These completely unexpected consequences of the dominance of the dollar

In 1971, John Connally, Richard Nixon’s Treasury Secretary, told his counterparts in other major economies, “The dollar is our currency, but your problem.” The background – the slow decline of the Bretton Woods monetary system – is ancient history.

But it’s remarkable that the formula still rings true after all these years. I say “remarkable” because the United States no longer dominates the world economy as it once did. In 1960, they accounted for roughly 40% of world GDP; today it is less than a quarter.

In addition, two other currencies – the euro and the yuan – now serve economies of comparable size to the US. And yet, the dollar remains dominant on the international financial markets. When an emerging market economy borrows abroad, its debt is still very much denominated in dollars. The financial dominance of the dollar seems to give the American exchange rate (see page 12) – the value of the dollar in relation to other currencies – enormous importance in the world economy. A recent paper by Maurice Obstfeld and Haonan Zhou asserts that there is a global “dollar cycle”; when the greenback is strong, it generates financial and economic stress in the rest of the world. And the dollar has been very strong in recent times.

When the greenback is strong, it generates financial and economic stress in the rest of the world.

This power of the dollar conceals three great mysteries. The first, and the least complex to break through, is the fact that it remains dominant while the American economy has lost its preeminence. The second, more puzzling question is why dollar fluctuations have such large global effects. Finally, it is necessary to understand why the dollar has appreciated so much during the recent period.

In 1971, John Connally, Richard Nixon’s Treasury Secretary, told his counterparts in other major economies, “The dollar is our currency, but your problem.” The background – the slow decline of the Bretton Woods monetary system – is ancient history.

But it’s remarkable that the formula still rings true after all these years. I say “remarkable” because the United States no longer dominates the world economy as it once did. In 1960, they accounted for roughly 40% of world GDP; today it is less than a quarter.

In addition, two other currencies – the euro and the yuan – now serve economies of comparable size to the US. And yet, the dollar remains dominant on the international financial markets. When an emerging market economy borrows abroad, its debt is still very much denominated in dollars. The financial dominance of the dollar seems to give the American exchange rate (see page 12) – the value of the dollar in relation to other currencies – enormous importance in the world economy. A recent paper by Maurice Obstfeld and Haonan Zhou asserts that there is a global “dollar cycle”; when the greenback is strong, it generates financial and economic stress in the rest of the world. And the dollar has been very strong in recent times.

When the greenback is strong, it generates financial and economic stress in the rest of the world.

This power of the dollar conceals three great mysteries. The first, and the least complex to break through, is the fact that it remains dominant while the American economy has lost its preeminence. The second, more puzzling question is why dollar fluctuations have such large global effects. Finally, it is necessary to understand why the dollar has appreciated so much during the recent period.

Regarding the first question, part of the answer lies in the role of history. Once a currency has managed to impose its global domination, this domination tends to self-perpetuate. Doing dollar transactions is easier and less expensive because a lot of people use it; borrowing in dollars tends to be cheaper because much of the world’s trade is invoiced in that currency and the low cost of financing encourages dollar invoicing. But even if there are good reasons to explain the dominance of the dollar, how come its fluctuations in value have such consequences? Obstfeld and Zhou argue that because so much of the world’s debt is denominated in dollars, any rise in the greenback causes balance sheet problems around the world. It’s logic.

But the magnitude of the consequences is astonishing. The strength of the link between the dollar and the prices of global commodities such as oil or wheat is particularly puzzling. Let’s approach the question this way: you might think that when the dollar rises against the euro, the price of, say, oil should fall in dollars, but rise in euros. However, this is not what the authors find: they point out that “a 1% appreciation of the dollar translates into a much larger percentage drop in the average price of world commodities”.

But why is the dollar soaring so high? At first glance, the answer seems obvious: it’s all the Fed’s doing. The Federal Reserve has raised interest rates to keep inflation under control, which, all else being equal, makes it more attractive to buy dollar assets and boosts the value of the greenback. But the Fed is not the only central bank to raise its rates: long-term rates have increased as much in Europe as in the United States. In December 2021, the interest rate on US ten-year bonds was 1.47%; the corresponding rate in Germany was -0.38%, which reflects the conviction of investors that the European economy is about to face several years of weak growth.

Today, the US rate is 3.26%, up 1.79 points since December; the German rate was at 1.67%, or 2.05 points more over the same period. Europe therefore seems to have carried out monetary tightening that was as effective, if not more so, than the United States. Why, then, has the euro plunged? It is not difficult to identify several possible reasons, in particular the fact that the gas embargo decreed by Vladimir Putin is hitting the Old Continent hard.

In any case, the strength of the dollar does not seem to be due solely to the anti-inflationary measures of the Fed.

Whatever the reasons, however, it is clear that a strong dollar is doing a lot of harm to the economies of the world. Once again, it’s our currency but their problem.

© The New York Times 2022