The Volatile Dollar

This article appeared in the July 2009 issue of Globe Asia.

The course of the us dollar over the past fewyears has been anything but smooth. From November2002 until mid-July 2008, the greenback lost 37% of itsvalue against the euro. This period of dollar weaknessbegan when Ben S. Bernanke, then a Federal Reserve governorand now the chairman, persuaded Alan Greenspan, then chairman,that the US was in the grip of deflation.

In consequence, the Fed pushed down on the monetary accelerator.By July 2003 the Fed funds rate had been squeezeddown to 1%, where it stayed for a year. This artificially low interestrate set off the mother of all liquidity cycles. Artificially lowinterest rates encouraged investors to take undue risks, chasingthe slightest available yields. To make the most of tiny yields,leverage became the flavor of the day.

Carry trades — borrowing in low-yield currencies, such asthe dollar, and investing in higher-yield ones — also becamepopular. Borrow, borrow, borrow. The resulting mountain ofdebt had to collapse, and it did. From mid-July 2008 until the endof November 2008, the dollar switched course, surging againstthe euro with a 28% appreciation. It was during this period that the asset bubbles created earlier started to pop. Inconsequence, the demand for dollars soared as carrytrades were unwound and investors scrambled tofind shelter from the storm.

As the skies began to clear in December 2008,the dollar reversed course again. Indeed, in the December2008-June 2009 period, the greenback lost11% against the euro. The volatile dollar has resulted,among other things, in a wild roller-coaster ride forcommodity prices.

The dollar-commodity price linkage exists becausemost commodities are priced and invoiced indollars. In consequence, even if a commodity's supplyand demand fundamentals don't budge, the nominalprice of a commodity will change as the value of thedollar changes. If the dollar's value sinks, the nominalprice of a commodity will rise and vice versa.

The accompanying chart traces the movementsin the dollar-euro rate and the path taken by the CommodityResearch Bureau's index of 22 commodities. As the dollar lostground, commodity prices took off. Indeed, the weak dollar accountedfor the bulk of the commodity price increases during thegreat commodity bull market which ended in July 2008.

Thin dotted line: USD/Euro (left axis)
Thick solid line: CRB all US commodities Spot Index (right axis)

Movementsin the dollar-euro rate

Contribution to oil price

For example, crude oil traded on the spot market at$19.84 per barrel on 28 December 2001. Adjusted for the changein the value of the dollar, assuming no changes in crude oilfundamentals, the nominal price of crude oil would have been $81.45 per barrel on 11 July 2008. In fact, the price on 11 July2008 was $145.66 per barrel.

Therefore, the drop in the value of the dollar contributed 51%of the price increase from the end of 2001 to mid-July 2008 andpositive fundamentals (changes in supply and demand) contributed49% of the increase in crude oil price.

The volatile dollar, which serves as the world's premier currency(see accompanying chart), has opened the door for complaints.For one thing, commodity producers and consumersdon't like the unstable commodity prices that accompany a volatiledollar.

Composition of world allocated foreign exchange reserves

Composition of worldallocated foreign exchange reserves

It's no surprise that both Russia and China have raised thespecter of replacing the dollar as the world's reserve currency.Moscow and Beijing have suggested using the InternationalMonetary Fund's Special Drawing Rights (SDR) instead of thegreenback.

The SDR was created in 1969. At present, it is an artificialmetric which consists of 0.6 US dollars, 0.4 euros, 18.4 yen and0.09 British pounds. Its value fluctuates with exchange rates.Today, one SDR is equal to 1.54 US dollars. The SDR is nota tangible medium of exchange or a claim on one. It's simply anaccounting metric the IMF uses to balance its books. It has noreal commercial application.

This led the Brazilian economist Prof. Alexandre Kafka, whoserved as an executive director of the IMF for over three decades,to lament that the IMF's "basket currency" had become a "basketcase." Until a few months ago, it appeared that a 40-year experimenthad ended in failure. Or has it?

While the dollar is not going to be displaced by the SDR asthe world's reserve currency anytime soon, the stars seem to bealigned for a full-blown debate about the SDR's future role.Perhaps another chapter in the long-running SDR saga isabout to open. As a precursor, the April 2009 Group of Twentymeeting in London concluded with a pledge to increase the IMF'sSDR allocation by $250 billion. That is almost an eight-fold increaseover the current stock of $32 billion.

In addition, the Russian bear is showing its teeth and Chinais gaining ground in the economic power game (see accompanyingtable). Both are beating the drums for wider use of the SDR.

Share of World GDP (%)
Share of World GDP (%)

Source: The Conference Board and Groningen Growth and Development Centre, Total Economy Database, January 2009 ( andauthor's calculations. Note: The GDP numbers are converted at Geary Khamis
PPPs to 1990 USD. N/A: Not available

And that's not all. The current IMF managing director isDominique Strauss-Kahn, a French socialist and a strong SDRadvocate. Interestingly, the last time the SDR received a big boostwas in the late 1970s, when the IMF's managing director was thedistinguished Frenchman Jacques de Larosière.

Dollar hegemony has never been a Paris favorite. With Moscowand Beijing joining in, the SDR promises to become a favoritetopic of the chattering classes, if not more.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C