The Fall of the Dollar Order

Diane B Kunz. Foreign Affairs. Volume 74, Issue 4. July 1995.

During the first quarter of 1995, the dollar plummeted to record lows against the Japanese yen and German mark. A cheaper dollar has brought tourist income to the US, setting off a boom in the service sector. Yet at the same time the declining dollar has made American manufactures more competitive against foreign goods, both at home and abroad. Treasury Secretary Robert Rubin says that a strong dollar is in the US’ national interest but suggests no steps to realize his incantation. Declaring himself helpless against the foreign exchange market turmoil, President Bill Clinton asserts that the ability of government to affect currencies in the short run may be limited. In the end, the administration is indifferent to the slide of the dollar as the premier reserve and trading currency.

A sailor embracing his girl in Times Square amid cheering throngs may be the dominant image of America’s victory in World War II. Today Times Square is full again, but this time with foreign tourists, who crowd into New York and other American cities, eagerly hunting bargains with their ever-strengthening currencies. During the first quarter of 1995, the dollar plummeted to record low against the Japanese yen and German mark A cheaper dollar has brought tourist income to the United States, setting off a boom in the service sector. Yet at the same time the declining dollar has made American manufactures more competitive against foreign goods, both at home and abroad.

All is well, proclaim Clinton administration officials. Treasury Secretary Robert E. Rubin says that “a strong dollar is in the United States’ national interest” but suggests no steps to realize his incantation. Declaring himself helpless against the foreign exchange market turmoil, President Bill Clinton asserts that “the ability of government to affect currencies in the short run may be limited.” In the end, the administration is indifferent to the slide of the dollar as the premier reserve and trading currency.

American domestic prosperity during the Cold War, as Clinton and Rubin hardly seem to recognize, was based on a triad of factors: American domestic economic policy, American security policy, and American foreign economic policy, in particular the role of the dollar. The synergy among these three elements has brought prosperity at home and security abroad. V-E Day marked the beginning of the dollar era. If the administration does not change its laissez-faire dollar policy and cut the budget deficit, boost savings, and take a hard line on trade, the 50th anniversary of V-E Day will signify its collapse.

The Battle of the Plans

The role of the dollar as the pivotal international currency began after 1945 American policymakers understood the need to avoid the political isolation that followed the First World War. They concluded it was equally important to end the economic autarky on which they blamed the Great Depression and the rise of fascism. In their view, the absence of U.S. representatives at the 1920s reparations restructuring conferences and Franklin D. Roosevelt’s destruction of the 1933 World Economic Conference signifed an American abdication of international economic responsibility, which shattered the international economic order. This time the United States would play its proper role.

Not surprisingly, since it held all the financial cards, the United States won the battle of the plans at the July 1944 Bretton Woods conference. The dollar, in fixed relation to gold at $35 an ounce, became central to the postwar financial system. As the United States agreed to make gold available for dollars to foreign governments or central banks at this rate other countries could hold dollars knowing they were as good as gold.

Bretton Woods would have a significant bottom-line impact on the American economy. Throughout the Cold War the United States could settle its international accounts in dollars rather than gold or other currencies. As French President Charles de Gaulle asserted, the power of the dollar “enabled the United States to be indebted to foreign countries free of charge.” Borrowing in other currencies might become attractive but would be more costly because the United States would assume the exchange risk. The dollar’s international role shielded the United States from the controls the International Monetary Fund and international lenders placed on sovereign borrowers. For example, when Britain needed funds in 1976, the price devised by the IMF and United States was submission to insulting fiscal and monetary restrictions. So far the United States has continued to borrow with impunity. But as just one of the pack of nations rather than in a class by itself, the United States would face external restrictions on its fiscal freedom it has not seen since the late nineteenth century.

For instance, like other commodities, oil is priced in dollars, giving the United States virtual immunity from the domestic effects of dollar fluctuations. But oil-producing countries will not long agree to the destruction of the purchasing power of their revenues. In 1973 dollar inflation helped bring on the first oil shocks. The Organization of Petroleum Exporting Countries likely will soon demand that oil be priced in a basket of currencies rather than dollars alone. In that case, a reduction of the dollar’s exchange rate will automatically raise the American domestic price of oil, bringing increased inflation. Additionally, a weaker dollar would raise interest rates on U.S. government securities and thus expand the relentless federal budget deficit.

