I want to respond to a reader who commented on yesterday’s post about the possibility that the U.S. dollar might be replaced by a new type of currency known as an “SDR”:

Reader: "[You suggest in your post that] 'Americans won’t be able to live quite as large as they have in the past.’ This is a vague statement. What exactly does it mean?  Does it mean that the value of the dollar is going to drop?   Maybe the author is purposefully being vague, because she is uncertain about the implications of issuing more SDRs?"

Apologies for sounding vague, but in fact, I can be quite specific about what would happen if the dollar was no longer the world’s major reserve currency. For starters, yes, the value of the dollar would drop, thus dimishing the wealth of the average American. But that’s going to happen anyway. The value of any currency tends to be correlated with the underlying strength of its economy. It’s been clear for sometime that the American government and the American consumer are carrying too much debt. Ultimately, that’s not good for either the U.S., or all the many countries that hold dollars as their main reserve, because endless amounts of American debt will eventually result in inflation that will devalue dollar assets.

The idea behind the SDRs is to break the dysfunctional economic relationship between the U.S. and the big export nations like China. Americans are encouraged to keep spending themselves into oblivion because it’s so cheap for them to do so, since the dollar is artificially buoyed by the rest of the world, in particular Asian exporters like China which would do a lot better to spend their surpluses on improving the lives of their own people rather than buying lots of dollars and burying them in the ground.

Theoretically, using a basket of currencies as the world’s reserve would bring more stability to the global economy by breaking this cycle. That could, eventually, help the dollar rebound (though probably not to its record highs). But first, as I said in yesterday’s post, the SDRs would have to be widely traded – and that’s not going to happen overnight. Hope this clears things up.  

The global arms race is slowing for only one major contestant, Europe, with potentially long-range implications for its status as a big power. Despite the worldwide recession, global arms sales rose 4 percent last year, with the U.S. and China leading the pack at $607 billion and $85 billion, respectively. Russia, too, has been bumping up its defense budget, now at $58.6 billion, in hopes of regaining its Soviet Union-level capabilities. But in Europe, cash-strapped governments are slashing defense budgets in favor of propping up popular social programs. 

Already this year, Italy has downsized its defense spending by about 7 percent and Spain has cut about 4 percent. Analysts are predicting that Britain's roughly $60 billion annual defense budget could face cuts as high as 25 percent in coming years. And top military and civilian officials, including Lord Paddy Ashdown, are calling for a new defense posture that fits leaner times. That could mean abandoning plans to shell out more than $38 billion to replace Britain's fleet of Trident nuclear submarines, and building only one (or neither) of an $8 billion pair of aircraft carriers, which ceremonially began construction last week.

[MORE AFTER THE JUMP]