Which Way the Dollar?

The dollar has done pretty well this year, compared to what many people expected. The chart below shows the dollar against the euro over the past two years (expressed as euros per dollar). While the dollar fell throughout most of 2003, so far in 2004 it has mostly held steady, despite a fall in demand for US bonds by Asian central banks.

This week’s Economist warns, however, that this may be just a pause before the dollar’s fall resumes. The crux of their argument is the usual one: the US current account deficit is unsustainable, and at some point foreign investors will lose interest and/or confidence in US assets, thus reducing the demand for the US currency.

The argument makes sense, and would probably be evidently true for any other country in the world. But those who say that the US is different have a point. No other country in the world has a currency that is effectively the world’s reserve currency. With any other currency, demand might fall if the world’s investors lose confidence and want a “harder”, more worldwide-acceptable currency. But the US has the most widely accepted currency in the world, and can’t run out of it. That might make a difference, in that it is conceivable that US assets will not become as unattractive as The Economist and others (myself included) have thought. It’s a question that I’m still wrestling with, and probably one that no one in the world knows the answer to.