The Dollar: Exorbitant or Extortionate Privilege?

The US Dollar has probably been the closest thing to a true global currency that the world has ever seen. For decades, the use of the US Dollar has been absolutely dominant in international trade. This has had tremendous benefits for the US financial system and for US consumers, and it has given the US government tremendous power and influence around the globe. But there are big changes on the horizon.

The soaring US debt now risks undermining the Dollar and its enjoyment of its exorbitant privilege, jeopardising the global economy. “The Dollar may be our currency, but it’s your problem”, is a phrase that John Connolly, US Treasury Secretary under President Nixon, used to a delegation of European visitors in 1971.  John Connolly’s statement still has a ring to it but the Dollar is losing its status as the world’s reserve currency. A reserve currency has to be stable to be effective, and for some time now, it has been clear that the US Dollar is losing the confidence of global markets. That privilege now is not only “exorbitant” but “extortionate”. How long the rest of world will allow the US to exercise this extortionate privilege is uncertain.

Republican presidential candidates have been very critical of the Federal Reserve having ominous powers that Congress barely understands and that trillions of Dollars can be created and injected into the economy with no obligation by the Federal Reserve to reveal who benefits. The US Dollar depreciation has been blamed on the Greenspan and Bernanke Federal Reserve which has imposed an unwanted monetary system that is beneficial for Wall Street.

The Federal Reserve’s quantitative easing has undermined the credibility of US financial diplomacy and has been seen as a welfare system for finance. What was the German reaction to the Fed’s massive quantitative easing plan? Germany’s finance minister, Wolfgang Schaeuble commented, “With all due respect, US policy is clueless.” Schaeuble said the issues that the Fed’s policy attempts to address are not the country’s fundamental problems. Quantitative easing is designed to lower interest rates: it makes the yield on treasury bonds go down, and then lower rates spread, in theory, to the rest of the economy. In Schaeuble’s words, it promotes liquidity, or the ease with which money moves around. It also promotes inflation, which, like low interest rates, theoretically encourages people to spend money now.

The Dollar’s resilience has been questioned at least three times in the post-war era – in the 1960s as gold reserves ran short, amid Japan’s rise in the 1980s, and during the emergence of the Euro in the late 1990s. The Dollar has always rebounded in a reflection of US economic prowess, unrivalled liquidity and stability of US financial markets and scale are benefits of the Dollar in global transactions.

BRICS (Brazil, Russia, India, China & South Africa) represent countries that have more than 41 percent of the world’s population and contribute 20 percent of the global economy and have recently signed a pact that they hope will reduce the demand for fully convertible currencies, such as the Dollar, for trade among BRICS nations. The agreement will allow credit in local currencies among BRICS export-import banks to boost trade. The internal trade among the BRICS nations, now at $230 billion, is growing at an average of 28 percent a year, and the coalition hopes to increase it to $500 billion by 2015.

The importance of the US Dollar’s predominance in global trade cannot be over-stated. Being the major global reserve currency supports the Dollar even though the US keeps borrowing and expanding its money supply. So the US is acutely sensitive to any signs that such reserve status is under threat. The BRICS countries are signing agreements to grant one another loans in their national currencies, not in Dollars. The Chinese Development Bank has formally offered 10bn Renminbi loans to other BRICS members, expected to focus on large oil and gas projects. Russia and China are now trading oil in Rubles, rather than Dollars. A Sino-Russia oil pipeline recently opened which will eventually pump 1bn barrels a year from Siberia to China. It will soon be joined by a gas pipeline too. These developments undermine the Dollar’s role as the global currency in which commodities are denominated, the bedrock of its reserve currency status.

The potential geopolitical implications of Dollar decline are immense. The US would lose its privileged/seigniorage position and with that the ability to achieve permanently higher returns on foreign assets than the returns paid to foreigners who invest in the US. A much cheaper Dollar will make the US poorer, since Americans will pay higher prices for everything they buy from abroad – such as clothes, computers, cars, toys, food. It will make the US military presence abroad more expensive, since the cost of contractors and local suppliers will escalate in Dollar terms. So the reign of the US Dollar as the world reserve currency is definitely being threatened, and the coming shift in international trade is going to have massive implications for the US economy.