The events of this past year’s Euro Crisis have upset not only the international balance of power between currencies but also the suspected future balance of those currencies. As the effects of the Great Recession hit debt-ridden countries like Greece and Portugal, worsening their economic prospects and compounding the effects of speculation-driven spending sprees, the viability of their sovereign debts began to fall into question. These debts, denominated in euros, represented not only a threat to the value of the currency in the short term but also to the solvency of highly exposed banks all over Europe.
This systemic risk, and eventually systemic crisis, revealed the paradox of the Eurozone’s partial integration: the interconnected nature of these economies had led to enough cross-national exposure that a collapse of one or more Eurozone economies threatened the entire system while at the same time, the economies were not connected enough to free member states from different monetary policy needs. As Greece’s import-export ratio worsened, the expansionary monetary policy it needed was off the table, worsening economic conditions and undermining any hope of paying off its sovereign debt. This dizzying combination of factors has led to dozens of proposed solutions, countless summits and negotiations, but only one near-universal conclusion: the euro system was plagued from the start and cannot be trusted as a stable alternative to the hegemonic dollar.
Since the mid-twentieth century, the dollar has enjoyed almost unrivaled status as the world’s preferred reserve currency, or the currency in which most nations denominate most of their international currency reserves. The deep pool of relatively liquid assets denominated in dollars, from the multi-trillion dollar pool of US government securities to the securities of many large corporations, and perceived stability of the currency have given sovereign investors and countries engaged in international trade a large incentive to keep their currency reserves in dollars. For the past sixty or seventy years, this has allowed countries to park their holdings in a stable currency and reduce transaction costs in international trade. This same system has led the majority of international commodities markets, most notably the oil market, to price goods in dollars in order to take advantage of these lower transaction costs and facilitate the mechanisms of trade. In turn, the United States has benefited from slightly lower transaction costs than any other country in the world (it hardly ever needs to exchange currency for trading purposes) and the ability to issue debt at a much lower interest rate than similarly situated countries, as there is almost always demand for assets denominated in the reserve currency.
While this system, known collectively as “dollar hegemony,” has endured with few disruptions since the end of World War II, the recent emergence of the euro as a seemingly strong and stable international alternative, as well as the unprecedented growth of the Chinese economy, have led to calls for the end of this system. Russian Prime Minister Vladimir Putin has decried dollar hegemony as allowing the United States to live “like parasites off the global economy,” while China’s central bank has taken the more subtle route of issuing a proposal for the creation of a new international currency to replace the dollar. All of these proposals have relied on the strength of the euro as the lynchpin of any shift, arguing that the existence of a second internationally viable currency warrants a shift away from the dollar and toward a more equitable international monetary system. According to the IMF, between the first quarter of 2006 and the first quarter of 2010 foreign exchange reserves denominated in euros almost doubled, all while the value of the euro remained 25 percent above that of the dollar.
Unfortunately for dollar hegemony’s detractors, Europe’s sovereign debt crisis has unleashed market turmoil that far outstrips anything seen in the United States, even at the height of the US financial crisis. The euro’s recent volatility, combined with the revelation of the inherent problems of the Economic and Monetary Union (EMU) and even calls for the breakup of the euro, have undermined many of the arguments for a shift away from the dollar’s international role. Three years ago, the consensus among currency experts like Barry Eichengreen and Jeffrey Frankel was that an end to dollar hegemony in the next decade was all but inevitable. Now, with the euro on the verge of collapse, the future of dollar hegemony is back up for debate as investors flock to the dollar’s safe haven and divest from the euro. At a time when doubts about the future of American power extend far beyond the dollar and into the realm of geopolitical hegemony, a bulwark against the fall of the dollar may be exactly what America needs to shore up its international position. With the euro’s fall in prestige and growing awareness of the dollar’s resilience, it seems likely the dollar hegemony and the privileges that come with it are here to stay.
