Is the US dollar about to lose its particular dominant role in the global financial system? People have asked this question throughout my professional career. Seriously: I published my first article on the subject in 1980.
Many things have changed in the world since I wrote this article, including the creation of the euro and the rise of China. Yet the answer remains the same: probably not. For various reasons – political fragmentation in Europe, autocratic whim in China – neither the euro nor the yuan is a plausible alternative to the dollar.
Moreover, even if the dollar’s dominance erodes, it won’t matter much.
What do we mean when we talk about dollar dominance? Economists traditionally attribute three roles to money. It’s a means of exchange: I don’t give economics courses in payment for shopping; I get paid in dollars to teach and I use those dollars to buy food. It’s a store of value: I keep dollars in my wallet and bank account. And it is a “unit of account”: salaries are fixed in dollars, prices are indicated in dollars, mortgage payments are specified in dollars.
Many currencies play these roles in national affairs. The dollar is special because it plays a disproportionate role in international trade. This is the medium of exchange between currencies: someone who wants to convert Bolivian bolivianos into Malaysian ringgit normally sells the bolivianos for dollars, then uses the dollars to buy ringgits. It is a global store of value: many people around the world hold dollar bank accounts. And it is an international unit of account: many goods manufactured outside the United States are denominated in dollars; many international bonds promise repayment in dollars.
Where does this continued dominance come from, given that the US economy no longer has the dominant position it held for a few decades after World War II? The answer is that there are self-reinforcing feedback loops in which people use dollars because others use dollars.
In this old article from 1980, I focused on the size and thickness of the markets. There are many more people who want to exchange bolivianos and ringgits for dollars than there are people who want to exchange bolivianos for ringgits, so it is much easier and cheaper to do boliviano transactions -ringgit indirectly, using the dollar as a “vehicle”, rather than trying to do these transactions directly. But all these indirect transactions make the dollar markets even bigger, reinforcing the currency’s advantage.
Gita Gopinath, the first deputy managing director of the International Monetary Fund, and Jeremy Stein, a Harvard economics professor, described another feedback loop involving pricing. Since many goods are valued in dollars, dollar assets have relatively predictable purchasing power; this strengthens the demand for these assets, which in turn makes it slightly cheaper to borrow in dollars than in other currencies. And cheap dollar borrowing in turn incentivizes companies to limit their risk by pricing in dollars, again reinforcing the dollar’s advantage.
So what could dislodge the dollar from its peculiar position? Not so long ago, the euro seemed like a plausible alternative: Europe’s economy is huge, as are its financial markets. As a result, many people outside of Europe hold assets in euros and, when selling in Europe, set prices in euros. But a remaining advantage of the United States is the size of our bond market and the liquidity – the ease of buying or selling – that this market offers.
Until its sovereign debt crisis in 2009, Europe seemed to have a relatively large bond market, since euro bonds issued by different governments seemed interchangeable and all paid roughly the same interest rate. Since then, however, default fears have caused yields to diverge:
This means that there is no longer a bond market in euros: there is a German market, an Italian market, etc., none of them are comparable in size to the American market.
What about China? China is a major player in global trade, which could make people hold a lot of yuan assets. But it’s also an autocracy with a propensity for erratic policies – as evidenced by its current rejection of Western Covid vaccines and its continued adherence to an unsustainable strategy of disastrous lockdowns. Who wants to expose his fortune to the whims of a dictator?
And yes, the United States has to some extent weaponized the dollar against Vladimir Putin. But it’s not the kind of action you might expect to become commonplace.
Overall, therefore, dollar dominance still looks pretty secure unless America also ends up being ruled by an erratic autocrat, which I fear looks like a real possibility in the not too distant future. .
But here’s the thing: even if I’m wrong and the dollar loses its dominance, it wouldn’t change much. What does the United States gain after all from the special role of the dollar? I often read claims that America’s ability to impose newly printed dollars on the rest of the world allows it to run persistent trade deficits. Friends, let me tell you about Australia:
The United States might be able to borrow a little cheaper, thanks to the special role of the dollar, and we get what amounts to a zero interest loan from everyone holding dollars – mostly $100 bills – outside the country. But these are insignificant benefits for a $24 trillion economy.
So is the global domination of the dollar threatened? Probably not. And the truth is, it really doesn’t matter.