Tuesday, October 13, 2009

The Problem for the Dollar

Since World War II, the dollar has been the reserve currency of the world. As such, global products like oil were priced in dollars. Central banks held large dollar reserves as a natural part of their facilitation of international trade. Why is everyone now talking of abandoning the dollar as the world's reserve currency?

The answer is very simple. Holding dollar reserves means holding a dollar-denominated asset. (No one holds dollars themselves...that would be silly). Up to now, holding treasury bills was the preferred method of holding dollar reserves. Increasingly, other countries no longer trust the security of US Treasury bills. That is the problem. Not the dollar per se, but how do you hold dollar reserves safely.

Maybe the Chinese will solve this problem for us. They could issue Chinese government bonds denominated in dollars. Then central banks around the world would hold Chinese government debt and the dollar could remain the reserve currency of the world. But as long as treasuries are the main instrument for holding dollar reserves, look for the world to abandon the dollar as the reserve currency.

This will be part of the Obama legacy...a legacy well earned.