Some argue that, even if the dollar is not protected by being a reserve currency, it is still safer than other currencies. If investors do not want to hold euros, pounds or yen, where else can they go?
That argument is also false. Large portfolio investors do not put all of their funds in a single currency. They diversify their funds among different currencies and different types of financial assets. If they perceive that the dollar and dollar bonds have become riskier, they will want to change the distribution of assets in their portfolios.
So, even if the dollar is still regarded as the safest of assets, the demand for dollars will decline if its relative safety is seen to have declined.
When that happens, exchange rates and interest rates can change without assets being sold and new assets bought.
If foreign holders of dollar bonds become concerned that the unsustainability of the US’ situation will lead to higher interest rates and a weaker dollar, they will want to sell dollar bonds. If that feeling is widespread, the value of the dollar and the price of dollar bonds can both decline without any net change in the holding of these assets.
The dollar’s real trade-weighted value already is more than 25 percent lower than it was a decade ago, notwithstanding the problems in Europe and in other countries.
And, despite a more competitive exchange rate, the US continues to run a large current-account deficit.
If progress is not made in reducing the projected fiscal imbalances and limiting the growth of bank reserves, reduced demand for dollar assets could cause the dollar to fall more rapidly and the interest rate on dollar securities to rise.
Martin Feldstein, professor of economics at Harvard University and president emeritus of the National Bureau of Economic Research, chaired former US president Ronald Reagan’s Council of Economic Advisers from 1982 to 1984.
Copyright: Project Syndicate