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LETTER FROM EUROPE

Should we worry about the future of the dollar?
**The dollar is the currency of the world's largest economy, most international financial transactions are conducted in dollars, economic data of the world are expressed in US dollars, and most foreign currency reserves of the central banks — several trillion dollars — are kept in this currency.
THE United States Federal Reserve System was established in 1913. It is, no doubt, the most powerful central banking authority in the whole world. Every word uttered by its chairman
is examined with care by national and international financial institutions. Why?
Among other things, the Federal Reserve controls the benchmark interest rate of the US dollar, which serves as the reference rate for most financial transactions. Aside from the inevitable impact it has on the US economy such as inflation, unemployment, gross domestic product, foreign trade etc., it also affects the value of the dollar in the currency market.
Now, one may ask: Why so much fuss about the exchange rate of one single currency? Why do the central banks of most countries, particularly the Asian ones, monitor the exchange rate movements of the dollar on a daily basis?
Before answering these questions it would be interesting to know how over the last several centuries the dollar has come to acquire such an important position in the global financial system.
Needless to say, there are several versions of the history of the dollar but almost all are, in one way or another, related to the history of Spain. In 1535, Mexico belonged to the Spanish empire and large silver mines had already been discovered in that territory. According to the most reliable version, Charles I, King of Spain and Emperor of Germany, fresh from Flanders to Spain, gave orders to mint silver coins similar to those circulating in Europe under the name of "thaler." It seems the Mexicans were not accustomed to the sound of the letters "th" and so they replaced it by a clear "d." Thus was born the silver "daler," which circulated freely not only in the Spanish territories but also in the English colonies of North America.
It was Alexander Hamilton, the brilliant secretary of the treasury of George Washington, the first president of the United States, who adopted the "daler" (the Mexican silver coin) as the new nation's own currency. Following the phonetics of the English language, it soon acquired the name "dollar."
President William McKinley, who destroyed the last vestiges of the Spanish empire in the Cuban War, and perhaps unwittingly launched the US on the path to eventually becoming the sole successor to the vast global empires of Britain and Spain, decreed that after March 1, 1900 "the value of the dollar would cease to be quoted in silver and would be quoted in gold." The victory of the United States in the Second World War converted the dollar into the world's only currency (reserve currency) that could be used anywhere in the world for all sorts of transactions.
At the Breton Woods Conference, New Hampshire (1944), the US government promised to deliver one ounce of gold for every 35 dollars, if so required by any country. The world recognised and accepted the position of the US not only as the foremost military power in the world but also as the first economic power. Therefore, most people thought that they could rely on the commitment of the US to honour its promise to change their greenbacks for gold at any time,
if they so wished.
Unfortunately, they were wrong. What changed the situation? In order to finance the Korean War, the government of the US started issuing vast amounts of dollar bills without adequate gold or silver backing. This process continued all through the sixties of the last century. The situation became unsustainable when some of the central banks became nervous and discreetly started changing part of their dollar reserves for gold. Finally in 1971, President Richard Nixon cancelled the commitment to change greenbacks for gold but kept printing more and more money without enough gold or silver backing.
Now we can come back to the central issue of this article: Why is the exchange rate of the dollar against other currencies so important? Well, this is primarily due to four reasons: the dollar is the currency of the world's largest economy, most international financial transactions are conducted in dollars and the economic data of the world are expressed in US dollars. The other factor which is equally important is the fact that most foreign currency reserves of the central banks -- several trillion dollars -- are kept in this currency. No wonder "the strength of dollar affects trade balances, capital flows, growth rates, profits, share prices, inflation rates, interest rates and even the relative size of the economies" of the world. (The Economist)
In fact, the value of a foreign currency is determined largely by the law of supply and demand, hence the importance of having a current account surplus. Persistent current account deficit of a country creates pressure on the currency. The current account deficit of the US is high, which is financed by borrowing from the rest of the world. To complicate matters further the US also suffers from budget deficits. Its national debt is uncomfortably high. Now the questions are: If the US as a country has got both fiscal and current account deficits and the interest rate is so low, why does the world lend money to the US and how long will it continue to do so?
Well, the answers are easy. In the short term, while the world retains its confidence in the US as a potentially solvent country, it will continue to finance its wars and its profligate spending habits. The size of its economy inspires confidence. There is also the fact that since the US has become the world's sole military superpower,
its creditors believe that it would somehow manage to get out of its current economic difficulties. But in the long term, the situation may become unsustainable. As Professor Paul Kennedy of the University of Yale writes: "We live in a world where one single country possessing only about 5% of the earth's population, has roughly 20% of its G.D.R, spends almost 50% of its total defense expenditures, and freely prints bills that account for 65-70% of global foreign-currency reserves." He is, of course, referring to the United States of America and the dollar.
Professor Kennedy concludes his article by saying: "Even in the shorter term, I guess I would be looking a little more keenly at the current distribution of my portfolios. And, as an international author, I am happy to take my fees and royalties in many currencies, just to be on the safe side." In other words, Professor Kennedy prefers diversification to concentration in US dollars alone. For the sake of long-term stability of the global economy, international investors and governors of central banks would do well to pay heed to Professor Kennedy's advice.
The writer is an Officer of the Order of Queen Isabel I (la Catolica) of Spain and a Daily Star columnist.