And the dollar reigns supreme
December 14, 2019
In recent years, both the Obama and Trump administrations have taken actions that undermine its international role, and yet the dollar retains its totally dominant position. Dreams of alternatives (SDR, renmimbi, euro) remain dreams and are likely to remain dreams for many years, possible decades to come. It is our problem, as the saying goes.
In order to achieve international status, a currency must fulfill four conditions.
Its value must be stable, which means low inflation.
It must belong to a large country that weighs heavily in global trade and finance.
It must sit on top of deep and efficient financial markets, which are smartly regulated under an independent judiciary.
It must be seen as a benevolent monopoly.
In order to challenge the existing leading currency, another currency must not just fulfill the same conditions. Its country must be seen on the ascent and, crucially, the current leader must make blunders that undermine the appeal of its currency.
For a long time, the dollar mostly was a benevolent dictator, even though the US was occasionally using its “exorbitant privilege” to achieve economic or political aims. The US authorities were aware that a currency’s international status is not God-given forever, it has to be earned every day. For example, during the 2008 global financial crisis, they treated the local subsidiaries of large foreign banks in the same way as they treated their own banks. They also provided substantial swaps – loans that could be called in instantaneously – in dollar to central banks of countries that housed large banks.
Yet, recently, the US has started to use more systematically the dollar for political ends. As it decided to crack down on tax evasion, it has passed the infamous FATCA, which forces foreign banks to report deposits of US citizens to their tax authorities and it imposes fines for past non-reporting. Forced to choose between betraying its customers to obey the US law and cutting all links to US financial markets, all but a few foreign banks decided to go along. The US has also punished foreign banks that were circumventing its embargoes, especially against Iran. This extra-territorial imposition of US legislation is raising eyebrows, not just in China and Russia, but also in countries that have long seen themselves as allies or friends. The European Commission has tried very hard to circumvent the commercial and financial sanctions against Iran imposed by Trump since he singlehandedly cancelled the Obama era Joint Comprehensive Plan of Action agreed upon between Iran, the US and the EU, along with China, France, Germany Russia, and the UK. Such is the power of the dollar that the European Commission failed to come up with an effective solution.
These are but a few examples of US extraterritorial actions. Alongside with the declining relative economic size of the US, they provide a strong incentive for challenging the international role of the dollar. Incentives, however, do not deliver relevant actions. At this stage, owing to the size of their economies, two currencies can pretend to mount a challenge to the dollar, the Chinese renmimbi and the euro.
China has not hidden its intent of doing so. Three years ago, after intense lobbying, the renmimbi joined four other currencies that define the IMF’s Special Drawing Rights (SDR). The Chinese authorities were elated. They saw this event as a first stage of the long march of the renmimbi toward becoming an international currency, possible the international currency. This showed that they misunderstood what an international currency is. The renmimbi remains largely an unconvertible currency, the largest Chinese banks are state-owned and the financial markets are neither free from public interference nor backed by effective and transparent regulation and oversight. A currency that is subject to government interference, in a country where there exist few checks and balances, does not stand any chance of becoming an international standard, and there is no indication that matters are about to change.
In theory, the euro could become a serious challenger. In fact, when it was launched, a number of observers thought that it would happen quite soon. Twenty years down the road, it hasn’t happened. There is even evidence that the share of the euro in international trade and finance, which initially grew as it replaced its constituent currencies, has receded over the last decade. Part of the reason, of course, is the debt crisis that has hit the Euro Area in 2010. The crisis has shown a number of flaws in its architecture: no crisis planning and relevant procedures, including the absence of a lender in last resort, the lack of adequate banking supervision, the failure of the Stability and Growth Pact to achieve fiscal discipline as intended, and surprising deep political divisions. The result has been contagion and a double dip when recession returned shortly after the global financial crisis. The associated doubts about the survival of the euro could only hurt its international currency status. Over the next decade, a number of reforms have started to plug some, but all of the holes. The architecture remains incomplete and lingering political divisions, especially between the North and the South of the area, do not bode well for completing the Banking Union, establishing a Capital Market Union and adopting an effective fiscal discipline framework. Until these steps are taken, the euro stands no chance of becoming a truly international currency, beyond the area neighborhood.
Finally, ever since Keynes tried to promote an international currency under IMF auspices, the idea occasionally resurfaces as it is suggested that the SDR could fulfill that role. Currently, the SDR is not a currency. It can only be exchanged among central banks. IMF can only issue SDRs when its membership agrees, which rarely happens. For the SDR to become a currency, two transformative steps would have to be taken: it should circulate in the private sector and the IMF should become a central bank. This is not going to happen. Simply looking at the travails of the ECB, which serves 19 rather similar and tightly integrated countries, it should be obvious that the transformation is out of reach.
So, we are stuck with the dollar. Since the link with gold was severed in 1971, the dollar has served the world well, which does not mean perfectly. Globalization has brought more trade and financial integration than ever, albeit with few jolts, allowing a number of poor countries to become emerging countries. The US has not abused its privileges too often, until recently. The fear is that the combination of rising protectionism in the US and the absence of any potential competitor might lead to more abuse, which would not usher a replacement in but stands to lead to a dangerous erosion of global trade and financial integration. Could that convince European leaders to become less inward-looking and fix the euro?
 The argument was spelled out in Richard Ports and Hélène Rey “The emergence of the euro as an international currency”, Economic Policy, 1998.
 Matteo Maggiori, Brent Neiman, and Jesse Schreger “The Rise of the Dollar and Fall of the Euro as International Currencies”, American Economic Review, May 2019.