Dollar Hegemony and Why It's Worth Worrying About

America’s worldwide economic dominance has been receding. Despite the Chinese economic slowdown, the US has continued to see its share of global trade drop.

At the same time, the Trans-Pacific Partnership is stalling and may not even pass the American Congress. Despite all of the negative signs, the US still holds incredible sway over global economic and financial systems through its one greatest advantage: the US dollar. Indeed, the dollar does not have any serious global rivals. The euro does not command as much respect far beyond the Eurozone and the Chinese Yuan is still pegged to the US dollar. At this point, the US dollar is still the clear global reserve and trade currency.

A global trade currency acts much like hubs do for airlines. A South African mining company can sell metals to an Indian basic manufacturer via a Hong Kong shipping firm without dealing with any cross-exchange rates. All three parties can process the transactions in USD, and Hong Kong also pegs its currency to the US dollar, maintaining a stable exchange rate. The relative stability and reliability of this exchange rate cannot be understated. Because most international transactions are done via the US dollar, trillions of dollars worth of transactions occur every year. This large amount of volume ensures that the USD FX rates are as fair and consistent as possible. Fairer prices and greater liquidity leads to lower fees and more commerce.

American economic power and stability makes the US dollar a strong choice for a global reserve currency. Any national currency is subject to the central banking policies of its issuing country, and a central bank often must balance its complex interests—including national economic growth, economic stability, and inflation.

A global reserve currency must be stable. In order for trade to flourish, transaction costs must be stable and unstable FX rates will make costs of commerce unpredictable. In this sense, then, the entire world piggybacks off of American reliability. During the 2007-08 financial crisis, for example, the Federal Reserve stabilized the US economy and headed off a banking crisis without seriously impacting the value of the dollar. Without such timely and appropriate intervention, the world financial system may have collapsed.

On the other hand, the financial crisis also perfectly highlighted why the dollar’s hegemony is dangerous. The Federal Reserve moved to stabilize the world economy once and Congress followed only when faced with economic disaster. The public backlash, however, has crippled the federal government. A new wave of populism, isolationism, and suspicion against the government has chipped away at an image of American economic and political competency. Multiple debt ceiling fiascos have called into question whether the US has the ability and the political will to manage such an important currency.

Secondly, because the dollar is used as the global reserve currency, the US government is able to borrow much more cheaply than its economic fundamentals would usually allow. US government debt is the safest dollar-denominated debt, and the demand for the dollar is as great of a driving force as the demand for US debt. This creates distortionary effects where competing investment products would need to produce higher returns for the same level of investment attractiveness. This means that investment money would be allocated less productively than otherwise possible.

Whether or not the US will do a good job maintaining a global reserve currency, from a world economic standpoint, it is important to protect such an important resource out of a single point of failure. The world needs a source of global fiscal leadership, and such leadership would do well to come from a global, rather than a national, authority.