Few topics have generated as much discussion in recent weeks as the evolving role of the U.S. dollar in the global trade and capital regime. The sanctions imposed on Russia by the United States and its allies have demonstrated the immense geopolitical power that control of the global currency system can confer.
These same sanctions also make clear, however, why the governments of other countries that might one day be subject to such penalties are doing all they can to opt out and establish an alternative global currency system—either one they control or one that is unlikely to be controlled by potential adversaries. That is why a vibrant debate has erupted over whether or not countries like China can establish a credible alternative to the dollar.
But while there has been much debate over whether or not the world—or at least part of the world, including countries like China, Iran, Russia, and Venezuela—can live without the dollar, there has been much less attention on an equally important issue: what the trade impact would be of a world less tied to the U.S. dollar. The two issues cannot be separated. The issue of the dollar is part of the debate over global capital flows, but capital flows are just the obverse of trade and current account flows. Savings, after all, can only be expressed as the excess production of goods and services.
This essay makes three related points. First, it would be extremely difficult, if not impossible, for countries like China and Russia to upend the dominance of the U.S. dollar. Most sophisticated economic policy advisers in China and Russia know this, even if they have to express this knowledge cautiously.
Second, for the U.S. dollar to stop being the world’s dominant currency would mostly require specific action by U.S. policymakers to limit the ability of foreigners to use U.S. financial markets as the absorber of last resort of global savings imbalances. While most analysts still believe that the United States will never willingly take the necessary steps to end U.S. dollar dominance, there is a growing awareness of the costs of playing this role to the U.S. economy. Although any move to limit the international use of the dollar would be opposed by parts of Wall Street and the foreign affairs and military establishments, as the costs rise, this outcome will become increasingly likely.
And third, a global economy without the U.S. dollar—or some unlikely alternative—as the currency lingua franca also would be a global economy in which large, persistent trade and savings imbalances are impossible. This is probably a good thing for the global economy overall, but with so many major economies locked into structural domestic demand deficiencies, any policy that forces an elimination or sharp reduction of global trade imbalances also would force deep institutional changes in the global economy—changes which also would likely be politically disruptive for many countries. This is especially the case for countries whose economies have grown around persistent trade surpluses.
Can the World Find an Alternative to the U.S. Dollar?
The dollar is the most widely used currency in international trade not just because of network effects, but also for other reasons that are hard for other countries, especially countries like China, to replicate. The world uses the dollar because the United States has the deepest and most flexible financial markets, the clearest and most transparent corporate governance, and (in spite of recent sanctions) the least amount of discrimination between domestic residents and foreigners.
This means that, for example, for China’s renminbi to compete with the U.S. dollar, Beijing would have to be willing to present the same benefits to foreigners. This includes giving up control of its current and capital accounts and substantially reducing its ability to control credit growth and the liabilities of its financial system.
All of these measures, at least for the foreseeable future, are extremely unlikely. In fact, not only has Beijing shown no inclination in recent years to accept any of these changes, but it has been moving in the opposite direction, especially with the centralization of bureaucratic and political power and the expansion of the state sector that China has undertaken in the past several years.
There is another, more important reason for the widespread use of the dollar. The global trading system is terribly unbalanced, with several large economies—including China, Germany, Japan, and Russia—locked into unbalanced income distributions that reduce domestic consumption and force up their savings rates. Because weak consumption, along with weak investment from private businesses who depend mainly on local consumers to buy the goods they produce, leads to weak domestic demand, these economies require large, persistent trade surpluses to resolve the excess production that drives their economies.
But surplus economies must acquire foreign assets in exchange for their surpluses. This is where the United States—and other Anglophone economies with similar markets and governance, like the UK—play their most important role. A country can only import net foreign savings by exporting ownership of assets, and the United States and other similar economies are the only stable, mature economies that are both willing and able to allow foreigners unfettered access to the acquisition of local assets. To put it another way, they are the only major economies both willing and able to run the permanent trade deficits that accommodate the needs of foreign surplus-running countries to acquire foreign assets. No other major economy can accept, or is willing to accept, this burden.1
It helps to consider the alternative assets surplus countries can accumulate to see why, in spite of decades of complaints in the international community, the U.S. dollar remains the dominant currency. In principle, surplus-running economies can accumulate small amounts of assets in other advanced economies, but with the exception of the European Union (EU) and perhaps Japan, none is big enough to balance more than a tiny share of the world’s accumulated trade surpluses. More importantly, Japan and the EU, along with most advanced, non-Anglophone economies, run persistent surpluses themselves, so they cannot accommodate the surpluses of countries like China and Russia. I will explain later why giving up these surpluses would be so difficult.
