The US dollar’s dominance in international finance has exposed the world economy and developing countries to the vicissitudes of the US monetary policy cycle. Plans for an alternative.
Paulo L. dos Santos is Associate Professor of Economics at The New School for Social Research, Devika Dutt is Lecturer in Development Economics at King’s College, London
Cross-posted from Developing Economics
“One of the chief contributions to peace that the Bretton Woods program offers is that it will free the small and even the middle-sized nations from the danger of economic aggression by more powerful neighbours. The lesser nation will no longer be obliged to look to a single powerful country for monetary support or capital for development, and have to make dangerous political and economic concessions in the process. Political independence in the past has often proved to be sham when economic independence did not go with it.” —Henry Morgenthou Jr (1945)
The world economy has a Dollar problem. Reliance on the currency of a single country as the world’s chief way to organise trade, carry out financial settlements, and store value creates a series of inequitable economic imbalances and policy tensions—both within the US and across the global economy. It bestows disproportionate economic and political power on the US government and financial institutions; exposes world trade and finance to instability and disruptions originating in the Dollar zone; imposes huge costs on the world’s small and even middle-sized nations; and fuels disproportionate growth in the US financial sector, bolstering its influence in that country’s political economy.
A Historical Problem
This problem is not new. In fact, the inability to develop an equitable and genuinely multilateral international monetary system is one of capitalism’s most striking institutional failures, going back to the early days of the industrial revolution. The gold standard of that time and its successors have always privileged some economies at the expense of others, and created policy biases favouring the interests of creditors and capital, at the expense of debtors and wage earners.
Only once in the history of capitalism did policy-makers from leading capitalist powers even consider the possibility of building a genuinely multilateral, equitable system: during the 1943-44 debates on the post-World-War-II economic order. But despite the aspirations and statements of participants like John M Keynes and then-US Treasury Secretary Henry Morgenthou Jr, the Bretton Woods conference led to the creation of a system centred on the US Dollar, under which foreign central banks could present dollars to the Federal Reserve for exchange into gold.
That system effectively charged US authorities with the supply of the world’s ultimate international reserves. In this task they were constrained only by the willingness of central banks in other states to hold Dollars instead of gold. As French Finance Minister Giscard d’Estaing put it in the 1960s, this arrangement defined an exorbitant privilege for the US economy, which enjoyed a lot of space for effectively issuing Dollars to acquire goods and assets overseas.
By the late 1960s, it became clear that the US economy could no longer uphold its obligations under the Bretton Woods system. Its steady loss of competitiveness in international trade, fiscal pressures from its protracted, losing war in Vietnam, and increases in social spending in response to domestic political turmoil, led to growing trade deficits, mass outflows of Dollars, and concerns that US authorities would not be able to meet foreign demand for convertibility of greenbacks into gold. In response, the US unilaterally abandoned its commitment to convertibility in 1971.
Coming amidst a series of successful national liberation and anti-colonial struggles across the world, the US’s inability to sustain the Bretton Woods system fed hopes that a new, equitable international monetary order could be constructed. The 1974 call by the United Nations for a New International Economic Order explicitly pointed to the need for a new monetary system centered on the “promotion of the development of the developing countries and the adequate flow of real resources to them” as means to dismantle “the remaining vestiges of colonial domination” and removing the obstacles in the way of international convergence in measures of economic development and living standards.
The Power of Weaker Promises
Unfortunately, the collapse of Bretton Woods was ultimately followed by the re-emergence of the Dollar as the de facto dominant international monetary form. This time, the Dollar was not backed by promises of convertibility into gold, but stood above all other currencies by sheer market dominance. This dominance reflected the power of the US state, which bolstered the credibility of its currency and bonds; a strong commitment by US policymakers to financial liberalisation and price stability, even at the expense of macroeconomic objectives like employment or income growth; and the development of large and highly liquid markets for effectively risk-free US government securities. Together these factors helped create a strong, worldwide preference of investors and security issuers for Dollar-denominated financial contracts—negotiated in markets where ultimate liquidity is provided either by Dollars or by US Treasury securities.
Over the past five decades, this system has contributed to the development of a series of imbalances and iniquities in the world economy.
