The Future of the Dollar

Alex Entz

Current Issue

In August 1971, President Richard Nixon, facing mounting costs from the Vietnam War and increasing demands for gold repatriation, abruptly severed the dollar's connection to gold. Overnight, the "Nixon shock" effectively dissolved the Bretton Woods system — which for nearly 30 years had fixed the exchange rates of the world's largest economies and pledged the convertibility of dollars to gold — thereby ushering in a strange new era that would lead to floating exchange rates. Just days later, the New York Times condemned Nixon for having "done his best to knock down" the international monetary system and damage the credibility of the dollar.

Yet nearly 50 years after Bretton Woods's demise, the dollar is still the world's predominant currency. From Cedar Falls, Iowa, to Phnom Penh, Cambodia, it is used in 85% of all foreign-exchange transactions. Nearly two-thirds of all reserves held by central banks are in dollars. Indeed, the dollar seems more valuable now than ever.

Can this state of affairs continue? World currencies have come and gone before, and today's global interconnectedness and geopolitical turmoil, combined with the enormous economic disruption from the Covid-19 pandemic, raise fresh challenges.

In particular, China's renminbi (RMB) poses a long-term threat to the dollar's dominance. Beijing's growing importance in global markets bears many hallmarks of the U.S. economic rise that powered the dollar. Moreover, China has made internationalizing the RMB a long-run priority, aggressively promoting a sphere of economic influence and pushing for foreign countries and companies to adopt its currency. China's economic size and presence at the center of commodity markets make a future with multiple reserve currencies look increasingly probable.

The question, then, is not whether other reserve currencies will rise, but when. Yet even in a future with multiple reserve currencies, the dollar need not lose its hegemony and all the benefits that station confers. Through prudent policies and decision-making, American political leaders can have a say in what the transition to a multipolar currency regime will look like — and ensure that the dollar maintains its global standing.

RISE OF THE DOLLAR

Modern reserve currencies are those that denominate a disproportionate share of central-bank reserves, are used extensively outside of their home countries in physical transactions, and are used widely by international financial markets in contracts, trades, and financial instruments. A significant number of countries peg their exchange rates to reserve currencies.

A country must satisfy several conditions for its currency to become a major reserve currency. First, it must have assets for investors and other governments to purchase. It must also have enough of those assets for sale — a quality known as "depth" — such that one investor's purchase of an asset, denominated in that country's currency, is unlikely to dislocate the market for other assets in that currency.

Second, the country needs a strong export sector. If a firm in Bangladesh trades often with a firm in the United States or frequently sells products in the United States, the Bangladeshi firm has an incentive to trade in dollars out of convenience. The central bank of Bangladesh, mindful of the need to provide dollar liquidity to this firm so it can pay its debt and continue to trade, also needs to hold dollars in reserves. As these decisions snowball, eventually almost all of Bangladesh's banks and firms will invoice and trade in dollars. A robust export sector increases the likelihood of this snowball sequence occurring in countries around the world.

Third, modern reserve currencies are sustained partly through domination of certain markets, particularly commodities and other goods that serve as inputs for final products. For example, globally traded commodities, such as oil, are priced in dollars.

Fourth, a country must have institutions, undergirded by the rule of law and adequate transparency, that support a healthy and sound financial system. This generally includes having an independent central bank and a political commitment to refraining from expropriating foreign assets.

Lastly, countries hoping to establish a reserve currency need some luck. The United States was able to found the dollar at the center of the international monetary order in part because Britain, in desperate need of lend-lease support to fight the Nazis, had little bargaining power at the Bretton Woods conference. Though establishing a new reserve currency is challenging, once established, dominant currencies can be difficult to dislodge.

Since the beginning of international trade and finance, there have been three global currencies: the Dutch guilder (which reigned from the 17th century to the early 1800s), the British pound sterling (predominant in the 19th and early 20th centuries), and the U.S. dollar (which gained dominance post-World War II). The sterling overtook the guilder as the global reserve currency after Britain became the center of international trade, taking in 30% of world exports by 1860. Britain's status as a colonial power reinforced its currency's global reserve status, as it could coerce colonies into using sterling in transactions. Britain's deep markets and non-interference in gold markets solidified the sterling's dominance in the 1800s by assuring investors that the currency was a safe store of value.