Some analysts have argued that surplus-running countries can instead invest their excess savings in the developing world, and while much of the developing world would welcome small persistent capital inflows, the problems with relying on them are fairly obvious. Their economies are far too small to absorb a reasonable share of global excess savings without causing significant domestic dislocations that would make repayment impossibly difficult. In fact, China has in the past six or seven years significantly reduced its already limited exports of capital to developing countries as the risks have become increasingly obvious, while Russia doesn’t invest much in the developing world.
Will Acquiring Commodity Reserves Provide an Alternative?
In recent weeks, some analysts have argued that, as a consequence of the sanctions imposed on Russia, the world is likely to see a shift in global reserve accumulation toward commodities. This, too, is unlikely. Countries like Russia, Iran, and Venezuela are all primarily commodity exporters, which makes the arithmetic of reserve accumulation very tricky. They would have to buy most aggressively when prices are high and their surpluses are large, and they would most likely have to monetize their reserves when prices are low and their economies are struggling. Not only would their reserve accumulation process thus exacerbate the volatility of commodity prices, which would be damaging for their economies, but, more worryingly, their reserves would be most valuable when they needed them least and least valuable when they needed them most. This is the opposite of what countries want from reserves.
China, of course, is the world’s largest commodity importer, so at first it might seem to be in the opposite position of commodity-exporting countries like Russia, in which case accumulating commodity reserves instead of foreign assets might seem to make a lot of sense. However, as the world’s largest importer of commodities by far, especially industrial commodities, it turns out that China’s economic performance is correlated with commodity prices in the same way as that of commodity exporters, only with the direction of causality reversed.
When the Chinese economy is growing rapidly, its commodity consumption is likely to rise sharply, and given its disproportionate role in commodity markets, rising Chinese consumption will drive up the prices of commodities. When the Chinese economy is growing slowly, on the other hand, commodity prices are likely to drop. Commodity acquisition as a reserve strategy, in other words, would exacerbate economic volatility and leave China, like commodity exporters, with reserves that are most valuable when it least needs them and, presumably, least valuable when it most needs them.
For many of the countries most determined to escape from the U.S. dollar’s dominance, in other words, investing in reserves is likely to lock them into acquiring assets when prices are high and selling them when prices are low. Only smaller economies that are net importers of commodities are likely to benefit from investing a significant portion of their reserves in commodities, and even these economies have to worry about the positive correlation between global growth and commodity prices. The value of reserves should be either stable or inversely correlated with the performance of the underlying economy, and most global commodities are unlikely to satisfy that condition.
Will the United States Force Other Countries to Stop Using the Dollar?
Much of the discussion about whether or not the U.S. dollar can maintain its global dominance assumes as a matter of course that it is foreigners who want to constrain the global use of the dollar and it is Americans who will fiercely resist this process. This only indicates, however, just how confused much of this discussion has been. As Matthew Klein and I discussed in our 2020 book, Trade Wars Are Class Wars, the structure of international trade and capital flows does not really pit nation against nation so much as it pits economic sector against economic sector.
Among other things, this means that it is not the United States as a whole that benefits from the global dominance of the U.S. dollar but rather certain constituencies within the United States that do, in contrast to other constituencies that pay the price for the dominance of the U.S. dollar. The beneficiaries include two major, politically powerful groups: Wall Street and the foreign affairs and defense establishments. By contrast, it is American workers, farmers, producers, and small businesses that pay what amounts to a significant economic cost.
This is because surplus-running countries benefit from their net absorption of foreign demand with a rising share of global manufacturing and the accumulation of foreign assets. But this rising share comes at the expense of the declining share of global manufacturing that deficit-running countries like the United States retain. What is more, by transferring part of its domestic demand abroad, the U.S. economy must make up for this loss either by encouraging more household debt or by increasing its fiscal deficit if it wants to avoid a rise in domestic unemployment.2
This is why the global dominance of the dollar now imposes an exorbitant burden on the U.S. economy, rather than the exorbitant privilege of old, and it is also why the United States likely will eventually have to refuse this role. For all the tremendous geopolitical power that control of the global currency system confers on Washington and Wall Street, it comes at a substantial economic cost to American producers, farmers, and businesses, and as the rest of the world grows relative to the United States, this cost can only increase.
