Exorbitant Privilege
The U.S. dollar has dominated global financial markets since the end of World War II. Almost 60 percent of global foreign exchange reserves are held in dollars, with the euro a distant second at around 20 percent. Around 90 percent of transactions in foreign exchange markets are invoiced in dollars, as is half of international trade. Reinforcing the dollar’s standing is its status as a safe haven currency during times of crisis. For example, during the Great Recession of 2008 and the Covid-induced financial crisis in 2020, investors sought U.S. dollars, expecting them to retain their value through the crises.
The U.S. government, economy, and citizenry reap huge benefits from the dollar’s “exorbitant privilege,” as a former French finance minister called it, in global financial markets. Because of the strong global demand for U.S. dollars and dollar-backed securities such as U.S. treasury bonds, the United States can borrow at far lower interest rates than other countries. The U.S. government and firms are also able to borrow from foreign creditors in dollars rather than foreign currencies, so the value of the debt does not change with fluctuations in exchange rates. A high demand for the dollar also strengthens its value vis-à-vis other currencies, leading to cheaper products for U.S. consumers—although, on the flipside, it also makes U.S. exports less competitive. The global hegemony of the U.S. dollar also gives the United States government the power to impose far-reaching and effective sanctions on its adversaries, a powerful foreign policy tool. However, despite its continued dominance, domestic and international challenges to the U.S. dollar are mounting.
Domestic Challenges
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Ironically, in part because of its extremely low borrowing costs, the United States has accumulated a staggeringly high amount of debt, at $32.11 trillion, that is unsustainable in the long term and could undermine confidence in the U.S. dollar. Politically, it is difficult for leaders to address the issue of spiraling debt. Though the American public supports reducing debt and spending, specific steps to do so—such as tax increases and reforming entitlement programs like Social Security and Medicare—are unpopular, especially among older Americans.
The ceiling on the amount of debt that the United States can legally hold is a more immediate threat. This rather unusual mechanism is a limit not on actual spending, but rather a limit on the Treasury’s ability to borrow to pay off debt it already owes, which cannot be raised without authorization from Congress. The United States is one of few countries in the world with such a debt ceiling. Breaching the debt ceiling would lead to default. That is why, since it was first instituted in World War I, the debt ceiling has been raised dozens of times by Congress. However, as demonstrated yet again recently, rising political polarization has made default a real possibility. Whenever the time comes to raise the debt ceiling every few years, one or both parties initiate a game of political brinkmanship to extract concessions from the other side. A default would be catastrophic and could severely undermine confidence in the U.S. dollar and its status as a safe haven. The credit rating of the United States would be downgraded drastically, thus ending the exorbitant privilege of the dollar. Even coming close to it can have consequences. In 2011, Standard and Poor’s downgraded the country’s credit rating when it got two days away from hitting the debt ceiling. More recently, Fitch Ratings did the same, despite the last-minute agreement between President Joe Biden and House Speaker Kevin McCarthy averting a default. The debt limit does not even help address rising debt, as evidenced by the national debt’s continued growth despite numerous debt ceiling standoffs in recent years.
International Challenges
The dollar’s global hegemony gives the U.S. government power to impose crippling sanctions and wage other forms of financial warfare against adversaries. Since 9/11, it has used this power with increasing frequency. In 2022, more than twelve thousand entities were under sanction by the Treasury Department, a more than twelve-fold increase since the turn of the century. U.S. sanctions have not had the best record in changing regimes’ behaviors, but they do ensure that targeted adversaries pay a significant price for continuing to engage in actions the United States opposes. Often, their usage is noncontroversial, as in the case of the sanctions on Russia for its invasion of Ukraine. However, if used excessively, they can make countries, including allies, want to move away from the dollar-based financial system. For example, European countries opposed the United States’ unilateral withdrawal from the Iran nuclear deal. However, due to the secondary sanctions, which were a part of the “maximum pressure” campaign on Iran, they were forced to cut off trade with Iran. This made them consider developing an alternative to the SWIFT and dollar-based systems. While this proposal went nowhere, if even U.S. allies have considered alternatives to the dollar-based system, then it is unsurprising that adversaries like Russia and China have been attempting to undermine the dollar’s hegemony.
Additionally, given the dollar’s global reserve status, the effects of the Federal Reserve’s monetary policies are not restricted to U.S. borders. For instance when the Federal Reserve hiked interest rates to fight inflation over the past year, it led to money supply decreasing, and investors moving funds from developing countries to the “safe haven” of U.S. treasury bonds, thus leading to massive capital outflows. This influx also leads to the exchange rate appreciation of the U.S. dollar vis-à-vis other currencies, and an increase in the dollar-denominated debt held by developing countries. Unsurprisingly, this impacts highly indebted countries more. The Latin American debt crisis of the 1980s was caused in part by the Fed’s aggressive rate hikes to control inflation. While the Fed may not be expected to take this into account when combatting inflation, it should still be noted that emerging markets could diversify their reserve holdings to a more multi-currency portfolio to have more autonomy over their monetary and fiscal policies.
A Move Away from the Dollar?
Due to the domestic and international factors highlighted above, international appetite to diversify from the dollar-based global reserve system is high. Have those factors led to a decline in the dollar’s power? Russia, unsurprisingly, has been forced to ditch the dollar as it looks to evade Western sanctions, but China, which has long pushed for internationalization of its currency, is the country at the forefront of efforts to weaken the dollar’s power. China recently expanded its currency swap agreement with Argentina. China also recently reached an agreement with Brazil, with which its annual trade is $150 billion, to trade in their own currencies instead of the U.S. dollar. In isolation, it may not seem much, but China is pursuing similar agreements with other countries. If they succeed, it would present a challenge to the U.S. dollar as the world’s default currency of trade given China’s dominance in global commodities trade. Global reserves have seen a gradual movement away from the U.S. dollar, too. The dollar’s share of global foreign-exchange reserves stood at slightly below 60 percent in the last quarter of 2022, down from over 70 percent in 1999. China, the largest overseas holder of U.S. treasuries, has cut its holdings of dollars as its relations with the United States have nosedived. Its current holdings are at their lowest point since May 2009.
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Despite all this, it is important to remember that the U.S. dollar remains dominant in global foreign-exchange reserves mostly because there is no clear alternative. Despite China’s efforts, the renminbi accounts for a mere 2.7 percent of global reserves. Due to the strict capital controls and limited convertibility to other currencies, fully challenging the dominance of the dollar remains unlikely. However, the United States should be cognizant of the domestic and international challenges to the status of the U.S. dollar, and act to quell doubts internationally so that it can retain its status even if a credible alternative emerges. Those steps could include tackling the United States’ public debt, and additionally, either eliminating the debt ceiling or linking it to congressional authorization of spending to promote good faith debates about spending increases or cuts without risking default. The United States should also use sanctions more judiciously. Sanctions are an essential tool of U.S. economic statecraft, and their usage is often justified, but they should not be used excessively. The dollar has stood strong for over seven decades. Its decline, if it happens, should at least not be due to the United States’ own missteps.
This post was written for the Council on Foreign Relations’ Renewing America initiative—an effort established on the premise that for the United States to succeed, it must fortify the political, economic, and societal foundations fundamental to its national security and international influence. Renewing America evaluates nine critical domestic issues that shape the ability of the United States to navigate a demanding, competitive, and dangerous world. For more Renewing America resources, visit https://www.cfr.org/programs/renewing-america and follow the initiative on Twitter @RenewingAmerica.
