Future of Dollar Hegemony
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.