The dollar’s central role in world financial markets reflects both faith in American leadership and the absence of reasonable alternatives. Currency dominance has also been a linchpin in America’s efforts to shape a global order around free markets and democracy while serving as a foundation for the sustained growth of a more integrated global economy. These roles now face rising risks. Both Republicans and Democrats question the benefits of an open and integrated economic order that seems to drain good jobs and demand repeated bailouts of bad banks and corrupt foreign governments. Meanwhile, allies and rivals alike raise doubts about the durability of U.S. leadership and the wisdom of depending so heavily on one dominant power.
Christopher Smart is a nonresident fellow at the Carnegie Endowment for International Peace, where he focuses on the interaction of global financial markets and international economic policy.
Such talk hardly portends imminent financial collapse or reconfiguration of the global order. America’s military and political strength remain paramount and investors still retreat to dollars whenever risks mount—even when those risks originate in the United States itself. Nevertheless, signs of an unravelling consensus are unmistakable. They lie not in the declining percentages of U.S. currency held in sovereign reserves, but rather the weakening faith in America’s ability to hold the system together. The clues are in the early elements of financial plumbing that bypass dollar markets, international financial institutions without active U.S. participation and increasingly rudderless economic gatherings of finance ministers. The risks for the existing global order are not that another power will displace Washington on these issues, but that there will be no leadership in areas that have become increasingly important to global commerce. Worse, the response to the next financial crisis will be uncoordinated and disastrous.
The U.S. midterm elections have triggered some renewed debate about America’s global agenda, yet there have been few voices to remind voters that international financial leadership benefits Americans and not just America’s banks. In fact, global dependence on access to the dollar gives Washington leverage to coordinate battles against terrorism and cybercrime, to shape rules against corruption and tax avoidance, and to protect privacy through the regulation of global data flows that will drive the next decades of economic innovation. Meanwhile, the United States must also build on summit communiques to make concrete progress in these areas with skeptical allies and rivals. For all its fits and starts, U.S. leadership continues to provide a crucial global framework for strong, sustainable and balanced growth. Yet faith in the dollar will only endure with a sense that the United States’ role has evolved from chief executive to managing partner that champions the integrity of a global financial system along with its own interests.
The fundamental choice to transact, invest or save in dollars reflects a judgement that they are most useful for those purposes. These judgements are slow and cumulative, but the choices can shift surprisingly and decisively. In many ways, the dollar emerged later than it should have, but perhaps sooner than expected. The U.S. economy surpassed Britain’s in the 1870s and was a larger exporter by the First World War. Yet the dollar first gained preeminence in bond markets by 1929, only to cede leadership back to sterling with the Great Depression. The end of the Second World War left the United States paramount with victorious armed forces, an unmatched economy and a network of global interests. In the decades since then, however, the dollar has endured the end of gold convertibility, inflationary fevers, expanding trade gaps, ballooning fiscal deficits, intermittent government shutdowns, a global financial crisis and even the loss of the U.S. Triple-A bond rating.
Foreign firms use dollars because their customers, suppliers and competitors do. In one survey by Harvard economics professor Gita Gopinath, now the International Monetary Fund’s (IMF) chief economist, the share of global trade invoiced in dollars is more than three times the U.S. share of global exports. Foreign governments accumulate dollars in reserves because they like to manage their own exchange rate against the world’s major trading currency. According to the IMF, the dollar still represents roughly 62 percent of all sovereign reserves, with the euro at 20 percent and the renminbi still accounting for less than 2 percent even though its share in global trade and finance is rising. Finally, investors favor dollars in part because firms and governments do, but also because the dollar markets are the deepest and most sophisticated, which makes them likely to be less expensive to tap for loans and more likely to deliver a reliable return.
The economic tradeoffs for the United States are clear. Issuing the world’s reserve currency offers the prospect to literally print money everyone accepts to buy guns without giving up butter. The dollar’s dominance also allows the United States to delay or shift any costs of global adjustment to other countries. Another benefit, the United States pockets the “seigniorage” income from what are effectively no-interest loans from the foreigners who hold two-thirds of the $100 bills in circulation. Among the costs, America’s easy access to low-cost credit may contribute to a stronger exchange rate that hurts exports and makes fiscal and trade deficits larger. Washington also bears responsibility to provide dollars and safe assets in a crisis.
