Since World War II, the US has provided two essential services to the rest of the world: an international currency and international military protection. Based on these conditions, John Connally, the Secretary of the Treasury in the Nixon administration, was right to say during the Bretton Woods crisis in the early seventies: “The dollar is our currency and your problem.” For two reasons, these golden times have now ended.
Since World War II, the US has provided two essential services to the rest of the world: an international currency and international military protection. Producing them was costly, both in terms of achieving dollar stability and undertaking military expenditures in many parts of the world. However, the benefits were far more important. Foreigners were prepared to hold more dollars than they actually needed and to forgo risk premiums even when the dollar weakened. The more the dollar was held abroad the more gains the US could collect, as the production costs of the dollar were lower than its value. This positive seigniorage allowed the US to import more goods and capital than it exported. US citizens could consume more and save less and US military supremacy guaranteed international political stability. That the US military shield was provided primarily through nuclear power enabled the US to enjoy economies of scale in providing this service. For this reason, it was worthwhile for the US to produce more security through nuclear arms than it needed for its own territorial safety. US allies, in turn, could free ride by not paying fully for their own military protection. Because the allies had a strong interest in ensuring that high US military expenditures did not endanger the stability of the dollar, they continued to hold the dollar as a reserve currency without demanding a risk premium from the US. In short, as part of the US balance of payments, the US exported military security as a service and received payments in terms of seigniorage and foregone risk premiums. For many years, the US enjoyed a surplus in this “invisible” balance of payments. Based on these conditions, John Connally, the Secretary of the Treasury in the Nixon administration, was right to say during the Bretton Woods crisis in the early seventies: “The dollar is our currency and your problem.”
For two reasons, these golden times have now ended. One reason is that, with the end of the cold war, the requirements for international security have changed dramatically. New threats, like combating terrorism, require more burden sharing among US allies. In this context, the economies of scale from the US nuclear umbrella are no longer as important as they used to be and US allies are less able to free ride on US military might. In fact, the US rejects free riding and demands more equal burden sharing, for instance in Afghanistan. As the allies’ dependence on the US military shield shrinks, their concerns about the future value of US dollar reserves held abroad increase. As a result, partner countries’ support for the international role of the dollar could decline as military expenditures outside their national territories increase. As the US reduces its exports of military security, its allies could reduce their implicit payments for this service by no longer holding the dollar at any cost.
Another reason for the end of this golden era is the significant weakening of US economic power, which coincides with worldwide concerns about the willingness and capability of the US to service its debt in the future. The recent economic and financial crises and stock market declines have contributed to a deterioration of the US net external asset position, which is the balance of US net equities (net portfolio investment and foreign direct investment) and net debt (treasury and corporate bonds.) US positive net equity has declined as stock prices have fallen while US net debt—larger than its equity position — has grown along with the country’s in its budget and balance of payments deficits. Unless the US equity position rebounds with the recovery of global stock markets, the US debt position seems more precarious than ever before. The downgrading of US debt equities by Standard and Poors, while flawed for a number of reasons, reflects this negative mood in the markets. An exchange rate adjustment through depreciation of the dollar would improve the US position but dollar-holding countries (particularly China) that peg their currencies to the dollar would incur losses as their dollar reserves shrink in value. Given the many risks of over indebtedness by domestic borrowers, such as municipalities and state-owned companies in China, this is what these countries want to avoid and this is why they will — for the time being — continue a “business as usual” approach toward supporting the dollar. They will do so, moreover, despite sound economic arguments for letting their currencies gradually appreciate against the dollar. This "soft landing” cannot, of course, be guaranteed. The problem is that in a state of panic, a marginal event can trigger a financial tsunami against the US and its currency. A small stick could break the camel’s back. Then the words of John Connally would have to be revised: the dollar would then be both the world’s currency and the world’s problem.
Can partner countries shoulder some of the commitments that the issuer of an international currency has to accept, such as withstanding the temptation to inflate their currency, to run an overly lax fiscal policy, or to intervene abruptly in foreign exchange markets? And can these countries also provide an international currency? In the long run, probably yes; in the short run, definitely no. Neither the Chinese Renminbi (RMB) nor the euro, not to speak of other currencies, can meet these commitments in the short run. The RMB is far from meeting the prerequisites to let it freely float, or as Stanford professor Ronald McKinnon correctly argues, there is no market exchange rate solution for a creditor country whose financial markets still use non-market-based measures. Over the next few years, China will continue to intervene abruptly in foreign exchange markets if national interests require it to do so. One such national interest would be to stem a tide of hot money inflows if speculators anticipate a gradual appreciation of the RMB against the dollar. The internationalization of the RMB will be faster in trade. It will be slower in its full convertibility as well as in its introducing the RMB to the short-run capital risk market as a transaction currency. Implementing a basket peg against all leading currencies is also no panacea if the weight of the dollar in that basket remains as large. Given the immense importance of China in the world economy and the second-round effects of a Chinese dollar problem for third countries via their links to China and their exchange rate with the dollar, the short-run message from China is straightforward: it is the world’s problem.
Despite the economic crises in Mediterranean euro countries, the euro continues to fulfill some functions of an international currency in Europe itself (invoice currency, transactions currency, reserve currency, anchor currency), but significantly less beyond Europe. Shifting reserves from the dollar to the euro as some surplus countries let the markets believe they are going to do is akin to the one-eyed man in the kingdom of the blind. Euro authorities (there are many with many different voices!) stand at a crossroads. Via many rescue umbrellas and efforts to buy time, they can move towards a “transfer or solidarity union” with so-called euro-dominated bonds issued at an interest rate equal for all euro members and a harmonized fiscal policy strongly influenced by the weaker countries. Alternatively, they can accept the insight that a few countries in the euro area are so insolvent that a significant debt cut is required. Such a cut would be in the interests of these countries if it were linked to a binding medium-term debt sustainability plan plus a sector recovery plan established and monitored by independent authorities. It is more likely that the euro countries will adopt the first approach—the transfer union. It is not clear whether financial markets would interpret the transfer union or the debt cut approach as better support for the international role of the euro. However, it is likely that the euro would appreciate more against the dollar with the transfer union than the debt cut approach because the former could spur the development of the euro area towards a single political entity. The transfer union approach would give the euro more international weight and alleviate burden sharing, although the costs would, of course, be primarily borne by Germany, the major net creditor. Also, it is clear that this approach to burden sharing is highly unpopular in Germany.
Admittedly, there is much fog around the issue of a “multipolar” world of few international currencies. This fog is created to some extent by the different speed of political decisions versus market anticipation. As a rule, politicians do not practice benign neglect with concern to the global repercussions of national policy-making. John Conally’s famous phrase about the dollar as a partner countries’ problem was an affirmation of benign neglect attitudes, but these attitudes are no longer shared by markets. They see the dollar problem as the world’s problem and thus expect and urge a global governance solution. Jitters and nervousness will dominate unless politicians fully understand the global dimension of the dollar problem and act accordingly.
(Slightly revised version of an article published on May, 15, 2012, in the Fair Observer under the title “The US Dollar: The World’s Currency and the World’s Problem”.)