Monday, August 30, 2010

What Makes the Dollar Special?

One of the most jarring things about America after returning from Argentina was seeing so many dollars bills everywhere. I remembered sitting in my Monetary Economics class at my university in Buenos Aires, listening to the professor drive home the point that Americans use the USD as local currency. They don't see anything special about it!, he exclaimed, wide-eyed and emphatic, as if it were an utterly preposterous idea.

And he's right, of course; we Americans look out and see the plurality of currencies and assume ours is just another member of the ranks.

Argentines, however, have an entirely different point of view. Argentina has what they call a "dual currency," which means that dollars are just as standard a medium of exchange as the Argentine peso. For example, most restaurants have a sign on the door that indicates the rate at which they exchange dollars and euros. Apartments are bought and sold in terms of dollars, not pesos, which means Argentines maintain dual accounts of pesos and dollars. I saw wealthy Brazilians vacationing in Patagonia with a stack of crisp $100 USD bills in their wallets, and I even saw Argentines with large sums of USD, even while they were traveling within their own country.

So then, what makes the dollar so special? Why does it hold such a privileged status in other parts of the world?

Most of all, because it is highly stable. Inflation is usually very low, America has never defaulted on a loan, the US Federal Reserve is highly disciplined.

That may sound incredibly boring, but it is enough to get an Argentine who's lived long enough teary-eyed. Just over the past 30-40 years alone, the Argentine monetary authorities have dropped about 13 zeros off the currency; prices were rising so fast during the hyperinflation of the 80s that grocery stores couldn't relabel their items fast enough; and in the 2001 economic crash the dollar exchange rate jumped from 1:1 to 4:1 overnight.

In response to such a high degree of instability, Argentines have sought refuge in the dollar. Highly durable goods, like apartments, are priced in dollars to protect against wild, transient fluctuations. During hyperinflation, even school kids as young as 10 had come to learn that as soon as they obtain extra spending money the first thing they should do is invest in USD.

Even in stable times, like now, holding pesos is still inferior to holding dollars. The exchange rate may say 4 pesos = 1 USD, but in all practicality the two are not equivalent. Having four Argentine pesos is just not as good as having one small dollar. The reason is that although the peso may be stable today, there is no guarantee it will stay stable tomorrow. The fragility of the Argentine market means that holding pesos always carries with it an implicit risk of devaluation.

By the same token, holding dollars carries with it an implicit guarantee from the US government that the currency will preserve its value over time. Because Latin American governments have a history of irresponsibly financing extra spending by printing more money (i.e. inflation), their central banks maintain a reserve of dollars to keep their populations' anxieties at bay. The idea is that if anyone loses faith in the local currency, they can simply swap it out for dollars.

Note how the dollar acts as a monetary guaranteer of the last resort: when people lose faith in all currencies, they turn to the dollar. Thus, what makes the dollar special is that everyone in the entire world trusts in it. It also means that the United States is not only underwriting the monetary stability of its own citizens, but also that of the entire world financial system. Everyone assumes that in a panic at least they'll be able to salvage their savings by converting them to dollars.

The USD is therefore not just another currency, but rather a promise. A promise that in this fiat world of meaningless paper bills, your savings actually mean something.

1 comment:

  1. I'm glad you posted this, since we talked about it at dinner. I was trying to explain this concept to one of my uncles in India to try and get a response from him about if he thinks that could happen with the rupee and kept forgetting some of the details.