The dollar remains the bedrock of the international monetary system. Its dominant status benefits the United States and reduces transactions costs for the rest of the world. But, as the United States pursues fiscally irresponsible policies that keep the debt high and other economies gain world GDP share, a multi-reserve-currency system is likely to emerge in the long run. This is not necessarily bad news—the United States can still retain most of its economic benefits, and transaction costs will stay low as long as the number of dominant currencies is limited.
The dollar is the world’s main currency. It accounts for 61 percent of official reserve holdings, is used in 85 percent of foreign exchange transactions, and serves as the currency of choice for 45 percent of international debt securities and more than half of world exports.
This is not a trivial advantage. Dollar dominance helps U.S. firms and residents avoid the costs and uncertainty of dealing in foreign currencies.1 It also means that U.S. firms can issue debt at relatively attractive rates and with no exchange rate risk. And the U.S. government benefits from low Treasury yields and foreign holdings of dollar bills.2
The rest of the world benefits through reduced transaction costs. On a small scale, tourists worried about their ability to exchange currency while abroad can hold dollars instead. More broadly, governments and banks need not hold a large menu of currencies to intervene and trade in exchange markets, as the dollar can facilitate trade between currencies .
But dollar dominance also holds significant costs for the United States and the rest of the world. The dollar’s status makes it easier for the United States to consume and invest beyond its means. Demand for the currency also pushes its value up—as seen several times during the Great Recession when the dollar appreciated as investors fled to safety—posing a challenge for U.S. exports. The need for global liquidity puts additional pressure on the United States to maintain a current account deficit. And, because the currency is used heavily for investment purposes, its value tends to be more volatile than that of currencies used purely for commercial purposes. At the same time, irresponsible U.S. economic policy also contributes to gyrations in the dollar’s value, leaving countries vulnerable to fluctuations in the value of their wealth. And loose U.S. monetary policy leaves other countries vulnerable to importing inflation from the United States.
Basing most international transactions in dollars was practically inevitable after World War II, when the United States accounted for about 50 percent of global output and held the only major convertible currency. But the subsequent recovery of Europe and Japan, followed by rapid growth in emerging markets, has shifted the regional composition of world GDP, as shown below, and a number of convertible currencies have appeared.
This raises the question: is the dollar still right for the job?
Searching for an Alternative
The benefits of a world reserve currency, just like a domestic currency, depend on its remaining liquid and stable. This requires deep financial markets and an open capital account. The United States is strong in this regard: it possesses the world’s largest and most liquid financial markets, has a long tradition of open financial policies, and maintains a strong legal system.
But the greenback also faces problems. After eight years of burgeoning fiscal deficits under President George W. Bush’s administration, followed by necessary increases in government spending during the financial crisis, the deficit reached 9 percent of GDP and gross federal government debt amounted to 93 percent of GDP in 2010. In addition, the crisis made a mockery of U.S. pretensions of having a “sophisticated” and “efficient” financial system.
Together, irresponsible fiscal policy and the financial crisis have devastated confidence in the dollar’s stability. Moreover, the willingness of future U.S. governments to impose sharp reductions in expenditures and increases in taxes to ensure debt sustainability—rather than ease the debt burden through inflation and dollar depreciation—remains uncertain, particularly as a substantial percentage of that debt is held by foreigners.
Nevertheless, the dollar maintains its role as the dominant currency for two reasons. First, reserve currency status, like computer operating systems, is subject to “first mover advantage”: the fact that the dollar is accepted in most transactions increases the demand for dollars and makes it harder for newcomers to gain market share.
Second, no reasonable alternative appears better for the job, at least in the short term:
- Euro: The euro, which accounts for the second largest share of international reserves (as shown below), is the most logical alternative. But Europe’s financial markets are not as deep as those of the United States; significantly, Europe has no instrument comparable to U.S. Treasury bills in market size or liquidity. And, while confidence in the European Central Bank (ECB) remains high, political agreements between the seventeen member countries (which may be difficult and time consuming to reach)—and not the ECB—are necessary for many of the decisions that affect the value of the euro. The euro crisis has exposed the instability inherent in a monetary union that has no binding arrangements for coordinated fiscal policies.
