The Dollar’s Primacy
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- Authors: JOSEPH JOYCE
- Published: March 1, 2022
Background and context
- When the COVID-19 pandemic triggered a “risk-off” flight of capital in the spring of 2020, private investors and financial institutions turned to US Treasury bonds as the alternative “safe asset.”
- The retreat from financial markets was soon reversed, in part because of the Federal Reserve’s formidable response to the threat of a global financial collapse.
- Fifty years after President Richard Nixon cut the link between gold and the dollar reserves held by foreign central banks, the US dollar continues to play a predominant role in the global financial system, with enormous spillover effects for US monetary policy.
- Author and reviewer: JOSEPH P. JOYCE, professor of economics, Wellesley College; review of Anthony Elson’s The Global Currency Power of the US Dollar: Problems and Prospects.
Reasons for the dollar’s predominance
- Historical roots: emergence of the United States as the world’s largest economy after World War II.
- Market structure: US financial markets are unequaled in terms of breadth and liquidity, which reinforces the use of the dollar in financial transactions.
- Network effect: the widespread usage of the dollar provides an incentive for new users also to adopt it.
Benefits of a dollar-based system
- US international traders and investors avoid the cost of foreign exchange transactions and exchange rate risk.
- The US government can continue to run fiscal deficits with low interest rates because of the demand for US securities.
- The cutoff of access to the dollar-based global banking network through sanctions serves as a valuable foreign policy tool.
Vulnerabilities and risks
- Dependence on fiscal deficits to supply safe assets to the world creates a “new Triffin dilemma.”
- Raises the question of whether there is a threshold of debt that would trigger concerns about the sustainability of the US debt.
- These concerns may become manifest if interest rates rise in 2022 as the Federal Reserve responds to inflation.
- Any increases in US interest rates will raise the cost to foreign governments of refinancing their external debt.
Potential alternatives and their constraints
- Multiple reserve currency system:
- A system including the euro and the Chinese yuan could have advantages over the existing dollar-based system.
- A number of conditions must be met before those currencies gain more acceptance, and the pace of adaptation and change is expected to be slow.
- Expanded use of the IMF’s Special Drawing Rights:
- Depends on reforms in the IMF’s operations and its voting structure, which must be negotiated.
- Digital currencies:
- Central banks are actively exploring the use of electronic means of payment.
- If a system of payments for international transactions emerges that is seen as safe, stable, and not dependent on any one country, then the dollar’s central role may be replaced by a different form of money altogether.
Overview based on The Global Currency Power of the US Dollar: Problems and Prospects, reviewed in F&D Magazine by JOSEPH P. JOYCE.
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