The United States is in a position of exorbitant privilege of the U.S. dollar ($USD) being the international reserve currency. The world’s demand for U.S. Dollars has allowed the U.S. Government and American citizens to borrow for cheaper than would otherwise be possible. The United States does not have to worry about a balance of payments crisis, meaning that since U.S. imports more than they export there would be too more supply of dollars than there was demand on the foreign exchange market, and hence the dollar would depreciate (lose value). Instead since the dollar is the reserve currency of the world, central banks around the world own a lot of dollars.
The position of world reserve currency does not come without its negatives as well, as economists like to say, there is no such thing as a free lunch. The United States suffers from Triffin’s Dilemma, which is the tradeoff between short-term domestic and long-term international economic interests. Triffin’s Dilemma was coined by Robert Triffin in 1960 who stated that a country whose currency was the world reserve currency (and foreign sovereign nations wished to have) would need to be willing to supply more currency to fulfill the global demand for foreign exchange reserves and hence would have a trade deficit.
This issue is further exacerbated by a U.S. president that wants to Make America Great Again, and bring American manufacturing jobs back. With the U.S. dollar in its position of the world reserve currency, the dollar is too highly valued for American exports to be competitive in the international market (among other reasons). Another important issue is that foreign nations are financing the U.S. government deficits (by buying U.S. treasuries) which is continuing to grow. This cannot be expected to continue forever, and neither can the U.S. Dollar’s reserve currency status, as the graphic below from J.P. Morgan indicates.
Source: JPM, Hong Kong Monetary Authority, December 2011
Alternative World Reserve Currencies
The only currency that is a natural alternative to the dollar as the world reserve currency is the Euro. It is completely feasible that the Euro could replace the American dollar as the world reserve currency as the U.S. Federal Reserve Chairman Alan Greenspan said is 2007, it is “absolutely conceivable that the euro will replace the US dollar as reserve currency, or will be traded as an equally important reserve currency.” Source Although at present (in 2019) this seems highly unlikely after Brexit, the continuing issues of fiscal bifurcation between the north and south of Europe, as well as slowing Eurozone growth. Additionally, Europe is far more reliant on exports than the United States, so they would likely not want to face the issues posed by Triffin’s Dilemma, particularly the German and French economies which are incredibly reliant on exports.
What about China?
The first issue with using the Chinese Yuan as a reserve currency is that they are an authoritarian, communist country – many nations globally (particularly the western ones) would not accept it. Other countries and banks do not want to own the Chinese Yuan, and indeed Chinese citizens do not either, which is most clearly shown by the capital flight out of China. The Chinese Yuan is not a widely accepted currency in the international financial markets, indeed in the SWIFT system (Society for Worldwide Interbank Financial Telecommunications, an interbank messaging service which allows financial institutions to issue letters of credit) the Yuan is a minuscule amount, only a small amount more than the Canadian Dollar or Australian Dollar.
China has also repeatedly been labelled a currency manipulator, which has tarnished their reputation internationally and has diminished their chances of acquiring the title of world reserve currency. The most important factor why China will likely not become the world reserve currency is because they are a major exported and would not be able to maintain their competitiveness in exporting with a less competitive exchange rate.
I believe this adequately highlights the issue at hand – there seems to be no currency that can challenge the hegemony of the U.S. dollar in international trade and the global financial markets. This is indeed a major issue as the United States deals with Triffin’s dilemma, a growing government deficit, and a president that wants to Make America Great Again.
U.S. Dollar Hegemony – “Evergreen” Issue
The issue of U.S. Dollar Hegemony is not a new issue, it has been understood for decades. The reason discussions are arising is because of the increase in populism. nationalism, and trade wars. This quote is one I noticed when I was reading George Soros’ The Alchemy of Finance which was published in 1987.
“A country with a large budget deficit and a large trade deficit cannot expect foreigners to accept an ever-increasing flow of its currency. Yet the international financial system cannot function without a stable currency as its foundation. This is the central lesson that emerges from the Crash of 1987.”