It led to the development of disproportionately growing international demand for Dollar-denominated assets and Dollar reserves. That demand has sustained persistent and at times large U.S. trade deficits since the early 1970s. Taken as an aggregate, the US economy has appropriated tens of trillions of Dollars worth of goods and services from its trading partners during that period as a result. Demand for Dollar assets has also fueled disproportionate growth in the US financial sector and its influence over the US polity.
The Dollar’s dominance in international finance has exposed the world economy and developing countries to the vicissitudes of the US monetary policy cycle. Ever since the 1980 “Volcker Shock,” significant tightening in the Dollar zone has been accompanied by a broader tightening of international financing and sudden stops of capital flows into developing countries, often triggering financial distress, depletions of foreign reserves, and currency crises, even when developing economy policymakers played by the rules of the game.
The Dollar standard also exposes the world to the consequences of mismanagement of the US financial sector. The 2008 financial panic triggered by the US subprime mortgage crisis perversely led to a sudden rush of capital away from developing countries and toward the perceived safety of the US Dollar. This contributed to serious strains in those economies. The Dollar illiquidity created by the crisis triggered a collapse in international trade finance, which is mostly denominated in Dollars, bringing international trade among all countries to a standstill towards the end of 2008.
The inconvertible Dollar system is deeply unequal and prone to periodic instability.
Power, Subordination, and Geopolitics
The informal Dollar standard also places significant measures of economic and political power in the hands of US policymakers. In fact, the Dollar’s power helps define new modalities of imperial subordination and financial extraction, and gives US administrations a formidable geopolitical weapon.
Successive US administrations have wielded their ability to determine who gets Dollar liquidity, and on what terms, in ways that have furthered the pecuniary interests of influential US agents, as well as broader US economic and policy agendas. This was clearest during the Latin American debt crises of the 1980s and 1990s, and the Asian Crisis of 1997, when onerous policy concessions were forced on governments facing severe currency or sovereign-debt crises. Since the financial crisis of 2007-09 the Federal Reserve has moved to bolster the Dollar’s status as the foundation of international finance by formalising its role as the ultimate international provider of liquidity through a series of swap and repurchase arrangements with some foreign central banks.
Widespread market preferences for Dollar-denominated assets and reserves, open capital accounts, and a system of liquidity provision firmly centered on US institutions have created new biases in international monetary management, particularly for developing countries reliant on capital flows. Policymakers in those countries have had to operate with one arm tied behind their back when formulating and implementing strategies for economic and social development. Ambitious policy initiatives are often hampered not only by the complex realities of post- and neo-colonial political economies, but also by the possibility that they may run afoul of the expectations of international capital markets and trigger potentially destabilising capital outflows and exchange-rate volatility. As with the gold standard, the de facto Dollar system often subordinates the pursuit of the economic and social interests of large domestic constituencies to those of investors–domestic and foreign. It is one of the central reasons why the promise of a New International Economic Order and the dismantling of all the vestiges of colonial domination is yet to be fulfilled.
To alleviate some of these pressures, many developing country governments have accumulated enormous Dollar reserves over the past 20 years. While this has helped many of them prevent the kinds of currency crises of the 1980s and 1990s, it has come at a considerable cost. For many countries, the differential between what national central banks earn on their reserve holdings and the interest national treasuries pay on their liabilities is around 1 to 3 percent of GDP. The Dollar standard imposes a sui generis form of financial tribute on treasuries of developing countries, in the form of spreads between what they earn on US Treasury securities and what they pay to the holders of their liabilities—foreign and domestic.
Recent US moves to freeze $630bn held by the Central Bank of the Russian Federation (CBRF) in response to Russia’s invasion of Ukraine have starkly underscored the geopolitical realities of Dollar power. The impairment of the better part of a trillion Dollars in international reserves, accounting for almost half of annual output for the economy that accumulated them, is without historical precedent. It also raises the spectre of what some have called the “militarisation of the Dollar.” As a senior Pentagon official explained it recently, this involves future uses of US “primacy in the global financial system… in ways that can absolutely pummel aggressors.”
