The U.S. dollar has been the lynchpin of the global monetary system since the end of World War II, promoting the geopolitical strategic interests of the United States and serving as a “public good” to facilitate the globalization of trade and finance. However, today the rise of China and growing threats to globalization present significant challenges to the long-term hegemony of the dollar. At a time when China aims to change the present dollar-centric monetary order, the dynamics of economic and domestic political forces in the U.S. also put into question its usefulness.
The weight of the dollar in global central bank reserves peaked in 2000 and has been falling gradually since then (chart 1). Today, the global economy has returned to a state of multipolarity last seen prior to WW1 when both Germany and the United States threatened the hegemony of pound sterling. In terms of its share of global GDP and trade and its status as a primary creditor to the world, China’s desire to shape a less dollar-centric global monetary system is legitimate (chart 2). China today has become the largest trading partner of most countries around the world and is the dominant importer of most commodities, so it is not surprising, given growing tensions with the U.S., that it does not want to have to rely on dollars to transact foreign trade (chart 3)
Chart 1
Chart 2, Countries share of world GDP, trade and capital exports
Chart 3, The largest trading partner of countries around the world
The current dollar fiat global monetary order also has become a burden for the U.S. economy. Since the 1950s, the U.S. has gone from being the dominant manufacturing power and exporter of the world and its primary creditor to the present day hyper-financialized and speculative economy with net debts of $30 trillion to the world. Moreover, the political mood in America has turned against the neoliberal policies of the past decades — anchored on the free flow of trade, capital and immigration and current account deficits — which seriously undermined American labor.
The gradual strengthening of a multipolar global monetary order will add instability and costs and further the geopolitical deterioration and rising inflation that we have seen so far in the 2020s. A world of less trade, more of it non-dollar centric, and declining global trade imbalances will be very different from the experience of past decades. Over the short-run, the dollar’s strength is likely to continue, driven by its safe-haven status in unstable times and the diminished supply of dollars resulting from more balanced global trade. Over the longer term, the dollar could weaken considerably from its currently overvalued levels. A decline in dollar hegemony implies a weaker dollar over time, but it is good to remember that because of powerful network effects reserve currency regimes are very sticky (e.g., more reserves were still held in pound sterling than in dollars until 1963).
The 75-year U.S. dollar reserve currency system has been unique in terms of its global reach, but in myriad ways it appears to be following in the steps of the previous regimes centered around the pound sterling, the Dutch florin and others before it. These currency regimes lasted for around a century going through distinct phases:
- Economic, trade and creditor dominance. Expansion of productive capacity and capital accumulation.
- Excess capital accumulation, leading to financialization and speculation at the expense of the productive sector.
- Economic decline, as new powers seek hegemony.
The current dollar reserve currency regime has followed this pattern since its launch at the Bretton Woods Conference in 1944.
Bretton Woods I (1945-1971)
The U.S. imposed a dollar-centric monetary system at the Bretton Woods Conference. Disregarding the argument made by John Maynard Keynes for a global bank that would resolve current account imbalances, all currencies were anchored to the dollar at a fixed price for gold. The U.S. came out of the war with by far the largest economy in the world, as a huge net creditor to the world and as the dominant manufacturing and trading nation, all of which secured reserve currency status for the dollar.
In the 1950s, the U.S. ran current account surpluses with its major global trading partners, which were largely rechanneled into aid and direct investments for the reconstruction of the war-torn economies of Europe and Asia. However, by the early 1960s, Japan and Europe had recovered and were running current account surpluses with the U.S., which were registered as increases in each country’s “gold” reserves held at the U.S Federal Reserve. Growing opposition to the system was best expressed by France’s finance minister Valerie Giscard D’Estaing who decried the “exorbitant privilege” enjoyed by the U.S. (the supposed advantage of paying for imports by printing dollars). The system showed its first crack when France sent a navy frigate to New York to repatriate its gold reserves. The depletion of U.S. gold reserves at a time of “American malaise” (e.g., political assassinations, racial riots, the Vietnam War fiasco), led President Richard Nixon to “close the gold window” in 1971, putting an end to Bretton Woods I.