But if the United States at some point refuses to run the permanently rising deficits that are needed to accommodate weak demand and excess savings in the rest of the world, deficits which underpin the global dominance of the dollar, how does this process ultimately resolve itself? Tariffs and other forms of direct trade intervention, as Klein and I explain, cannot work because they are largely ineffective in shifting the global savings imbalances that drive the U.S. trade deficit.
The only way for the United States, and other Anglophone economies, to be relieved of trade deficits is for an interruption in the global flow of capital that prevents savings imbalances from being exported. There are basically three ways in which this is most likely to happen. One way would be for the current system to be maintained until the United States is no longer able to carry the economic burden, in which case, amid a collapse in the credibility of the U.S. dollar, the world would abandon the currency. This would force the United States and other economies to adjust in a chaotic and disorderly way.
A second way would be for the United States unilaterally to opt out of the current system by constraining foreigners’ ability to dump excess savings into the U.S. economy, perhaps by taxing all financial inflows that do not lead directly to productive investment in the U.S. economy. There have already been such proposals in the U.S. Congress, and while as of yet they have been rejected, there are likely to be many more.
This would entail a substantial reduction in U.S. financial power abroad and in the power of Wall Street, and it would extremely painful and in some cases even destabilizing for countries—like China, Germany, Japan, Russia, and Saudi Arabia—that would likely prove unable to quickly resolve domestic demand and savings imbalances. This move would, however, boost U.S. manufacturing, raise domestic wages, and force U.S. businesses once again to rely on raising productivity rather than lowering wages to achieve international competitiveness.
Finally, the United States and the world’s other major economies could organize a new global trade and capital regime, based perhaps on ideas similar to those originally proposed by economist John Maynard Keynes at Bretton Woods, which, among other things, relied on a global synthetic currency (which he called the bancor) designed to absorb global imbalances and spread out their consequences across the major economies. Washington and its allies could do so by negotiating a new set of trade agreements that would force members to resolve their domestic demand imbalances at home, rather than force their trade partners to absorb them. By requiring countries with temporary surpluses to exchange these surpluses for bonds denominated in the new synthetic currency, it would also spread more widely the adverse consequences of those surpluses.
While either of the last two options would ultimately benefit the U.S. economy, the second of the two would be the least disruptive for the global economy and the one most likely to allow the United States and its allies to continue maintaining some degree of control over global trade and capital flows. But one way or another, Washington should take the lead in steering the global trade and capital regime away from its excessive reliance on the U.S. dollar. For all the uninformed and excited discussions about foreign antagonists forcing the U.S. dollar to lose its global dominance, this will never happen because no other country, including none of the country’s antagonists, is willing to take on the exorbitant burden that the U.S. dollar places on the U.S. economy. Washington itself must end the age of the U.S. dollar’s dominance for the benefit of the American economy.
How Would the World and Global Trade Be Affected by an Abandonment of the Dollar?
If the United States—and presumably the other Anglophone economies—were to take steps that eliminated the role of their domestic financial markets as the net absorbers of foreign savings, by definition they would also no longer run current account and trade deficits. But because these countries account for 70–75 percent of the world’s current account deficits (with the developing world accounting for most of the rest), this would also mean that, unless some other large economy proves willing to convert its surpluses into massive deficits, the world would have to reduce its collective trade surpluses by 70–75 percent.
To understand the implications, let’s assume a country that runs persistent trade surpluses is forced to adapt to a world of much lower trade deficits, and hence of much lower trade surpluses. As I have explained elsewhere (here, here, and here, for example), in countries that run persistent surpluses, domestic savings must exceed domestic investment. Domestic savings are high, in turn, mainly because ordinary households, who consume most of their income, receive a very low share of the GDP they produce—compared to shares of businesses, the government, and the very rich.
Countries that run persistent surpluses, in other words, do so because deficiencies in domestic demand caused by distortions in the distribution of income make them incapable of absorbing all they produce domestically. To put it in another way, these distortions force up their savings rates above their investment rates. This means that, if an external event were to force a sharp contraction in a country’s trade and current account surpluses, there are broadly speaking five ways (or some combination thereof) by which its economy could adjust to bring savings and investment back in line.
