Why the Euro Will Save the US Dollar

Many commentators have raised an alarm that the United States is gambling with its debt driven fiscal policy. They believe that the government is continuing to issue debt to pay for social programs. Fears have also arisen because one of the main foreign buyers of US debt, China, is signalling that it may decrease its holdings of dollar denominated debt. Other large buyers might follow similar strategies if they fear for the dollar's value. This could potentially endanger the dollars standing as a worldwide reserve currency. Such a move would likely force the Federal Reserve to increase volume of dollars in circulation. This expansionary policy is, in effect, a devaluation of the dollar which will lead to inflation.

One of the earliest and most influential economic equations I've ever learned was the simple MV=PY. This simple equation states that the supply of money times its velocity will be equal to the price level times output. If the velocity of money and output are constant (or at least moving at a glacial pace), then the price level is depended on the amount of money in the system. Thus, the amount of currency in circulation will drive inflation.

A large problem might exist for foreign buyers of Treasury debt is where they would move their money. Obviously, these countries might use some of this money for domestic spending and investment. Yet, there might be too much money to use just for those purposes. Countries would still need some type of assets to hold their reserves.

It was often mentioned that countries might move assets out of dollar denominated debt and into Euro denominated assets. The Euro was seen as a potential currency competitor of the dollar. However, as recent events, such as the debt problems in Greece, have unfolded the safety and value of the Euro have been questioned. Bets have been placed against the Euro and the value of some Euro denominated debt has fallen precipitously. So, it is increasingly unlikely that major foreign holders of US debt would move into Euro denominated debt.

The question then becomes 'where else?' Fortunately for the US government there really aren't many other options. It is possible that countries would also attempt to move into physical assets such as gold and oil, however, there are not enough of these assets to compensate for a move out of Treasury debt. The pound is unlikely because of domestic currency issue in Great Britain. The yen is unlikely because the Japanese followed a similar monetary policy as the US has, just many years earlier. Their debt pays little to no interest and their currency is not exactly safe from inflation. The only other major world currency is the yuan in China. A move to have that become a reserve currency is almost impossible as it is the Chinese who are a major investor in US debt. They are a country of surpluses to invest elsewhere, not domestically. Additionally, China has attempted to undervalue their currency relative to the dollar - any move away from US debt would likely break this peg.

As the Euro-zone is facing domestic currency problems, it is unlikely that the world would move to the Euro as a replacement for the dollar as a reserve currency. These problems might act to save the value of the dollar even in the face of what are normally inflationary devaluation policies. The dollar's savior is its demand, not its actual value. If there is nothing else to move into, demand will remain high in the face of the government's attempts to devalue.