We desperately need an international system that is not based on the dollar. Yet the Yen is not yet ready to serve as the international reserve currency – partly because the Japanese financial markets are not sufficiently open, and partly because the rest of the world is not ready to accept Japanese hegemony. The ideal solution would be a genuine international currency, issued and controlled by a genuine international bank. International lending for balance-of-payments purposes would then be designated in the international currency, and the value of the currency would be tied to gold or a basket of commodities, ensuring that debts would have to be repaid in full. Only when the dollar loses its privileged status will the United States cease to flood the world with dollars. The sooner we make the transition, the better the chances of arresting the economic decline of the United States” – p. 369, George Soros (The Alchemy of Finance)
More recently the issue of the U.S. Dollar as the world reserve currency was discussed in the aftermath of the Financial Crisis of 2007/2008. An essay by Zhou Xiaochuan, the Governor of the People’s Bank of China titled, Reform the international monetary system was published on March 23, 2009.
Zhou Xiachuan open by directly addressing the issue of the global recession and the following economic malaise and asking “what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF?” The author never directly addresses the issue of U.S. dollar hegemony, and tactfully omits even mentioning the dollar in the essay, instead in my opinion the crux of his argument was that an international reserve currency should be created which is to be “anchored to a stable benchmark and issued according to a clear set of rules, therefore to ensure orderly supply; second, its supply should be flexible enough to allow timely adjustment according to the changing demand; third, such adjustments should be disconnected from economic conditions and sovereign interests of any single country… The desirable goal of reforming the international monetary system, therefore, is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.”
The most recent call for an international reserve currency was from Mark Carney, the Bank of England Governor during his speech at Jackson Hole in August 2019. Carney said that the world’s reliance of the US dollar “won’t hold”, and he suggest replacing it with a digital currency based on a wider variety of global currencies, stating, “When change comes, it shouldn’t be to swap one currency hegemon for another.” This is tactful rhetoric and I believe was Carney simply attempting to open the issue up before the next crisis, there are other ways for the global currency to be anchored which may be chose instead, such as gold, silver, or a basket of commodities.
Alternative Measures for an International Reserve Currency
With the issues posed by Triffin’s dilemma, and the rhetoric from Marc Carney and Zhou Xiachuan, I believe during the next financial crisis there may be an overhaul of the international financial system. If the issue causing the next crisis is exacerbated by the United States whether through a trade war, an appreciating U.S. dollar causing damage to Emerging Market corporates for example because they borrow in dollars and earn revenue in local currencies, or any other reason. The U.S. will find it hard to both save face and maintain U.S. dollar hegemony over the international financial system.
So what is a natural alternative to the current system? Look at the chart below
The most important nations in the world economy are here – the United States, the three biggest E.U. Economies (Germany, Italy, France), Russia, China, Switzerland, Japan. In July 31, 2019 an article titled “Central banks make record $15.7bn gold purchases” was published in the Financial Times. Guess who were the leading buyers of gold? It’s a not so open secret that it’s powerful eastern nations trying to divest U.S. treasuries and acquire gold, as articles such as Russia Is Dumping U.S. Dollars to Hoard Gold (Bloomberg – March 28, 2019), and China Scoops Up More Gold for Reserves During Trade War (Bloomberg – August 7, 2019).
So the United States, and the European Union have a large amount of gold reserves, whereas China and Russia are increasing theirs. Is it a radical position that the new international reserve currency will involve gold in some regard – perhaps an international currency pegged at some price of gold?
A similar proposal was proposed by John Maynard Keynes a few years before his death at the Bretton Woods conference.
