“They get our oil and give us a worthless piece of paper,” exclaimed Mahmoud Ahmadinejad at an OPEC summit in November 2007. Unkind words about the American currency from an Iranian president could normally be dismissed as political bluster, but in this case it was bluster with a disturbing kernel of truth to it. Over the course of 2007, states with large dollar holdings were becoming increasingly fearful about the dollar’s long-term global purchasing power, but they simply had less incentive to sound the alarm about it.

A dollar was once redeemable for a fixed amount of precious metal, but has for four decades now been redeemable only for near-worthless metal—pennies, nickels, dimes, and quarters. It is valuable only to the extent that vast numbers of people believe that vast numbers of other people will continue, of their own volition, to exchange intrinsically valuable things for it. Should this confidence evaporate, the dollar is truly just “a worthless piece of paper.”

It is hard to imagine that this confidence could be fatally undermined any time soon. History, however, does not provide kind testimony to the durability of national monies. Many dozens of them lost more than half of their purchasing power between 1950 and 1975 alone—including the dollar, which lost 57 percent.

The Iranian president was not alone, however, in disparaging the dollar on the world stage in autumn 2007. The dollar is “losing its status as the world currency,” Xu Jian, a Chinese central bank vice director, told a conference in Beijing on November 7. “We will favor stronger currencies over weaker ones, and will readjust accordingly,” said Cheng Siwei, vice chairman of China’s National People’s Congress, at the same meeting. Their concerns were echoed two weeks later by Chinese premier Wen Jiabao. “We have never been experiencing such big pressure,” Wen said. “We are worried about how to preserve the value of our [US$1.5 trillion in] reserves.”

On the same day as Xu and Cheng’s comments, the price of gold climbed to US$833.50 per ounce, a record high in nominal terms (though in real terms still substantially below its peak in the early 1980s). Oil prices leapt to a record high US$98 a barrel. The stock market tumbled. The ABX indexes tied to high-risk mortgages fell sharply. The newswires also reported an estimate that US banks would have to write down as much as US$600 billion as a result of the housing market bust and the associated collapse of the Structured Investment Vehicle (SIV) markets. Last but not least in the parade of worrying economic news, the dollar fell to a record low 1.46 dollars/euro, down more than 75 percent from its high in 2000.

Teasing out cause and effect at any given moment is never simple in financial markets, but the signs are recognizable from the 1960s. Like China and the dollar-saturated Persian Gulf states today, European governments made similar remarks in the ‘60s about the reliability of the dollar as a store of value—just a few years before President Nixon demonetized gold in order to pre-empt a run on America’s dwindling gold stock. In the private markets, the illustrious French economist Jacques Rueff noted that people were turning to “tangible goods, gold, land, houses, corporate shares, paintings and other works of art having an intrinsic value because of their scarcity or the demand for them.” Sound familiar? Indeed, this is the story of our decade to date. In the 1960s, Rueff pinned the blame squarely on “the growing insolvency” of the dollar. Then, as today, US monetary policy was spreading inflation to countries importing such policy through fixed exchange rates, encouraging them to seek out other more reliable long-term stores of wealth.

Today, of course, foreign governments are not asking the United States for their gold back, as it reneged on its redemption pledge long ago. But they are warning that they will begin exchanging their growing hoards of dollars for other currencies and assets. Even a gradual diversification would mark the coming of a new age in international monetary relations. It would end the age of what Rueff called “the precarious dominance of the dollar” in the global monetary markets.

Financial Globalization

During the life of the Bretton Woods system, up until the early 1970s, capital flowed across borders mainly to settle current account deficits, in such a way that current account transactions largely determined capital flows. This has changed in recent decades with the globalization of finance.

According to the McKinsey Global Institute, the sum of international financial assets and liabilities owned and owed by residents of high-income countries leapt from 50 percent of aggregate GDP in 1970 to 100 percent in the mid-1980s to 330 percent in 2004. I calculate that one part of the international capital flows of the United States, total trade in long-term securities, increased from US$373 billion in 1982 to US$52.1 trillion in 2006, while total US trade in goods and services only increased from US$575 billion to US$3.65 trillion in the same period. Therefore, this portion of capital flows is now more than fourteen times the dollar volume of US trade in goods and services. Most of these capital flow transactions are autonomous, in the sense that they are not carried out to finance current account deficits. Instead, they take place as part of an ongoing worldwide diversification of investment.

Private capital entering the United States declined sharply with the collapse of the dot-coms in the early part of this decade. Yet the vacuum left by the evaporating private inflows was filled with foreign official capital inflows, most of it owned by central banks. They were invested primarily in US Treasury bonds, which in terms of risk are similar to those issued by governments of other major countries, such as Germany, France, or the United Kingdom. Yet the yields paid on US securities, when adjusted for persistent dollar depreciation, have been consistently lower than those paid on securities issued by these other governments.

Worldwide reserves denominated in all international currencies increased from a US$2 trillion equivalent to a US$5.7 trillion equivalent from 2001 to 2006. About 60 percent of the increment, or about US$2.2 trillion, was denominated in dollars. The total increase in reserves was equivalent to 178 percent of the total level of reserves in 2001. Central banks of developing countries account for 82 percent of this increase, mostly owing to exports of oil, other commodities, and, in the case of Asia, non-commodity goods and services. They more than doubled their reserves between 2004 and 2007, to what the IMF estimates as US$4.1 trillion.