The End of Exorbitant Privilege: Inflation, the Global Dollar and What Comes Next

This post is the first of two parts. 

This year has been rife with anxiety about inflation. Economist Lawrence Summers sent up an early warning flare in March, speculating that debt-financed government coronavirus pandemic relief payments could overheat the economy. Summers got some vindication from consumer price index numbers this summer, including 5.4% annualized CPI growth in June.

Inflation terrifies people for a lot of reasons, including its erosion of the purchasing power of wages and the value of dollar-denominated debt. But in May, a leading foreign exchange trader named Stanley Druckenmiller warned of an even bigger long-term risk of inflation: That it might threaten the U.S. dollar’s status as the world’s dominant “reserve currency.” The U.S. dollar is overwhelmingly the preferred currency for international trade – for instance, the huge global oil trade is dollar denominated and settled. The dollar is also the most widely held foreign currency in central banks. This produces major economic benefits for Americans – what has come to be known as the “exorbitant privilege” of the dollar – and its decline could harm the U.S. economy.

We’re still miles away from the kind of hyperinflation that can truly wreck a currency or an economy – Argentina is currently dealing with 50% inflation, for comparison. There’s also a lot of evidence that current U.S. inflation is highly concentrated in a few sectors, and bond investors have remained stubbornly skeptical of inflation doomsaying.

But whether inflation pushes things along or not, it’s clear the dollar’s reserve status is already under pressure. In May, the dollar’s share of global reserves dropped to a 25-year low. Since 1999, the dollar’s share has dropped from about 71% to just below 60%.

And the competition is only heating up. The eurozone has begun issuing debt that could make it a more viable reserve. China has spent more than a decade trying to make its currency more appealing internationally – including, some observers argue, through its creation of a central bank digital currency (CBDC). And the adoption of bitcoin as legal tender by El Salvador hints at the possibility that a digital currency or other exotic instrument could become part of the equation.

So what’s causing the decline, and why could inflation accelerate it? If the dollar’s retreat continues, how serious would the impact on the U.S. be? And how viable are the leading candidates for taking up the dollar’s mantle?

In the 21st century, reserve status is not an official designation but rather a competitive position based on which currency is most trustworthy and most useful for global trade. That means the dominant reserve currency can change: before World War I, it was the British pound. As recounted by University of California at Berkeley economist Barry Eichengreen, the dollar continued to gain dominance as the U.S. sold arms to combatants during World War II, increasing its gold reserves.

That transition also reflects the general rule that dominant global trading nations tend to have dominant global currencies. Businesses or governments needed to hold American currency to buy American products, and the United States remained the dominant global manufacturer for many decades after the end of World War II.

Some countries also hold various currencies for use in stabilizing the global price of their own currency. If the pound drops against the yen, for instance, the Bank of England might sell yen from its reserves to try and bring prices back down (this is the basic mechanism that algorithmic stablecoins try to mimic). Exchange-rate policy has broadly shifted over the past century, though, and fewer countries now have formal currency pegs that demand large reserves.

Utility for trade and currency pegging aren’t enough to make a reserve currency, though. The dollar also came to make up more and more of foreign central bank holdings because it was trusted – in part because it was backed by gold under the Bretton Woods agreement. After the end of the gold standard in 1971, the dollar retained its dominance not just because of U.S. economic strength, but because of trust in the stability of the U.S. government and its economic policies.

The lack of any viable alternatives to the dollar, though, has also been crucial to its continued dominance. That may still be its best defense today.

There are at least four headwinds that could plausibly threaten, or at least weaken, the dollar’s position as a global reserve currency. They are fiscal weakness (the national debt); monetary weakness (inflation); political instability and problems with the structure of the market for treasury bonds.

Most international reserves are held in the form of bonds, which are a form of loan. That means reserve status depends on a country’s ability to pay off those loans. In the case of the U.S. and the dollar, repayment is “a long-term concern,” according to Stanford University economist and bond market expert Darrell Duffie, “but not for the next few years or even the next few decades.”

