The structure of the international financial system makes regime change difficult
Joshua Zoffer
The dollar’s outsized role in international trade, payments and banking means governments alone cannot decide its fate © Bloomberg
Criticism of dollar dominance has arrived back at its ancestral home in Europe. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, first decried the dollar’s “exorbitant privilege”: the ability of the US to finance large balance-of-payments deficits due to its currency’s dominant status in global finance.
Over the past decade, calls to reduce the dollar’s role have come mostly from Russia, China and Iran. The past two years, however, have seen German foreign minister Heiko Maas and Bank of England governor Mark Carney add their voices.
There are signs that central banks are voting with their feet. IMF data show that central banks’ holdings of dollar reserves have fallen slightly, despite the dollar’s high yield relative to other major currencies.
But those who see these developments as cracks that could bring down the edifice of dollar hegemony overstate their point.
The structure of the international financial system makes regime changes in the global currency system exceptionally difficult. The dollar is going nowhere fast.
In that sense, little has changed. In the late 1960s, France led a push to replace the dollar with IMF Special Drawing Rights, a synthetic foreign reserve asset. But SDRs could be used only by official entities, not in private transactions, and never really caught on. Meanwhile, the dollar’s role expanded as financial globalisation took off.
This precedent is particularly telling because confidence in the dollar was then at its historical nadir. Even after President Nixon unilaterally severed the dollar’s link to gold in 1971 — collapsing the Bretton Woods agreement — weaning off the dollar proved impossible.
Half a decade later at the height of the financial crisis, China’s then central bank governor Zhou Xiaochuan made a similar argument for SDRs to replace the dollar. Needless to say, despite the US’s role as “patient zero” in the crisis, little changed.
There are a few reasons why the dollar’s role has proven so durable.
First, the market in dollar-denominated assets, especially government debt, is far deeper than any other. Foreign exchange reserve managers typically hold high-grade securities, not cash. As a result, they often have nowhere else to turn but dollar assets, especially ultra-liquid Treasuries.
Second, a consequence of the imperative of holding dollar assets is that many central banks have a lot of them. China and Japan each hold more than $1.1tn in US Treasuries, let alone other dollar assets.
A dramatic shift away from the dollar would imperil the value of these holdings, putting large holders in a Catch-22. Historically, this barrier has been overcome only when conditions are so dire — such as the shift from pound to dollar during the wars of the 20th century — that adding on the cost of a currency regime change will not make things much worse.
Third, the dollar’s outsized role in international trade, payments and banking means governments alone cannot decide its fate.
Roughly half of world trade is invoiced and settled in dollars, and the proportion is especially high for crucial commodities such as oil.
That dominance reflects, in part, the efficiency associated with using a single dominant currency.
But it also reflects the centrality of American consumers in the global economy.
Finally, the benefits of a global currency can be provided only by strong institutions trusted by governments and private market participants alike. At the depths of the financial crisis, the US government and Federal Reserve used measures like emergency dollar swap lines to provide desperately needed liquidity to foreign banking markets.
There are two reasons to think things are different today. The US has weaponised the dollar to a greater extent than ever before. It has used its ability to kick banks and countries out of the global dollar system to conscript them into its foreign policy. Other countries have chafed at this, contributing to the dollar’s unpopularity. Cracks are starting to form, with Russia proving to be a particularly notable voice in shifting away from the dollar.
At the same time, digital currency has come into its own. In theory, it is now possible to build a digital finance and payments network with the scale to rival the dollar far more rapidly than at any prior point in history. But digital currencies have their own drawbacks, such as the trustworthiness of the provider. It is difficult to imagine a deep market in financial assets denominated in such a currency, or a world where governments issue debt denominated in Facebook’s Libra.
Moreover, a crucial element of the greenback’s appeal is that dollars represent claims on American goods and services. Fiat currencies are backed not just by governments but by the strength of the economies in which they are used. Today’s digital currencies cannot lay claim to anything remotely comparable.
If a digital currency is to rival the dollar, it will be one managed by a national government or international institution.
That seems a long way off yet.
Although the US would be wise to answer concerns about the dollar, the currency’s role is safe for now.
The writer is a student at Yale Law School
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