The dollar's displacement of the pound began in earnest with the signing of the Federal Reserve Act of 1913. With a strong economy, a central bank to appease investors, and the lamps going out all over Europe, the dollar went from non-existent in international reserves to threatening the sterling for dominance by the late 1920s. This trend increased after Britain, struggling with an overvalued pound tied to gold, stopped exchanging pounds for gold in 1931. However, the stickiness of reserve currencies softened the blow for the sterling: Even after Britain's economic dominance declined, network externalities and inertia sustained London's outsized influence in interbank markets.

The transition from the pound to the dollar was not seamless. In the decades between the 1910s and 1940s, the world had multiple reserve currencies. Pointing to this period, economist Barry Eichengreen has argued that the global trading system can accommodate multiple reserve currencies. For example, on the eve of World War I, fewer than half of global foreign-exchange reserves were in sterling, while one-third were in francs. Then from the Great Depression through 1944, half of public debt was denominated in sterling, while 40% was denominated in dollars. Only after World War II's conclusion, with capital controls in place in most other major economies, did the dollar emerge as the sole preferred reserve currency.

Today, the dollar's role as a reliable unit of account and store of value is key to its status as the world's reserve currency, as is the United States' role as a leading provider of safe assets. For the last 20 years, the dollar's share of world reserves has been roughly constant at around 62%, up from 57% in 1995. Meanwhile, the dollar is now the principal anchor currency for about 60% of all countries, up from less than 30% in 1950.

BENEFIT AND BURDEN

Since at least 1945, the dollar has been the undisputed heavyweight champion of the global trading regime. American policymakers should want this dominance to continue for several reasons.

For one, it benefits America's fiscal position. Other central banks — especially those in developing countries — want to hold dollar-denominated assets that they can easily sell in order to purchase their own currencies and support their economies in times of need. As a result, most foreign-currency reserves held by non-American central banks are in dollars. These massive purchases create enormous demand for U.S. Treasury securities, pushing their price upward and putting downward pressure on U.S. interest rates. If another currency were to supplant the dollar, it would reduce the demand for U.S. private and government debt by encouraging investors to buy assets denominated in another currency, thereby causing U.S. interest payments on debt to rise. With U.S. debt at historically high levels, even small changes in interest rates would be very expensive.

The United States also benefits from non-negligible seigniorage revenues thanks to the heavy foreign use of dollars in hand-to-hand currency transactions. Seigniorage refers to the "profit" made by a government that issues currency, given the difference between the value of currency and the cost involved in producing and distributing it. At present, roughly two-thirds of dollars are held abroad. This cash does not earn interest, which allows the Federal Reserve to invest the cash it receives in return for these dollars in U.S. Treasuries, thereby earning seigniorage returns. A rough estimate of seigniorage gains per year in the mid-1990s was between $11 billion and $15 billion. Today, that number may be roughly $20 billion.

Additionally, the dollar's pre-eminence cushions the U.S. economy from shocks originating abroad. No matter the condition of the global economy, the dollar is viewed as an attractive investment. When the U.S. economy is strong, investors pour money into the American market, increasing the demand for dollars and strengthening the currency. When the global economy is weak or its outlook uncertain, investors also push money into the U.S. market, which similarly drives up the value of the dollar. A stronger dollar insulates U.S. consumers, protecting their standard of living. This benefit was evident during the Covid-19 financial panic earlier this year: From March 9 to 20, as the depth of the problem began to sink in, the dollar rallied 8% even as other major currencies cratered.

If dollars were used less often to invoice trades, U.S. prices would be subject to more exchange-rate pass-through from foreign currencies. Foreign politics and business cycles would dictate prices in the United States more often, creating more uncertainty and removing some of the insulation that American consumers have from global economic upheaval.

The dollar's pre-eminence also improves the competitiveness of U.S. businesses. American firms do not have the uncertainty associated with, and do not typically need to hedge against, exchange-rate movements. This is particularly true for corporations issuing debt in dollars; they do not need to worry about currency mismatch.