Inflation is at least potentially a more immediate threat. One major article of faith that helped the dollar gain reserve status was that the U.S. would not start indiscriminately printing money, because dollar inflation would erode the value of dollar-denominated international holdings. (The French franc lost its reserve status in the 1960s when the cost of the Algerian Revolution drove the French government to print money.) While the bond market has so far ignored the threat of inflation, it could easily turn on a truly irresponsible administration.

That said, Eichengreen argues there are many factors that are more important than low inflation for a dominant reserve currency. Economic stature is key, which explains the long-term decline in dollar reserves. The rise of Japan, Mexico, Korea, China, Brazil and many other countries as productive hubs means more of their currencies are circulating around the world as trade instruments than in the mid-20th century.

The U.S. now produces only a little over 10% of all global exports, making the dollar less and less useful for trade. But it remains a uniquely powerful economy, which seems to explain why U.S. bond markets haven’t buckled under inflation fears: The continued appetite for Treasurys reflects the belief that a surge of debt spending right now will shore up the U.S. economy in the long term, and that it’s a worthwhile trade-off for some inflation risk.

Equally crucial is the openness and reliability of financial systems themselves. This includes a stable system of financial rules, and institutions that can quickly convert bonds or other instruments into cash. There was a scare on this front last March, when the start of the pandemic triggered panicked selling of U.S. bonds that overwhelmed Treasury markets.

The good news, according to Duffie, is that this was a problem of market structure related partly to bank reserve requirements, rather than a lack of demand for U.S. Treasurys. But he says fixing problems in the Treasury market is necessary for the dollar’s continuing health. “[Buyers] want Treasurys because they can be liquidated quickly,” he says. “The concern that the market’s not going to work ... could change the price at which the Treasury can sell [bonds] in the first place.”

Finally, political stability, trust and transparency are also important for currency dominance. This is a continuing barrier to adoption of the Chinese yuan – but it’s also a rising risk for the U.S., given what some see as trade hostility, rising unrest and antidemocratic efforts by some U.S. political factions.

The good news is that right now, most of the threats to the dollar are either gradual or fairly far out on the horizon. “In the short run, there’s no serious risk” of dollar displacement, says Yaya Fanusie, a former CIA. analyst and an adjunct senior fellow for currency issues at the Center for a New American Security (CNAS).

Still, if and when enough of these underpinnings fail, the world could turn away from the dollar incredibly quickly. There’s an assumption that a reserve currency benefits from incumbency, or what the tech world might call “network effects.” But history teaches us that those effects are hardly determinative: the U.S. dollar itself first overtook the British pound in international finance in 1925, just 10 short years after the founding of the Federal Reserve in 1914.

Running a global reserve currency isn’t all wine and roses. U.S. Treasury economist Kenneth Austin has argued that reserve status harms the U.S. economy, and manufacturing in particular, because it makes U.S. exports more expensive. 

But the current consensus is more focused on some major advantages the U.S. and its residents gain from the dollar’s reserve status. Some of them are matters of convenience, such as the ability of U.S. travelers to pay with dollars around the world, or the ease with which U.S. businesses can manage invoicing and exchange-rate risk.

But other advantages are more profound. The most striking is what’s known as “seignorage”: that foreign governments are willing to trade $100 worth of real goods and services for a $100 bill that only costs the U.S. Mint a few cents to produce. The same more or less goes for Treasury bonds.

This produces some pretty astounding effects. About $500 billion in U.S. currency circulates worldwide, along with about $7 trillion worth of U.S. government bonds. Those ledger entries were granted in exchange for things like manufactured goods from China that have immediate material impacts on American quality of life. Eichengreen describes this as an "asymmetric financial system" with the international community "supporting American living standards and subsidizing American multinationals."

In theory, this is justifiable because dollars and bonds can in turn be used to buy goods back from America – both bills and bonds are essentially debts. But reserve currency status limits this backflow, because the dollars are held as a long-term store of value. Bonds, as long as they stay trustworthy, can stay parked in foreign banks for decades. The $500 million or more in U.S. cash circulating internationally, meanwhile, is at least as likely to be used for transactions between third countries as it is to come back home and make a claim on goods.

