Budget cuts are the dollar's savior

Americans should look at the battle of the budget in Washington as bigger than typical power-play antics. Not only is the tussle over spending a way to define government’s role. It will also dictate the future of US leadership – and its values – in the global economy.

The best measure of that influence lies in the continuing strength of the US dollar as the world’s dominant currency for countries to hold in reserve and for use in trade.

The closer Democrats and Republicans get to a deal on dramatic cuts in the deficit, the more likely the greenback will keep its perch as the global banknote of choice.

Without a credible agreement to reduce trillions in US debt, however, the wolves will soon be at the gate in an attempt to dethrone the dollar, and Americans will lose the benefits of easy trade in dollars and the use of credit from countries recycling dollars back into purchase of Treasury bonds.

The nipping of the wolves has already begun. It is led by China, and supported by countries from France to Brazil. The dollar’s dominance will be a topic at this week’s meeting of the Group of 20 countries and the International Monetary Fund (IMF). But the tone for those conferences was partly set Thursday in the third summit of the so-called BRIC nations – Brazil, Russia, India, China – plus South Africa this time.

They agreed to use their own currencies for trade – a practice that would diminish the dollar. Together, the five BRICs have 40 percent of the world’s population and command more than a sixth of the world’s economy, a portion expected to match the US share in a few years.

China has already begun reducing its vast holdings of US dollars. That is the most worrisome sign yet of how much both markets and countries are losing confidence in Washington’s ability to rein in its debt, despite the recent agreements between President Obama and Republicans on the remainder of this year’s budget.

China is also building up its own currency, known as yuan or renminbi, as an instrument of trade while calling for a new way to have a global reserve currency other than the dollar. “The current international currency system is the product of the past,” China’s president, Hu Jintao, said recently.

So far, Washington has been fortunate that the euro, the yen, the yuan, or the IMF’s own synthetic currency (“special drawing rights” ) have not come close to knocking the dollar down. America’s giant and open economy, as well as its political stability as a democracy, are hard to beat. A recent IMF report in February said the dollar would remain the world’s most important reserve currency for the “foreseeable future.” (About 61 percent of global reserves are in dollars.)

But the US dominance only assumes Washington finally sees the error of its profligate ways before there’s a run on the bank, so to speak, as investors perceive the US Treasury may not back up its bonds. Just as the US dollar began to take over from the British sterling in the 1920s as the world’s top currency, China’s yuan may be on its way to take over the dollar.

But how soon? And will it be slow and organic, or quick and drastic?

China’s mercantile way of controlling its economy and manipulating the value of its currency only works against its hopes of usurping the dollar. Its authoritarianism is inherently unstable, and its values run counter to those set by the US in the global system.

But if China inches toward democracy and freer markets during this century, its currency, along with others, might define a new multipolar currency system in which the US dollar becomes merely a first among equals.

How that trend plays out depends in large part on the political battles in Washington over issues like Medicare and tax reform. The leaders there need to see their roles in that long-term contest over the values of the global system.