The Chaotic Interlude (1971-1980)
America’s insouciance with regards to unilaterally breaking the dollar’s tie to gold and imposing a pure fiat currency system was expressed by Treasury Secretary John Connally’s comment, “it’s our currency but it’s your problem.” The result was a collapse of confidence in American monetary stewardship and a flight to dollar alternatives. Dollars as a percentage of total central bank reserves fell from 50% in 1971 to 25% in 1980, replaced mainly by gold but also by Deutsche mark and Japanese yen.
The Petrodollar System and The Golden Age of the dollar (1980-2000)
An agreement between Saudi Arabia and the United States in 1974 (the U.S. Saudi Arabian Joint-Commission on Economic Cooperation) committed Saudi Arabia to invoice petroleum sales in U.S. dollars and hold current account surpluses in U.S. Treasuries in exchange for defense guarantees and economic support. The pact guaranteed ample global demand for dollars and reinstated America’s “exorbitant privilege” of running perpetual current account deficits (chart 3).
Fed chairman Paul Volcker’s success in quelling inflation and President Ronal Reagan’s neoliberal pro-business agenda put an end to the 1970s malaise and set the stage for the golden age of the dollar. This period was characterized by a persistent decline in inflation and interest rates, underpinned by stable prices for oil and gold and deflationary forces from both domestic sources (deregulation, lower taxes, decline of unions, immigration) and international sources (globalization, lower tariffs, free flow of capital) (chart 4)
Confidence in the dollar returned and central banks increased the weight of dollar reserves, from a low of 25% in 1980 to a peak of 60% in 2000, while gold reserves fell from 60% in 1980 to 12% in 2000. Low and declining inflation gave birth to the Fed’s “great moderation” thesis and allowed it to promote the great financialization of the economy, all buttressed by growing current account deficits and foreign capital inflows. With Wall Street at the core of the process, this period saw the U.S. become a huge net debtor as foreign countries accumulated surpluses and became the financiers of U.S. debt and other assets. This period also saw the widespread elimination of capital controls around the world and the growing influence of “hot money” tourist capital flows into foreign assets (chart 5).
Chart 5
Bretton Woods II (2000-2012)
China’s “opening up” under Deng Xiaoping during the 1980s, the maxi-devaluation of the RMB in 1994 and accession to the WTO in 2000 drove China’s “economic miracle” and the commodity super-cycle (2002-2012). China’s rise inaugurated a new global monetary regime which has been dubbed Bretton Woods II. Like in Bretton Woods I, the U.S. promoted the growth of a potential rival through trade and investment (under the premise that China would become more democratic and market-oriented over time). Once again imbalances emerged, as China’s mercantilist policies led to massive current account surpluses with the U.S. which were parked in U.S. Treasury bills. “Chimerica,” as the symbiotic relationship came to be known, made China the factory floor for the U.S. consumer. The China “trade shock” accentuated the deflationary forces of the 1990s. This enabled the Federal Reserve to pursue loose monetary policy despite soaring commodity prices, which broke the “petrodollar” anchor of price stability of the prior twenty years.
Without the stability of the price of oil and gold that was at the core of the “Petrodollar system” Bretton Woods II was an anchorless pure Fiat Reserve Currency Model relying entirely on the faith and credit of the Federal Reserve. Since 2000, recurring financial crises (2001, 2007, 2020) have been met by a desperate and increasingly unorthodox Federal Reserve determined to combat deflationary forces by supporting extremely high levels of debt and equity prices through quantitative easing and international swap lines.
Rising tensions between China and the U.S. since Xi Jinping took power in China in 2011 have undermined “Chimerica.” Since 2017, China has been reducing its holdings of Treasury bills, and no longer recycles its current account surpluses into Treasury bills. The sanctions imposed on Russia after the invasion of Ukraine and acrimonious relations with Saudi Arabia have further undermined the appeal of recycling current account surpluses into Treasuries.
