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13 October 2022

As good as gold

How the dollar has ruled the global economy no matter the crisis at home.

By Adam Tooze

The dollar is king. This year the strength of the US currency has humbled the yen, the euro and the pound sterling. US interest rates are putting pressure on dollar debtors around the world.

This is not a surprise. It is often said that the dollar wins whatever the state of the world economy. It is a safe haven in crisis; in a boom, money surges into the dollar because US business is the prime generator of profits. But what is increasingly hard to ignore is how the dollar’s monetary pre-eminence is out of proportion to America’s actual economic standing in the world.

Thanks to the explosive growth of emerging markets such as China and India, the world economy is increasingly multipolar. As a result, the US accounts for little more than 20 per cent of global GDP and yet its share of currency reserves is closer to 60 per cent and the dollar is involved in 85 per cent of all foreign currency transactions. If currency is conventionally thought of as an attribute of sovereignty, then this preponderance of the dollar would seem to confirm the continued existence of a US financial empire. And yet in 2022 this is at odds with America’s polarised and dysfunctional politics and the great power competition it faces abroad. It seems almost anachronistic that the Federal Reserve still functions as the de facto central bank of the world, like a hangover from the era of the Marshall Plan in the mid-20th century, or the moment of unipolarity in the 1990s.

How long can this anomaly continue? Are there alternatives to the dollar? In times of war the question becomes an urgent one.

At the start of 2022 economists debated the possibility of a Sino-Russian axis (with India as a potential third member), and a new currency system based on commodities such as oil, wheat or minerals. Cryptocurrencies were touted as the unpolitical, private alternative.

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Such speculation has faded and the exchange rate of the US currency is once more a dominant force on the world economy. Talk of alternatives to the dollar seems like an exercise in wishful or alarmist thinking, a sign of an unease with an unbalanced world, rather than a realistic analysis of likely macroeconomic trends.

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The century of dollar dominance has always been marked by controversy. The dollar emerged as the commanding world currency owing to the First and Second World Wars. While the Europeans and Japanese consumed themselves in conflict, the Americans were war profiteers. That did not endear them to the rest of the world.

For the British elite in the wake of the Battle of the Somme in 1916, the realisation that the future of the war effort, and with it the Empire, hinged on American money came as an unholy shock. In France in the 1920s, American tourists were both loved and hated for their purchasing power. Trotsky mocked the way Europe’s old elite humbled themselves before midwestern bankers such as Charles Dawes, who brokered the reparations settlement with Germany of 1924. Things were not helped by America’s aggressive deflations, first in 1920 and again in 1929, which tipped the world into recession, and by the ludicrously dysfunctional American policy mix.

Full-blown isolationism would at least have been consistent. Instead, while the American government refused to muddy its hands with the difficult business of reparations, Wall Street lent to European governments and businesses on a vast scale. Meanwhile, Congress imposed rigorous protectionism, making it impossible to service those debts. By 1933, not just Hitler’s regime but the governments of Britain and France had defaulted on their debts to the US.

When it came to devising a new currency system for the world after the Second World War, John Maynard Keynes was determined to avoid dollar hegemony. To tame America’s capricious policy, he proposed a system that would subject everyone to the same pressure to adjust domestic policy to international economic constraints. It is an idea that has repeatedly resurfaced, most significantly in 2009, in Chinese demands for a new currency system to be based on a synthetic global currency, presumably managed by the IMF or another global body. But the idea never stood a chance. Even under the gold standard, in the pomp of its power after 1945, Washington was not going to accept its subordination to a global monetary corset.

Instead, from the 1950s onwards, the gold reserves of Fort Knox were used to anchor the dollar and the rest of the world’s currencies that were pegged to the US currency. This made the US currency as good as gold – provoking protests from the French about exorbitant privilege. It was a highly unstable arrangement. How could the Fed, a national central bank, which had a commitment to national stability, ensure enough liquidity for a global system? As the Belgian economist Robert Triffin pointed out in 1960, if the Fed acted to correct excess demand in the US, it risked choking off the world economy. Once again, the call went up: world stability depended on a universal currency. In the 1960s the IMF created a synthetic global currency, the SDR, but like Esperanto it never caught on. Instead, the system was held together with swap lines that allowed the Fed to provide dollars to fellow central banks in addition to other interventions, such as bans on open trading in gold.