What's more, the dollar's hegemony is a valuable tool for exerting global influence and achieving U.S. foreign-policy aims. The dollar's status helps the United States push policy priorities at the multilateral institutions that oversee the global financial order. These institutions, most notably the International Monetary Fund (IMF) and the World Bank, have been bulwarks of U.S. influence and the rules-based order against more autocratic competitors. The dollar's role, and the attendant importance of the U.S. financial system, helps ensure the United States remains a dominant voice in global affairs.

Losing dollar hegemony would blunt the ability of the United States to wage economic warfare. The legacies of the Vietnam, Afghanistan, and Iraq wars have conditioned the American public to view direct U.S. intervention abroad with skepticism, leading political leaders to search for other means of challenging adversaries. Economic warfare is often the favored alternative, and it has increasingly served as a replacement for military operations in recent decades. At present, the U.S. Treasury Department operates over 30 sanctions regimes, targeting a range of countries as diverse as North Korea, Iran, and Burundi. These sanctions programs block the assets of prohibited individuals and entities, and do so through the compliance of private-sector actors. Businesses and banks that transact with a prohibited entity are subject to enormous fines, encouraging extensive due-diligence efforts. Meanwhile, sanctions bar prohibited foreign entities from accessing the U.S. financial system.

Since the dollar is the world's reserve currency, there is widespread compliance with U.S. sanctions. The sanctions force banks and private firms to make a choice between having access to the U.S. financial system or transacting with a sanctioned entity. As the United States is the world's largest economy, this decision is a no-brainer for most banks and private companies, even if they are domiciled in foreign countries; they simply cannot risk transacting with companies that violate U.S. sanctions. The United States thus gains significant foreign-policy leverage from the dollar's reserve-currency status.

If the dollar were to lose its place as the dominant currency, it would lose these advantages. But the full picture of reserve-currency status is not entirely positive. In fact, the dollar's role as the global reserve currency brings considerable risk.

Reserve-currency status tends to create a seemingly insatiable appetite for the issuing country's debt, both private and public. If left unchecked, this propensity can lead to credit bubbles. The boom in credit that fed the mid-2000s housing bubble, for example, led to the worst recession in 80 years. The roots of this financial crisis can be traced back to Thailand in 1997, when asset bubbles forced the Thai government to devalue its currency, the baht, and sever the baht's peg to the dollar. This kicked off a continent-wide financial unraveling, culminating in the 1997-1998 Asian financial crisis. Spooked by the sudden perceived riskiness of east-Asian markets, mutual funds and other investors began selling holdings in those countries, forcing central banks to defend overvalued exchange rates pegged to the dollar in the face of large capital outflows. As the contagion spread, several central banks were forced to abandon their pegs, devaluing their currencies and making existing dollar-denominated debts significantly harder to pay off. In the span of five years, 11 countries would experience debt crises.

In the aftermath of these crises, developing economies made big changes. Their central banks piled into U.S. assets, building up heavy dollar reserves to prevent future crises. Thus, starting around 2000, a tsunami of foreign savings crashed onto the shores of the United States, pushing down borrowing costs and increasing both household and firm leverage. These credit inflows were accompanied by an increased preference for safe assets. As Ricardo Caballero, an economics professor at the Massachusetts Institute of Technology, notes, this increased demand outstripped U.S. production of safe assets, leading to the creation of assets that were deemed AAA-rated but turned out to be much riskier (such as the now-infamous tranches of subprime mortgage-backed securities). Demand for dollar assets, viewed as a safe haven, drove U.S. interest rates increasingly downward, which pushed investors into riskier asset classes and caused rates in corporate bonds, mortgage-backed securities, and other structured products to drop. Consumption and real-estate speculation exploded, and when the music stopped, a glut of household, public, and corporate debt resulted in widespread foreclosures and the United States' worst recession since the Great Depression. A painful deleveraging would follow throughout the next decade.