The Roots of Power
In the aftermath of the collapse of the international monetary system during the Great Depression and World War II, forty-five nations met at the Bretton Woods Conference to establish the rules of a new system to govern the international economy in the post-war order. The demise of the pound-sterling during the Great Depression as a result of runs on the Bank of England left only the dollar as a viable candidate for use as the world’s preferred reserve currency. The new system fixed exchange rates against the value of the dollar but maintained the majority of reserves in gold, convertible for dollars at a fixed rate. However, the accumulation of dollar reserves by countries needing to park cash or attempting to hedge against possible shocks led to the accumulation of dollar liabilities exceeding the US supply of gold. As the disparity between the dollar supply and gold supply worsened, countries became increasingly fearful of a systemic collapse and in 1971 began redeeming their dollars for gold. After Switzerland and the United Kingdom demanded to convert billions of dollars into gold, President Nixon declared an end to the convertibility of dollars into gold and the international community soon agreed to let their currencies float against the dollar.
Despite the collapse of the Bretton Woods system and a devaluation of the dollar after the abandonment of dollar pegs, however, the dollar retained its central role in the international foreign exchange market, and dollar holdings continued to grow. Highly developed financial markets in the United States and stable issue of government debt provided a deep and liquid market for dollar-denominated assets, while the relatively mild response to the demise of the Bretton Woods system led to increased confidence in the dollar’s long term stability. Most notably, in 1975, the Organization of Petroleum Exporting Countries (OPEC) began pricing its oil exclusively in dollars in order to reduce transaction costs and give exporters a place to park their earnings. The sale of oil, at the time the world’s fastest growing commodity, in dollars cemented the dollar’s hegemonic position in the foreign exchange market and left every oil purchasing nation no choice but to buy into the dollar-dominated system. The international monetary system was born, and the United States’ role as the world’s provider of liquidity was set in stone.
The Spoils of Hegemony
As the issuer of the international reserve currency, the United States has garnered two unique economic benefits from dollar hegemony. First, for other countries to be able to continually accumulate dollar reserves by purchasing dollar-denominated assets, capital has to flow out of the United States and goods have to flow in. Effectively, the international economy must allow the United States to purchase a growing quantity of goods in order to facilitate the flow of capital into the coffers of other nations. As a result, the value of the dollar has to be kept higher than the value of other currencies in order to cheapen the price of imported goods. While this arrangement has come at the cost of an ever-growing current account deficit, it has also subsidized US consumption and fueled the growth of the US economy. Effectively, when a US citizen buys a cheap imported good priced in dollars, the exporter of that good must use those dollars to purchase dollar-denominated assets or invest that dollar in the United States, compounding the exchange effects of the system and aiding US economic growth.
The second benefit of this system is its effect on the market for US government debt. The largest market in the world for a single financial asset is the multi-trillion dollar market for American bonds. This market, considered by many to be the most liquid in the world, allows any nation or large investor to park massive amounts of cash into a stable asset with a relatively desirable rate of return. While the depth and stability of US financial markets as a whole were part of the original reason nations gravitated toward the dollar as a reserve currency, the explosive growth of US government debt has made US Treasury bonds the center of the foreign exchange market and the most widely held form of dollar reserves. The use of the US Treasury securities in currency reserves has created an almost unlimited demand for US debt; if the federal government wishes to issue debt, someone will buy it if only as a way to acquire dollar holdings. This artificially high demand means that the United States can issue debt at extremely low interest rates, especially relative to its national debt and overall economic profile. And while the United States has had to pay off its existing debt by issuing new securities, no nation wants to call in its debt for fear that it would devalue the rest of its dollar holdings. While precarious and arguably dangerous in the long term, the reality is that as long as the dollar is the international reserve currency, the United States will have a blank check that no one wants to cash.
