Thursday, January 3, 2013

Will the U.S. Dollar Lose its Preeminence?

I get asked once a month or so if the U.S. dollar is likely to lose its global preeminence.  John Williamson has a nice discussion of this topic in "The Dollar and US Power," which is available at the website of the Peterson Institute of International Economics.

Williamson first points out that the dollar is indeed the preeminent global currency (citations omitted): " The US dollar is absolutely dominant as the intervention currency: Most countries intervene in nothing except dollars. It is the major unit in which about 60 percent of official foreign exchange reserves are held ... It was estimated in the past that close to a half of all international trade was invoiced in dollars (Hartmann 1998), as opposed to under 12 percent of world trade that involved
the United States in 2011. So far as foreign exchange trading is concerned, most takes place against the dollar, resulting in a share of foreign exchange trading of about 85 percent ... For the moment, the dollar is quite unrivalled."

How does the preeminence of the U.S. dollar benefit the U.S. economy? Williamson points out the classic tradeoff. On one side, the advantages of "seignorage;" on the other side, an inability to control one's own exchange rate. Here's Williamson on seignorage:

"The standard economic analysis holds that the United States gains by international use of the dollar because of the collection of seigniorage. Historically the term seigniorage meant the ability of the sovereign to make a profit when it minted metal into money. In our context the term is used to signify the ability to make a profit from international holding of the currency. There are generally reckoned to be two sources of profit from foreign holdings of the dollar. One arises from holdings of dollar bills (in practice, $100 bills) by foreigners (in practice, mainly drug dealers): In effect, the US gains an interest-free loan to the extent that foreigners hold dollar bills. The other arises from the fact that many foreigners wish to hold dollar assets. The preferred form of assets are US Treasury bills, and therefore the interest rate on US Treasury bills is somewhat lower than it otherwise would be; and the saving is regarded as a part of seigniorage."
However, the gains from zero-interest loan of the use of U.S. currency to drug dealers, along with those who borrow in U.S. dollars getting an interest rate that's a tiny bit lower, are not large. The tradeoff is that when everyone else is using your currency, then the exchange rate value of that currency will be largely determined in global markets.

Williamson also tackles the question of whether the preeminence of the U.S. dollar gives the U.S. government additional power in the practical world of power politics. He writes:"I have the impression that the additional national power which stems from commanding an international currency tends to be exaggerated by strategic thinkers. One needs to designate the specific mechanisms which would be involved rather than assuming the result."

The one possible exception, he argues, is that a U.S. dollar standard might make it more possible for the U.S. government to enforce financial sanctions on unfriendly governments. "It is difficult to see how US power in many dimensions is enhanced by virtue of the widespread private international use of the dollar. For example, the US ability to wage war in Iraq and Afghanistan was in no way dependent upon private international use of the dollar. ... There seems to be one large exception: the ability of a country to enforce a financial blockade, such as that currently directed against specified Iranian entities. ... The United States can order its own companies not to do business with Iran, but this power is present in any sovereign government and is in no way dependent on the role of the dollar. But because third countries generally pay Iran in dollars, the United States government does have additional leverage. Any payment in dollars ultimately involves a transfer on the books of the Federal Reserve banks ...  The Fed can require that any institution for which it does business has to certify that it either has no prohibited connection with Iran or is in receipt of a waiver. They can similarly require that an institution that contracts with the Fed impose similar requirements on the institutions on behalf of which they are acting. (Of course, the Fed does not inspect each transaction, but depends upon financial institutions to do the screening, with stiff penalties possible if prohibited transactions slip through. A recent example occurred when Standard Chartered Bank was accused by the New York state Department of Financial Services of having hidden some $250 billion of financial transactions with Iran.) Thus the United States has the ability to stop transactions in terms of dollars. Insofar as foreign institutions insist on paying out of their dollar holdings, and/or Iran insists on receiving dollars, Iran is going to be vulnerable to US pressure."

In a global economy where the total size of China's economy will probably exceed that of the U.S. within the next few years, can the U.S. dollar stay on top? As Williamson points out, the key issue here is not the size of a nation's domestic economy, but rather the fact that  the U.S. dollar is already being extensively used for international transactions gives it a kind of momentum, making it likely that it will continue being used for this purpose for at least a few decades into the future. Williamson writes:
"Those who wish to transact in this [global] market are not greatly interested in the fact that the good citizens of Idaho overwhelmingly use the dollar, but they are vitally interested in the fact that the dollar is already used extensively in London, Frankfurt, Dubai, Singapore, Hong Kong, and wherever else international trades are executed. This factor gives a great deal of inertia to the international role of currencies. Because of inertia, I see the dollar having a great advantage over any other national currency for the next quarter of a century. (However, I would hesitate to forecast for as long as 50 years.)"
Similarly to Williamson, I don't see the global preeminence of the U.S. dollar as a large-scale advantage for the U.S. economy, although it should make it at least a little easier for U.S. banks and firms to operate in world markets. One can draw up schemes and scenarios in which the U.S. dollar is replaced by some mix of the euro, China's renminbi yuan, Japan's yen, India's rupee, and perhaps a few others. But such a change would require an enormously high level of international financial cooperation, and thus seems highly unlikely. By default, the U.S. dollar seems likely to remain the preeminent global currency for some decades to come.