In What Do We Trust? Currency and the Search for Stabiliy

February 19, 2003
By Arthur Eliason

In his interview for In the National Interest last week, Maurice R. Greenberg observed, in response to a question about exchange rates, "The Euro has appreciated not because Europe's economy is doing better than that of the United States, but because of negative perceptions about the U. S. economy.  Once the war with Iraq is over, we will see an upturn in the economy, a psychological lift.  I believe that we will see a much-improved U. S. economy in the second half of 2003."  (http://www.inthenationalinterest.com/Articles/vol2issue6/vol2issue6Greenberg.html)

Perception is indeed driving economic reality.    There are very real fears about the stability of the dollar and deep concerns that, in the event of another paralyzing terrorist strike or a protracted war with Iraq, the value of the dollar could quickly erode.  Since mid-2002, when it became clear that the Bush Administration was intent on including Iraq within the parameters of the war on terrorism, banks and businesses around the world, accustomed throughout the 1990's to considering the dollar the de facto currency of a globalized world, have been searching for alternate ways to preserve the value of their assets.

Asian central banks, in particular, have been shifting a portion of their holdings from dollars to gold, and this has led to a steady increase in the price of gold.  On March 8, 2002, gold was valued at $289.15 an ounce.   Two weeks ago, gold closed at $382.10 an ounce, the highest price ever in the past five years, although the price has since declined to the $350 per ounce range (closing Friday at $351.30).  What is significant about this development is that the price of gold has more or less appreciated since February 2002 and is higher now than the "spikes" that occurred in the gold price in the run-up to Y2K and in the immediate aftermath of 9/11.

The other development has been the devaluation of the dollar vis-à-vis the euro.  Mr. Greenberg is correct to note that this is not due to any fundamental strengthening of the European economies at the expense of the American.  After all, when the euro was first unveiled, it was heralded as an "alternative" to the dollar, and promptly began a steady decline to the greenback, reaching its lowest point in October 2000, when it was worth approximately 80 cents.  Since mid-2002, however, like the price of gold, the value of the euro has increased, due to perceptions that the dollar is more volatile.  On December 6, 2002, the euro closed worth more (on a one-to-one basis) than the dollar, and has remained the stronger of the two currencies ever since (this past Friday, one euro was worth approximately $1.07).

What will be interesting to observe will be the Russian reaction to these developments.  The decline of the dollar has not been in Russia's interest, because most of its energy exports are denominated in dollar terms, yet most of its imports come from the EU and are priced in euros; a good deal of its external debt is also euro-denominated.  The decline of the dollar has thus lessened the value of Russia's energy supplies, cutting into its revenues, while making its imports more expensive.  Indeed, the fact that many Russian retailers have switched the so-called "unit" price for goods from dollars to euros means that Russian consumers have experienced a six percent increase in prices (in other words, a good priced at 100 units that in December was dollar-denominated is now still priced at 100 units, but pegged to the euro).  It is not accidental that the Russian Central Bank has tried to stabilize the position of the dollar in the last month.  Another response might be to accelerate sales of gold to take advantage of increased demand; Deputy Industry Minister of Yakutia Vladimir Fedorov recently announced that this republic, one of the key gold-producing regions of Russia, was planning to produce 18 tons of gold in 2003.

At any rate, it is clear that markets are keeping their finger of the pulse of Washington.  The fall in the gold price that took place this past week occurred in part because traders assumed that the moderate tone of the report presented by Hans Blix to the UN Security Council meant that the imminence of war was decreasing.  Yet the sense of walking on a tightrope remains acute.  The dollar plays an important role in facilitating the smooth operation of the global economy.  If it falters, there is no immediate successor, for both gold and the euro have their limitations.  And this could be an additional source of economic instability not only for the United States, but for international energy and commodity markets.

Arthur Eliason is an independent consultant in international business and economic affairs.