- A surge in unemployment: Such a country’s savings would decline if a collapse in its exports caused manufacturing unemployment to surge. Unemployed workers, of course, have negative savings.
- A boost in consumer lending to spur domestic demand: The country’s savings would decline if the central bank, in response to a collapse in exports, quickly forced banks to increase consumer lending dramatically so as to replace foreign demand with domestic demand. Even if it were possible to do this efficiently, rising household debt would eventually be unsustainable.
- A jump in government deficit spending to spur demand: Savings would decline if the country’s government, in response to a collapse in exports, quickly expanded the fiscal deficit so as to replace foreign demand with domestic demand. Even if it were possible to do this efficiently, rising fiscal deficits would eventually be unsustainable.
- Income redistribution: The country’s savings would decline if the government were able to engineer a substantial redistribution of income to ordinary households. This would be sustainable and by far the best long-term outcome for both the country and the world, but any substantial redistribution of income would be a slow and difficult process, and it would almost certainly be politically disruptive, as is clearly the case, for example, in China.
- A surge of investment: The country’s government could engineer a massive increase in investment. The private sector is unlikely to respond to a collapse in exports by increasing investment, and indeed private firms would probably reduce investment, so the increase in government investment would have to be enough to absorb both the contraction in the trade surplus and any reduction in business investment. This is what China did, for example, in 2009–2010.
There are only a limited number of ways in which a country that runs persistent surpluses can adjust to a global contraction in aggregate trade deficits, all of which are very difficult. This just reinforces how it is the willingness and ability of the United States to run large, persistent deficits that underpins the role of the dollar as the world’s dominant currency, and how it is these deficits that most benefit, directly or indirectly, the countries that claim to be most eager to dethrone the U.S. dollar. These are also the countries—especially China—who claim to be most keen to have their currencies replace the U.S. dollar even as their domestic economic policies make this impossible.
What Happens Next?
The world is stuck with the U.S. dollar, not because it creates an exorbitant privilege for the U.S. economy over which Washington will fight, but because it allows many of the world’s largest economies to use a portion of American demand to fuel domestic growth. These economies, in other words, can run large surpluses to balance their domestic demand deficiencies by exchanging excess production for real assets—such as American real estate, factories, stocks, bonds, farmland, mines, and real businesses—that other countries would be unwilling (and largely unable) to give up.
That is why, while the U.S. dollar may create an exorbitant privilege for certain American constituencies, this status creates an exorbitant burden for the U.S. economy overall, especially for the vast majority of Americans who must pay for the corresponding trade deficits either with higher unemployment, higher household debt, or greater fiscal deficits. This is also why the end of the U.S. dollar’s dominance has little to do with the political desires of countries like Russia, China, Venezuela, and Iran, and everything to do with the political decisions of Americans. Once Washington understands the cost of this exorbitant privilege—although this may unfortunately take many more years—U.S. leaders will take steps, either unilaterally or collectively, that force the world off its dependence on the U.S. dollar.
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1 Some analysts have suggested that the issuer of a major reserve currency does not need to run persistent deficits, and in support they point to the current account surpluses that Great Britain ran for much of the period when sterling was the world’s leading currency. But aside from the fact that a major currency under the gold standard exists under completely different circumstances (its main virtue is the credibility of its commitment to gold), the world didn’t need sterling to be used to absorb excess savings at the time.
On the contrary, the economies of the world were eager at the time to import savings so as to boost domestic investment, so they needed the leading economy of the time to export savings, not import them, which Great Britain duly did. In fact, the United States was also a net exporter of savings (it ran persistent surpluses) until the 1970s as the world was rebuilding itself from two world wars.
The point, in other words, is not that the issuer of the global currency must run permanent deficits, but rather that it must run surpluses when the world wants to import savings and it must run deficits when the world wants to export excess savings. This is what it means to say that the issuer of the global currency must effectively give up control of its capital account to balance whatever the rest of the world requires.
2 Net foreign capital and financial inflows must be balanced by an excess of domestic investment over domestic savings. In a developing country in which investment is constrained by scarce domestic savings, like the United States in the nineteenth century, the likely impact of net foreign inflows is to raise domestic investment. In advanced economies with easy access to capital, like the United States today, the likely impact of net foreign inflows is to reduce domestic savings, either by encouraging higher household debt, setting off a larger fiscal deficit, or forcing higher unemployment.