The Past, the Present and the Future of the Fiat Dollar

The U.S. dollar reserve currency regime in place since President Richard Nixon broke the dollar’s link with gold in 1971 is unique in nature and scope. It is the first fiat currency entirely reliant on the market’s trust in the issuer, which is the U.S. government, and it is the first truly global currency. Because of the lack of support from a traditional metallic anchor such as gold, U.S. monetary authorities have had to work hard to provide incentives for financial agents around the world to hold dollar assets. The policies required to preserve dollar hegemony have evolved over time as global conditions have changed. Today, the dollar system is once again experiencing significant pressures from multiple sources, including from the U.S. itself, which is questioning its usefulness.

To understand the current state of the dollar system, it is important to understand its history. The post-WWII dominance of the U.S. dollar can be broken up into six distinct phases.

Phase 1 – Bretton Woods Harmony, 1945-1964 – This period, following the Bretton Woods agreement (1947) which created a gold-anchored system centered around the U.S. dollar, was characterized by U.S. capital exports to rebuild war-torn Europe and Asia, and large U.S. current account surpluses.

Phase 2 – Bretton Woods Disharmony, 1964-1971 – The rapid recovery of European and Japanese industrial output during the 1950s resulted in manufacturing surpluses being exported to the U.S. and the beginning of U.S. trade deficits. Led by the French, who denounced America’s “exorbitant privilege” of seigniorage and trade deficits (1965), America’s main trading partners increasingly questioned the integrity of the Bretton Woods system and began to repatriate gold reserves held at the New York Fed. Rising inflation in the U.S. due to the Vietnam War and the “war on poverty” further increased concerns that the dollar was overvalued.

Phase 3 – Chaos and Inflation with the Launch of  the Fiat dollar system, 1971-1981 – The cutting of the gold anchor severely undermined the credibility of the dollar as a reserve currency. The 1970s saw a surge in demand for alternatives, including gold, the Deutsche mark, the Swiss franc, and the Japanese yen. Two key policy initiatives successfully checked the dollar’s decline. First, in 1974 the U.S. convinced Saudi Arabia to invoice oil exports in dollars and channel its central bank reserves into U.S. T-bills. In exchange, the U.S. agreed to provide defense guarantees and military hardware. This recycling of oil revenues into U.S. financial assets created a new anchor for the dollar sometimes called the Petrodollar system. Second, in 1981 U.S. Federal Reserve Chairman Paul Volcker jacked up interest rates to nearly 20% to shock inflation into decline. Concurrently, the elections of Ronald Reagan in the U.S. and Margaret Thatcher in the U.K. launched the Washington Consensus for free markets and free capital flows in global markets. These deflationary policies started a 40-year trend of falling prices and interest rates.

Phase 4 – The Heyday of the Dollar, 1981-2001 – This period can be considered the zenith of the dollar system. It starts with Reagan and Volcker and is marked by disinflation, the globalization of trade and capital flows, and the great financialization of the American economy. The pillars of this phase of peak dollar hegemony were (1) persistently high U.S. current account deficits that were recycled into U.S. financial assetss by America’s mercantilist trade partners (Japan, Germany, Korea, Taiwan) and commodity producers; (2) an increasingly activist and interventionist U.S. Fed that aimed to backstop Wall Street; and (3) a relatively stable oil price which buttressed the Petrodollar system. During this period the dollar’s share of total central bank international reserves went from 22% to 64% while gold’s share fell from 65% to 15%.

Phase 5 – Chimerica and Fed Adventurism, 2001-2012 – The entry of China into the WTO in 2001 heralded “hyper-globalization” and China’s economic miracle and infrastructure boom, resulting in a commodity super-cycle. The deflationary impact of China trade offset the inflation caused by the surge in the price of oil and other commodities, allowing the U.S. to pursue expansionary monetary policies. The extraordinary surge in China’s exports to the U.S. gave rise to the “Chimerica” concept, by which China’s enormous trade surpluses were recycled by China into U.S. treasury securities. The Great Financial Crisis saw the U.S. Fed doubling down on its commitment to buttress Wall Street and the Great Financialization, allowing Fed Chairman Bernanke to aggressively pursue expansionary monetary policies aimed at boosting asset prices to create a “wealth effect.”

