For decades, the United States has benefited from the dollar’s dominance on international markets. Washington must avoid squandering these advantages through political infighting and irresponsible policymaking.
Exceptional Privilege
Since the conclusion of World War II, the U.S. dollar has dominated world financial markets. Nearly 60 percent of the world’s foreign exchange reserves are held in dollars, with the euro coming in a distant second with 20 percent. Ninety percent of transactions on foreign exchange markets and fifty percent of international commerce are invoiced in dollars. The dollar’s status as a safe haven currency during moments of crisis strengthens its standing. During the Great Recession of 2008 and the Covid-induced financial crisis of 2020, investors pursued U.S. dollars in the expectation that they would maintain their value.
The U.S. government, economy, and populace garner enormous benefits from the dollar’s “exceptional privilege” in global financial markets, as described by a former French finance minister. Due to the robust global demand for U.S. dollars and dollar-backed securities such as U.S. treasury bonds, the United States is able to borrow at significantly lower interest rates than other nations. In addition, the U.S. government and companies can borrow from foreign creditors in dollars rather than foreign currencies, so the value of the debt is not affected by fluctuations in exchange rates. A high demand for the dollar strengthens its value relative to other currencies, resulting in inexpensive products for U.S. consumers; however, it reduces the competitiveness of U.S. exports. The global hegemony of the U.S. dollar provides the U.S. government the ability to impose extensive and effective sanctions on its adversaries, a potent foreign policy instrument. However, domestic and international threats to the U.S. dollar are increasing despite its sustained dominance.
Domestic Difficulties
Ironically, in part due to its exceptionally low borrowing costs, the United States has accumulated a staggering $32.11 trillion in debt, which is unsustainable over the long term and could undermine faith in the U.S. dollar. Politically, it is challenging for leaders to confront the problem of escalating debt. Tax increases and reforming entitlement programs such as Social Security and Medicare are unpopular, particularly among older Americans, despite the fact that the American public supports reducing debt and expenditure.
The limit on the quantity of legal debt the United States can hold is a more immediate danger. This rather unusual mechanism imposes a limit not on actual expenditure, but on the Treasury’s ability to borrow to repay its existing debt, which cannot be increased without congressional approval. The United States is one of a handful of nations with such a debt limit. Exceeding the debt limit would result in default. Since it was first established during World War I, Congress has raised the debt ceiling scores of times. Recent events have demonstrated, however, that rising political polarization has made default a distinct possibility. Every few years, whenever it is time to raise the debt ceiling, one or both parties engage in a game of political brinkmanship to extract concessions from the opposing side. A default would be catastrophic and would threaten the dollar’s status as a secure haven. The United States’ credit rating would be severely downgraded, putting an end to the dollar’s exorbitant privilege. Even approaching it can have consequences. Standard and Poor’s downgraded the country’s credit rating in 2011 when the debt ceiling was two days away from being reached. More recently, Fitch Ratings did the same, despite President Joe Biden and House Speaker Kevin McCarthy’s last-minute agreement to avert a default. In spite of numerous standoffs over the debt ceiling in recent years, the national debt has continued to rise, demonstrating that the debt ceiling does nothing to resolve the rising debt.
International Obstacles
The global hegemony of the dollar provides the United States government the ability to impose crippling sanctions and engage in other forms of financial warfare against its adversaries. Since September 11, 2001, it has utilized this power more frequently. More than twelve thousand entities were sanctioned by the Treasury Department in 2022, an increase of more than twelvefold since the turn of the century. Sanctions imposed by the United States have not been particularly effective at altering the behavior of regimes, but they do ensure that targeted adversaries pay a significant price for continuing to engage in actions that the United States opposes. Frequently, their application is uncontroversial, as with the sanctions imposed on Russia for its invasion of Ukraine. However, excessive use can cause countries, including allies, to seek alternatives to the dollar-based financial system. For instance, European nations opposed the unilateral withdrawal of the United States from the Iran nuclear agreement. However, as a result of secondary sanctions imposed as part of the “maximum pressure” campaign against Iran, they were compelled to cease all trade with the country. This prompted them to contemplate creating a substitute for the SWIFT and dollar-based systems. If even U.S. allies have considered alternatives to the dollar-based system, it is not surprising that adversaries such as Russia and China have been attempting to undermine the dollar’s dominance.
Moreover, because the dollar is a global reserve currency, the effects of the Federal Reserve’s monetary policies are not limited to the United States. For example, when the Federal Reserve raised interest rates to combat inflation over the past year, it led to a decrease in the money supply and investors shifting funds from developing countries to the “safe haven” of U.S. treasury bonds, resulting in massive capital outflows. This influx also results in an appreciation of the U.S. dollar relative to other currencies and an increase in developing countries’ dollar-denominated debt. Unsurprisingly, this has a greater impact on highly indebted nations. The Latin American debt crisis of the 1980s was in part caused by the Federal Reserve’s aggressive rate increases intended to combat inflation. Despite the fact that the Fed may not be expected to take this into consideration when combating inflation, it should be noted that emerging markets could diversify their reserve holdings into a multi-currency portfolio in order to have greater control over their monetary and fiscal policies.
A Departure from the Dollar?
Due to the aforementioned domestic and international factors, the international desire to diversify away from the dollar-based global reserve system is strong. Have these factors contributed to the dollar’s decline in value? Unsurprisingly, Russia was forced to abandon the dollar in order to avoid Western sanctions. However, China, which has long advocated for the internationalization of its currency, is at the vanguard of efforts to weaken the dollar’s strength. China and Argentina recently expanded their currency exchange agreement. China recently reached an agreement with Brazil, with whom it conducts $150 billion in annual trade, to conduct transactions in their respective currencies rather than the U.S. dollar. It may not seem like much in isolation, but China is pursuing similar agreements with other nations. Given China’s dominance in global commodities trade, their success would pose a challenge to the U.S. dollar’s status as the world’s default trading currency. Even global reserves have gradually moved away from the U.S. dollar. In the final quarter of 2022, the dollar’s share of global foreign-exchange reserves was just below 60 percent, down from over 70 percent in 1999. China, the largest overseas holder of U.S. treasuries, has reduced its dollar holdings due to deteriorating relations with the United States. Since May 2009, its current holdings are at their lowest level.
Despite all of this, it is essential to keep in mind that the U.S. dollar continues to dominate global foreign-exchange reserves because there is no obvious alternative. In spite of China’s efforts, the renminbi represents only 2.7% of global reserves. Due to stringent capital controls and limited convertibility to other currencies, a complete challenge to the dollar’s dominance remains improbable. Nevertheless, the United States should be aware of the domestic and international threats to the status of the U.S. dollar and act to dispel international doubts so that the dollar can retain its status even if a credible alternative currency emerges. These measures could include addressing the United States’ public debt and either eliminating the debt ceiling or linking it to congressional authorization of spending to facilitate debates about spending increases or reductions in good faith without risking default. The United States should also employ sanctions with greater discretion. Sanctions are an essential instrument of U.S. economic diplomacy, and their use is frequently justifiable, but they should not be overused. The dollar has been resilient for more than seven decades. Its decline, if it occurs, should at least not be the result of American errors.
