Chinese officials and private investors around the world have been worrying aloud about whether their dollar investments are safe. Since the Chinese government holds a large part of its $2 trillion (Dh7.3 trillion) of foreign exchange in dollars, they have good reason to focus on the future value of the greenback.
And investors with smaller dollar holdings are right to ask themselves whether they should be diversifying into non-dollar assets — or even shunning the dollar completely.
The fear about the dollar's future is driven by several different but related concerns. Will the value of the dollar continue its long-term downward trend relative to other currencies? Will the enormous rise of US government debt that is projected for the coming decade and beyond lead to inflation or even to default? Will the explosive growth of commercial banks' excess reserves cause rapid inflation as the economy recovers?
Fears exaggerated
But, while there is much to worry about, the bottom line is these fears are exaggerated. Let's start with the most likely of the negative developments: a falling exchange rate relative to other currencies. Even after the dollar's recent rally relative to the euro, the trade-weighted value of the dollar is now 15 per cent lower against a broad basket of major currencies than it was a decade ago, and 30 per cent lower than it was 25 years ago.
Although occasional bouts of nervousness in global financial markets cause the dollar to rise, I expect the dollar will continue to fall relative to the euro, the Japanese yen, and even the Chinese yuan. The Chinese (or Saudis or Indians or others outside the euro zone) should, of course, be concerned about the dollar's decline relative to the euro.
But the big risk to any investor is the possibility inflation will virtually annihilate a currency's value. That is not going to happen in the US. The rate of inflation actually fell in the US during the early 1980s, when the US last experienced large fiscal deficits. Federal Reserve Chairman Ben Bernanke and his colleagues are determined to keep inflation low as the economy recovers.
Looking forward, investors can protect themselves against inflation in the US by buying Treasury Inflation-Protected Securities (TIPS), which index interest and principal payments to offset the rise in the consumer price level.
So the good news is that dollar investments are safe. But safe doesn't mean the investment with the highest safe return. If the dollar is likely to fall against the euro over the next several years, investments in euro-denominated bonds issued by the German or French governments may provide higher safe returns.
Martin Feldstein, a professor of economics at Harvard, was chairman of President Ronald Reagan's Council of Economic Advisors and president of the National Bureau for Economic Research.
