In short, the dollar rules, to the great benefit of the U.S. Could it lose its dominion? It could. Flabby monetary policy could bring on nasty inflation, a collapse in Treasury bond prices and the dollar and a lot of economic hardship.
Two worrisome signs are a flight of private money from the dollar and negative real interest rates. Private investors are starting to move their money to China and other countries with currencies they expect to appreciate. As a result China’s foreign exchange reserves have increased rapidly while its trade surplus has begun to shrink. For real rates, compare the nominal return on short‐term Treasury bills (less than 1.5%) with the rise in the consumer price index over the last year (5%). Someone sitting on cash in the form of T bills is seeing his wealth shrink (and this is before income tax is subtracted). Neither U.S. savers nor foreign central banks are willing to undertake this sacrifice forever.
Asian countries and the Gulf states are sitting on huge piles of dollars from being net exporters, and their central banks have been gathering up those dollars to maintain their link to the greenback and to keep their own money from appreciating too fast against it. They invest most of those reserves in U.S. government bonds. Foreign central banks purchase roughly 80% of all the new debt issued by the U.S. government.
The Fed’s loose monetary policy and the resulting flight from the dollar have therefore paradoxically strengthened America’s credit standing, as the greenback’s weakness has induced foreign central banks to buy unwanted dollars and use them to purchase U.S. government bonds. This has drained new Treasurys from the market. Meanwhile, with the collapse of the housing bubble and the implosion of some hedge funds and special investment vehicles, private paper has gotten harder to use as collateral, so there has been a domestic flight to quality and Treasurys. All of which is why the prices of Treasurys remain elevated and their yields low.