Phase 6 – A New Cold War, Sanctions Diplomacy, The Anchorless Dollar, 2012-2023 – Xi’s rise to power in China in 2012 marked the end of the China “economic miracle” and resuscitated the traditional Leninist ideology abandoned in the 1980s, with a focus on reestablishing Party control over all aspects of Chinese politics and society. The shift in China completely undermined the premise of “Chimerica” and transformed what has been seen as a beneficial partnership into a bitter rivalry. Over the past decade, a new Cold War has spawned an alliance of anti-American countries (China, Russia, Iran, North Korea) all of them facing U.S. financial sanctions. Since 2012, the U.S. dollar has been essentially anchorless for the first time since the early 1970s, without a clear mechanism for recycling U.S. trade deficits into U.S. assets. Dollar hegemony has been threatened by a broad initiative by China and others to diversify reserves into alternatives. This has meant mainly a revival in interest in gold but also China’s efforts to create a “sinodollar” by recycling dollar reserves into loans as part of Xi’s Belt and Road Initiative. China has also structured several bartering agreements with Russia, Iran, Saudi Arabia, and others which aim to bypass the dollar system.

The dollar’s strength since 2015 has relied on a fortuitous combination of the two factors that historically have boosted the value of the greenback. First, growing geopolitical tensions have raised the dollar’s safe-haven status, leading to massive amounts of capital flight into U.S. assets. By some estimates, capital flight from developing countries into the U.S. has been in the order of $1 trillion annually, over half of that coming from China’s private sector (Brad Setser, CFR). Second, America has experienced a remarkable phase of economic “exceptionalism” underpinned by the shale oil boom and by the extraordinary global domination and financial success of its Silicon Valley tech titans. This powerful phase of American Exceptionalism has boosted growth and wealth creation in the U.S. and sucked in savings capital from around the world.

The chart below illustrates how the dollar has trended according to economic, political, and social factors related to growth, inflation, and cycles of American malaise and exceptionalism.

The next chart looks at the M2 measure of money supply in real terms in the U.S., highlighting how Fed policy became more and more activist and interventionist over time. From the end of Bretton Woods in August 1971 until mid-1997, the Fed pursued a tight monetary policy, with annual increases of M2 at 1.45%. In the mid-1990s Fed Chairman Alan Greenspan, facing “exuberant” markets and increasing leverage in the financial system, moved the Fed’s focus to monitoring systemic risk. In reaction to repeated “shocks” (e.g., the Asian and Russian financial crises, the collapse of the LTCM hedge fund, the bursting of the tech bubble, and the Great Financial Crisis), the Fed injected liquidity into the financial system. Under Greenspan, Bernanke, and Powell, the Fed has injected increasingly large amounts of liquidity to preserve financial stability. Starting in 1997, in sharp contrast to its previous behavior, the Fed has always increased the money supply during downturns. The annual real increase in M2 over the 1997-2024 period has been 3.82%, nearly three times the rate of growth of the 1971-1997 period of Fed monetary discipline.

The following chart shows the long-term evolution of the composition of reserves held by central banks around the world. Under the Bretton Woods system, central banks held mainly gold reserves while gradually increasing dollars and reducing sterling. After the collapse of Bretton Woods, central banks shifted reserves back into gold and into alternative currencies (mark, yen, franc), so that by 1980 the share of dollar reserves had fallen back to the 1962 level. During the dollar’s heyday, from 1981 to 2001, dollar reserves rose from 22% to 65%, mainly at the expense of gold. Since 2001, the dollar’s share of reserves has been gradually eroded by the euro and alternative currencies. Over the past ten years, central banks, led by China, have started to accumulate gold reserves, ending a 30-year period of neglect for the “barbarous relic.”

