Our Dollar, Your Problem

1. The Dollar's Unprecedented Global Reign

The dollar is the undisputed lingua franca of today’s highly globalized trade and financial markets.

Unrivaled dominance. The U.S. dollar holds a position of global financial supremacy unlike any currency before it, including the Spanish "pieces of eight" or the British pound sterling. Its reign, now over a century old, is considered "late middle-aged" but still robust. This dominance extends across various metrics:

• 90% of foreign exchange transactions involve the dollar.
• Almost 60% of foreign exchange reserves are held in U.S. dollars.
• 80% of global oil trade and over 40% of global goods trade are priced in dollars.

Network effects. The dollar's pervasive use creates powerful network effects, making it incredibly convenient for international trade and finance. Its role as a "vehicle currency" means it's often cheaper to convert one foreign currency to another via the dollar than directly. This convenience solidifies its status as the global common language of commerce.

Foundational strengths. The dollar's dominance is rooted in several enduring U.S. strengths:

• The U.S. economy remains the world's largest (by market exchange rates).
• Its financial markets are the deepest, most liquid, and most open.
• A strong rule of law offers superior protection for foreign investors.
• The U.S. university system and immigration policies attract global talent and capital.

2. Past Challengers Faltered

The Soviet Union might once have been a serious challenger to the United States militarily, but it never came close to being a serious challenger economically.

Soviet central planning failed. Despite initial impressive growth and technological feats (like space travel), the Soviet Union's centrally planned economy proved too inflexible and corruption-prone to compete with market economies. Its inconvertible ruble never gained significant international traction beyond its bloc, ultimately collapsing with the USSR.

Japan's bubble burst. From the late 1970s to early 1990s, Japan was widely feared as an economic rival, with superior manufacturing and a sophisticated financial system. However, U.S. pressure via the 1985 Plaza Accord forced a sharp yen appreciation, fueling an asset bubble that eventually imploded in the early 1990s. This, combined with:

• Diminishing returns on investment.
• Demographic decline.
• Rising competition from other Asian economies.
  Japan's economic dynamism stalled, and the yen never became a global challenger.

The Euro's regional focus. The euro's creation was a remarkable political achievement aimed at fostering peace and economic integration in Europe. While successful regionally, it remains largely confined to Europe due to:

• Balkanized government debt markets.
• Lack of a strong central fiscal authority.
• Absence of a fully integrated banking union.
• Slower economic growth compared to the U.S.
  The 2010-2012 European debt crisis further exposed its vulnerabilities, preventing it from truly rivaling the dollar globally.

3. China: The Present-Day Contender's Limits

China’s growth problems are only partly due to diminishing returns from investment.

Spectacular but slowing growth. China's economic transformation has been monumental, lifting hundreds of millions from poverty and making it the world's second-largest economy (or largest by PPP). However, its growth model, heavily reliant on real estate and infrastructure investment, is facing severe diminishing returns. This is evident in:

• Real estate and infrastructure accounting for 25-31% of GDP, higher than pre-crisis Spain or Ireland.
• Overbuilding in "tier 3" cities, leading to falling prices and empty properties.
• Local government financing vehicles (LGFVs) accumulating massive off-balance-sheet debt.

Multiple headwinds. Beyond real estate, China faces other significant challenges that will likely slow its growth trajectory:

• Slowing productivity gains as it reaches the technology frontier.
• Increasing centralization of authority under Xi Jinping, prioritizing political loyalty over technocratic merit.
• Demographic decline due to past policies and high living costs.
• Deglobalization trends and Western "homeshoring" policies.

Dollar decoupling inevitable. While China's economy may not eclipse the U.S. as quickly as once predicted, its strategic interest lies in decoupling the renminbi from the dollar. China is already:

• Pricing more trade in renminbi.
• Experimenting with renminbi swap lines.
• Developing its own central bank digital currency (e-CNY) and parallel payment rails to circumvent potential U.S. sanctions.

4. The Perilous Allure of Fixed Exchange Rates

The problem with having a rigidly fixed exchange rate against the dollar is that it places tight constraints on a country’s monetary policy, which needs to move interest rates in synch with the Fed.

Stability vs. fragility. Fixed exchange rates offer transparency and simplify trade, making them appealing to many nations, especially those with less trusted domestic currencies. However, they are inherently fragile, often leading to devastating financial crises when they collapse. This is due to the "impossible trinity" (or "trilemma"): a country cannot simultaneously have a fixed exchange rate, open capital markets, and an independent monetary policy.

