Dollar Hegemony Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The U.S. dollar is the anchor currency in the international system. The dollar’s hegemony depends not just on the economics of its being the major reserve currency, but also on the political condition that it is the currency of the hegemon in the international system—the United States. An economic system depends for stability on the structural/positional power of the hegemon as the leader. The hegemon has the power and capability to define the rules of the game, provide for the anchor currency, and act as the lender of last resort. It undertakes the tasks of supervision and management of the system, as this control provides it with significant economic benefits and political influence. The system continues to be stable so long as a majority of other states perceive it to be mutually beneficial. However, stability is not synonymous with equitable distribution of welfare among the states.

After World War II, the United States instituted the Bretton Woods regime as the framework for an international economy. According to the rules of this regime, a pegged exchange rate of $35 for an ounce of gold was established. This dollar-gold exchange standard collapsed in 1971 due to several reasons. First, as the United States lost its advantage in trade due to international competition, its current account deficits started to rise. The United States, however, was not interested in curbing its growth or social welfare through austerity measures.

Second, given the U.S. desire to maintain policy autonomy of expansion by exercising its privilege to print money, the peg was no longer viable. The consequence of this was that the available liquidity of currency in the system surpassed the gold reserves. Finally, with deficits on the rise in the United States, domestic inflationary pressures increased. This brought the dollar under speculative attack of investors who had lost confidence in the U.S. ability to maintain the peg, resulting in the dollar’s devaluation. This galvanized countries like France to convert their dollar reserves into gold. Facing these kinds of pressures, the Nixon government found it politically expedient to rescind the U.S. commitment to the peg. The international monetary system then experienced the rise of the floating exchange rate with market exchanges determining the value of a currency.

However, even though the dollar was no longer the de jure hegemonic currency, it became the de facto hegemonic currency for several reasons. First, with the development of deep financial markets in the West, particularly the Euromarket in 1960s, the dollar had become the most traded currency. Second, the American economy provided enormous investment opportunities to the rest of the world because of its excellent regulatory institutional environment. This capital inflow from the developed and the developing world enabled the United States to finance its trade and fiscal deficits by borrowing heavily from the capital markets. It did this by selling government bonds at cheap interest rates.

Third, many countries in southeast Asia, Latin America, and the Gulf had their currencies pegged to the dollar to provide for exchange rate stability. Fourth, whenever there were windfall profits in the primary commodity market of oil, petrodollars accumulated. This provided for additional sources of liquidity in the system and countries without high rates of domestic savings, like Latin America, borrowed in hard currency at cheaper interest rates to propel growth. Since these countries had their currencies pegged to the dollar, their fortunes were tied to changes in the fortunes of the dollar. This created potential sources of financial crises as changes in U.S. interest rates and the value of the dollar created unpredictable swings in these countries’ currencies and consequent capital flight. Fifth, with increasing financial crises across the world, the major emerging economies like China and India were invested in building up huge dollar reserves as a buffer against crises.

Finally, the American economy is the largest consumer economy in the world. This means that the majority of the world is dependent on exports to the United States. Consequently, major exporting economies like China are invested in keeping their currencies depreciated against the dollar to boost exports. This enables the dollar’s value to be propped up by artificial measures of sterilization (buying up hard currency inflows with local currency) undertaken by these economies.

Alternatives

Over the years, two alternative currencies have emerged as contenders to the dollar—the euro and the yen. However, despite the shift in portfolio allocation by investors with changing shifts in market expectations about currency values, the dollar continues to rule for several reasons. First, Japan is dependent on the United States for strategic reasons of protection from its neighbor China. It also has huge investments in assets in the United States. Consequently, it is not in Japan’s interest to allow the dollar’s value to precipitate drastically (a phenomenon called “hard landing”). Second, both Japan and the EU are major trading partners of the United States, and hence, cannot afford to allow the dollar and the U.S. economy to collapse. Consequently, throughout post-1970s period, the G-7 countries’ central banks have coordinated to ensure that the dollar’s hegemony is maintained by propping up its value every time there is a threat of serious dollar depreciation. Third, given that the dollar represents a liquidity that cannot be parked elsewhere, most countries cannot dump their dollar reserves without significant loss of value. Finally, despite growing attempts to create currency pegs to a basket of currencies, as China has sought to do with the yuan, most countries believe that besides the dollar there is really no good alternative.

Impact

What are the consequences of dollar hegemony in terms of world welfare? Due to global interdependence of economies, other countries dependent on the U.S. economy have to bear the burden of adjustment of the spillovers of economic outcomes in the United States. Dollar hegemony enables the United States to maintain its policy autonomy, pursue inflationary policies, and externalize the burden of inflation onto others. This has often forced other countries to pursue policy austerity of high interest rates and stringent fiscal cutbacks to ensure that they can draw in capital. The curtailing of fiscal expenditure impacts distributive issues of consumption within a country. Countries have also been forced to build dollar reserves to ensure that capital flight does not affect them. This means that their gains from trade cannot be used for distributive purposes inside their countries.

A current example of the impact of dollar hegemony is the effect of an emerging recession in the U.S. economy on the rest of the world. The securitization crises, the depreciation of the dollar, and growing recession in the United States have forced countries to lower their interest rates to prevent speculative capital inflows from overwhelming the stability of their economies. This has added to the growing inflationary spiral around the world as consumers borrow and spend heavily due to the sudden increase in domestic credit. This has added to the current crises of rising food prices and emerging famines in vulnerable economies.

Bibliography:

“Economic Focus: A Tale of Two Worlds,” Economist (May 10–16, 2008);
“Economic Focus: Policing the Frontiers of Finance,” Economist (April 12–18, 2008);
Jean Gabriel, The Dollar Hegemony: Dollar, Dollarization, and Progress (Writers Club Press, 2000);
Eric Helleiner, States and the Reemergence of Global Finance: From Bretton Woods to the 1990s (Cornell University Press, 1996);
Henry Liu, US Dollar Hegemony Has Got to Go (Asia Times Online Co. Ltd., 2002);
“The Great American Slowdown,” Economist (April 12–18, 2008).

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