The Not-So-Mighty Dollar

I first noticed that something had changed when I visited Damascus in the summer of 2006. Previously, the way to enter Syria without a month-long wait for a visa had involved flying to the capital, having a pre-arranged meeting with a certain man at the airport and giving him an envelope containing $200 in greenbacks. This time, he told me in a hasty cellphone call, this practice would no longer be accepted. “Things are just not so stable any more, so there has been a change,” he told me. “This time you will have to bring €200.” And so it went, over the next three years, in the swathe of cash economies that surround Europe’s perimeter: drivers in Diyarbakır, guards in Chisinau, bootleg cellphone merchants in Tbilisi all began switching their baseline currency of exchange away from the increasingly volatile dollar. The bribe, the grey market deal, the payoff and the wheel greasing had become transactions denominated in the more solid and reliable currency of the European Central Bank. When times got tough, it was the people in the shadows who were the first to flee the Fed.

The crucial question today is whether their loss of confidence in the dollar will be followed by the larger and more transparent players in the world economy: the petroleum firms, the parts manufacturers, the pension plans, the sovereign wealth funds and the central bank reserves of Dubai, Moscow, Beijing. It has now been 65 years since the United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire, established the principle, through the creation of the International Monetary Fund, that the foreign exchange reserves of trading nations should be denominated in U.S. dollars. The dollar immediately became the world’s default means of exchange. A currency, of course, is nothing more than a unit of debt, a promise to be repaid sometime in the future at the same value. Now that the United States is engaged in a long-term devaluation, as a result of an economy whose future is by no means assured, the dollar no longer serves as an absolute guarantee of future value. For half a century the world has assumed that Treasury bills and other U.S. debt instruments are the preferred “safe” places to store even the largest accumulations of earnings. This has been enormously beneficial to Washington: simply holding dollars in your bank account acts as an interest-free loan to the United States government, and this “seigniorage” revenue provides the U.S. Treasury more than $20 billion in free revenue a year, on top of all the low-interest loans provided by the $2.4 trillion in T-bills held internationally ($800 billion of which are in Chinese state hands, $725 billion in Japanese).

All of this has allowed the U.S. to run a unique economy, one that is capable of sustaining extraordinary levels of public and consumer debt, because that debt has always had a buyer, and one that is capable of dismissing large current-account deficits by periodically depreciating the currency used for all the transactions. Only now, as the U.S. Federal Reserve rolls the printing presses and holds interest rates close to zero in an effort to resurrect a debt-devastated economy, are serious voices beginning to suggest that this new instability might end the dollar’s six-decade primacy. If it were to occur, and something replaced the dollar as the world’s standard unit of savings, exchange, reserve and account, it would mark an event of seismic magnitude, comparable to the end of sterling’s two-century reign, and with similar geopolitical repercussions.

During the past year we have seen tantalizing hints of such a shift. It has become customary, in the lead-up to G20 summits in London and Pittsburgh and the G8 summit in L’Aquila, for officials and sometimes leaders from China, Russia or the Gulf states to make it known that the agenda will include a declaration of a shift of the “world’s reserve currency,” however that is defined, away from the dollar. None of these threats has yet materialized into a summit motion (to say nothing of an actual shift in reserve currencies) in large part because there has been no consensus as to what ought to replace the dollar. The Kremlin has suggested a move from dollars to rubles, and then, when those became weak, to a “super-reserve currency” which would be held in Special Drawing Rights, the esoteric but stable measure, based on a basket of currencies, used to denominate loans issued by the IMF to many countries. Chinese officials, including central bank head Zhou Xiaochuan, have repeatedly said they would like to see international transactions denominated in either SDRs or Chinese renminbi. And leaders of Eurasian countries, possibly speaking with the support of Moscow, have proposed this year a shift to a new global currency called the “acmetal” (a conflation of the words “acme” and “capital”) or a new noncash currency that Kazakh president Nursultan Nazarbayev has proposed should be called the yevraz. Interestingly, the euro, which is probably the only currency possessing the appropriate combination of guaranteed stability, political neutrality, widespread circulation and broad liquidity, has been missing from all these proposals.

A more tangible threat seemed to emerge in October 2009 when the British journalist Robert Fisk reported in The Independent, citing sources from Arab and Chinese banks, that “Gulf Arabs are planning—along with China, Russia, Japan and France—to end dollar dealings for oil.” If the secret talks were successful, he wrote, those countries would shift their transactions to “the Japanese yen and Chinese yuan, the euro, gold and a new, unified currency planned for nations in the Gulf Co-operation Council, including Saudi Arabia, Abu Dhabi, Kuwait and Qatar.” All of this was swiftly denied by the countries involved, but the report carried enough of a ring of truth to send the dollar plunging by almost half a basis point in speculative trading the next day. There was good reason for this: Despite the denials, Gulf states and OPEC members have spent the past decade discussing, often in public, plans to move away from dollar-denominated petroleum transactions. What made this report new and market moving was, first, the novel inclusion of Japan and China in the meetings, and, second, the widespread belief among some currency traders that the dollar might soon lose its status as the world’s top currency.

