Stephen King: A question of faith... will the dollar escape unscathed from QE2?

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Andrew Feinberg

White House Correspondent

Will 2011 be yet another vintage year for economic and financial crises? Following Northern Rock in 2008, Lehman Brothers in 2009 and the eurozone in 2010, anything is possible. Admittedly, economic developments last year were not as bad as many people, myself included, feared. But neither were they that good. Levels of activity in the Western world remained very depressed, even allowing for a bit of a growth spurt in the UK and Germany in the middle of the year. And in the emerging world, policymakers found themselves struggling with the return of inflationary pressures.

Crises of the kind we have lived through in recent years are not simply a bunch of unrelated accidents. They have common antecedents, most obviously debt and trust (or the lack of it). And these problems are still with us. Before the Northern Rock crisis in 2008, the idea that Western banks might go bust – or be on the verge of going bust – was almost unimaginable, yet today bank failures have become almost commonplace. Just think of Bear Stearns, Lehman, RBS and Anglo-Irish.

The same goes for governments. Pre-crisis, government debt levels were high but not out of control. They have since gone through the roof. Investors are beginning to wonder whether governments still have the economic and political strength to repay their many creditors. Reflecting this fear, yields on peripheral government debt within the eurozone have risen dramatically. Might 2011 see the default of a Western government? And, if that happened, would the developed economy's fledgling recovery remain on track?

The relationship between creditors and debtors threatens to become even more stretched in 2011. A huge philosophical gulf has already opened up between Europe and America. Whether in or out of the euro (congratulations to Estonia, by the way, which has just become the 17th member of the single currency), European nations now mostly accept that they have been living beyond their means and have to put their financial houses in order. The US, conversely, is still intent on increasing its borrowing as it struggles to cope with the biggest increase in its unemployment rate since the 1930s. Which side of the Atlantic will ultimately win the argument? Although eurozone nations are still struggling, largely because the euro's political arrangements are not good enough to cope with the unfolding government debt crisis, I am tempted to believe that, ultimately, Europe will be well served by confronting its debt problems head on.

European nations are still a long way from getting everything right. Left to their own devices, nations delivering excessive austerity are finding themselves trapped in a world of economic stagnation, leading to more and more bank failures, government bailouts and increases in public debt. Eventually, a time will come where both debtors (the peripheral nations) and creditors (most obviously Germany) will have to accept their share of the pain: to do that in an orderly manner, the eurozone will almost certainly have to turn itself into a much more centralised fiscal union. While this may be politically tricky, it is surely better than allowing the eurozone to fall apart.

Let's imagine that Europe gets its act together, even if it has had to look an existential crisis in the eye to do so. Where does that leave the US? The remarkable thing about the American economy in 2010 was its ability to increase its government borrowing seemingly without a care in the world. Adjusted for the scale of economic activity, US government debt is already well above levels of debt seen in many of the less-disciplined European nations, yet it is still able to borrow from its creditors at remarkably low interest rates. Could this all change in 2011?

The US finds itself in a very fortunate position. As the issuer of the world's dominant reserve currency, it has become a magnet for anxious and insecure investors who spend their time wondering whether the euro will ever survive. Even though Washington has yet to come up with a plan for fiscal consolidation, creditors the world over have mostly been happy to carry on lending to the US government.

This act of faith will be sorely tested in 2011, not so much because the eurozone will resolve its problems (although I think it will, eventually) but, instead, because America's creditors will slowly recognise that their money isn't really safe in the US. The danger comes not from the remote possibility of an outright sovereign default, but rather from the increased probability of a major dollar collapse. The Federal Reserve is, after all, printing lots of extra dollars in a bid to kick-start the US economy recovery. All those extra dollars will serve only to depress its value, underlining the risks foreign creditors are taking in holding Treasuries and other US dollar assets.

Those creditors include, most obviously, the Chinese, the Russians and the Saudis. They have a collective interest in moving the world to a new monetary order, one which is not so heavily dependent on the US dollar. Certainly, comments from Dmitry Medvedev and Vladimir Putin in Russia and from various members of the Chinese leadership have signalled a growing concern with a dollar-based world financial system. It is easy to see why. All those extra dollars will leave creditors either nursing losses on their holdings of US assets, or having to mop up the inflationary consequences of all the extra liquidity created through the actions of US policymakers. Indeed, with Chinese inflation already worryingly above 5 per cent, the fight against inflation has already commenced.

For emerging nations to detach themselves from the dollar will be no easy task. But the more the US tries to take advantage of the greenback's reserve currency status, the greater the incentive for emerging nations to walk away. While it is possible to imagine a new world order where an increasing number of nations choose to conduct their international business in renminbi or roubles, this is not going to happen overnight. We know from the collapse of the gold standard in the inter-war years, and the break-up of the Bretton Woods system of fixed but adjustable exchange rates in the early 1970s, that the disintegration of an existing international monetary order can be a very messy affair.

It is tempting to think – and certainly many Americas not surprisingly do – that a major dollar decline could provide an escape route for the US economy. It would do nothing of the sort. A weaker dollar would ultimately increase the costs to the US of accessing international capital markets and, of course, increase the cost to American consumers of all those imports. And, by debasing its currency, the US would be revealing its true colours: a nation addicted to debt and unable to live within its means. Symbolically, this would surely be the most unsettling message.

As China looks to build its first aircraft carrier, paid for by a flourishing economy with newly global ambitions, the US will no longer be able to claim to be the role model for others to look up to in a mixture of admiration and fear. Nations elsewhere in the world will increasingly head eastwards to secure their economic interests and, as they do so, China will increasingly challenge the US for economic and political supremacy.