Some of the dollar’s durability comes from the absence of viable alternatives. Europe’s common currency was a political project to bind the continent after centuries of war, although a clear aspiration of some European leaders has been to create a counterweight to dollar dominance. Yet the European financial crisis fragmented its financial markets and triggered questions about the viability of the European project itself. Postwar Japan deliberately protected the yen from an international role so that domestic capital could be directed for domestic purposes and the exchange rate could be managed. More recently, Japanese economic woes and competition from China have proscribed any real role for the yen, which remains at roughly 4.5 percent of international reserves. Chinese officials have a clear aim to expand the role of the renminbi in global trade, finance and sovereign reserves. For example, foreign governments have issued debt and central banks have established swap lines in Chinese currency. Even the likes of Germany and Chile have added it to the mix of their global reserves. Yet for now the reach of China’s currency remains restricted. Even if there is no economic crisis that interrupts more than two decades of blistering growth and reforms open the capital account and exchange rate, China’s domestic financial markets are not deep or liquid enough to absorb vast global flows. Ultimately, these require fundamental reforms in corporate governance, regulatory transparency and a system of checks and balances that a government can trust. Even the nineteenth century Rothschilds preferred lending money to constitutional monarchs, whom they considered better credit risks than unconstrained absolute monarchs.
“Great powers have great currencies,” wrote the Nobel Laureate Robert Mundell, and it seems uncontroversial that global influence and global money are intertwined. Indeed, if the military strength and economic wealth of the United States underpin the dollar’s central role, America’s global influence is enhanced because its currency dominates trade, finance and sovereign reserves. In the extreme, the United States has been known to leverage its military strength on behalf of economic interests—and indeed, the dollar itself. At different times, for example, Japan, Germany and Saudi Arabia have been reminded that U.S. security guarantees warranted their financial support when the dollar came under strain. Alternatively, during the Suez Crisis, the dollar’s dominance allowed the United States to force a British military withdrawal under threat of triggering a run on sterling.
Yet much of the dollar’s influence stems directly from the prestige of America’s institutions and trust in its intentions. Military and economic power support the dollar’s dominant share of trade and investment, but faith in U.S. political institutions has bolstered its role as both a reserve currency and a safe haven. In a world of imperfect choices, other countries have come to rely on the U.S. record of building rules-based financial institutions, proposing agendas for policy coordination and shaping progress toward open markets. This has been the story of the postwar Bretton Woods institutions, U.S. engagement in debt relief negotiations and the response to financial crises.
Meanwhile, currency power ultimately depends on trust in the intentions of the issuer. The issuer’s interests may naturally come first, but its usage will grow if these interests are essentially aligned with shared goals of global growth and stability. The most important economic conferences of the twentieth century convened military and political allies for difficult negotiations around monetary and financial policy. How much more difficult will these discussions become with strategic rivals around the table? How eager will China or Russia be to cooperate when the G20 leaders next convene to address a global crisis? The United States put its own interests first long before the Trump administration, but it has generally interpreted this to include the construction of global financial rules and institutions that apply to all. The growing concerns among allies and rivals are the doubts of bank customers who have been told that all fees have been raised because management needs to prioritize shareholders first. The statement may be technically correct, but it’s a questionable business strategy. At a moment when other economic powers continue to emerge, these agreed rules and shared constraints become all the more important to protect U.S. interests. Amid accelerating political and technological change, they become more valuable still.
The scope of financial diplomacy is tricky to distinguish from broader applications of economic power, which are often deployed in commercial channels through higher or lower trade barriers or outright embargoes. If the impact of offering or withholding commercial benefits has become diluted in an integrated world of many alternative suppliers, however, the importance of financial tools has grown. While America’s economic power rose through the twentieth century with its commanding share of global GDP, its financial leverage grew far more sharply over the last three decades. Benn Steil and Robert E. Litan wrote in Financial Statecraft: The Role of Financial Markets in American Foreign Policy that in 1970, some 90 percent of cross-border money flows were related to the trade of goods and services, while in the early 2000s some 90 percent are for investments or swaps or futures or a financial purpose unrelated to trade.
Financial diplomacy begins with the coordination of macroeconomic policy, investment regimes and banking regulation, but dollar dominance has given the United States a privileged role in a broad field of negotiations including debt restructuring, battles against terrorism and transborder crime. Most notably, targeted financial sanctions have dramatically bolstered political leverage to isolate bad actors like Venezuela over human rights or Russia over transborder aggression. Washington has sometimes failed to capitalize on all these tools due to poor political leadership or bureaucratic dysfunction, but that may make its accomplishments all the more remarkable across two broad areas. First, U.S. financial diplomacy has been the dominant voice in setting the rules and institutions that reinforce the openness and stability of the global financial system, and consequently support world economic prosperity. Second, the dollar’s dominance has opened conversation on a range of matters that raise global standards and improve cooperation beyond finance.
