For 80 years, since the Bretton Woods exchange rate system was designed, the US dollar has been the dominant currency in global trade and finance. The Ukraine-Russia War and the emergence of cryptocurrencies are firing the imagination of a different world, in which the US dollar no longer reigns supreme. 

It is a familiar pattern: a crisis is gripping the world, and the US dollar is soaring. It was thus in 2020 at the start of the COVID-19 pandemic, in 2008 during the global financial crisis (which originated in the US no less), and now in the face of a global energy and inflation shock. When the world is fretting about the future, investors seek refuge in US capital markets, pushing up the US dollar in the process. The greenback, as measured by the Federal Reserve’s Nominal Broad Dollar Index, is just coming off a 20-year high.

The US dollar’s status as a safe haven during crises is a manifestation of its dominance in global financial markets. Approximately 50 percent of international trade is invoiced in US dollars, and 50 percent of all debt instruments and securities worldwide are denominated in dollars. In foreign exchange markets, the global market for currencies, the US dollar makes up one side of nearly 90 percent of all transactions. Currently, central banks hold 60 percent of their foreign exchange reserves in US dollars to facilitate investments, transactions, and international debt obligations, making the dollar the world’s leading reserve currency. Japan alone, as the largest non-US holder of US government debt, holds more than $1.1 trillion, followed by China which holds nearly as much.

For the US, the dominance of the dollar has several advantages: increased seignorage revenue from currency held abroad; lower yields on government debt due to small risk and liquidity premia; lower transaction costs due to smaller currency market spreads; market power for US financial institutions which issue currency; a strategic instrument to be used in the pursuit of international geopolitical goals; and a high degree of policy flexibility, in particular the freedom to pursue domestic policy goals while at the same time running persistent balance-of-payments deficits – a feature which former French finance minister Valéry Giscard d’Estaing called the “exorbitant privilege.”

This privilege also comes with a significant responsibility. The Federal Reserve Bank needs to assume the role of “lender of last resort” to provide global capital markets with liquidity during times of need, which might interfere with domestic policy objectives. And, of course, running persistent balance-of-payments deficits may become unsustainable eventually and lead to fragility and volatility. Attempts to reverse balance-of-payments deficits typically prove ineffective, a phenomenon known as the Triffin dilemma.

For the rest of the world, the US dollar’s dominance poses problems that are being exposed by the energy crisis and the COVID-19-induced supply chain disruptions. The vast majority of energy (oil and gas) contracts are invoiced in US dollars, so energy prices typically move together with the US dollar. For energy-importing countries, this means that measured in their own currency, the adverse impact of higher energy prices is exacerbated by an appreciating US dollar. Furthermore, the US dollar’s prevalence in the world’s capital markets limits central banks’ monetary independence. If, as is currently the case, the Federal Reserve is slamming on the brakes to get on top of US inflation, the widening interest gap between the US and the rest of the world and the ensuing appreciation of the US dollar will force other central banks’ hands in terms of policy choices. They can follow the Federal Reserve’s lead and also raise interest rates, risking a severe economic contraction, or they can adopt a more dovish stance and import inflation.

Emerging markets face an additional constraint, namely the difficulty, or inability, to borrow from international lenders in their own currency, known as the “original sin.” Large dollar-denominated sovereign debt can cripple these economies as the debt burden balloons following an appreciation of the US dollar. This, too, forces central banks’ hands: they can tighten domestic monetary policy to shore up the domestic currency but risk a recession, or they can keep interest rates low, inducing damaging capital outflows and a vicious cycle of currency depreciation and mounting debt. It is no surprise that many past sovereign debt crises were associated with a strong US dollar and rising US interest rates.

There is widespread unease about the current international monetary architecture and yet there is little prospect of it changing any time soon. Too entrenched are the current arrangements and too aporetic the alternatives. The US plainly has no interest in giving up its exorbitant privilege while no other nation currently has the means to become a monetary hegemon. China has made some concerted efforts to expand the use of the renminbi, for example through the Belt and Road Initiative, but progress remains slow. International investors are extremely sensitive to sovereign risk, and as long as the renminbi is not freely convertible and the Chinese government remains autocratic, the renminbi’s appeal is limited. No other nation has the political and economic heft to rival the US.

Harvard economist Kenneth Rogoff recently argued that Russia’s restricted access to the dollar-dominated global financial system, following the US-led sanctions, would accelerate the scramble for alternative solutions. This view was echoed by the International Monetary Fund’s (IMF) First Deputy Managing Director Gita Gopinath. While there may be some readjusting of portfolios in the short run, a Russia or China-led economic bloc is hardly going to inspire confidence in fund managers and bankers worldwide and induce them to shun US dollar-denominated securities.

Some governments and investors have pinned their hopes on cryptocurrencies, and possibly central bank digital currencies, to dislodge the US dollar from its pedestal. But digital currencies have proven far too volatile and untrustworthy to be taken seriously as money, preventing these assets from providing the kind of liquidity that gives the US dollar its special status. This may yet change, as digital currencies mature and gain further acceptance – although I’m highly sceptical. Even if they do reach respectable adulthood, governments all over the world will likely regulate them away in an attempt to retain the sovereign’s monopoly of money issuance. El Salvador’s recent decision to make Bitcoin legal tender is looking like a very costly mistake. The cryptocurrency is not used widely and has wreaked havoc with the government’s budget. It is more likely that El Salvador will reverse this decision than other countries accepting Bitcoin for payment of tax liabilities.

Historically, multiple national currencies have always co-existed and vied for regional pre-eminence, either through direct political influence or through an organic evolutionary process determined by trade relationships and capital flows. This overall dynamic is unlikely to change. Some commentators believe that the US dollar’s influence will fade as Uncle Sam’s share of global GDP shrinks over time. That view is too simplistic. The Chinese renminbi will continue its rise as a global currency, but only to a point. Unseating the US dollar would require either an alternative national hegemon, with trustworthy financial markets, a transparent legal system, stable politics, and the absence of capital controls, or, alternatively, a withering of the nation-state that would enable modern, digital private monies to deeply penetrate the global economy. My crystal ball tells me that both are very unlikely in the foreseeable future.

Dr Timo Henckel (PhD London School of Economics) is Senior Lecturer in the Research School of Economics and Program Director at the Centre for Applied Macroeconomic Analysis (CAMA), both at the Australian National University (ANU). He is also chair of CAMA’s RBA Shadow Board, which offers its own policy recommendation on the Monday before the official RBA decision. Dr Henckel has published and taught widely in his areas of expertise which include central banking, international finance, behavioural macroeconomics, and political economy.

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