- Yen: Japan remains mired in slow growth and high levels of debt. An aging population, coupled with strong resistance to immigration, is likely to limit the economy’s prospects and thus its potential for the large, liquid markets required for a major reserve currency.
- SDR: There has been much discussion of increasing the use of the IMF’s special drawing rights (SDR)—a basket of four currencies—particularly since China proposed such a move in 2009. But SDRs—composed of the dollar, euro, pound, and yen—account for only about 1 percent of international reserves and the private sector does not hold SDRs, impairing their usefulness in currency market interventions.3 Considerable investment would be required to create deep markets to trade SDR-denominated financial instruments. And the SDR suffers from the euro’s problem of no single government backer, but in spades. For example, SDR issuance requires agreement among 85 percent of IMF members—an overly cumbersome process when liquidity is urgently needed.
- Gold: A few diehards are holding out for a return to the gold standard, but linking global monetary developments to a metal of uncertain supply could be considered reckless. More importantly, under the pre-1914 gold standard, countries surrendered control of their monetary policy to maintain fixed parity rates. Present-day governments committed to maintaining full employment would not (and should not) be willing to surrender the ability to manage their economies.
- RMB: The importance of the renminbi (RMB) is likely to increase as China continues to grow rapidly and integrate with the global economy. China hopes to transform Shanghai into an international financial center by 2020, and has recently taken at least symbolic steps to increase renminbi use in international financial transactions. However, China’s financial market lacks depth, and official limits on currency trading and on the renminbi’s convertibility make it considerably less attractive to foreign holders. Opening the capital account could expose China to considerable volatility, however, and would require that China’s development rely less on exports and industrial production financed by captive bank deposits (Chinese depositors could transfer their deposits to foreign banks, driving up domestic interest rates) and supported by an undervalued exchange rate (capital inflows could force appreciation). Finally, China is still a relative newcomer to the international scene and its political system is not free from challenges. Building investor confidence in the renminbi will take time.
The Dollar’s Prospects
Given today’s lack of alternatives, the dollar should retain its dominant status for a while. How long depends on how quickly Europe can build common fiscal arrangements and political unity, and how long China—and potentially other developing countries such as Brazil or India—take to transition to more open and sophisticated financial systems. A decade may be sufficient for the first task, while the second may require more time. In the interim, the international monetary system will likely move toward a multi-currency arrangement, reflecting the system’s flexibility, as countries on the European periphery expand their use of the euro and Asia increasingly accepts the renminbi.4
At the same time, the pace of the dollar’s decline will depend to a large degree on U.S. policy. Failure to restore fiscal sanity could accelerate the flight from the dollar, perhaps spurring progress in China and Europe or even building pressure for greater reliance on other international alternatives like the SDR.
Inertia is a powerful force in international monetary arrangements, but not an immutable one. British weakness enabled the dollar to gain dominance over the pound in international reserves in the 1920s—only ten or so years after its entry on the international scene. Without commitment to a credible fiscal program to achieve a sustainable debt position, the dollar will inevitably suffer the same fate.
This may not spell disaster across the international monetary system—the dollar would retain most of its benefits even as one of a few dominant currencies and transaction costs for the rest of the world would stay low as long as the number of reserve currencies was limited. But it is indicative of irresponsible U.S. policies that have larger consequences, both for the U.S. economy and for the rest of the world.
William Shaw is a visiting scholar in Carnegie’s International Economics Program.
1. A U.S. firm exporting to Japan, for example, is typically paid in dollars, which it can use to pay its suppliers and workers. A Japanese exporter, on the other hand, may not be paid in yen and has to consider how exchange-rate fluctuations could alter the local value of its sales. Non-U.S. exporters can manage such risks through futures and forwards contracts, but at a cost.
2. Seigniorage revenues are a part of this benefit, though—at an estimated $30 million per year—they represent little more than a rounding error in the deficit, and there are some offsetting costs not included in this calculation, such as controlling counterfeiting and maintaining stocks of dollars (Goldberg 2010).
3. Countries with dollar holdings are committed to providing them to monetary authorities in return for SDRs, so holding SDRs and then converting them to dollars for the purposes of intervention is a feasible strategy (Williamson 2009). However, the expanded use of SDRs would likely require further international agreement.
4. See Eichengreen (2010) for a discussion of the growing regional use of the two currencies.