Then in 1971, facing even larger deficits than in the 1960s, Richard Nixon, the president, simply abandoned the dollar peg. Global currencies gyrated wildly. But as the White House tapes recorded, Nixon said he “didn’t give a s*** about the lira”. The dollar plunged, the price of dollar-denominated commodities like oil surged. The Organisation of the Petroleum Exporting Countries (Opec) considered repricing oil in another currency. But the shift never happened. No one else wanted to be the global anchor, certainly not the Germans, whose Deutsche Mark was the obvious alternative. The government didn’t want to jeopardise Germany’s status as a champion exporter.

In 1979 Paul Volcker, chairman of the Fed, finally did the unthinkable. To end the inflation that had troubled the US (and world) economy since the late 1960s, he tightened monetary policy, driving interest rates up and unleashing the economic crisis that many had long feared. The US economy slumped and dollar debtors around the world went into crisis. The US had to bail out its own over-extended banks. Yet what emerged from the “Volcker Shock” was a new dollar system based on floating exchange rates, the further empowerment of Wall Street and the final defeat of organised labour. Budget constraints on the US were removed again, and from the 1980s it made full use of this freedom, borrowing on a huge scale from Japan and then from China. By the early 2000s analysts were warning of a dollar crisis ahead. Beijing would surely exercise the whip hand its ownership of trillions of dollars of US Treasury securities gave it. Enraged by Nato’s offer of membership to Ukraine and Georgia, in 2008 Vladimir Putin suggested a concerted Sino-Russian raid on the dollar. This would entail dumping their holdings of Treasuries so as to deliberately crash the market. The Russians sold out. The Chinese did not.

The crisis that year was one internal to the dollar system – the meltdown of bank balance sheets. But rather than plunging in 2008, the dollar rose. From Europe to East Asia, banks around the world were pleading for dollar liquidity. The Fed obliged, dishing out dollars on an epic scale. The same thing happened in 2020: faced with the Covid crisis, the Fed flushed the entire global financial system with the dollar. As ever, instead of overturning dollar hegemony a crisis reinforced the central role of the American currency.

The pattern repeated in 2022. In response to Putin’s invasion of Ukraine the US and Europe imposed sanctions on Russia. In an unprecedented move they violated their commitment to honour central bank claims in favour of the Russian central bank. But after some feverish talk about alternatives to the dollar, what has happened? Instead of selling dollars and fleeing into any other currency, global demand for dollars is stronger than ever.

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How does an inherently unstable system, whose emergence from 1916 was resisted and whose end has been repeatedly foretold, endure every crisis? What is the secret ingredient that holds the dollar system together?

The significance of Money and Empire, the new book by the economist Perry Mehrling, is that he takes us to the heart of this question. Like Mehrling’s previous books, Money and Empire uses the biography of a leading economist as a device for making a far more general argument. In this case, Mehrling’s medium is Charles P Kindleberger.

Charles P Kindleberger. Photo by The Truman Library

Kindleberger’s career began and took off in the years of the Great Depression, the Second World War and the Marshall Plan. Disillusioned with Washington politics and blacklisted on account of his association with American leftists by McCarthy’s witch hunts, Kindleberger made his career in the prestigious economics department of the Massachusetts Institute of Technology.

Kindleberger is best known for his argument that every successful phase in the world financial system has depended on the presence of a willing hegemon. The Bank of England played this role during Pax Britannica in the 19th century, as has the Fed in recent decades. The disaster of the interwar period, which Kindleberger chronicled in The World in Depression: 1929-1939 (1973), was partly down to the fact that there was no equivalent hegemonic central bank.