The ability to impose order on unruly global markets is, in many ways, what distinguishes the dollar from other international currencies. It is the world’s safest asset whenever political or financial turmoil spikes. In many of the same ways that the overwhelming power of the U.S. military can force order onto a conflict zone, so the U.S. Federal Reserve and Treasury have played pivotal roles in stabilizing financial markets through swap lines and loans. As with much U.S. diplomacy, these are both acts of broad generosity and narrow self-interest. As the ultimate backstop, the United States remains at the center of official conversations about the state of the global economy and the agenda for growth. Washington is still the most influential voice in key institutions that set the framework for macroeconomic cooperation and the rules of banking and finance. U.S. preferences are not automatically adopted within the IMF, the World Bank or the Financial Stability Board, but most of the fingerprints on important outcomes are still American. Finally, the United States has been at the table during key negotiations between over-indebted governments and their creditors, usually shaping offers of debt relief in exchange for more transparent markets and stronger rule of law. From the post-Soviet transition and the Asian crisis to the more recent travails of Greece, Ireland and Portugal, finance ministers from across the continent kept a sharp eye on Washington’s views even if the formal U.S. role was more limited.
Remarkably, American influence has also extended beyond stability and sound macroeconomic fundamentals. The dollar’s dominance, for example, has bolstered tools to attack money laundering, transnational crime and terrorism. The impressment of banks to monitor and punish a range of real and suspected rogues stems from their desire to retain access to the dollar system. This has led to greater cooperation among governments in ad hoc investigations of drug dealers and more coordinated efforts through the Financial Action Task Force (FATF). Muscular U.S. legislation that required foreign banks to report on clients with U.S. tax liabilities was met with dismay at its extraterritorial reach and threats of stiff fines. Yet within a few years, governments and banks everywhere signed up and Europe even introduced its own version. Meanwhile, as U.S. banks have been drawn deeper into protecting client personal and financial information, the dollar’s importance has been shaping broader rules around privacy and global data flows. Just as the strength of the U.S. economy has induced other economies to discuss new labor and environmental standards during trade talks like the Trans-Pacific Partnership and even revisions to the North American Free Trade Agreement, the dollar’s paramount importance provides additional U.S. leverage to improve standards of government transparency.
If U.S. financial diplomacy depends on trust that America will champion fair and cooperative rules, then it may just be the first casualty of President Donald Trump’s “America First” strategy. Still, the forces that have been weakening U.S. influence on systemic issues have been building through years of neglect. From George Washington’s warning about foreign entanglements to confusion over U.S. priorities after the Cold War, isolationist impulses have come and gone. Today, they have become intertwined with a sense of helplessness amid forces of globalization blamed for their withering impact on middle-income families. In the wake of the global financial crisis, these forces have led to much deeper skepticism about U.S. engagement in general and the merits of financial diplomacy in particular. In some ways, the shifts echo dynamics around British economic leadership after the First World War, when the cozy arrangements of central bankers to defend the gold standard were upended by a labor movement that had been empowered by its war contributions and pressed for a new approach to international financial policy. The “Occupy Wall Street” and anti-globalization movements have left significant marks on mainstream parties and traditional U.S. commitments to international organizations like the IMF, which some viewed as an outrageous diversion of taxpayer money to bankrupt governments. More recently, these forces fueled the campaigns of Trump and Senator Bernie Sanders, both of whom decried a U.S. system that seemed rigged against American workers while the global economy was rigged against America.
Pressures on the dollar’s role have been rising abroad as well. For all its importance, there has been no discernible strategy to protect and burnish the currency’s reputation. Indeed, Washington gridlock over fiscal deficits or debt limits might even suggest a deliberate effort to actually undermine confidence in the dollar. Naturally, doubts about U.S. financial leadership deepened sharply during a global financial crisis that was triggered by what many saw as American carelessness that allowed worthless subprime real estate assets to infect the world’s financial system. Notwithstanding an impressive G20 response led by Washington, the U.S. commitment to a stable global system has faltered amid lengthy Congressional delays in approving reforms of the IMF that included modest power-sharing with emerging economies. America’s allies worry about the reliability of U.S. engagement to shape the global financial system, including more reforms and capital at the Bretton Woods institutions.