As Eichengreen observes, the dollar's singular role "is both a benefit and a burden." It finances our lifestyle, enhances American competitiveness, and helps us achieve our geopolitical aims. But it also provides the kindling for debt-driven recessions. The central challenge for American policymakers, then, is determining how to reap the benefits of dollar primacy while avoiding its worst excesses. But to even have that conversation, policymakers must first ensure dollar primacy against competitors.

COMPETITORS TO THE DOLLAR

In the 1970s and '80s, intellectuals and the American public more broadly considered Japan to be the gravest economic threat to the United States. Though the Japanese yen steadily appreciated after the United States abrogated the Bretton Woods system, Japan's aggressive, export-led growth stirred U.S. fears. American consumers viewed Japanese state assistance to knowledge-intensive manufacturing industries as unfair and anti-competitive, producing a trade imbalance between the two. As recently as the early 1990s, more than a quarter of Americans believed Japan to be the world's strongest economic power, and more than half saw this economic strength as a bigger threat to the United States than the Soviet military.

But today, few regard the yen as being a credible competitor to the dollar. After an enormous dual-equity and real-estate bubble burst in the early 1990s, Japanese growth slowed and inflation collapsed to almost zero. In 1999, the Japanese central bank hit the zero lower bound on short-term interest rates and embarked on quantitative easing two years later. As these efforts failed to improve the country's economic situation, Japan's lost decade stretched into two.

Beginning in 2012, prime minister Shinzo Abe's much-heralded package of monetary loosening, fiscal expansion, and structural reforms spurred the return of low inflation and boosted equity values. But growth in Japanese gross domestic product (GDP) remains meager, and with a shrinking population, a debt-to-GDP ratio of nearly 250%, a slow-to-reform corporate culture, and what amounts to nearly unprecedented central-bank monetization of debt, there is reason to be pessimistic about Japan's long-term economic dynamism.

So if not the yen, then what? Over the past two decades, the common answer has been the euro, which was introduced in 1999. The euro is backed by the European Central Bank, which has a limited mandate focused on price stability. Most of the continent of Europe — which has a larger population than the United States — has adopted the euro. And some of Europe's economies are among the most dynamic in the world today. Moreover, about 20% of global reserves are held in euros — the second-largest share of reserves.

But the euro's potential for dominance is undermined by several major problems. The first is that the euro is a blanket currency thrown over the economies of 19 countries that do not share a common asset market. For a major reserve currency to develop, investors need to be able to park their money in deep, liquid markets, and few such markets exist in the Eurozone. In fact, the United States has roughly twice the level of marketable debt as the Eurozone. The only European country that could potentially rival the U.S. government-debt market in terms of depth would be Germany, but the Germans are famously — to their credit — fiscally sober. German public debt is less than $3 trillion, or just 10% of public U.S. debt. The raw size of the U.S. Treasury and mortgage markets — along with a vibrant corporate-debt sector — creates significant opportunities for reserve banks and investors to purchase assets that they can then easily find buyers for. To date, the euro has no such market.

The euro also faces anemic growth and weak prospects in the years to come. In recent years, the United States has grown significantly faster than the European Union, with flexible labor markets and dynamic private and public markets fueling the type of creative destruction that is largely absent from sclerotic French and German markets. This leaves investors asking why they should put their money in a market on the decline when they can have assets in a more stable, unified, higher-growth jurisdiction.

The Eurozone's final problem — its politics — is paramount. As a monetary union without a fiscal union, the Eurozone has struggled to offset damaging credit booms and busts. This has led to wide divergence in economic outcomes, which fuels political resentment between countries. In his 2016 book The Euro: How a Common Currency Threatens the Future of Europe, Nobel-prize-winning economist Joseph Stiglitz argues that Europe would need to create a single banking system and agree to the mutualization of debt, with the European Central Bank as an issuer of cross-country obligations, for the euro to surpass the dollar. Until recently, such debt mutualization seemed highly unlikely: Germany — the Eurozone's de facto leader — and the "Frugal Four" (Austria, Denmark, Sweden, and the Netherlands) all torpedoed fiscal transfers to Greece during that country's 2009-2015 debt crisis.

