The Oct. 1 Baker Institute conference commemorating the 30th anniversary of the Plaza Accord covered many monetary policy issues, both past and present, with the appearance of several notable figures in currency policy. Former Federal Reserve chairman Paul Volcker himself made an appearance, via a video interview with Russell Green, the Will Clayton Fellow in International Economics at the institute. Among other things, Volcker and Green discussed the status of the U.S. dollar as the world reserve currency and the possibility of that status being supplanted by the euro or the Chinese yuan (also known as the renminbi). When asked whether either of these currencies could possibly replace the dollar, Volcker said that the Eurozone no longer has the stability necessary for a reserve currency and the yuan does not have the transparency necessary for international investors and nations to have faith holding it in reserves. This is clearly an important issue, but what does it really mean to be a reserve currency? Why do countries (and, in the case of the European Union, currency zones) try to gain reserve status for their currencies? To fully understand why the dollar may be under threat as the world reserve currency, these questions must be addressed.
China has recently made a push for their currency to be included in the International Monetary Fund’s Special Drawing Rights, a step towards becoming a world reserve currency. However, simply being included on an official list does not immediately lead to reserve currency status. Reserve currencies, by definition, achieve that status by being widely seen as a safe enough asset to be held as a reserve for protection. Despite recent uncertainty about the state of U.S. debt, the dollar, in the form of U.S. Treasury bonds, remains the safest and most liquid asset available to emerging economies. This is proven by China’s own decision to hold large reserves of U.S. dollars. The popularity of a given currency, which is tied to its perceived stability and safety as an investment, determines its status as a global reserve currency. Therefore, for the dollar to be under serious threat of losing its position, there must be an alternative currency that is held in higher regard by the rest of the world. As Volcker stated, as of now, despite the United States’ recent financial woes, it is still doing better than everyone else. As a result, global demand for the dollar remains high and the dollar remains strong internationally.
The large demand that comes with being a reserve currency tends to increase the value of a currency. This explains why, in spite of the Federal Reserve injecting money into the economy, the dollar remains strong. This allows the U.S. to maintain large debts by borrowing more cheaply than otherwise. This strength, however, comes with the disadvantage of a higher exchange rate, hurting exporters. This begs the question, even if China could establish its currency as a global reserve, should it do so?
Alex Alexander is a junior at Rice University majoring in economics.