The U.S. dollar has long been a pillar of stability in the international order. Is that about to change?
The Bretton Woods Agreements in 1944 established the dollar as the world’s reserve currency. It was selected for the strength of the U.S. economy, its reliability, and the American ability to protect foreign owners of U.S. assets. The 1970s saw the collapse of the Bretton Woods system as growing economic tension forced the U.S. to abandon the dollar’s gold backing. As we approach monumental points of the economic tension in our history, can the dollar survive once again?
So what puts the dollar on such a high pedestal today? This past February, Federal Reserve Governor Christopher Waller made his case for dollar dominance at the “Climate, Currency, and Central Banking” conference sponsored by the Global Interdependence Center and the University of the Bahamas. Waller argued that the dollar’s strength comes from the quantity of its use. After all, the dollar accounted for nearly 60% of global reserves in 2022. For comparison, the next highest held currency was the euro at twenty percent. The dollar was used in three-quarters of export invoicing for all regions, excluding Europe, and makes up 60% of currency in international banking. The U.S. dollar is also used as domestic currency in many countries outside of the U.S.
Understanding today’s fiscal climate requires us to get back to basics. What is the dollar? The U.S. dollar is a type of fiat currency, something not backed by a physical commodity like gold or silver – it rests solely on the government’s promise to pay the bearer. Fiat currency allows central banks increased control over monetary policy like interest rates or the amount of money printed to determine the currency’s value. This amount has an inverse relationship with the value of the currency – prices will increase to create a new equilibrium as the value of the currency decreases.
Seems like a secure system, right? Some have argued that the U.S. is not sufficiently adapting to a new world. Waller’s words are reminiscent of past leaders clinging to power, hoping the status quo won’t change. The American attempt to hold onto financial power may result in isolation as it tries to suppress a global movement towards financial inclusion. So, what does the future hold instead? New ideas about money today point toward geoeconomic fragmentation and digital alternatives.
The world has become increasingly economically integrated – integration looks like the reduction or elimination of trade barriers and the coordination of monetary and fiscal policies. The goal is to reduce costs for both consumers and producers and to increase trade between countries. Geoeconomic fragmentation is defined by the IMF as a policy-driven reversal of this economic integration. In February 2022, when Russia invaded Ukraine, key Russian banks were sanctioned with bans from the Society for Worldwide Interbank Financial Telecommunications (SWIFT) system, a network used to quickly and securely exchange information like money transfer instructions. The ban greatly reduced Russia’s global transactions in hopes they would back down from the war. The European Union is an example of perfect economic integration as it works to facilitate the free movement of goods and create cohesive trade agreements. The UK’s exit from the European Union in 2016 is another prime example of this fragmentation. If this constant fissure of economic methods continues, countries may back away from international financial infrastructure.
A transition away from cohesive international finance will lead to the birth of new monetary systems that lack international operability and increase transaction costs. Although the U.S. dollar is safe for now, if global fragmentation continues, the global currency configuration will have to adjust to reflect new economic realities. Changes in reserve systems have historically been slow due to a lack of viable alternatives – but that could soon become a different story in our transition to the growing financial digital age.
There are two main digital alternatives to the dollar: cryptocurrency and central bank digital currencies. Crypto is a digital currency created using cryptographic techniques that allow people to buy, sell and trade goods in a secure and “decentralized” way, removed from mainstream trade. Why is this so special? Cryptography is the mathematical practice of encoding and decoding messages, in this case for the purpose of keeping transactions secure. These forms of payment, like bitcoin and ethereum, are isolated from government intervention. Cryptocurrencies have risen to approximately 3% of the global money supply. By contrast, central bank digital currencies use the same technology as crypto currencies – but through a centralized approach allowing more regulation. These currencies function as a digital record of a country’s official currency, meaning they are also fiat currencies not backed by real silver or gold value. Cryptography is also used in blockchain technology – blockchain is a database that stores information as “blocks” linked together by cryptocurrency. Both of these concepts are crucial to understanding potential for future fragmentation when assessing threats to the dollar.
How are the BRICS capitalizing on these weaknesses? The name “BRICS” refers to a group of countries consisting of Brazil, Russia, India, China and South Africa. Originally established in 2009, BRICS was created as a bloc to challenge U.S. power and the western led international order with the goal of establishing a more diversified trade economy. However, BRICS is not a formal organization like the United Nations or the World Bank. Despite its unofficial status, its primary goal for 2024 is to increase its role in the international monetary and financial system. To reach this goal, the group is working to create an independent payment system based on digital currencies and blockchain. So why does BRICS want to increase its influence? The movement is part of a global movement towards de-dollarization, as well as a political alliance positioned against U.S. interests. “The new currency will help bring the financial markets of the BRICS member states closer and increase mutual trade turnover,” states files released on the Russian Finance Ministry’s website.
However, the U.S. dollar is not going to go down without a fight. As Steven Kamin, a former director of international finance at the Federal Reserve Board, puts it, “everyone uses the dollar because everyone uses the dollar.” This is often referred to as the network effect, where the dollar’s value increases as more countries use it. China’s political strategy emphasizes a move away from the dollar hegemony they so despise – but despite this directive and their apparent diversification away from the dollar, their execution of such a task has proven hard to carry out.
One theoretical explanation for this phenomenon comes from a concept called the “Imperial Circle.” Coined by a paper from the New York Fed, the idea is that the U.S. dollar has increasing importance in global commerce. When the Fed increases interest rates, the dollar gains value at the expense of emerging markets. This results in an economic slowdown that is felt much more by foreign countries who rely on the dollar than the U.S. domestically. The tension embedded in this concept has been widely explored. In an interview with Bloomberg columnist Daniel Moss, he states, “The weight of the US economy is declining over time because of the rise of Asia. But at the same time, the rise of Asia is combined with a more prevalent role for the dollar… Many countries are short safe assets. This is very important. Until you break that, it’s difficult to replace the dollar, even if you start invoicing in something else. Safe and liquid is what pension funds in Asia demand because those countries do not have the capacity to absorb their savings. That creates a natural driver of dollar demand. It underpins the hegemon.” Moss explains why the dollar has become more important even as the US is losing stake in the global GDP relative to China and India – its relative liquidity and stable nature afford it the privilege of widespread use.
In such a complicated web of international finance, the question now becomes: is this change good or bad? Dollar hegemony gives the U.S. an advantage in two big ways. First, the U.S. can borrow from the world at lower interest rates. Foreign countries are always willing to hold dollar assets, which allows the U.S. to run trade deficits indefinitely. This keeps the dollar’s value high and American imports cheap, lowering total costs for U.S. households, governments, and companies. Second, dollar hegemony insulates the U.S. from economic and geopolitical shocks (yes, even including shocks caused by American behavior). In times of crisis the dollar is considered a “safe haven.” This means that the world rushes towards the dollar instead of away during turbulent times, from wars to financial crises.
Dollar dominance has its pros and cons for the rest of the world. Near-universal acceptance of the dollar decreases transaction costs in international trade and investing simply as a result of its status as the global medium of exchange. However, dollar hegemony allows the U.S. Fed to affect the interest rates of other countries, a potentially unfair and destructive practice. When the U.S. economy tightens, borrowing becomes more expensive for Asian countries. Additionally, dollar dominance makes foreign countries’ trade less competitive. As U.S. Treasury secretary John B. Connally famously remarked to a group of European finance ministers, “the dollar is our currency, but it is your problem.”
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