But Covid-19 might be changing this dynamic. Led by German Chancellor Angela Merkel and French President Emmanuel Macron, in July the European Union agreed to issue €750 billion in common debt to finance fiscal transfers to countries struggling to recover from Covid-19. In the long run, the partial nature of the Eurozone's union could continue to force it into ever-closer fiscal union to rescue the economies of its periphery countries in times of crisis. In that case, the response to the pandemic could represent the first step toward creating markets that rival the United States, at least in size.

But the more likely outcome is that zealous defenses of national sovereignty will scuttle efforts to forge a permanent fiscal union between countries. Given the politics inherent in being liable for debt issued to finance another country's perceived largesse, a fiscal union is likely to remain limited in size, and designed to address crises and their aftermath, rather than become a large, permanent feature of the bloc. In fact, it's conceivable that closer union could spur additional euro-skeptical backlash. Several countries have repeatedly threatened to leave the euro, and post-Brexit, euro-skeptic politicians in countries such as Italy have made significant noise. Even if unlikely, another defection should not be considered an impossibility. In the meantime, investors will find no security in the economics of doubt.

And then there's China. Internationalizing the RMB is a core element of China's strategy to emerge from the "hide and bide" policy meant to conceal its rise. Internationalization would lessen China's dependency on the United States, help the country develop its markets, and establish Shanghai as an alternative financial center. In this vein, the Chinese government has pushed private firms to invoice and settle trades in RMB, required state firms to follow suit, and encouraged RMB adoption by other central banks. China's enormous Belt and Road Initiative, through which it seeks to use its state-owned enterprises to finance and build infrastructure in up to 68 countries, will also help internationalize the RMB by creating a trading order that revolves around Chinese companies and financial architecture.

After China moved off a fixed exchange rate in 2010, its intentions to internationalize the RMB became apparent. Increasing usage of the RMB was driven by investors seeking access to long-reclusive Chinese assets. The share of Chinese trade settled in RMB rose from 0% in 2010 to 25% in 2015. In 2018, Chinese firms started denominating oil contracts in RMB. This is particularly crucial for China, which is now the world's largest importer of oil. As China's economic reach expands and its wealth attracts more investment and consumption, increasing numbers of firms will find it economical to invoice and trade in RMB. The RMB's rise as a secondary global reserve currency thus seems inevitable.

But while China's size and geopolitical aims appear to position the RMB as an immediate challenger to the dollar, the country faces some significant short-term hurdles. Currently, just 2% of cross-border transactions are conducted in RMB. In fact, since 2015, efforts to internationalize the RMB have been reversed, with actions by the People's Bank of China making clear that political leaders will continue to control the currency's value. And rather than continuing to liberalize its capital account, China — spooked by outflows — has tightened capital controls.

To compete directly with the dollar for hegemony, China has to end capital controls, liberalize interest rates, and allow the RMB to float. All of this would entail a significant shift in its development model as well as a diminution of Communist Party control. Even then, investors may not want to hold RMB and risk further exposure to an economy showing signs of stagnation. China's growing importance in global markets makes the RMB a long-term competitor to the dollar. But in the near term, it will be limited by Beijing's prevailing desire to focus on domestic markets as a means of pursuing its broader social and geopolitical goals.

Some challengers to the dollar are more speculative. The IMF, for instance, allocates a reserve asset called the "Special Drawing Right" (SDR) to member countries, with a value based on a basket of currencies. (China achieved a major milestone in the internationalization of its currency when the IMF included the RMB in this basket in 2015.) SDR was intended to act as an additional form of liquidity in the dollar-based Bretton Woods system, and the IMF has disbursed SDR on four occasions since 1970. But despite China calling for expanded use of SDR repeatedly in the 1980s and '90s, and again in 2009, SDR has found only marginal use as a reserve asset. It is also difficult to see where the momentum for using SDR in oil contracts or other investments would come from.

Then there's Libra, Facebook's new cryptocurrency. Cryptocurrency enthusiasts have long viewed distributed ledgers as having the potential to end-run the traditional banking system and, as the New York Times reported after Libra's rollout, Facebook "has sky-high hopes that Libra could become the foundation for a new financial system not controlled by today's power brokers on Wall Street or central banks." Libra's value is based on the value of a basket of currencies — much like SDR — and is meant for individual use, particularly to send money across borders. This latter function would replace expensive systems like Western Union and networks of hawala dealers popular across much of the Islamic world.

