Stephen King: Why the dollar and the euro are like VHS and Betamax

It's a bit odd to think about competing currencies in the UK. Shops will happily take pounds sterling but, with a handful of exceptions, they won't take anything else. Some people are so "iffy" that they find even Scottish bank notes unacceptable (unless, of course, they're in Scotland, in which case Bank of England notes are sometimes frowned upon). Elsewhere in the world, though, dual currency systems are sometimes almost de rigueur.

In Rio de Janeiro, people will happily accept US dollars rather than Brazilian réals. During Israel's hyper-inflation in the early 1980s, dollars offered significant advantages over shekels. In Moscow, you'll find many people happy to accept euros rather than roubles.

These are informal "dual currency" arrangements. They work on the basis that the alternative currency - whether dollars, euros or anything else - offers a reliable store of value and medium of exchange.

Dual currency arrangements, though, are not limited to the informal sector alone. The huge rise in holdings of central banks' foreign exchange reserves in recent years suggests that policymakers in many countries are happy to build up holdings of foreign currencies as a claim on future global output. They, too, need to be sure of their alternative currency's reliability as a store of value and medium of exchange. China and Japan hold a lot of dollars in their foreign exchange reserves. The same holds true of Russia and, despite constant rumours of diversification into euros, Middle Eastern oil producers.

The IMF publishes useful data spelling out, to the best of its ability, the degree to which holdings of foreign exchange reserves have changed over time. The dominant reserve currency is the dollar. The euro launched a modest challenge to the dollar's pre-eminence in the early years of this decade, but the initial momentum has now ground to a halt (even though the euro's market value has been a bit firmer in recent years). The yen has dwindled in importance while sterling has made a marginal comeback.

What, though, does reserve currency status actually imply? The usual answer is the issuer of the reserve currency can borrow from the rest of the world for free or at least at only a very low rate of interest. But why should others be willing to lend so readily to the issuing country?

On this topic, the academic literature can be a bit long-winded but, in essence, investors will hold a currency as a "reserve" if it comes from a large country which offers deep and liquid financial markets, a good track-record of financial stability and ongoing price stability. Not surprisingly, the dollar has, through recent history, been the currency of choice. People's views about US domestic and foreign policies may vary, but the dollar transcends these differences: it ticks all the reserve currency boxes.

A few years ago, many economists began to speculate that, with the advent of the euro, that perhaps the dollar's pre-eminence as a reserve currency would be challenged. After all, the euro shares many of the dollar's reserve credentials. As the IMF data shows, though, the euro's popularity as a reserve currency has never really taken off: most investors still prefer dollars.

One reason for this preference relates to the currency policies pursued by countries elsewhere in the world. In China's case, stability against the dollar has been an important plank of its macroeconomic policies over the past couple of decades. There's a good reason for this. China has a poorly functioning domestic monetary system where the relationship between changes in interest rates and the performance of inflation is distinctly murky.

In these circumstances, an exchange-rate target against a major trading partner makes some sense. Although the renminbi is beginning to move up slowly against the dollar, the Chinese are unlikely to abandon their dollar-centric view of policy any time soon. If China's foreign exchange reserves continue to rise, as they probably will, it's a fair bet China's demand for dollars will continue to grow.

Might we reach a point, though, where the dollar's pre-eminence is challenged by the euro or, perhaps, by the emergence of some other major currency? If this happens, it's likely to be because something has gone badly wrong with the US economy.

To see why, it's worth thinking about videotape. When videos first came out, Betamax offered superior picture quality compared with VHS, but that didn't prevent VHS from stealing a march on its rival (VHS tapes were longer and re-winded faster than Betamax). Once VHS had its nose in front, there was no going back: even for ardent fans of Betamax, there was no point owning a Betamax machine because the local video store would offer only VHS tapes.

The same holds true for the dollar. The euro may have all the qualities required to make a good reserve currency but there's already one in existence that works well enough. On this argument, the euro will replace the dollar as a reserve currency only if the dollar can no longer perform the role. It's not so much that there's anything very wrong with the euro but, rather, that if the dollar is on one side of 90 per cent of foreign exchange transactions, the cost of engaging in non-dollar transactions is likely to be disproportionately high. Everyone, individually, uses dollars because all of us, collectively, are happy to recognise the dollar as the world's reserve currency.

So might anything go wrong? The obvious danger lies with the widening US current account deficit and the concurrent build-up of liabilities to foreigners. Remember that others' holdings of dollars represent claims on future US output. If those claims are cashed in, the US will have to produce more to keep its foreign creditors happy, which means less for the domestic population.

One easy way for that to happen would be through a substantial rise in the US's cost of borrowing from abroad: in other words, big increases in US interest rates. Alternatively, like any other bad debtor, the US could default. I'm not suggesting the Treasury Department would fail to meet its direct obligations to holders of US government debt but, rather, that a decline in the dollar would reduce the true value of foreign claims on future US output.

Why, though, might other countries want to cash in their claims? Historically, reserve currencies have lost their way in line with the issuing country's economic, political and military decline. Spain's demise at the end of the 16th century and the UK's demise in the 20th century are two obvious examples. In these cases, the emergence of other superpowers was a major contributor to the story: for the Spanish, it was the Dutch and English, while for 20th-century Britain, the US provided the strategic threat.

This, though, is as much a longer-term problem for the euro as it is for the dollar. Should US geopolitical power dwindle in the future, it's unlikely that tired old Europe with its rapidly ageing population would be the threat to US hegemony. This leaves two options. Either Europe changes its spots, perhaps because of the dynamism that might result from extending euro membership to eastern Europe and - who knows? - to countries in the Middle East and North Africa. Or, more likely, the euro and the dollar suffer the same fate, overtaken by currencies that reflect the increasing economic, political and military influence of China and India, Asia's two emerging superpowers.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com