The dollar and American foreign policy
The dollar’s central role in international finance since World War II carried political benefits, economic benefits, and economic costs, but overall has been a valuable tool of American foreign policy advantageous to American interests. During the Cold War, the dollar as reserve currency was a lynchpin of the liberal economic order which partially defined the ideological divide between the U.S. and the U.S.S.R. and was also a major strategic tool against the Eastern bloc. The dollar’s special status makes it a potent shield against hostile actions by nations with large dollar holdings. During the era of dollar dominance, the United States benefitted generally from global economic growth and specifically from the demand for dollars as the medium of international exchange. The strength of the dollar has also carried economic costs, from the depletion of U.S. gold reserves to decades of U.S. trade and budget deficits.
A reserve currency is held in significant quantities as part of the reserves of governments and central banks. There are several regional reserve currencies, but since 1944 the dollar has been the dominant global reserve currency. In addition to its formal role as a reserve currency, the dollar also serves as transnational money. The dollar performs the three functions of money in international commerce: a medium of exchange, a unit of account, and a store of value. (Goldberg 2010) As a medium of exchange, the dollar is sought after for trade between nations that do not have fully trustworthy currencies, for example, “the international trade of developing nations is mainly invoiced in U.S. dollars.” (Faudot and Ponsot 2016). The dollar acts as a unit of account in international balance of payments accounts and as part of the system of transnational institutions like the IMF and World Bank (International Monetary Fund 2017). The dollar is highly sought after as a store of wealth because it is widely regarded as a “safe haven” in times of crisis (Dobbs et al. 2009).
Before the dollar became the dominant reserve currency, the international financial system had gone through several transformations culminating in thirteen years of economic chaos. From 1870 to 1918, international trade was conducted on the gold standard. Under the gold standard, countries held reserves of gold bullion or of foreign currencies backed by gold. The bullion and foreign reserves backed a fractional portion of the paper currencies. For example, Britain held reserves equal to 46% of their currency, Belgium 41% and Finland 80% (Lewis 2013). The system was not based on any treaty, but on each nation backing its currency directly or indirectly with gold. By 1918 inflation from World War I had led most countries to suspend gold backing for their currencies and currency values floated at market rates. By 1925, the dollar and the British pound sterling were backed directly by gold and other countries held dollars or sterling as reserves, with sterling as the dominant reserve currency. This system ended when Britain suspended gold payments in September 1931. The next thirteen years were characterized by trade wars, economic chaos, and shooting wars (Choi 2017).
The dollar became the reserve currency towards the end of World War II at the United Nations Monetary and Financial Conference held at Bretton Woods, New Hampshire in July 1944. The forty-four participants in the conference agreed to value their currencies “in terms of gold as a common denominator or in terms of the United States dollar.” (Proceedings and Documents 1944). In practice, the other nations pegged their currencies to the dollar and the dollar was redeemable in gold internationally. The nations were allowed to adjust the par value of their currencies, but the value of the dollar itself was fixed to gold and could not be adjusted (Stephey 2008).’
The demand for dollars as reserve currency led the United States to incur trade deficits. Other countries could devalue their currencies, but despite the continuing deficits the United States was obligated to value the dollar as agreed in gold. By 1971, the United States gold reserve covered only 22% of liabilities to foreign banks. In May 1971, West Germany left the Bretton Woods system followed in August by Switzerland. The French demanded payment of $191 million in gold in August. The common but unconfirmed story is that the French sent a warship to New York to collect (Kolb 2014). On August 15, 1971, Richard Nixon ordered the end of dollar gold redemption (Frum 2008).
The end of the Bretton Woods system did not end the dollar’s role as the dominant reserve currency. Over the following two years, attempts to revive Bretton Woods failed. The system of market priced currencies has been the international order since. With no major currency redeemable in gold and no serious move to create a global currency, the power of the world’s largest economy has made the dollar the dominant currency.
The dollar played a key role in the liberal economic order in the West during the Cold War. Open markets were an ideological goal of the West, with the fourth point of the Atlantic Charter calling for “the enjoyment by all States, great or small, victor or vanquished, of access, on equal terms, to the trade and to the raw materials of the world which are needed for their economic prosperity.” In addition to establishing the role of the dollar as the reserve currency, the Bretton Woods system established the first two international institutions intended to create this liberal post-War economic order, the World Bank and the International Monetary Fund. In 1947, the third major institution was formed when the General Agreement on Trade and Tariffs (GATT) was signed by 23 nations in Geneva, Switzerland. GATT’s purpose was a “substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis.” (GATT text 1986, 1). The dollar performed a central role in making the liberal economic order possible by performing the functions of money in the international economy.
The liberal economic order was also a tool of American policy toward the Soviet Union. The Truman Doctrine initially focused on using economic aid to attack the “misery and want” that threatened to bring Communist revolution in southern Europe. From economic aid to Greece and Turkey, the principle expanded to the Marshall Plan. The Marshall Plan provided over $12 billion to Western Europe for reconstruction, establishing a market for American goods and encouraging the system of open markets (State Department 2017). The Truman Doctrine focused on promoting “freedom and its many [economic] blessings” and “made freedom the centerpiece of…postwar American foreign policy.” (Spalding 2006, 5).