In a bid to avoid fears that a private U.S. company was running a kind of central bank, Facebook wisely outsourced governance to a non-profit board of companies in Switzerland, known as the Libra Association, on which each investor company will have a vote. But Libra faces many of the same issues that plagued Bitcoin, the biggest of which is take-up. There is a market for remittances, to be sure, but the question of what use most individuals living in countries with stable currencies have for Libra remains unanswered — most people involved in licit activities will continue to happily use their home currencies without so much as a second thought.

Libra isn't the only alternative to the traditional banking system available. Last year, perhaps spurred by Facebook's announcement, Bank of England Governor Mark Carney dinged the dollar's dominant role and suggested that central banks should jointly create a virtual currency to serve as the global reserve currency. This option has obvious benefits for countries that feel the spillover effects of U.S. fiscal and monetary policy through economic and exchange-rate linkages. American policymakers, however, would be wise to protect U.S. interests by declining to join the project. Without U.S. involvement, such a project is unlikely to come to fruition.

PRESERVING DOLLAR HEGEMONY

There are certainly rising challengers to the dollar, including the euro and the Chinese RMB. But in the near future, the biggest threat to dollar primacy is mismanagement by and inattention from American political leaders. To continue reaping the benefits of dollar hegemony while avoiding its excesses, policymakers should consider taking several steps.

To begin, America must reduce its national debt. The debt level stood at more than $23 trillion in March 2020, when Congress added over $3 trillion to the tab to provide economic relief during the pandemic. Thanks to this necessary but decidedly massive expense, the debt is projected to reach or exceed 100% of GDP by October 1. Yet in contrast to the popularity of fiscal conservatism in the United States during the 1990s and up until just a few years ago, today's politicians on both sides of the aisle seem to have lost their appetite for cutting debt.

Some argue that less concern about the debt is warranted. Proponents of modern monetary theory, for instance, claim the U.S. government is not constrained by deficits, since it issues its own currency and can print as much money as it needs. Other debt skeptics suggest that the surge of foreign capital brought to U.S. shores by a global savings glut will depress yields and keep interest rates low into the foreseeable future. The U.S. government's response to Covid-19 seems to be proof of this hypothesis, with U.S. Treasury yields falling to historic lows even while spending has spiked.

This view, however, is deeply imprudent. While U.S. debt is buoyed by global savings today, that debt could become an albatross in short order. High levels of wealth concentration are fueling a savings boom, but such inequalities have fluctuated before, and foreign governments may find alternate uses for their excess savings. China's savings rate, for example, may fall if the country adopts a social-security program. Furthermore, most developing countries already have adequate levels of reserves and may begin seeking higher returns by diversifying into non-U.S. assets. If precautionary savings fall, countries could shift reserve compositions out of U.S. assets to higher-yield jurisdictions, causing yields on U.S. debt to rise — threatening to create a combustible mix of a high debt load and rising interest rates and payments. Fearing monetization of debt, investors may seek to quickly move investments out of dollars, thereby damaging the dollar's attractiveness.

In addition to reducing the national debt, U.S. policymakers should also work to trim the current account deficit. Trade deficits need not be balanced by trade surpluses over the long term; in fact, the U.S. derives significant benefits from a global financial order in which it absorbs capital inflows in exchange for purchasing the goods exported by developing countries. Enormous trade imbalances cannot be run in perpetuity, however, and they are not necessary for the United States to continue providing the world's reserve currency. Current account deficits could flood the world with too many dollars, leading to dollar depreciation. In fact, a similar phenomenon contributed to the British sterling losing its reserve status in the early 20th century. And it's worth noting that in the 1950s and '60s, the United States was able to provide dollars to the world without running current account deficits.