It is a compelling theory. But, as Mehrling shows, talk of hegemony is easily misunderstood. Hegemony suggests the authority of governments and states. And central banks, as we know them today, are national state institutions. But as their history illustrates, the state is not a given thing. It is made historically and through interactions with interests at large. And the boundaries of the state are porous. Private interests intermingle with state power. The Bank of England may have been founded in 1694 but it was not nationalised until 1946. The United States did not have a central bank at all until 1913. Its financial system was regionalised. New York was umbilically connected to the City of London. The regional Fed branches in the United States are to this day stacked with business executives from the districts they represent. Only the Fed board in Washington DC is a truly public institution.

Kindleberger was trained in the 1920s by a generation of American monetary economists who saw themselves as simultaneously helping to engineer a nationally integrated US financial system (centred on the Fed) and a global financial system (centred on the dollar). The First World War both created the US national financial system and began to remake the international system around the US. As the centre of finance shifted from London to Wall Street, the dollar emerged, according to Kindleberger, not so much as a national currency foreign to the rest of the world – in which they nevertheless borrowed, lent and transacted – but as the native currency of the 20th-century global financial system. In this sense the dollar was truly a successor to gold – the common denominator of the pre-1914 London-based regime.

As Mehrling argues, Kindleberger is best thought of less as an inter-national economist than as a cosmopolitan economic thinker. To describe the world economy and its currency system as international implies that its building blocks are national economies. For Kindleberger, what counted was the mesh of private financial transactions running from commercial centre to commercial centre, across national boundaries and in whatever currency happened to be most convenient and offer attractive margins.

Kindleberger was at odds with both the monetarist and Keynesian spirit of the post-1945 period. Despite their differences, over how best to control inflation and manage unemployment, both main schools of macroeconomics focused on the stabilisation of the national economy, while international connections were of secondary import. The world economy appeared as a series of national islands rather than what Hyun Song Shin, a senior economist at the Bank for International Settlements, would later call the interlocking matrix of private balance sheets.

For much of his working life Kindleberger was an economist at odds with his times. His career spanned the heyday of the national economy between the 1930s and the 1980s, whereas his conception of the economy was better suited to the world of globalisation before 1914 and the second phase of globalisation from the 1970s.

This tension was evident in Kindleberger’s confident insistence that far from being doomed by America’s budget deficit and its trade imbalance, the Bretton Woods international monetary system could be saved. What the US authorities needed to do was not to impose national restrictions on capital flows. On the contrary, the key was to trust to the logic of the US-centred financial system. Some money might flow out in the short-term, but it would come back and the safest way to ensure that was to not prevent its exit. After all, where was large-scale global money to go? Then as now, there was no real alternative to the dollar.

For Kindleberger, Nixon’s freeing of the dollar from gold, the deliberate destruction of an international monetary system for the sake of national economic and political priorities, was the disastrous denouement of the national economic point of view. But his own alarm also proved to be overdone. Rather than tearing the world economy apart, the end of Bretton Woods would confirm Kindleberger’s basic point: the resilience of the dollar system lies not in the robust health of the US national economy or its national politics, but in the strength of global financial network that is woven in dollars, and the willingness of the Fed to support that network as a lender of last resort.

This remains the central insight today. When we evaluate the world economy and conclude that the dollar’s role in global finance is disproportionate to its share of global GDP, that America’s trade deficit is unsustainable, that congressional politics is a mess and presidential leadership is dangerously erratic, we are conflating two fundamentally incommensurate visions of the world economy: the one cosmopolitan, the other national or inter-national. The resilience of the dollar is pre-eminently the effect of a cosmopolitan power structure. And as Mehrling writes, “while the United States may well have become unable to lead”, the global dollar system not only survives but expands, as private actors find ways through derivatives trades to insulate themselves against national shocks and the network of central banks centred on the Fed finds ever new instruments “to put a floor underneath the muddle”.

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