The global credit crisis of 2007-2009, a consequence of unregulated loaning and excessively low interest rates, has discouraged international investment in U.S. financial assets and debt securities. Decreasing confidence in American assets will mean less financing for the U.S. budget and deficit.
There are no signs of a decreasing budget deficit and some speculate that it will take up 13.5 percent of this year's GDP. Obama's economic stimulus package and proposed health care reform certainly will not assist in reducing the deficit.
Altogether, these economic factors will necessarily decrease international and domestic demand for the dollar, thus creating a surplus of currency that will cause a significant depreciation of the dollar.
Globalization also affects the value of the dollar. As emerging markets, such as China, play a more significant role in the global market, the United States' economic dominance will inevitably reduce.
Naturally, emerging markets as well as central banks will attempt to find alternatives to the U.S. dollar, which currently dominates the largest portion of central banks' reserves and is the main currency used to settle trade and financial transactions.
China is especially concerned with the depreciation of the U.S. currency since 60 percent of its official reserves is held in dollars. Russia has a similar problem with its reserves and is consequently diversifying its basket of currencies by increasing the share of euros.
According to Foreign Affairs journal, Russia has increased its shares of euros to about 47 percent while reducing its share of dollars to 42 percent. In general, European countries are opting for increasing their shares of euros, especially since the euro is, for the most part, more liquid than other international currencies.
Diversification may be a viable option for European countries, but China's situation is slightly more complicated. Although China would certainly appreciate alternatives to dollar reserves, its dependence on the American economy substantially limits its options. If the country's central bank attempted to exchange large amounts of dollar reserves for say, euros, the dollar would depreciate substantially, meaning that China's holdings would suffer even more losses.
Essentially, if the American economy crashes, so will China's, consequently turning an already unbearable global financial crisis into a global depression.
China may eventually consider diversifying its basket of currencies, but at a very gradual pace.
Although the international community is diligently working to provide potential alternatives to the American currency -- such as the euro -- the dollar's international dominance has not disintegrated.
Despite the negative effects of the financial crisis, domestic and foreign investors have looked to the market of U.S government debt securities, the most liquid market to date, for financial security. That said, the demand for U.S. Treasury bonds still remains strong because they are the most liquid government bonds in the world.
In order to facilitate trade and financial transactions, foreign investors need currency that can be easily converted into cash and the dollar, of course, is the best and in many cases the only option for this kind of economic activity.
The euro is the second best option, but the heterogeneity of European-governments' debt securities, due to varying economic situations within the European Union, adds to the euro's riskiness and differing degrees of liquidity.
On a more domestic level, the depreciation of the dollar would actually help reduce the current budget deficit. A weaker dollar means the U.S. exports are more affordable to foreigners and foreign imports are more expensive to Americans.
Consequently, both domestic and foreign consumers would favor purchasing cheaper American products, thus driving up the demand for the dollar. As the demand for the dollar increases, the supply of the dollars decreases, meaning that the value of the dollar will eventually appreciate. When the dollar appreciates, the U.S. will regain its competitive advantage, perhaps not as notably as in the past, but its economic position will nonetheless remain unchallenged, at least for now.
As a result of the financial crisis, emerging markets are eager to reduce their dependency on the American economy. However, the international community has failed to provide credible alternatives to the dollar, at least for the moment. International markets will eventually adjust to the declining dollar, just not in the near future.
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