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 also 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.
To understand how the dollar's reserve-currency role helped cause the recent bubbles, and the ensuing crisis in the world financial system, we must apply the analysis of the great French economist and central banker Jacques Rueff, who was the first to explain the process. As a financial attaché in London in the early 1930s, Rueff witnessed the collapse of the post—World War I monetary system. He correctly diagnosed the stock-market boom of the 1920s, and the subsequent crash and price deflation, as the result of massive official accumulation — and subsequent liquidation — of foreign-exchange reserves. Foreign countries' dollar reserves were certainly not the only factor involved, but before and during the Depression they were large enough to play a decisive role.
Many years later, in the 1960s, Rueff correctly predicted (and tried to prevent) the breakdown of the dollar-based Bretton Woods system. This 1944 agreement made the gold-convertible U.S. dollar the official reserve currency of the world monetary regime; it also fixed exchange rates within narrow limits. When the U.S. abandoned gold convertibility in 1971, thereby eliminating fixed exchange rates, the dollar's reserve-currency role expanded sharply; other countries may not have liked it, but without gold there was no practical alternative. Rueff died in 1978, but today's international monetary system — based on the paper dollar, which is backed by nothing but faith in the American economy — has the same potentially fatal flaw that he pointed out in two earlier gold-exchange standards. As was true in the 1920s and the 1960s, the dollar's reserve-currency role has led to the main pathologies that now plague the world economy: the speculative "hot money" flows that first inflated and then deflated stock, bond, and real-estate prices; the sharp rise and fall of commodity prices, especially of oil and other energy commodities; Congress's apparently incorrigible fiscal irresponsibility; and the mushrooming U.S. deficit in international trade and payments.
The key difference between a reserve-currency system and the gold standard is that foreign- exchange reserves, in the form of government bonds, are not only assets of the national authority that holds them, as gold was; they are also (unlike gold) debts of the country that issues them. Thus, when foreign monetary authorities acquire U.S. debt securities as reserves, U.S. monetary authorities are, in effect, borrowing the same amount.