Renewed Interest in Alternatives
The prospect of the US government wielding the power of the Dollar as the world’s reserve currency in pursuit of its perceived national economic or geopolitical interests is deeply troubling. It has also rekindled debates about possible alternatives to the informal Dollar standard. Some of the debate has involved unserious prattle by cryptonistas and the usual, cranky calls for a return to some kind of commodity standard.
But there have also been much more serious discussions about the possible emergence of the Renminbi, the Euro, or a collection of regional currencies as potential alternatives to the Dollar standard. While those prospects are unlikely, they are also problematic in at least two ways. First, any movement toward another national currency as the foundation for the international monetary system is all but certain to subsume the issue of international monetary reform under fraught issues of geopolitical power. International monetary relations would become a terrain not of international cooperation but one of rivalries and confrontation. Second, neither a national currency nor currency blocks actually address the fundamental incongruence at the heart of the global economy’s problems of international monetary management.
Problems in the relationship between international and domestic monetary functioning have beset modern economies since the beginning of the industrial revolution. Capitalism developed economies, polities, and currencies that are typically national in scope. But it has also created international production systems, trade, and financial flows that create deep interdependencies between national political economies. This gap between national institutional capacities and international influences over domestic economic outcomes has been filled by inequitable arrangements like the Dollar standard.
The world’s international monetary system is clearly in need of a radical overhaul. While many scholars and commentators have expressed skepticism about the institutional and political expediency of transcending the Dollar system, the reality is that monetary reform is much like the international coordination of efforts to decarbonise the planet’s economy — economic and policy interdependences between countries make the development of effective and genuinely multilateral institutions a necessity of global economic governance, and an integral part of any equitable international economic order.
A Multilateral Clearing Union
The establishment of a Multilateral Clearing Union (MCU) opens the way towards a radically different and more equitable institutional solution to the problems of international monetary functioning—one that could help address some of the critical issues of global economic governance, including poverty alleviation; timely convergence in incomes, living standards, and productivity; and the rapid decarbonisation of the planet’s industrial infrastructure. The inspiration for a multilateral clearing union comes from John Maynard Keynes’ proposals to the Bretton Woods conference in the 1940s. Unlike Keynes’ proposals, however, we can develop a genuinely multilateral institutional solution, designed for a world economy with inconvertible currencies and significant measures of capital-account openness, cross-border investment, and exchange-rate flexibility.
The proposal for an MCU is grounded in the understanding that, in a world of interdependent national economies and polities, an equitable international monetary system must seek to maximise the space available to all national authorities to pursue macroeconomic objectives in line with their domestic policy preferences—particularly authorities in poorer or externally vulnerable economies. This cannot be accomplished by using a national currency as the basis for international monetary functioning, as the experience with Dollar standards has shown. Nor can it be accomplished by using a multi-national or bloc currency as the domestic monetary form, as the painful experience of Greece, Spain, Portugal, Ireland, and Italy during the Eurozone crisis has shown.
What is needed is a system that as much as possible decouples domestic and international monetary functioning.
That goal can be pursued with a system where all international trade and investment is denominated not in any national or bloc currency but in a new monetary unit issued and supported by an international organisation tasked exclusively with the multilateral governance of international trade and investment: A Multilateral Clearing Union.
The denomination of international trade and finance is a highly consequential choice. It establishes the contractual terms of how importers settle their outstanding balances to importers, and how agents meet payment obligations arising from their international liabilities. Today, that almost always involves making payments in Dollars. That in turn defines the financial risks faced by those facing international payment obligations. Any appreciation of the Dollar relative to the domestic currency creates potential financial strains. As a result, national economic policy is constrained by the possibility of destabilising depreciations of the currency relative to the Dollar, including those triggered by events not in the domestic economy but in the Dollar zone or other economies. The denomination of international payments also defines, as discussed above, the institutions in a position to provide credit and liquidity to those facing potential payments difficulties.
A genuinely multilateral clearing union would use a weighted average of national currencies as its unit of account. That choice would fundamentally transform the nature of exchange-rate risks associated with international liabilities arising from international trade and financing. Instead of facing risks of any appreciation in the Dollar relative to the domestic currency, economies where a large number of agents face payments denominated in a basket of world currencies would face only the risk that the domestic currency would depreciate relative to all other currencies. That would ensure that domestic exchange-rate risks would come to reflect more closely developments not in the US or other regions of the world economy, but in the domestic economy. Those are developments over which national policy makers have direct influence, and for which they bear direct responsibility. Lower measures of exchange-rate risk in turn would leave national authorities with greater scopes for pursuing a variety of macroeconomic, social, or industrial-policy objectives.