American policymakers have several options when it comes to narrowing the current account deficit and maintaining long-run dollar hegemony. Less government spending and borrowing, for starters, would not only improve the U.S. fiscal position and trade balance, it would also boost the U.S. savings rate — perhaps the most direct method by which to secure the dollar's future. America's current account deficit largely finances consumption, with abundant foreign capital pushing down interest rates and encouraging households to borrow excessively — just as they did in the run-up to the 2008 crisis. Reducing government spending, along with adopting tax incentives and requiring lenders to have more "skin in the game" by bearing more exposure to risk (particularly on housing and student loans), would encourage more saving.

To reduce its trade imbalance, the United States must also continue exporting significant amounts of goods. Despite popular perceptions, the United States is currently manufacturing and exporting at near all-time highs on a value basis. Should this rate begin to fall, very minor import tariffs would improve U.S. terms of trade, thereby boosting exports. The trade imbalance would also benefit from efforts to "re-shore" parts of manufacturing supply chains critical for U.S. national security and technological primacy. Both policies point to the desirability of reforms at the World Trade Organization (WTO) to restore room for domestic political prerogatives. Unwinding some of the WTO's "deep integration" rules while maintaining the architecture supporting free and open trade will create a more durable model for trade going forward.

The most notable legislative effort to rein in the current account deficit has been proposed by Senators Tammy Baldwin and Josh Hawley — their bill would give the Federal Reserve an additional mandate to tax foreign purchases of U.S. assets to help balance capital inflows and outflows. Such a tax, if kept small, would likely not undermine the standing of the United States as the chief destination for foreign investment, nor would it significantly damage the desirability of the dollar. Taxes of the magnitude required to bring the current account into balance, however, could impose significant losses on foreign central banks and other actors seeking safe assets. This might push credit into riskier asset classes in other countries, stoking a series of international bubbles. Additionally, granting the Fed the power to levy taxes could further politicize an institution whose independence is of paramount importance. Taxing speculative and short-term foreign capital, however, would help balance the current account deficit and encourage longer-term investment that would be less prone to producing asset bubbles.

Lawmakers should also empower the Fed to ensure the functioning of dollar-denominated markets. Roughly 40% of global debt is held in dollars. When a country has companies that transact heavily in dollars, dollar supply must be provided in part by firms. These firms thus incur exchange-rate risk, and the potential for a currency mismatch can foment global instability. During the 2008 financial crisis, a global scarcity of dollars posed a significant threat to the dollar's role as the international reserve currency. Borrowing costs spiked for firms as companies struggled to acquire dollars needed to pay back debt and deliver trades. A similar scramble for dollars occurred in March once the scale of the Covid-19 crisis dawned on investors.

To address the dollar shortage during the 2008 financial crisis, the Fed offered up to $580 billion in currency swaps, restoring dollar liquidity to ease these pressures. Between mid-March and the end of April this year, 10 central banks drew $440 billion from quickly reconstituted swap lines. Committing ample dollars to foreign central banks in times of crisis — which they can use to ease funding pressures domestically — reinforces the dollar's role as a safe haven. It is thus crucial for political actors to encourage the Fed to use this authority as necessary. Senators questioning nominees to the Fed's board of governors should ensure they support the institution taking on this role.

The United States must also seek to minimize dollar manipulation. Since the collapse of Bretton Woods, major U.S. intervention in currency markets has been relatively rare and largely confined to moments of crisis — for example, the G-7 pushed down the value of the yen after Japan's Fukushima nuclear disaster in 2011. One notable exception was the Plaza Accord in 1985, where a dollar appreciation of nearly 50% in five years prompted congressional threats of protectionist legislation. This led the Reagan administration to coordinate a meeting between the finance ministers of the United States, the United Kingdom, France, West Germany, and Japan in New York City, where they signed an agreement to coordinate foreign-exchange interventions designed to depreciate the dollar. These measures depreciated the dollar by 40% over the next two years, deflating the speculative bubble that had fueled a ballooning U.S. trade deficit.