Whether or not you agree with US fiscal policy, it is indisputable that the ability to finance its debt has allowed the United States to provide its citizens with a high standard of living and fund its enormous military programs. Essentially, dollar hegemony has served as the backbone of US primacy. Domestically, the ability to run effectively unlimited budget deficits has allowed the United States to fund its massive entitlement programs and, more recently, afford sweeping bailouts at the height of the recession. The United States has used its unlimited allowance, afforded by dollar hegemony, to finance its high standard of living and maintain the prosperity required of a hegemon. More importantly, the United States has used the demand for American debt to fund its military apparatus. Each year, the United States spends over US $600 billion on its military, excluding spending on the wars in Iraq and Afghanistan, constituting over forty percent of global military spending. Since the establishment of the post-World War II international order, the United States and its allies have relied on US military might to enforce
their wishes upon the world and maintain the Western-dominated order. The ability to intervene militarily in any conflict that threatens US interests and maintain US geopolitical influence and hegemony is a direct result of dollar hegemony. For the past sixty-five years, the United States has relied on its excessive spending to fund its position of privilege and relied on the dollar’s position as the international reserve currency to fund this spending.
The United States’ Undoing?
Despite the dollar’s long history as the international reserve currency, the past few years have seen a growing number of calls for the end of dollar hegemony. Countries as diverse as France, Russia, and China have decried the dollar’s monopoly in foreign exchange markets, while in 2009 reports of a shift away from dollar-based oil trading surfaced in the Middle East. Reported plans to move away from the dollar reflected international frustration at a system fueling the United States’ “exorbitant privilege,” as the French have called it, one that rests its stability on the financial conditions of a country mired in debt and facing a financial meltdown. The implications of a true end to dollar hegemony, a shift away from the dollar as a reserve currency and pricing standard for oil transactions, could be catastrophic for the United States. In the worst case scenario, a drastic drop in demand for dollar-denominated assets would cause the interest rates on Treasury Securities to skyrocket, sending ripples through the US economy as the value of the dollar plummets. What is certain, however, is that whatever decrease in demand for US debt occurs will constrain the federal government’s ability to spend and the ability of the United States to defend itself. The United States has built its foreign policy around its vast military capability; a sudden budgetary shock and drop in military spending would leave the United States vulnerable as it scrambles to regroup in a new security environment. The ability of the United States to respond to threats across the globe would be diminished, and enemies would be incentivized to take aggressive action to take advantage of this new weakness. In particular, a rapidly militarizing China might be emboldened by its partial decoupling from US economic fortunes to adopt a bolder stance in the South China Sea, threatening US allies and heightening tensions with the United States. While war with China is all but off the table in the status quo, an international system devoid of both US military might and Chinese dependence on US debt as a place to park excess liquidity might lead to the conflict feared on both sides of the Pacific.
While these fears were well-founded a few years ago, Europe’s sovereign debt crisis has undermined the world’s faith in the euro and destroyed its potential to replace the dollar. The crisis has amply demonstrated the euro’s potential for volatility and revealed the uncertainty at the root of the entire EMU project. Any currency for which there is potential for dissolution cannot be a significant part of world reserves, let alone the international reserve currency. Those relying on the strength of the euro to argue for a shift away from the dollar have been proven sorely mistaken by recent events, silencing many of these detractors. More importantly, the rapid change in the euro’s fortunes has given many international observers a bit of perspective on the dollar’s success over the past forty years. Since the 1970s, the dollar has endured OPEC’s oil embargo, the dot-com boom, the Great Recession, and a number of international conflicts. The dollar’s resilience during all of these events has been proven all the more remarkable by the euro’s susceptibility to crisis. Major players in the economic community will hopefully come out of this period more appreciative of the role the dollar has played and the stability it has provided and give the dollar a bit of breathing room.
Only one potential alternative still sits on the table: the Chinese renminbi. However, despite China’s efforts to internationalize the currency by increasing deposits denominated in yuan and allowing cross-border settlements in yuan, China’s economy remains yet unproven. Its fast-paced growth has been fueled by exports to the United States cheapened by the very system they have sought to undermine. The renminbi has a long way to go both in terms of its international prestige and the establishment of a track record of stability. For now, the decline of the euro leaves the dollar as the only viable international reserve currency and the United States as the only country able to issue it. While there is no doubt this issue will return to the forefront, for now it seems that the United States will emerge from the Great Recession with a tighter grip on hegemony than it has had in a decade. The global need for dollar hegemony will allow the United States to continue to run up deficits, fund its military supremacy, and maintain an international order premised on a Western-dominated economic system.
Staff Writer Josh Zoffer