The dollar has dived as investors switch out of what was a safe haven currency during the initial phase of the credit crunch, preferring to put their money into rising shares. The advantage to the US economy is bigger exports to China – one reason fo
r last month's spat, as both levied trade tariffs against the other.
In Britain, Mervyn King, the impish governor of the Bank of England, has been having fun deliberately talking sterling down in a bid to boost exports. He has succeeded all too well, with the pound heading towards parity with the euro. A weak currency fuels inflation – because imports get dearer – but King believes the massive surplus capacity in the UK economy resulting from the recession will keep domestic prices in check.
All this is reminiscent of the exchange rate games played during the Great Depression when countries tried to export unemployment by cheapening their currency. While today's G20 countries have been pronouncing on the value of mutual co-operation, they have also been trying to gain a sneaky advantage through competitive currency devaluations.
The danger in this strategy is that it can provoke retaliation. Yesterday, the dollar fell following reports that the Gulf states are in secret talks to replace the greenback as the currency for trading in oil. This would be bad news for America as it could no longer simply print dollar bills to pay for its petroleum imports.
This year has seen a chorus of proposals to dump the dollar as the global reserve currency. Some 70 per cent of the world's central bank currency reserves are held in dollars. China alone has $2 trillion (£1.3tn) held in the form of US Treasury bonds.
In March, Zhou Xiaochuan, governor of the People's Bank of China, proposed the dollar be replaced by a new international reserve system managed by the International Monetary Fund. In June, the IMF itself floated the idea of replacing the greenback with so-called special drawing rights – an artificial currency backed by a basket of existing currencies. And last month, the UN Conference on Trade and Development blamed the dollar for the current crisis and called for the creation of a new, "international" trading currency.
Such pronouncements should not be taken at face value. The Chinese make them periodically as a way of putting pressure on the White House. When pressed, Beijing usually mutters dropping the dollar is a long-term aspiration.
The reason for this reticence is simple: being a global reserve currency has disadvantages as well as advantages and no-one but America is anxious to volunteer. On the advantage side: America can print dollars to buy imports while the world's central banks merely put this cash in the vault or use it to trade with everyone else. The disadvantage lies in the so-called "Triffin Dilemma", named after the Belgian economist Robert Triffin.
As the supplier of the world's reserve currency, America has no choice but to run current account deficits; i.e. get in hock to the rest of the world. If the US stopped running deficits (thus supplying reserves to everyone else) the resulting shortage of liquidity would cause global trade to collapse.
Conversely, as foreigners pile up paper claims on America (that $2tn in the Chinese central bank) everyone gets edgy. If the dollar loses value, China loses its savings. But if China starts buying Texas with its dollar hoard, Americans will panic. Being a reserve currency is like keeping a time bomb in your living-room.
The truth is that there is no immediate replacement for the dollar as a reserve and trading currency, particularly as the US financial system is still the most flexible and liquid one in the world. Ultimately, I favour a new global currency, but that's decades away. Meantime, for economies seeking protection from the risks of piling up dollar-denominated reserves, there is the option of regional currency federations, such as the eurozone.
As for the UK, let's hope Mervyn King is right about our low inflation prospects. Otherwise his dicing with the value of sterling could so frighten foreign lenders that the government cannot fund its borrowing next year without sending interest rates into orbit.