With all international commercial payments and financial flows denominated in its own unit of account, the MCU would be in a unique position to support the development of sustainable patterns of trade and investment — and it could do so in ways that avoid the biases present in previous international monetary systems.
As imbalances in payments arise from international trade and investment, the MCU could readily accommodate the need for credit or liquidity from economies experiencing deficits through its own unit of account—on terms that would be reliable and well known in advance to all. The objective would be to create a system where national authorities not only have more policy influence over the risk of destabilising movements in their exchange rate, but also know the costs of dealing with such outcomes in advance. That would represent a significant improvement on current arrangements, under which economies experiencing deficits wishing to forestall a currency crisis must draw either on previously accumulated reserves that are costly, or start cumbersome and onerous processes to obtain Dollar loans from Washington-based institutions. It would contribute to a better environment for domestic macroeconomic policy choices and tradeoffs, generally expanding the policy space facing developing country governments.
Along similar lines, the MCU would help ensure that potentially destabilising imbalances are not understood and addressed exclusively as problems of the economies running deficits. In fact, from the perspective of the MCU, those imbalances would appear as decreases in the holdings of MCU units by economies experiencing deficits, and as equivalent increases of MCU holdings by economies experiencing surpluses. Since both sides of all international imbalances appear on its own balance sheet, the MCU would be in a unique position to help address them in a balanced fashion, in line with collectively stipulated policy values.
Over short time horizons, the MCU could develop mechanisms to prevent persistent increases or decreases in holdings of its units by national economies, including by imposing financial costs on economies running persistently large national imbalances, be they debits or credits. It could also limit the size of positive MCU balances any country can hold, which would automatically also limit the total size of negative MCU balances across all countries. This may be done by committing all national authorities either to using excess MCU holdings in international commercial or capital transactions, or to exchanging them for domestic currency – putting upward pressure on its valuation, and thereby moderating international demand for domestic goods and assets. Similar measures aimed at offsetting rapid growth or decreases in MCU holdings could also help prevent potentially destabilising capital flows.
Over longer time spans, the MCU could develop ways to draw on positive MCU holdings to support investments in economies experiencing persistent pressures on their trade balance, supporting projects that contribute to narrowing productivity gaps. Seen from the global, systemic perspective of an MCU, persistent differences in productivity and living standards across national economies are sources of systemic instability demanding collective policy responses. By helping make this reality clear, the MCU would make an invaluable change in the way multilateral development policy is conceived and implemented.
A Journey of a Thousand Steps
The institutional solution sketched out above represents an ambitious goal that faces a number of important political and institutional difficulties. There is resistance to reform by politically powerful constituencies in the global economy that benefit from the status quo. Any new initiative will sooner or later face the challenge of defining its relationship with existing institutions like the IMF and the World Bank. And any MCU will face the challenging task of developing specific mechanisms for encouraging long-term stability in international trade and finance, in ways that are institutionally sustainable.
These difficulties notwithstanding, the case for radical reform is compelling.
Dissatisfaction with the international Dollar standard and concerns with the economic, policy, and political powers it bestows on any US administration are growing. Patterns of trade and investment have changed radically in recent decades, with direct commercial and financial linkages among developing countries growing rapidly. In an increasingly decentralised network of international trade and investment, the fundamental inadequacies of a single, national currency are increasingly evident. The growing relative weight of developing countries in the international economy also means that key constituencies that would likely benefit from reform have greater institutional and political capacities to push for a more equitable, multilateral system.
Perhaps most poignantly, in light of recent geopolitical events, movement toward a genuinely multilateral international monetary system can ensure that the substitution of the Dollar is not caught up in the kind of great-power politics that accompanied the demise of the British Pound’s role at the centre of the international monetary system. Instead, work towards the development of an MCU can be rightly understood as the start of a broader process of building an equitable, multilateral collective system of global economic governance for a world of fundamentally interdependent nation states.