The defining characteristic of dollar hegemony has been large and chronic U.S. current account deficits, which are recycled by trading partners into U.S. financial assets, mainly T-bills. These deficits were initially denounced by the French and others as an “exorbitant privilege,” meaning that they gave America the ability to pursue growth and consumption without the discipline imposed by the classical British-run gold standard (1816-1914). As shown in the chart below, under the fiat dollar system these deficits have been persistent. During global downturns they have regularly been excessive, allowing the U.S. to serve as the consumer of last resort for the world and to promote the supply of cheap foreign goods for American consumers.

In recent years, however, under both presidents Trump and Biden, these chronic current account deficits have been blamed for the deindustrialization of America and the loss of millions of well-paid manufacturing jobs. Moreover, it is now argued that America’s loss of industrial capacity has made it very vulnerable to unreliable global supply chains and untrustworthy trading partners, leaving it weakened to address economic and security objectives. What was previously seen as an “exuberant privilege” is now widely considered an “exuberant burden,” and anti-trade policies such as tariffs and subsidies are easily justified by politicians. In the current presidential campaign, both parties have argued for “balanced trade” and justified tariffs to boost American manufacturing. Given that chronic and persistent deficits have been at the core of the dollar system, it is logical to believe that the world monetary system is in a phase of transition to something different.

The Future of the Fiat Dollar Reserve System

If the fiat dollar currency reserve model is no longer attractive for the U.S. and foreign central banks are diversifying into alternatives to the dollar, what will replace the current model? Some ideas being discussed by Washington insiders and policy think tanks are as fiollows:

1. A return to a commodity-centric model.
   • Zoltan Pozsar, a prominent financial strategist, has argued that geopolitical conflict is driving the world to a multipolar monetary system where the dollar, alternative fiat currencies, and commodities will all be important. Pozsar sees gold and a variety of other commodities anchoring the yuan and other non-dollar currencies. He points to the accumulation of gold by Russia and China and China’s initiatives to build financial ties with commodity heavyweights Iran and Saudi Arabia. According to Pozsar, a new multi-polar order will take shape where regional financial systems will dominate, at the expense of the U.S. dollar.
   • Jeff Currie, a highly regarded Wall Street commodity analyst who is currently the Chief Strategy Officer of Energy Pathways at The Carlyle Group, also sees a prominent role for commodities in a new evolving global monetary system. According to Currie, the Petrodollar system which somewhat anchored the dollar from 1974 to 2001, is being replaced by  “superconductor” commodities which are replacing oil at the center of economic activity. The countries that control the supply and stock of the metals that are cost-effective to conduct electricity (copper, silver, gold, aluminum, and nickel) will play a key role in the new system. Unsurprisingly, given its significant lead in the electrification of its economy, China has been very active in building stocks of these metals and securing global supplies in Africa, Latin America, and wherever it can deploy capital and influence.
2. A return to restricted international capital flows.
   • Prior to the 1980s and the rise of the Washington Consensus, almost all countries had controls on international capital flows. In many emerging markets, these controls were lifted only in the 1990s. In countries like Brazil, this has complicated monetary policy as “hot money” flows in during good times and leaves in bad times, and, in recent years, the deregulation of capital flows has greatly facilitated high levels of capital flight. Ironically, the U.S. has the opposite problem. With the largest and most liquid capital markets in the world and  attractive market returns available relative to the rest of the world, the U.S. is a magnet for global capital. Some analysts (e.g. Michael Pettis) have argued that the U.S. cannot address its current account deficit without taxing foreign inflows. This raises the possibility that in coming years the U.S. will be imposing regulatory restrictions on foreign inflows while countries like Brazil will be obstructing outflows.

The global monetary system may be in a phase of transition to a system that assures more balanced trade. This will produce a series of losers and winners, very different from those of the past 40 years. Mercantilist countries that repress their domestic consumption and capture foreign demand (e.g., the East Asia tigers, Germany) may have a difficult road ahead. Countries with large domestic markets and that can reindustrialize (e.g., the U.S., Brazil) may be better positioned. Regional groups with well-defined trade rules that assure balanced trade (NAFTA) may also prosper. None of this is certain, but countries should be planning for a new world monetary order.