the dollar was convertible into gold at $35 an ounce.
Since 1973, the dollar has been unanchored and has been anything but a stable store of value. Based on the U.S. Dollar Index -- which measures its value in terms of a basket consisting of the euro, Japanese yen, British pound, Swiss franc, Swedish krona and the Canadian dollar -- it has risen from its 1973 base of 100 to as high as 140 in the 1980s and 120 in 2002 to a low around 74 in early 2008 as the financial crisis deepened. It currently hovers around 80.
The components of the Dollar Index seem almost quaint as they ignore the BRIC countries -- Brazil, Russia, India and China. Back then, their presence was barely felt in the world economy. And the old world order persists elsewhere; Belgium and the Netherlands have greater voting rights in the IMF than China, now the world's second-largest economy after surpassing Japan this year.
Seen from a historical perspective, if the 20th century was the American century, it would be natural that the dollar would the dominant currency. The 21st century is being called the Asian century. Brazil is part of that, now that China is its main trading partner, overtaking the U.S. So, too, is Australia, which is booming as a commodities supplier to Asia.
The demand for dollars from the rest of the world has been of inestimable benefit to the U.S. economy. It quite simply allows Americans to consume more than they produce and save less than they invest; in other words, to live beyond our means. The dollar's dominance will not be toppled in 2011 but will wane over the coming decade and beyond. And America will have to start picking up the tab for what had been a free lunch.