Reports during the summer of 2019 suggested that President Donald Trump was considering selling the dollar against foreign currencies to weaken its value and thereby boost U.S. exports, reversing the strengthening of the dollar that had occurred since 2014. As authorized by the 1934 Gold Reserve Act, the Treasury Department maintains a nearly $100 billion fund to intervene in foreign-exchange markets. Fortunately, the administration decided to drop the proposal. Given its unilateral nature, a U.S. intervention could have been overwhelmed in short order by a foreign-exchange market awash with trillions of dollars in daily transactions, and a failed currency intervention would have shaken the confidence of many who look to the United States as the center of the global economic order.

Recent calls by critics of the Fed on both the right and the left to end or hamper its independence must also be firmly rejected by lawmakers as a foolhardy — and transparent — power grab intended to grease the levers of the printing press to boost their party's political prospects. Artificial booms always and everywhere create very real busts, and historical evidence supports non-intervention. The sterling's status as the global reserve currency, for instance, was maintained partly because both the government and the Bank of England declined to intervene in financial markets, even allowing foreigners to physically export gold when Britain was on a gold standard.

Capital controls and other interventions diminish investor confidence. If debt loads become significant and investors expect the United States to stoke inflation in order to diminish its liabilities, a shift from the dollar would result. In fact, an inflationary bout is likely the easiest way to destroy the dollar's hegemony. Even in hyper-partisan times, therefore, the Senate must continue to carefully vet nominees to the reserve board, ensuring that the Fed represents a diversity of approaches to monetary policy.

Lastly, as mentioned above, the dollar's global presence gives the United States a potent foreign-policy tool. Yet the overuse of sanctions carries significant long-term risks, as it could encourage U.S. allies and trading partners to lessen their reliance on the dollar. It could also spur the creation of an alternate financial system, undermining the very "plumbing" within which the current sanctions regime operates. Indeed, myriad workarounds to U.S. sanctions authorities are already in development — like the Instrument in Support of Trade Exchanges (INSTEX), developed by the European Union to maintain trade channels with Iran after the United States withdrew from the Joint Comprehensive Plan of Action and re-imposed secondary sanctions.

INSTEX tries to circumvent secondary sanctions by facilitating what are functionally barter transactions. Though it will likely fail to deliver appreciable economic results, it represents just the first attempt to create a parallel financial architecture that excludes the dollar. Perhaps the most worrisome outcome would be a China-led effort to create a state-backed cryptocurrency that could be anonymized and thereby shield participants from sanctions, providing an alternative means for goods and money to move across borders. The People's Bank of China has reportedly been experimenting in this realm since 2014. If companies move to denominating commodities in such a cryptocurrency, they could create a credible workaround to the international financial system and undermine a key benefit of the dollar's reserve status.

A MATTER OF POLITICAL WILL

Inertia in international financial markets, widespread use of the dollar in commodity pricing, and the predictability and size of the U.S. economy all provide assurance that the dollar will remain the world's reserve currency for the foreseeable future.

But even if the dollar faces no credible competitors in the medium term, China's rise and the United States' continued inability to address significant economic imbalances make a multipolar future the most likely long-run outcome. If China continues to experience strong economic growth, further exerts its economic influence overseas, and resumes liberalizing its financial markets, RMB-denominated assets are likely to become a destination for more foreign investors. China has committed itself to being a leading global power by 2050, and the country's leadership is not likely to be dissuaded from this path.

Multipolarity is coming. Fortunately, the loss of dollar hegemony is not inevitable; maintaining it is ultimately a matter of political will. By making tough decisions today to tame U.S. fiscal and trade deficits and preserve the dollar's role as a safe haven, American policymakers can continue to promote American values abroad and secure prosperity at home for decades to come.

Alex Entz wrote this essay as a graduate student at Princeton University. He was formerly a senior analyst at the Federal Reserve Bank of New York and a policy advisor and speechwriter in Washington, D.C. Any views expressed here are solely his own. The author would like to thank fellow Princeton classmate Eric Parolin for his thoughtful insights.


Insight

from the

Archives

A weekly newsletter with free essays from past issues of National Affairs and The Public Interest that shed light on the week's pressing issues.

advertisement

Sign-in to your National Affairs subscriber account.


Already a subscriber? Activate your account.


subscribe

Unlimited access to intelligent essays on the nation’s affairs.

SUBSCRIBE
Subscribe to National Affairs.