They also chafe at the extra-territorial reach of U.S. sanctions that seem both excessive and designed to protect American commercial interests rather than reinforcing global norms. While financial sanctions against Iran may be viewed as broadly successful, they raised grave concerns in Paris when U.S. regulators assessed nearly $9 billion in fines on the bank BNP Paribas for payments to Iran based on an expansive interpretation of U.S. jurisdiction. Worries about running afoul of U.S. regulators have also led banks to “de-risk” their businesses, leaving fragile states in Africa and the Caribbean dangerously close to losing access to dollar finance altogether. Meanwhile, rivals like Russia and China denounce financial sanctions they view as U.S. power run amok, and quietly explore alternative credit card and payment arrangements that avoid the dollar altogether. With Venezuela financially sealed off by U.S. sanctions, Moscow and Beijing are the only prominent economies sending delegations to engage the Maduro government on its debt woes.
Current trends, of course, suggest that other economies will grow and leave the United States with a declining share of the global economy. Challengers and scholars have argued that a world of several, more or less equal reserve currencies would be fairer and more stable. Indeed, political scientists have long debated the relative merits of a single global hegemon over a system of several competing powers. On global financial and economic matters, the United States has used the system to its own advantage, but a fundamental thrust of postwar financial diplomacy has been to create open, predictable and transparent rules. Indeed, America’s “strong dollar” policy is an act of systemic responsibility, forswearing exchange rate targeting so that others will do the same to the longer-term benefit of the system. Even the sharpest tools in the U.S. sanctions kit have been deployed so far less on behalf of parochial interests than in an international effort against crime, terrorism or territorial sovereignty.
Moreover, neither historical precedents nor current scenarios suggest fewer financial crises or more prosperity during periods when several currencies vied for dominance. The tumultuous story of the interwar gold standard alone should give pause to anyone rooting for a multi-currency world. France never intended to bring the system down, but, as Jonathan Kirshner has observed in Currency and Coercion: The Political Economy of International Monetary Power, its persistent efforts to undercut the dominance of sterling contributed directly to the outcome. While it is possible under current circumstances to imagine that Europe could help stabilize markets in cooperation with the United States, it is difficult to imagine such leadership on its own given its clumsy decisionmaking process. China still has a long struggle ahead to win over the trust of its immediate neighbors, let alone its global rivals. In a system of several currencies, each of the major players is more likely to seek an edge over its economic area than to enforce rules of trade and investment that benefit everyone.
A great irony of the current political landscape is that deep within the turgid prose of international financial communiques lurks a surprisingly populist agenda. The Trump administration seems unlikely to seize the chance, but presidential candidates who emerge in the near future should pay attention. If the United States is to protect its own financial tools and reinforce the stability of the global system, it must underscore the actual successes and the potential for more progress. For voters concerned about security, the work of the U.S. Treasury and its counterparts through FATF has dramatically improved cooperation against drug gangs and terrorists. For voters who chafe at a political system they view as rigged to favor the rich and powerful, the Organization for Economic Co-operation and Development, the Asia-Pacific Economic Co-operation and others have been developing mechanisms with U.S. support to crack down on tax havens and official corruption. Meanwhile, America’s engagement with the G20 and the G7 has shaped conversations on how reforms to the global financial system can help alleviate global inequality, establish better strategies to reduce excessive sovereign debts and champion financing mechanisms that address climate change.
Neither America nor its currency are headed to inevitable decline. Yet a period of populist resentment over current financial structures along with shifting allocations in the global economy have triggered questions about the U.S. commitment to the postwar Bretton Woods consensus. The Trump administration’s rhetoric and protectionist measures have raised even more questions. Even a casual review of history confirms that the current system is based as much on U.S. power and luck as consensus, but its reinforcement for a more turbulent era ahead will require still more policy creativity. Disgruntled domestic interests need to be reminded of the rare political benefits the United States derives from issuing the world’s safe-haven currency. Political leaders also need to demonstrate just how international financial engagement can support a global economy that is not just strong and sustainable, but also fair and accessible to others. U.S. financial diplomacy more than most diplomatic endeavors requires trust to succeed: the trust of voters that American engagement will help address their central fears and the trust of other countries that the dollar and its institutions offer the best mechanism for managing financial stability and economic growth.
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