This article is excerpted from the January/February 2016 issue of Dollars & Sense magazine.
Change Without Change
The Bretton Woods rules of the game worked fairly well for twenty-five years. In fact, from the perspective of the United States one might say they worked too well. While the Bretton Woods system promoted U.S. commerce, opening up trade and investment opportunities around the (capitalist) world, it also provided a stability in global affairs in which firms based elsewhere—in Japan and Europe—were able to also expand and ultimately challenge the dominant position of U.S firms.
A critical juncture in global commercial arrangements then came in 1971: the Bretton Woods system fell apart. A combination of heavy spending abroad by the U.S. government (on the Vietnam War), the economic challenge from other rich countries, and inflation in the United States led the U.S. government to drop its promise of redeeming dollars for gold. Yet, while the system fell apart, there was surprisingly little change in international trade and investment. The relative economic and military power of the United States, though not as extreme as it had been in the immediate post-World War II era, continued. And the perceived threat of the Soviet Union served as a glue, binding the world’s major capitalist powers in Europe and Asia to the United States, and leading them to accept continued U.S. economic, as well as military, dominance.
After 1971, various new arrangements were put in place—for example, a system of partially managed “pegs” was established. Yet the dollar remained the central currency of global commerce. Prices of internationally traded goods—most importantly oil—continued to be set in dollars, and countries continued to hold their reserves in dollars.
Although 1971 marked the beginning of a new era in international financial arrangements, the dollar retained its dominant position. Regardless of the various economic problems in the United States, the dollar has remained both relatively stable and in sufficient supply to grease the wheels of international commerce. Indeed, an ironic example of the continuing role of the dollar came in the Great Recession that began in 2008. Even while the U.S. economy was in the doldrums, businesses and governments elsewhere in the world were buying U.S. government bonds—a principal means of holding their reserves in dollars—since they still considered these the safest assets available.
Power and a Symbol of Power
In years leading up to the Great Recession, China had entered the global for-profit economy and was exporting at a high rate, exceeding its imports. The Chinese government used the extra money that China was obtaining from its trade surplus to heavily invest in U.S. government bonds. That is, China built up extensive reserves in dollars. In effect, China was loaning money to the United States—loans which filled both the federal budget deficit and the U.S trade deficit. What many observers decried as a dangerous situation—We are becoming indebted to the Chinese! Horror!—in fact served both the U.S. and Chinese governments quite well.
The international role of the dollar is a symbol of U.S. power and is based on that power. At the same time, the dollar’s role works to enhance that power, giving the U.S. government and U.S. business the liquidity needed for carrying out global operations—everything from wars to benign commerce.
There are problems with the system. The continued role of the dollar depends to a large extent on the avoidance of significant inflation in the United States. Yet restraints on inflation—e.g., the Federal Reserve raising interest rates—generally work against expanding employment. So maintaining the role of the dollar can come at the expense of most people in the country.
Also, there is always the risk of change. Just as the position of the dollar supports U.S. power in world affairs, if that position is undermined, U.S. power would suffer. In recent years, there has been some threat that other governments would challenge the dollar with their own currencies. China, in particular, has attempted to establish its own positon in world affairs, which, if successful, could ultimately undercut the dominance of the dollar. Indeed, the fear associated with China holding reserves in dollars (i.e., as U.S. government bonds) is to some extent based on concern about the potential implications of China shifting out of dollars (or threatening to do so). Yet, especially with the recent weakening of the Chinese economy, this particular challenge does not appear likely in the near future.
Over the last several decades, the role of the dollar in world affairs has become like the role of the English language. Both developed as a consequence of the extreme power of the United States in the global economy, and both give advantages to the U.S. government, to U.S. firms, and to any individuals engaged in international activities. Most important, the roles of both the dollar and the English language have become thoroughly entrenched. Even as the power of the United States weakens, then, those roles are likely to continue for some time to come.
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