Because the United States put the dollar at the center of the western monetary system and also made the largest contributions to various international institutions, it received the lion’s share of voting rights in the IMF and World Bank. As a result, the United States grew accustomed to treating multilateral institutions as branches of the federal government; During the Mexican rescue of this year, the Clinton administration virtually ordered the IMF and Bank for International Settlements to tender nearly $28 billion. While some European governments were livid, they acquiesced because the United States is still dominant in international finance. The administration’s failure to support the dollar, in company with other American autarkic actions, weakens the ties that bind the United States and its allies, diminishing the ability of the United States to create a favorable international climate, politically and economically.

Cheap Money

For 25 years American administrations have undermined the role of the dollar for short-term gain. Richard Nixon, like Bill Clinton, took office aware of the burdens but not the benefits of the dollar’s international status. Consumed with creating a domestic economic boom in time for the 1972 election and believing the world would be quintipolar, he jettisoned the Bretton Woods patching devices of his predecessors with a stab at the heart of the international financial order. On August 15, 1971, he closed the gold window, ending the convertibility of the dollar. American gold reserves could no longer support the dollars in circulation. Nixon, for his part, refused to pay the political costs of attracting foreign dollar deposits–higher interest rates and deflationary measures. He also believed that trade and not financial issues would determine the relative position of nations in the future, and he saw no reason to forfeit his domestic well-being to maintain sufficient American gold reserves and preserve Bretton Woods in effect.

Instead, as the United States recorded its first trade deficit since 1940, Nixon and Treasury Secretary John B. Connally blackmailed Western allies into permitting a ten percent dollar devaluation. After three years of intense international financial turmoil (double-digit inflation, oil shocks, the beginning of the Third World debt explosion) the industrial world accepted a managed floating system with the dollar as king. Various attempts to refashion the international financial order, such as the Committee of 20, failed, destroyed by a combination of clashing national perspectives and governmental responses to the oil shocks and recession.

The dollar order survived; in fact, at less cost to Washington. The United States no longer had to make the sacrifices required to maintain gold reserves, back the international system, or fix the price of the dollar. Normally the decision to scuttle a fundamental international commitment is expensive, but not in this case. The continued fact of the Cold War made the United States uniquely important to its allies, giving it additional scope for imperious actions. Because none of its allies would manage the stage for the international financial system, faute de mieux, the United States retained the role at much-reduced cost.

After the financial and military stumbles of Jimmy Carter, Ronald Reagan took office promising a new kind of economics. In practice, supply-side theory hurt the domestic economy, but it fueled a dizzying rise of the dollar. The ever-larger American budget deficits ($400 billion in accumulated deficits for the fiscal years 1982-84 alone) were partly responsible as American borrowing sucked in capital from around the world. At the same time, Federal Reserve Board Chairman Paul A. Volcker raised interest rates to usurious levels. The result was a tidal wave of foreign investment, bringing morning to America. Buoyed by foreign investors, the dollar reached its inflated peak in 1985. Secretary of State George P. Shultz and Treasury Secretary James A. Baker, backed by American allies, orchestrated a series of Group of Seven accords that, between 1985 and 1989, brought the overvalued dollar in line with purchasing power parity. Together with vast improvements in U.S. productivity, this corrective allowed large parts of American industry to regain competitiveness. Because the dollar had been overvalued, the decrease in its international value was relatively cost-free; the surge in American exports more than compensated for the increased price of imports.

But the end of the Cold War meant the end of America’s security card. It is unlikely to get economic freebies from its old allies anymore. Achieving victory on a platform of “it’s the economy, stupid,” Bill Clinton took a narrow view of American economic interests. Despite protests to the contrary, Clinton and his two treasury secretaries, Lloyd M. Bentsen and Robert Rubin, placed a low priority on the dollar’s international role. Instead they saw a debilitated dollar as the most politically acceptable way of dealing with the American trade deficit. Administration officials act as if they lived in 1985, when the dollar had indeed risen to economically unjustified levels. With purchasing power parity of Japanese yen estimated at a mere 180 to the dollar, they sat by as the dollar fell to less than half that level.