Even after the end of the Cold War, the reserve currency status makes the dollar politically useful as a shield. Nations which hold large dollar reserves are constrained from acting against the U.S. interest in ways that would decrease the value of their own dollar holdings, at least in the short term. For example, China with a GDP of $11 trillion and a population of 1.4 billion appears at first glance to be a serious strategic and economic threat to U.S. interests, and may be in the long term. But China holds an estimated $2.7 trillion U.S. dollars as part of its $4 trillion foreign currency reserves (Wildau 2014). An action that decreased the value of the dollar by 10% would reduce the value of Chinese foreign reserves by an amount equal to 1.8% of China’s GDP, a significant disincentive to Chinese action against U.S. interests.
In the economic sphere, reserve currency status provides two main benefits to the United States: cheap imports and cheap interest. Since most countries grow their money supply as their economies grow and many grow their money supply to cover government deficits, there is a constant demand for larger foreign reserves to back the expanding money supply. The resulting demand for dollars increases the price of the dollar relative to other currencies. The strength of the dollar relative to other currencies makes imports cheaper for the United States. The strength of the dollar also makes dollar denominated debt securities, including federal and corporate bonds, attractive as investments increasing their prices. It’s a basic rule of finance that the price and yield (interest rate) of securities is inversely related (Campbell 2014). So, the strong dollar makes it cheaper for the U.S. government, corporations, banks and, indirectly, bank customers to borrow.
The major economic costs of reserve currency status are the flip side of the economic benefits. The cheaper imports, and more expensive U.S. exports also resulting from the strong dollar, have resulted in decades of consistent trade deficits for the United States. The resulting loss of export oriented jobs has led to lower employment, higher social welfare costs, and a lower federal tax base. Those have combined to feed the federal budget deficit (Pettis 2013).
The need to maintain the dollar’s value while providing sufficient dollars for a growing global economy also constrains domestic economic policy. Ideally for the dollar as reserve currency, there must be a trade deficit precisely big enough to match the increased demand for dollars as the world economy grows. This means that dollar growth should be curbed during times of global recession and dollar growth should be increased during times of global expansion. During a recession, Keynesian economics would suggest an expansionary fiscal policy and monetarists recommend an expansionary fiscal policy, both opposite to what is required for the dollar as reserve currency. During a global expansion, the opposite is true. There is a body of economic research that shows trade deficits are the result of a difference in national savings rates between the trading partners. While that’s arguably true, any attempt to improve the savings rate that successfully reduces U.S. trade deficits would have a deflationary effect on the world economy amplified by the dollar’s role as reserve currency (Pettis 2013).
The net economic effect of the dollar as reserve currency is positive for the United States, though not a huge advantage. “In 2007–2008—a “normal” year for the world economy, the net financial benefit to the United States was between about $40 billion and $70 billion—or 0.3 to 0.5 percent of U.S. GDP. In a “crisis” year—such as the year to June 2009—MGI estimates that the net financial benefit fell to between—$5 billion and $25 billion because the dollar appreciated by an additional 10 percent due its status as a “safe haven.” (Dobbs et al. 2009).
The dollar’s status has led to criticism internationally at least since 1965, when French finance minister Valery Giscard d’Estaing proclaimed that the U.S. enjoyed an “exorbitant privilege” because of that status (Goldberg 2010) (Porter 2013) (Subachi and Driffil 2010) (Pettis 2013). The dollar actually produced only a marginal direct economic benefit for the United States, dwarfed by the increased volume of global economic activity made possible by the post-War liberal economic order. Since the financial crisis of 2008/2009, calls for a replacement for the dollar have been magnified with much attention given to an increased role for Special Drawing Rights (SDR) from the International Monetary Fund. The U.S. dollar has the highest weight in the basket of five currencies included in the SDR at 41.73% (International Monetary Fund 2017), so while increased use of the SDR may diminish the role of the dollar, it would remain a substantial part of the reserve equation. Suggestions for an international currency are not new, John Maynard Keynes referred to the Bretton Woods System as “the exact opposite of the gold standard,” and suggested eliminating it entirely in favor of an independent global currency in the 1940s (Stephey 2008). Since its creation, the euro has also been mentioned as a future dollar replacement or dollar counterpart. In a November 2009 interview with Le Monde, European Central Bank President Jean Claude Trichet said that the euro was not intended to be a reserve currency and added that a strong dollar was “is in the interests not just of the United States, but of the entire international community.” (Delhommais and Leparmentier 2009)While the dollar may be diminished as other currencies assume a larger role, for the foreseeable future, the dollar remains, in the words of currency trader George Soros, “the weakest currency except for all of the others.” (Porter 2013)
By providing a relatively stable reserve currency, the U.S. dollar has promoted international trade and a growing global economy for 70 years. The United States has enjoyed moderate net economic benefits from the dollar’s status directly. More importantly, the United States has also enjoyed the benefits of increased global economic activity and open markets. Politically, the liberal economic order contributed to the collapse of the Soviet Union. Perhaps most importantly, the dollar’s special status has made it a political shield against countries who would act against the interests of the United States. While there has been international criticism of the dollar’s special status, there is currently no serious alternative. As a tool to promote U.S. interests, the dollar has been effective and efficient.
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