Dollar is taking a bashing while it is down, but not out

You know the outlook for the US dollar is bad when two personalities as varied as Sarah Palin and Robert Zoellick are sounding the same bleak prognosis.

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You know the outlook for the US dollar is bad when two personalities as varied as Sarah Palin and Robert Zoellick are sounding the same bleak prognosis. On Wednesday, Ms Palin, the head mistress of America's intellectually inbred, implied that US President Barack Obama's record budget deficits were undermining the dollar's credibility as the world's reserve currency. "We can see the effect of this in the price of gold, which hit a record high today in response to fears about the weakened dollar," she wrote on her Facebook site. "All of this is a result of our out-of-control debt."

Her remarks followed comments by Mr Zoellick, the head of the World Bank and arguably the most supple mind in Washington, that "the United States would be mistaken to take for granted the dollar's place as the world's predominant reserve currency". Set aside the fact, which Ms Palin withheld from her adoring web lemmings, that the dollar's descent last week only intensified a trend that began eight years ago with the arrival of a Republican president and his own contempt for fiscal restraint.

The dollar's fortunes are darker now than almost a year ago and considerably grimmer than they were when George W Bush, the former president, squandered a budget surplus on import duties, price supports and an unnecessary war. All told, the dollar has shed 30 per cent of its value over the past seven years, a third of which has been lost under Mr Obama's watch. Last week's attack on the dollar was triggered in part by a report in the UK press about a conspiracy among oil producers and their client states to discard the dollar as the standard currency for global energy markets. The account was apparently bogus, the dollar soon stabilised and there remains a surplus of countries willing to purchase US sovereign debt.

But while reports of the dollar's demise as the world's reserve currency remain premature, they have accelerated in frequency along with the exponential increase in America's indebtedness and its stubborn reliance on foreign creditors to bankroll what is still the world's largest economy. Less than a year ago, for example, only the wonkiest of financial gnomes knew what the IMF's special drawing rights (SDR) were. That changed in March when Zhou Xiaochuan, the governor of China's central bank, suggested SDRs, a synthetic currency used to settle transactions among central banks, might replace the tanking dollar as the world's reserve currency.

Mr Xiaochuan, who helps manage Beijing's estimated US$800 billion (Dh2.93bn) in dollar-denominated reserves, has a clear interest in reserve-currency diversification. Since then, however, other governments have indulged in various forms of dollar bashing. The Russian prime minister Vladimir Putin criticised the Federal Reserve chairman Ben Bernanke for an "uncontrolled issue of dollars"; the government of Kazakhstan has called for the dollar's demotion; and Iran has announced it was switching its reserve currency from dollars to the euro.

Lest such protests be dismissed as political theatre, note that just last month the respected Peterson Institute for International Economics published a paper that suggested SDRs should be expanded in circulation and that they could represent a viable alternative to the dollar. Last week's dollar sell-off was significant for several reasons. For some months now, investors have been unwinding their flight-to-quality dollar positions, taken a year ago with the fall of Lehman Brothers, for higher-risk opportunities elsewhere.

When the Australian central bank last week announced its surprise decision to raise interest rates, it accelerated dollar-selling for such high-yield, commodity-linked currencies as the Norwegian krone and the Canadian and New Zealand dollars. The Financial Times reported last week that anticipated demand for commodities is so great that some large investors, concerned about the limits of paper futures contracts, are inquiring about the feasibility of warehousing everything from precious metals to livestock.

While it is unclear whether other central banks will respond in kind to Australia's credit tightening - the Fed will probably be among the last to do so - its pre-emptive strike illustrates how uneven the contours of recovery are and just how challenging efforts by the Group of 20 (G20) leading and developing nations co-ordinate deleveraging might prove to be. Scattershot rate increases are bound to place increasing pressure on the dollar, raising the spectre of sustained inflation, while diminishing faith in Washington's ability to reverse its decaying fiscal condition will most certainly raise the price of servicing its debt.

As late as last summer, economists were uncertain whether a recovering global economy would have bullish or bearish implications for the dollar. The events of last week pointed emphatically towards the latter. The US economy is fundamentally frail and its political system is teetering toward the sclerotic. While the dollar will no doubt drift along as the reserve currency for some time, responsible central governments are most certainly preparing for the day when its authority can no longer bear the weight of its liabilities.

That alone augurs for an inflationary spiral, which in the words of Theodore H White, the late American journalist and historian, happens "when a government has made too many promises it cannot keep and papers over the shortfall with currency which, ultimately, becomes confetti - and faith is lost". @Email:business@thenational.ae