And on October 6, the challenges to the dollar expanded from the financial world into the sphere of global politics. Sha Zukang, the United Nations undersecretary general for economic and social affairs, used meetings of the IMF and the World Bank in Istanbul as a platform to call for a de-dollarization of the world economy. “Important progress in managing imbalances can be made by reducing the reserve currency country’s ‘privilege’ to run external deficits in order to provide international liquidity,” Sha, a former Chinese ambassador, told an audience consisting of most of the world’s finance ministers. “Greater use of a truly global reserve currency, such as the IMF’s Special Drawing Rights, enables the seigniorage gained to be deployed for development purposes, as asserted in the Monterrey Consensus in 2002.” It marked the first time the United Nations had intervened on the topic of reserve currencies. It is significant that Sha’s remarks drew few criticisms, coming as they did during a period when the U.S. is deeply unpopular for having precipitated the credit-led economic crisis, for having rapidly devalued the currency in which its debts are held and for a mounting collection of military and diplomatic sins. Not only is the dollar weak, but it no longer has good political reasons to stay on top, except its own inertia.

But it is worth remembering that we have been here before, not so long ago, and the dollar has survived worse. The dollar’s status seemed doomed in 1971, when the crisis-stricken United States closed the gold window and transformed the dollar into a floating currency, and in 1985, when a deep recession and a mounting U.S. current account deficit led to an emergency devaluation of the dollar, conducted by Britain, France, West Germany, Japan and the U.S. under the Plaza Accord. Both these exchange rate shocks seemed to end the dollar’s utility as a reserve currency. Suddenly, countries holding large dollar reserves, such as Japan, found themselves absorbing huge losses as their savings depreciated. Credible scholars predicted a quick end to the dollar-centric world. And many did walk away from the dollar: Between 1978 and 1989, it fell from 73 percent of international reserves to below 50 percent. But it was never abandoned, and it recovered fast. By the end of the century, it had rebounded again to 71 percent. It also remained popular as a currency of exchange: as of 2007, about 86 percent of all international business transactions were denominated in dollars, and two thirds of the world’s countries peg their currencies to the dollar in some way. Indeed, group of newly liberalized countries in East Asia spent the 1990s accumulating dollars as their reserve currency. Mere exchange rate instability or unreliability, then, has never been enough to hurt the dollar’s supremacy.

Something is different this time, however. In both 1971 and 1985, not only were most dollar-holding economic players allies of the United States in the Cold War, but most of them were actually U.S. military dependencies. Indeed, the dollar’s chief rivals then, the deutschmark and the yen, always had geopolitical weaknesses that prevented them from adopting a reserve currency status. West Germany and Japan had constricted spheres of influence, limited negotiating powers and restricted-access capital markets that prevented them from seizing the day. And the U.S. had the political ability, and often used it, to influence allied countries to support the dollar, often in exchange for large-scale fiscal, foreign-aid, military or political assistance. In 1971, Richard Nixon was able to avert a domestic crisis by introducing import tariffs and removing the dollar from the gold standard, and most countries followed loyally by switching to an all-dollar system. Today, little of that applies. The United States remains the largest market in the world by a very wide margin, backed by a military larger than those of all other countries combined, the largest foreign-aid budget in the world and money and capital markets rivalled only by those of London. But it no longer sits at the centre of a circle of medium and smaller powers that have good reasons to support the dollar. Its European allies have their own reserve-class trading currency and no need for “Eurodollar” support; its Chinese, Arab and Russian interlocutors have watched in deep alarm as their sovereign funds and current-account surpluses have vanished into the receding horizon of the debt-crisis bailout, their T-bills and Federal Reserve notes disappearing into the thin waters of quantitative easing. They still depend on U.S. consumer markets, but increasingly less so. Emerging markets such as India and Brazil, both of which have changed from foreign-aid recipients into donors, no longer depend on American largesse and are just as happy to peg their currencies and denominate their savings in euros or yuan. This moment marks the perfect confluence of financial and political forces against the dollar, driving it into a nadir of unpopularity.