Keynes was negotiating for the British and proposed an international currency called Bancor within a multilateral clearing system called the International Clearing System. “On 11 February 1942 a fourth draft was given to ministers. The union was now called ‘International Currency (or Clearing) Union’. It was to be based on international bankmoney, called ‘bancor’, and fixed – but not unalterably – in terms of gold, and accepted as the equivalent of gold by all members of the Union for the purpose of settling international balances. Keynes assumed that through adequate measures it would be possible ‘to prevent the piling up of credit and debit balances without limit, and the system would have failed in the long run if it did not possess sufficient capacity for self-equilibrium to prevent this.’” page 35-36 Van Dormael “Bretton Woods – Birth of a Monetary System”
The clearing mechanism made a lot of sense as well, “Gold, since it still possessed great psychological value, would have a substantially unchanged position. Bancor would be entitled to obtain bancor credit by paying gold to the credit of their account, “thus securing a steady and ascertained purchaser for the output of the gold-producing countries and for countries holding large reserves of gold”. Members, however, could not demand gold against their bancor credits. Thus the convertibility between bancor and gold was one-way. If the Clearing Union found itself in possession of a stock of gold, it could decide to distribute the surplus to member countries possessing credit balances, proportionately to such balances.”
This system of course was not adopted, and instead of a supranational currency, the conference adopted a system with pegged exchange rates tied to physical gold with prominent roles played by both the IMF and World Bank. The system established at Bretton Woods established the United States dollar as the major reserve currency at a fixed price. This system lasted until 1971 when president Richard Nixon ended the convertibility of the U.S. dollar to gold. Since then the United States has been on a “shadow gold standard”, understanding the value of gold as a monetary asset, and enjoying their “exorbitant privilege and export U.S. debt rather selling their gold holdings.
In the Bancor system, “Gold, since it still possessed great psychological value, would have a substantially unchanged position. Bancor would be defined in terms of gold and member countries would be entitled to obtain bancor credit by paying gold to the credit of their account, “thus securing a steady and ascertained purchaser for the output of the gold-producing countries and for countries holding large reserves of gold”. Members, however, could not demand gold against their bancor credits. Thus the convertibility between bancor and gold was one-way. If the Clearing Union found itself in possession of a stock of gold, it could decide to distribute the surplus to member countries possessing credit balances, proportionately to such balances.”
During the Bretton Woods discussions the U.S. Treasury Secretary Henry Morgnethau requested his team of economists and researchers look into the Bancor plan, one of his leading economic advisors Henry White said, “Obviously, a new unit of currency would have to be defined… To set the value of the new currency in terms of some existing currency has the disadvantage of subjecting the new unit to the variations of the currency to which it is tied and also to raise questions of ‘favoratism’. A unit of account does not have to be set in terms of gold. It could, of course, be set in terms of some commodity other than gold – tin, platinum or any material. It could even be set in terms of an average basket of goods or an aggregate of goods. But examination of the various possibilities will reveal that the only practical solution is to set the new currency unit in terms of a given volume of gold.” (emphasis mine)
A new international currency could be denominated in various currencies like Mark Carney suggested but this faces the issue of favoritism, which is the exact issue we face with the U.S. Dollar as world reserve currency. Denominating the currency in terms of an average basket of commodities or goods is also an option but there would be the difficulty of determining weightings, which would favor some commodity exporting countries over others. A gold backed international currency would be the best system, and one that most major world economies could agree on.
The natural alternative to the current system of U.S. dollar hegemony is an international currency backed by gold operating in a system like John Maynard Keynes envisioned. It should not be a controversial idea considering it was proposed by the most respected economist in history. Keynes’ Bancor ideas solves Triffin’s dilemma and would create a system of international trade far superior to the current system.
Unfortunately the system will likely only be reformed during the next crisis, if it even gets resolved then. I will conclude with an article from George Soros writing in the aftermath of the 1987 crash, “it is the United States that has the most to gain from a reform of the international currency system. It would allow us to consolidate our position in the world which we are otherwise in danger of losing. We are still in a position to strike a favorable deal, especially in view of our military might… The alternative is a period similar to the 1930s: financial turmoil, beggar-thy-neighbor policies leading to worldwide depression and perhaps even war.“ (The Alchemy of Finance)