In Search of a New Regime: Bretton Woods III?
As Nobel Laureate Joseph Stiglitz has said, “the system in which the dollar is the reserve currency is a system that has long been recognized to be unsustainable in the long run.” Eventually the “exorbitant privilege” and its geopolitical benefits turn into an “exorbitant burden” of deindustrialization and foreign liabilities. Moreover, for the first time since WWII, the world’s largest trading nation, China, does not support the regime. This raises the question of what comes next?
China has declared its determination to move the current world monetary order towards a less U.S. centric model. Given the deterioration in China-U.S. relations and the prospect of economic decoupling, it is likely that China’s trade and current account surpluses with the U.S. will dwindle over the next decade. Without a reliable substitute for the U.S. consumer, China now aspires to a symbiotic relationship with natural resource producers, whereby it ‘barters” manufactured goods in exchange for commodities. China’s rapprochement with Russia and its diplomatic advances in the Persian Gulf and the steppes of Central Asia are evidence of this focus on creating a new global payments system which focuses on commodities and bypasses the highly financialized dollar correspondent network promoted by the U.S. China aspires to do the same with large economies like Brazil and Indonesia. A Xi visit to Saudi Arabia, rumored to be scheduled for next month, would be of great concern to Washington.
Zolltan Pozsar of Credit Suisse has recently written about a new global commodity anchored reserve currency model which he calls Bretton Woods III. The idea is that in a world torn by geopolitics, sanctions and financial instability countries will do more trade in other currencies than the dollar and prefer to hold reserves in commodities. Geopolitical tensions this year — Russia’s invasion of Ukraine and the imposition of sanctions on its trade and foreign reserves, and growing tension in the Taiwan Strait which have resulted in the imposition of draconian controls by the U.S. on semiconductor exports — may have been a watershed which will accelerate financial decoupling.
Does China want the renminbi to serve as a reserve currency?
China, at least in the short run, “wants to have its cake and eat it too.”
China would like to reduce its vulnerability to U.S. sanctions by promoting a new monetary order that is not dollar-centric and do this in a way that allows it to continue to expand its geopolitical influence on Asia and its primary trading partners, mainly commodity producers. However, facing a decade of low growth due to debt, a real estate crisis, poor demographics and plummeting productivity, it also wants to preserve the millions of jobs tied to exports of manufacturing goods. Like all Asian Tigers (Japan, Korea, Taiwan) it needs to pursue the mercantilist policies of the past: an undervalued currency and export subsidies. For now, these mercantilist tendencies imply current account surpluses, which would make it difficult for China to create the expansion of RMB liabilities required in a reserve currency system.
However, under the firm hand of Chairman Xi, China is now rapidly moving to a different economic model that is different from the one followed since the 1980s and at odds with the East Asian model. As it ages rapidly and faces a sharp decline in its workforce, China will cease to be both the “factory of the world” and the major creditor to the world. This trend will accelerate this decade as China adopts widespread autarkic policies to reduce its vulnerability to potential sanctions from geopolitical adversaries. Over the next decade, China is likely to move to a less production-oriented and more consumer- and finance -oriented economy. This implies more balanced trade and more appropriate conditions for promoting the RMB as a reserve currency.
Conclusion
The move to a multipolar world and parallel monetary regimes will add instability to the global economy during the coming decade. Though declining global trade imbalances are positive in the medium run, the reduction in global dollar liquidity will support dollar strength at first but accelerate alternative reserve currency holdings over time. Commodities will probably play a more important role in future monetary regimes, which will benefit the major global commodity producers.
There is great uncertainty about the reshaping of a new monetary order, but certainty about one thing: more instability. The quote from Stiglitz concludes: “The system in which the dollar is the reserve currency is a system that has long been recognized to be unsustainable in the long run. It’s a system that is fraying, but as it frays it can contribute a great deal to global instability, and the movement from a dollar to a two-currency or three-currency, a dollar – euro [sic], is a movement that will make things even more unstable.”