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The Dollar Standard, Surpluses and Deficits
In part one of this series, we briefly examined how and why after the Second World War the dollar became the central vehicle currency in the international monetary system. In this second part, we will discuss why the dollar hegemony – albeit a voluntary system – produces dangerous imbalances, which consistently require ad hoc solutions and use of unconventional monetary policies (UMP) to stabilize fragmented and globalized monetary accords.
The United States is forced to run constant deficits if others run surpluses.
Although the dollar anchoring and exchange rate shadowing is based on voluntary choice, dangerous imbalances are largely due to the dollar’s privilege as the most used currency in international trade and investments. Such a global monetary arrangement is unstable because the world economy mainly relies on just one national currency to provide global liquidity.
However, to provide such liquidity and satisfy the world’s demand for dollars to conduct trade and investments, the US is forced to run current account deficits. Constant US deficits, however, force others to run excessive surpluses. Furthermore, to prevent their currencies from appreciating and thus jeopardizing their export model of growth, central banks around the world also want to accumulate reserves to cushion the risks of another financial crisis. In other words, since the global balance-of-payments must equal to zero, the United States is forced to run constant deficits if others run surpluses.
66 Problems but the Dollar Ain’t One
Because central banks value liquidity and safety above everything else, the need for stability is the essential pre-requisite of a safe reserve currency. Moreover, because the dollar is, in theory, capable of maintaining a stable value, settling and invoicing trade in dollars has also become the global norm.
In fact, economist Barry Eichengreen stated in his fantastic book “Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System” how dollar shadowing in exchange rates produces stability because 85% of all foreign exchange transactions are denominated in dollars. Moreover, central banks want to have reserves in the same currency in which a country’s debt is denominated: US dollar bond markets are strengthened by the fact that US-dollar denominated debt currently accounts for around 40% of bond holdings.
Additionally, since a great majority of global financial transactions – and especially energy transactions – are denominated in dollars, countries around the world tend to choose the dollar. Therefore, changes to the status quo are complicated because the dollar is used even in international trade where the US is not the source or destination of the traded goods/services. Consequently, it is no wonder that at least 66 countries peg their currencies to the dollar or outright use the dollar as their chosen legal tender.
Why is the American Dollar Demonized?
When all the above-listed numbers on the supremacy of the dollar are tallied up, why is the dollar-standard criticized by both America’s friends and foes? For example, in 2011, America’s nemesis, Vladimir Putin, attacked the dollar’s “exorbitant privilege” by calling the US “a parasite, who is living off the global economy.”
The former Governor of the People’s Bank of China Zhou Xiaochuan echoed Putin’s distrust towards dollar hegemony in the aftermath of Federal Reserve’s ZIRP (Zero Interest Rate Policies) by saying, “if the domestic policy is optimal policy for the United States alone, but at the same time it is not optimal policy for the world, it may bring a lot of negative impacts.”
As a matter of fact, both Russia, China and even the European Union have taken substantial steps in trying to adopt a new financial paradigm. This new paradigm would by-pass their reliance on the dollar standard (SWIFT-payment system). As a result, cooperation in global trade and investment has turned into a race towards the bottom with conflicting interests.
The Paradox of Dollar Standard as a Safe Haven
Critics of the dollar standard point out that the US is a recipient of undeserved capital from countries, who are purchasing US debt-securities to protect against the risks that were created by the dollar standard to begin with. In other words, the world’s appetite for safe US Treasury Bills to secure their portfolios has exacerbated the development of dollar-based instabilities. Essentially the lack of safe alternative investments provides a monopoly position for US debt securities. Therefore, as dollars from abroad flow back to the US through foreign purchases of Treasury bills, high US consumption and low savings-rates are facilitated and perpetuated through “reversed aid” coming from emerging economies.
Paradoxically, when the 2008 financial crisis unraveled in the US and quickly spread around the world, as an investor one would assume that capital would have escaped from the source of the crisis towards safety. However, to the consternation of many, foreign investors poured their money back into US government securities even though the financial Armageddon started from US markets.
However, the dollar standard is not imposed on other countries as a mandatory monetary arrangement. Other economies have chosen the dollar standard. In 1971 the Treasury Secretary under President Nixon, John Connally famously told European leaders how “the dollar is our currency, but your problem.”
A Vicious Cycle in the Economics
In a globalized and interconnected world, the financial industry is especially tightly interlinked. Subsequently, when the Federal Reserve in the US pursues domestically desirable policies to fulfill its dual mandate of 1) low inflation and 2) full employment, these expansionary policies often have unintended consequences in economies that have chosen to shadow the dollar.
However, when the Federal Reserve keeps low interest rates in the US to stimulate the domestic economy, investors during good times seek higher yields from countries where interest rates are higher. Often such appealing rates are found from emerging economies, which rely heavily on an export-led model of growth.
Yet, when foreign investors pour money into these economies, the domestic currency tends to appreciate undermining their export competitiveness. In order to depreciate the domestic currency to bolster export industries, central banks intervene in the foreign exchange market. As pointed out earlier, 85% of foreign exchange transactions are denominated in dollars, resulting in a situation where foreign demand for dollars forces the international monetary system to exacerbate the original problem.
US Debt Breeds Uncertainty of the Dollar
On top of consistent US deficits, the chronic indebtedness of the US is casting doubts over the reliability of the dollar in terms of stability. Economies relying on the export model of growth find the US expansionary policies detrimental due to the ramifications of diminishing terms of trade.
Consequently, these economies are forced to accumulate dollar-denominated reserves in order to intervene in the foreign exchange markets to prevent their currencies from appreciating. Unfortunately, such “herding effect” has led to the pursuit of detrimental competitive devaluations, which threaten the external stability of the global financial system.
In the next and last article, we will examine the possibilities of dollar alternatives and see if there is a realistic opportunity to reform the global financial apparatus without creating serious collateral damage.
The material for the series has been compiled from the author’s own 2013 graduate school thesis titled “Instabilities in the International Monetary System and the Prospect of Special Drawing Rights as a Stabilizing Tool.“ The full work with a bibliography is available upon request.