For Now Anyway, World Economic Stability Depends on the US Dollar

In a series of three articles, I will strive to shed light on the structure of the global financial system, which operates under the dollar standard. In so doing, it gives the United States a benign hegemonic position to influence the direction of world affairs. By examining economic history, the fundamental causes as well as consequences of the 2008 Great Recession and potential reforms to stabilize such a system, readers can speculate whether dollar’s exorbitant privilege as de facto reserve currency is sustainable.

The 2008 Recession revealed the inherent problems of the international monetary system. The combination of various existing and overlapping issues has generated global discussions about the international monetary system structure, which is by design dependent on the business cycles of the reserve issuing country, namely the US.

Naturally, the rest of the world is eager to blame America and the dollar for its domestic economic problems and loudly demand dramatic changes whenever financial storms loom in the horizon. As a matter of fact, the world economic community tends to blame the dollar for the past and present instabilities of the global financial system.

The Dollar Standard as an Historical Accident

Currently the international monetary system is largely facilitated through the dollar, which has dictated the flow of international trade and finance, accounts for the majority of the global reserves, and operates as the most prominent anchor currency for other economies. Through a variety of events, which have shaped the globe’s historically important geopolitical, economic and cultural trends, the dollar has played extremely pivotal role in dominating the direction of these events.

The dollar was the only stable and reliable currency after WWII.

The greenback hasn’t always been de facto international reserve currency. Up until the end of the first World War, the British empire (with the pound sterling) held the position of a global superpower issuing its currency to be utilized elsewhere. Although the dollar standard started to strengthen through the establishment of the Federal Reserve in 1913, the aftermath of the world wars ensured that the dollar was to be used as the dominant global reserve currency.

After World War II, the rest of the world struggled with pernicious inflation, destructive currency controls and basic reconstruction of annihilated societies. The dollar, however, was the only stable and reliable currency, which had open capital markets and an intact and liquid financial system.

Therefore, settling global trade and multilateral investments in dollars was the expected norm. In addition, the Marshall Plan (officially known as the European Recovery Program) ensured that the dollar was the primary currency used in rebuilding Europe, thereby increasing the external network value of the dollar.

From Bretton Woods to Nixon Shock

The purpose of a multilaterally accepted reserve currency is to fulfill three basic functions:

a medium of exchange

a means of payment

a store of value

To qualify for these functions, the reserve issuing country must have a large and resilient economy capable of absorbing sudden negative shocks. Further, the reserve country must have political stability and, in most cases, strong military leverage to pursue both political and economic interests.

In such framework, the US is and was the only credible candidate for guarding the financial system through its own currency. When the winners of the World War II gathered in 1944 at the Bretton Woods conference to hash out the new architecture of the international monetary system, the structure was therefore naturally built around the premise of the dollar.

In practice, every country pegged its own currency to the dollar and the dollar was tied to the value of gold. The world essentially returned to the gold standard, which had been abolished to pay for war expenditures.

Even after the 1970-1973 time frame, which can be described as a period filled with ad hoc monetary arrangements, collectively inconsistent monetary policies, and President Nixon’s disastrous decision to take the dollar out from the gold standard, the dollar has still maintained its dominance.

In other words, the good old sawbuck regardless of its deficiencies continued to dominate after the Bretton Woods system collapsed. With all the monetary calamities, why did the dollar still prevail?

The Nth Currency Stabilizer

Economist and 1999 Nobel Prize winner Robert Mundell eloquently explained through his pioneering work on optimal currency areas why the dollar continues to dominate. In a world with n countries with n currencies, the facilitation of international trade and investment in a highly complex; a globalized world currency would not only be inefficient, but also costly. Therefore, to simplify global financial transactions, governments are forced to choose the nth currency as the central vehicle currency to minimize the number of foreign exchange markets.

Without the nth currency, the world would have circa 150 different currencies, which would create 11,175 different foreign exchange markets. By having all currencies traded against the dollar, the number of markets in the system would be reduced to n-1.

The efficiency gains from one anchoring currency would be greater because international trade and investment benefits from economies of scale. The dollar emerged as the champion after World War II and the size of the American economy was large enough to facilitate global trade. As such, it is only reasonable to observe that even though the dollar system can be considered biased, it is the least of all evils. This, however, does not mean that the dollar paradigm should be excluded from critical examination, especially in the aftermath of the Great Recession.

Indeed, in recent years, the unavoidable problems caused by the dollar standard have become more acute. Because many economies shadow the dollar exchange rate under the above mentioned n-1 arrangement and use it to control their own inflation rates, US domestic economic policies often spill over to other countries.

The US justifiably tends to pursue its own domestic economic interests, which. unfortunately. are often unaligned with global interests. This causes resentment toward America from other stakeholders in the international monetary system. The role of the dollar as the anchoring currency is arguably beginning to fade away as, for example, emerging markets are becoming increasingly frustrated about continuously absorbing the negative externalities from the Federal Reserve’s near-zero interest rate policies.

But this is a broad and complex topic. In Part 2, I examine why the dollar standard — despite of its strong network value — exacerbates global financial instabilities.

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.