A history of collapses. The 1990s saw a wave of fixed exchange rate crises:

• Mexico (1994): Peso collapsed by over 50% despite NAFTA, requiring a U.S./IMF bailout.
• Asia (1997-98): Thailand, Indonesia, and Korea suffered massive currency depreciations and deep recessions.
• Russia (1998): Ruble peg collapsed, leading to default and a global financial scare.
• Brazil (1999): Real peg collapsed, though Brazil successfully transitioned to inflation targeting.
• Argentina (2002): Currency board collapsed, leading to the largest sovereign default in history at the time.

The "Mirage" of fixed rates. Experience shows that with relatively open capital markets, rigidly fixed exchange rates rarely last more than five years. Governments often try to maintain them too long, leading to overvalued currencies, unsustainable current account deficits, and eventual speculative attacks that overwhelm central bank reserves and trigger widespread financial distress.

5. Emerging Markets Adapt to Dollar Dominance

By putting a bit more “sand in the wheels” of their financial systems, without necessarily using heavy-handed controls, and by having ample reserves on hand, Asia’s central banks could stabilize exchange rates more effectively than economists had previously imagined.

Learning from crises. Post-1990s crises, many emerging markets, particularly in Asia, adopted a new approach to managing dollar dominance, often termed the "Tokyo Consensus." This involved:

• Massive reserve accumulation: Piling up (mostly) dollar reserves to self-insure against capital flight and avoid IMF programs.
• Improved domestic regulation: Strengthening bank capital requirements to limit dollar-denominated borrowing risks.
• Greater central bank agency: Granting central banks more operational independence to pursue stable monetary policy.

Softening the peg. Instead of rigid pegs, many adopted "managed floats" or "crawling pegs," allowing for modest daily fluctuations while intervening to smooth larger movements. This injected uncertainty for speculators and encouraged domestic firms to hedge currency risk. The goal was to gain some monetary independence without fully floating.

Resilience in recent shocks. This adaptive strategy has shown remarkable success. During the 2008-09 Global Financial Crisis and the 2020 pandemic, large emerging markets generally weathered the storms better than expected, often by allowing their currencies to depreciate to absorb external shocks. This contrasts sharply with their vulnerability in earlier decades.

6. The Illusion of Global Currencies

Without political and fiscal union to complement monetary union, a global currency is a recipe for discord and financial crisis.

Keynes's bancor dream. John Maynard Keynes envisioned a post-WWII global currency ("bancor") issued by a "Clearing Union" to foster cooperation and reduce dollar dependence. This utopian vision, however, was politically unrealistic then and remains so today. A global currency would face far greater challenges than the euro, including:

• Vastly larger income gaps and cultural differences.
• Profound political chasms between nations.
• The inherent difficulty of establishing a global fiscal authority.

SDRs: A pseudo-currency. The IMF's Special Drawing Right (SDR) is the closest existing approximation to a global currency, but it's merely an accounting unit indexed to a basket of major currencies. It's not a true currency, cannot be held by private individuals, and its "money-printing" capacity for aid is often misunderstood:

• SDR allocations are distributed by IMF voting shares, disproportionately benefiting rich nations.
• Funds effectively come from rich countries' contributions, often debt-financed.
• It's a non-transparent aid mechanism, not a magical cost-free solution.

Cryptocurrencies: Underground appeal, limited mainstream. Cryptocurrencies like Bitcoin derive fundamental value from their use in the massive global underground economy (estimated at 17-36% of GDP in many countries). However, they face insurmountable obstacles to mainstream adoption in legal, tax-compliant transactions:

• Governments possess powerful tools to regulate, tax, or appropriate any private currency.
• Exchanges, crucial for user accessibility, are essentially banks and can be regulated.
• Governments can make crypto use difficult and expensive, quashing network effects.
• A Bitcoin standard would reintroduce gold standard problems (deflation, severe crises).

7. The Dollar's "Exorbitant Privilege"

The United States has been able to run immense current account deficits—at times reaching 6 percent of GDP—year after year.

Lower borrowing costs. A primary benefit of dollar dominance is the willingness of foreigners to hold vast quantities of U.S. debt, driving down interest rates for the U.S. government. This is due to:

• The depth and liquidity of U.S. financial markets.
• The perception of U.S. debt as safe and easily tradable.
• Its widespread use as collateral in global financial transactions, creating a "convenience yield."

Financial power and influence. Beyond direct borrowing benefits, dollar hegemony grants the U.S. immense geopolitical leverage:

• Weaponized sanctions: The ability to impose financial sanctions as an alternative to military intervention, as seen with Russia.
• Information access: Privileged access to information on global payments and transactions.
• Rule-setting power: Influence over the rules and policies of international financial markets and institutions.