A Sterling Failure

Britain’s simultaneous decline as an economic and geopolitical power provides an instructive parallel. Britain’s financial strength in the nineteenth and early twentieth century became an arm of foreign policy. The pound tightly bound the empire and commonwealth to London. London’s control over international finance gave Britain an informal empire that provided national benefits at a much-reduced cost. Invisible exports shielded Britain from its comparative slippage in manufacturing, which began in the late nineteenth century. Dependent on imported food, British governments derived an extra measure of comfort from a strong pound.

After Britain left the gold standard on September 20, 1931, London organized the sterling area of nations, which conducted their trade in sterling and allowed the Bank of England to hold their foreign reserves. Coupled the following year with the imperial preference tariff system, the sterling area allowed Britian, like the United States after 1971, to gain the benefits of being central to an international financial system at reduced cost. Dominating the sterling area lessened the costs of imperial defense and during World War II enabled Britain to appropriate, without discussion, the equivalent of $13.5 billion for wartime expenses from the empire and commonwealth, a sum roughly equivalent to the entire U.S. expenditure on the Marshall Plan.

But Britain could not afford both social democracy and superpower status. Its attempt to have it all led to the balancing act that characterized British foreign financial policy from 1945 to November 20, 1967, when Prime Minister Harold Wilson devalued the pound for the second time since World War II. The sterling area dissolved, and the pound’s international reserve role largely disappeared. Britain’s simultaneous departure from areas “east of Suez,” all but relinquishing its international geopolitical position, was not accidental. Geopolitical power depends on financial power, each of which supports the other.

America’s general indifference to the fate of the dollar is extremely unfortunate. To hang on too long to a currency whose value is beyond one’s resources, like the British, is one thing. To ignore the real benefits of controlling the international currency system is another. As Britain’s poor economic statistics during the Cold War illustrate, devaluing a currency is not an economic panacea. If anything it can serve as an excuse for poorly run industries to avoid the changes required to survive in an increasingly competitive world.

And Then There Were Three

Twenty years ago Nixon managed to shirk American responsibility for the international financial order yet gain increased U.S. leverage. Cold War security needs gave the United States a dominant say in Western councils and provided successive administrations with large margins for error in their economic dealings. At the same time, no heirs to the American international economic mantle had yet emerged.

Now a real possibility of a tripolar world exists. Japan could lead an Asian bloc, while Germany leads in Europe, and the United States remains only with the Americas. With a growing portion of Pacific Rim countries’ debts denominated in yen, holding rapidly depreciating dollars increases the cost of debt payments. The recent tendency among Asian nations to shift their reserves into yen could become self-sustaining: the more countries dump dollars, the lower their value. As the yen area solidifies and the yen becomes the common Pacific currency, Americans will need to sell dollars for yen to conduct business with any Asian nation. Washington will no longer be able to use international demand for dollars for trading and reserve purposes to compensate for its Pacific Rim trade gap, now the locus of the U.S. trade deficit. In 1992, out of an overall trade shortfall of $84.5 billion, $77.2 billion consisted of deficits with Japan, China, and Taiwan. To say that a cheaper dollar will end the trade deficit with the Pacific is to ignore the last five years. A single European currency with Germany as its locomotive (in 1990 Germany per capita trade surplus was the largest in the world) is scheduled to become a reality before the end of the century, making a European trading and currency bloc likely. The death of the dollar order will drastically increase the price of the American dream while simultaneously shattering American global influence.

But this finale is not yet a foregone conclusion. There are sound economic and political reasons for Asians and Europeans to eschew a yen bloc and rigid European currency area, but the administration has to keep the faith. It has to support the dollar not at its overvalued level of the early 1980s, but at a parity that reflects international economic reality. Safeguarding the dollar’s value and bolstering American foreign economic policy is the only guarantee of long-term American domestic prosperity and a crucial factor in establishing international economic and political stability. Without a pronounced shift in Washington’s policy, the decline of the dollar could resurrect the ghosts of the 1930s.