Yet there is a seeming pause taking place, as the world’s economies ask themselves what they can possibly do next. Into this void have stepped Eric Helleiner, a professor of political science at the University of Waterloo, and Jonathan Kirshner, a professor of government at Cornell University, who assembled a group of political scientists and economists to debate the dollar’s future. From the meetings of these disparate experts they have produced a valuable collection of essays, The Future of the Dollar, which was produced in time to take into account the financial crisis that began in 2008. There is no consensus to be found here on the dollar’s future: prognostications range from those of Kirshner, who believes that both the dollar and the United States itself have become so unpopular that there will be a sudden and dramatic shift to another world reserve currency soon, to economic historian Harold James at Princeton University, who sees no reason to expect a decline in dollar holdings, because making such a shift would exact an unaffordably high political price.

A big part of the problem is that “reserve currency” is one of those phrases, like “newspaper of record,” which sounds authoritative but has little solid meaning beyond its own declaration. This book, and especially Helleiner’s own analysis, is deeply rooted in the work of the British economic historian Susan Strange, whose 1971 study Sterling and British Policy was the first to ask why the pound remained the world’s “top currency” for nearly a century after the purely financial reasons for its dominance had ceased to apply. If the choice of reserve currencies were based on economic logic, sterling might have ended its reign in 1873, when a global depression set it reeling, or in the first decade of the 20th century, when there was rush from sterling to gold, or in the Great Depression of the early 1930s, when its value plummeted and it was forced to scrap the gold standard and float. Strange concluded that the answer is political rather than monetary: the pound became a “negotiated currency,” in which “foreign governments in the sterling area came to see their enduring support for sterling’s international role as linked to specific benefits they might derive from their relationship with the British state.” As a bankrupt Britain clambered through the post-war decades, these benefits ceased to exist, or more precisely had been replaced by similar benefits accruing from the United States.

Many of the authors here follow the analysis of the economist Paul Krugman, who in a celebrated 1984 essay, written in the midst of an earlier “terminal” dollar crisis, noted that the sheer size and scope of a reserve currency keeps it in place long after it has outlived its economic usefulness, as an “inertia of incumbency” prevents a collapse. That inertia may well hold the dollar aloft for many years to come. But even Krugman predicted that the dollar would reach a “critical point, leading to an abrupt unravelling of its international role.” Whether we have reached such a point depends, in large part, on whether some other currency can step in to become the world’s unit of savings and exchange. Of course, it might not be a single currency. The political economist Benjamin Cohen anticipates a “leaderless currency system,” in which various countries compete for the affections of reserve-seeking states. But most contributors agree that this state of affairs would be unsustainable except in the short term: the whole point of a reserve currency is to be one that is universally exchangeable, tradable, redeemable and widely held.

And this points to the fundamental flaw in most of the alternatives that have been proposed this year: whatever their strengths, they lack the dollar’s liquidity and its ability to be quickly and easily traded and redeemed in Treasury debt instruments. The renminbi and the ruble are still distrusted by traders and investors as politically controlled currencies, with insufficient guarantees of stability and a dangerous lack of secondary trading markets. The euro would appear to be a stronger bet, as it is, for the first time in the post-war era, a stateless currency whose controlling institution, the European Central Bank, with a much stronger mandate than the U.S. Federal Reserve to guarantee stability (in other words, it will not devalue itself to bail out any state’s economy, much to the chagrin of Spain and Ireland).

But while this makes the euro very appealing, Helleiner does a very good job of describing its fatal flaw: the euro is completely lacking in the “very liquid and open financial markets” that reserve funds seek. The best way to understand this problem is simply to point out that the largest market in euro-denominated debt and securities is London, the capital of a country that has no fiscal relationship to the euro. If you want to hold your savings in euro-denominated treasury instruments, you have to deal with the debt of 16 very different eurozone countries, some of which will be easier to sell than others. As Helleiner notes, the eurozone financial markets “remain quite fragmented, and, in the absence of a single fiscal authority, crisis management remains decentralized and there is no central European equivalent to the all-important U.S. Treasury bill market.” The IMF’s SDRs also represent the debts of a great many nations, but they suffer even more seriously from this lack of liquidity; they are currently traded in zero financial markets, and governments will be wary of holding them until they can be more assured of being able to sell them quickly and reliably.

We are clearly on the edge of something. There is, as Helleiner notes, no longer any glue holding together the vast but rickety infrastructure of the dollar. Although far more cautious than some of his contributors, he warns of a very likely scenario where a few defections (China comes to mind here) would soon generate “a herdlike momentum away from a depreciating dollar,” a situation where “a sudden change in expectations could perhaps generate quite rapid change.” The last time around, it took a war and the complete exhaustion of Britain to trigger such a total change. This time around, with the Cold War logic of the old dollar consensus gone, we are nervously awaiting the dawn of the post-post-war era.