So that’s about $7.5 trillion worth of goods and services that the U.S. has obtained at a fire-sale discount. That torrent would not just slow, but potentially reverse as the dollar’s reserve status declines. This would most likely be a gradual process with incremental effects, as we’ve seen with the dollar’s declining share already. 

But a run on the bank is also a possibility. If the dollar experiences a sharp shock – let’s say something on the scale of a second U.S. Civil War – foreign nations would move quickly to trade dollar bonds for superior assets from U.S. entities. There’s nothing to stop this without implementing currency controls, which would ultimately end reserve status in itself.

Such a rambunctious unwinding of the dollar would be hugely damaging. But that kind of collapse would most likely only follow events so catastrophic that reserve status will be the last thing on our minds. For France in the 1960s, the death knell was out-of-control spending driven by the desperate attempt to hang onto the last shred of its Empire. For England in the 1940s, it was a full-scale Nazi offensive.

But unless things were already really disordered in the U.S. itself, a slow decline in the dollar’s relative importance wouldn’t actually trigger disorder or impoverishment. Seignorage is nice, but the $7.5 trillion that the U.S. has gained from it over several decades is only about one-third of its annual GDP. According to Eichengreen, seignorage is only the 23rd most important factor in America’s global economic status.

The U.S. also enjoys very cheap borrowing thanks to the dollar’s reserve status, lowering its interest payments on all those bonds by hundreds of billions of dollars per year. The U.S. government can even borrow at two to three percentage points below what it earns on its own foreign investments. But less appetite for dollars would make borrowing more expensive. That could be the biggest threat losing reserve status poses to U.S. domestic economic security, since it would sharply reduce government revenue available for domestic spending.

Finally, the dollar also grants the U.S. some less tangible benefits in geopolitical power. “The status quo for U.S. national economic security is that we have tremendous leverage,” says Fanusie. “We can enforce policy interests with sanctions, all that stuff.” While it’s hard to put a dollar value on the power of international sanctions, you can imagine it’s a tool that U.S. political leaders don’t want to lose.

Global currencies are effectively in competition for use in trade and reserves, with convertibility and stability the key metrics. After World War II, the dollar’s reserve status was preserved in large part by the lack of competition: the economies of France, England and Germany were quite literally reduced to rubble, and a series of devaluations linked to rebuilding efforts and imperial decline severely eroded faith in the pound and franc.

The landscape now is much different. The euro, the yen and the yuan all have some features that would make them viable global reserves, and China in particular has been aggressively pursuing greater international yuan flows for at least a decade. The development of the “digital yuan” has been widely interpreted in the West as part of that strategy, for instance.

But, despite some declines, the dollar has held on to its reserve and trade dominance. At least for now, experts believe each of the potential dollar competitors has some fatal shortcoming that makes it less preferable. Japan, for instance, holds most of its debt domestically, making it unavailable for reserve holdings. China has domestic policy priorities that conflict with its reserve ambitions.

In an upcoming companion piece, we’ll be going into the strengths and weaknesses of competing fiat currencies in more detail. We’ll also be exploring the viability of a new kind of reserve option: cryptocurrency.

The idea of cryptocurrency as a global reserve hit the big time when El Salvador declared its intent to hold bitcoin (though not explicitly as a reserve). Crypto has some appealing reserve properties, including its openness and liquidity. Even more appealing may be that a true crypto like Bitcoin would take monetary management decisions, and the power to abuse them, away from any single country.

The idea of crypto reserves is novel and strange, and would involve a lot of challenges, uncertainty, and structural changes, all of which we’ll dive into in that forthcoming companion piece. But crypto also has more legitimacy in mainstream economics than you might guess. Former Bank of England head Mark Carney has proposed a synthetic reserve currency using some crypto-like technology, and forex titan Stanley Druckenmiller has said he thinks some sort of crypto will be the next major reserve currency.

Time will tell, but at this point, I wouldn’t count it out.

Stay tuned for the second part of this essay next week.