THE most disturbing aspect of the current financial crisis is that no U.S. official has correctly identified its primary cause. Experts variously attribute the economic reverses to subprime lending, derivative trading, excessive leverage, and regulation that was either too lax or too strict (take your pick), but these are symptoms rather than causes. Ignored is the main culprit: the dollar’s role as the world’s main official reserve currency. Though he almost certainly doesn’t realize it yet, President-elect Barack Obama will either set the dollar’s reserve-currency status on the path to extinction or risk becoming the next victim of what we call “the reserve-currency curse.”
Official reserves are money held by governments and central banks for the settlement of international payments. A Spanish bank may not want to accept Indian rupees, and it might be inconvenient for Qatar Petroleum to accept Mexican pesos for a million barrels of oil. An official reserve currency is one everybody agrees to accept, and right now that currency is the dollar. But foreign-exchange reserves are commonly held in the form of government debts of the nation that issued the currency. In the case of the United States, that includes all those government bonds piling up in China and elsewhere. The problem is that, unlike gold, official dollar reserves increase the money supply in one country without decreasing it in another. When reserves are being increased, the effect is inflation. When reserves are liquidated, the effect is deflation-potentially dangerous deflation.
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