"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 pres-sure," 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. …