"Banker to the World." The U.S. acts as the world's financial intermediary, attracting safe foreign capital (often into bonds) and investing it in riskier, higher-return assets abroad (like equities and direct foreign investment). This portfolio composition has historically generated higher returns for U.S. investors, offsetting the accumulation of foreign liabilities.

8. The Hidden Costs of Dollar Hegemony

The United States today spends vastly more on its military than does any other country: 3.7 percent of GDP in 2024.

The military burden. Maintaining global superpower status, which complements currency dominance, comes at an enormous cost. The U.S. military budget far outstrips that of any other nation, and its allies often "free ride" on U.S. defense spending. This disproportionate burden:

• Was 6.8% of GDP in the late 1980s and 11% during the Vietnam War.
• If it returned to 6.8% today, it would mean an additional $900 billion annually.
• Limits resources for domestic social programs, infrastructure, and green transition.

Global insurance provider. The dollar's role as a safe haven means it tends to appreciate during global crises, as capital flows into the U.S. While this offers a "convenience yield" to bondholders, it also means the U.S. effectively provides insurance to the world. This can lead to:

• Disproportionate losses on U.S. foreign investments (which are riskier) during downturns.
• The U.S. "taking it on the chin" when global financial markets are stressed.

Vulnerability to U.S. policy. The world's reliance on the dollar means that U.S. macroeconomic policy missteps can have far-reaching, destabilizing consequences globally. The U.S. does not fully internalize these external costs, potentially leading to:

• Excessive risk-taking in fiscal or monetary policy.
• Unintended ripple effects on other economies.

9. Internal Threats: Debt and Central Bank Independence

The greatest dangers to the dollar supremacy, however, come from within, and it does not matter which party is in power, especially if one or the other has too much of it.

Unsustainable debt trajectory. U.S. government debt has ballooned to 121% of GDP (mid-2024), nearly quadruple its 1980 level, with projections showing it rising to 166% by 2054. This is driven by:

• Political appetite for tax cuts (Republicans) and spending increases (Democrats).
• Rising old-age entitlements (Social Security, Medicare) as the population ages.
• The pervasive belief that "deficits don't matter" due to "lower forever" interest rates.

The "lower forever" fallacy. The notion that real interest rates will remain ultra-low indefinitely is a dangerous complacency. While rates were near zero post-2008, history shows such periods are temporary deviations. Forces pushing rates higher include:

• Massive rise in global debt (public and private).
• Increased investment needs (e.g., climate mitigation, AI infrastructure).
• Reversal of the "peace dividend" and rising geopolitical tensions.
• Aging populations eventually dissaving.

Central bank independence under assault. Trust in the Federal Reserve's commitment to stable inflation is paramount for fiat money. However, Fed independence faces increasing political pressure:

• From the left: Calls for the Fed to tackle inequality, social justice, and climate change, stretching its mandate and instruments.
• From the right: Proposals to curb Fed power, including presidential input on interest rates or drastic staff cuts.
• The risk of "mission creep" dilutes the Fed's primary focus on price stability.

10. The End of the Pax Dollar Era?

If runaway U.S. debt policy continues to crash up against higher real interest rates and geopolitical instability, and if political pressures constrain the Federal Reserve’s ability to consistently tame inflation, it will be everyone’s problem.

A confluence of challenges. The "Pax Dollar" era, characterized by the dollar's unchallenged dominance and relative stability, appears to be peaking. While the dollar won't collapse overnight, its future will likely be marked by:

• Increased competition: China's strategic push for renminbi internationalization, coupled with the rise of cryptocurrencies and central bank digital currencies, offers alternatives to the dollar-centric system.
• Internal vulnerabilities: The U.S.'s unsustainable debt trajectory and the erosion of central bank independence pose the greatest threats.
• Geopolitical fragmentation: Rising global tensions and deglobalization trends will further fragment the financial system, reducing the dollar's universal appeal.

The cost of complacency. The widespread "this time is different" thinking regarding low interest rates and inflation is a dangerous gamble. History shows that periods of high debt and political pressure on central banks often lead to:

• Higher average real interest rates.
• More frequent bouts of inflation.
• Increased financial instability and crises.

Everyone's problem. The dollar's future is not just an American concern. If the U.S. fails to address its internal fiscal and monetary challenges, the resulting volatility will ripple globally, affecting trade, finance, and stability worldwide. The era of the dollar's "exorbitant privilege" may give way to an "exorbitant duty" that the U.S. is increasingly unwilling or unable to bear.

Last updated: August 7, 2025