12. The Dollar as Key Currency and the Real Crisis of Global Capitalism
February 18, 2011
Global capitalism as it exists today has a blatantly “asymmetric” structure. On the one side stands the United States, whose dollar is used by all other countries; on the other stand all the other countries that have to use the US dollar for mutual transactions. The US dollar is the “key currency;” the rest are not. When a Thai wants to buy something from a Brazilian, he first exchanges his Thai bhat for dollars and uses these dollars for payment. When a Brazilian’s debt to a Thai comes due, she exchanges her reals to dollars and uses these dollars for repayment. But when an American buys something from a Brazilian or pays back borrowing debt to a Thai, he can use his own national currency for both payment and repayment. An American can make purchases and borrow funds regardless of whether he is at home or abroad. Of course, this is an exaggerated picture. The euro is rapidly establishing itself as a key regional currency and continues to expand its sphere of influence outside the euro zone, while the Japanese yen and to a certain extent the Chinese yuan as well may be regarded as local key currencies in some parts of Asia. Direct transactions also take place between two non-key currency countries, using their local currencies. In this sense, it is perhaps more accurate to picture the current international currency system as a hierarchy, with the dollar standing at its apex, the euro on the second tier, the yuan and yen on the third, and all the rest on the lower layers. But what is crucial is the asymmetrical relationship between the dollar and all other currencies.
When the Soviet Union collapsed in 1991, many people, still caught up in Cold War thinking, saw the development of this asymmetrical structure between the one “key” currency and all the other “non-key” currencies as marking the emergence of a new imperialistic economic order unilaterally dominated by the triumphant and hegemonic American economy. But to identify this key/non-key relationship with the traditional master/slave, ruler/ruled relationship is to miss the essence of the matter.
It is true that the major impetus behind the dollar’s rise to an unrivaled position as the world’s key currency was the overwhelming strength that the US economy attained after WWI and consolidated during World War II. At the end of WWII, America accounted for half of the world’s GDP and with Europe and Japan reduced to rubble by the war, it was the only country with the manufacturing capacity to produce sophisticated investment goods and fancy consumption goods. People around the world craved made-in-America, and desperately sought the dollars they needed to buy these products. As Western Europe and Japan began to recover “miraculously” from the destruction of war (thanks partly to American aid), America’s relative economic strength started to decline. Western Europe and Japan more or less caught up with the US in terms of economic productivity during the 1970s and 80s. The US was then pressed hard by East Asian economies in 90s, followed by the rapid rise of China, Russia, India, and Brazil during the first decade of the twenty-first century. The US trade balance was in the red by the late 1950s, the current balance has been running a chronic deficit since the 1980s, the capital account turned negative in 1990s, and the dollar has a 35-year history of trend depreciation. In fact, American GDP now makes up only 25 % of global GDP, and American trade volume mere 15% of the world total. Yet the US dollar remains the predominant currency used in trade and financial transactions around the world, at least outside of Europe. For instance, the percentage of trade goods invoiced in US dollars is far higher than the US share in imports to Asia, Latin America, and Australia.  Or, to use another measure, the dollar makes up about 63 % of central banks’ reserve currency holdings, against 17% for the euro and 2% for the yen.  People around the world do not necessarily hold US dollars for the purpose of importing American products or borrowing from American banks. 
Up until 1971, some economists still adhered to the commodity theory of money, arguing that the reason for the dollar’s continued status as the world’s sole key currency despite the relative decline of American economic hegemony, was the pledge of the US government that dollars (at least those held by foreign governments) were convertible into gold at a fixed rate of 35 dollars per ounce. It was the solid value of gold as a commodity, they believed, that backed the international circulation of the dollar. This naive belief was shattered in August 1971. Faced with the mounting fiscal burden of the Vietnam War and a sharp deterioration in gold coverage of the dollar, President Richard Nixon ended the convertibility of the dollar into gold and started a process that led to the demise of the fixed exchange rate system for all major currencies by 1976. The intention of this so-called Nixon shock was to relieve the US from its burden of maintaining the dollar as the key currency and to turn it into just one of the many national currencies whose exchange rates were to be determined freely in foreign exchange markets.
Contrary to the intention of the US authorities, however, the dollar continued to circulate as the world’s sole key currency, even though it had completely lost its convertibility into gold. In fact, its key currency status even became went up slightly immediately after the Nixon shock.  This episode illustrates the defining characteristic of the key currency. The fact that people around the world hold large amounts of dollars for the purpose of buying commodities or borrowing capital from the United States does not suffice to earn it the label of the key currency. This merely makes it a strong currency, like the euro and the yen. The dollar becomes the key currency of the world only when it comes to be used as the means of settlement for trade and investment transactions that do not directly involve the United States. For example, a Japanese buys goods from an Australian and pays in US dollars. The Australian accepts payment in US dollars because he or she expects to be able to use the dollars for a capital transaction with a Canadian. The Canadian accepts the dollars because he or she expects to be able to use them to pay for a purchase from a German. And the process may continue indefinitely without any American involvement in the transactions whatsoever. People around the world accept dollars as the key currency merely because they expect other people around the world accept dollars as the key currency. Once again, we see the bootstrapping process of money at work.  After all, the key currency is the general medium of exchange for global capitalism, and the relationship between the key currency and all the other non-key currencies in the international economy is analogous to that between money and non-monetary commodities in an intra-national economy.
The above characterization leads us to an important proposition about the nature of a key currency: namely, that no one-to-one correspondence exists between the circulation of one country’s national money as the key currency and the real economic power, either absolute or relative, of that country. This has been borne out abundantly by the history. The British pound retained its key currency position until around 1940, even though the British economy had been overtaken in its size by the US as early as 1872, and despite the facts that its exports also began to lag behind US exports after 1915. It was only in 1945 that the US dollar took over from the pound as the unrivaled key currency of the global economy.  This proposition of course applies to the current key currency status of the US dollar as well. Once a particular nation’s money has become accepted as a key currency, it is able to maintain that status regardless of changes in the strength of that nation’s economic fundamentals, not to mention its military might, diplomatic presence, or cultural dominance. Every time some sign emerges of the weakening of the US economy, a crop of reports appears pronouncing the dollar’s death as the key currency. But for the reason described above, these reports have inevitably turned out to be greatly exaggerated.
Yet, we cannot rest assured by this proposition for the future of the dollar as key currency. There is another side of the coin (or greenback, in this case).. Inasmuch as the key currency is supported primarily by the same bootstrapping process as money, it is subject to the same instability—depression (a bubble of money as money) and hyperinflation (a bust of money as money). If a depression were to occur in global capitalism, it would likely be caused by a sudden surge in people’s demand for the dollar as the key currency in place of the other non-key currencies. The so-called Asian currency crisis gave us a glimpse of such a possibility. Suddenly in 1997, large amounts of Thai baht, Malaysian ringgit, Indonesian rupiah, Korean won, Russian rubles, and Brazilian reals were dumped on foreign exchange markets. A selling-off of the Japanese yen started in 1998, and even the newborn euro became a target of distress selling. Aggregate demand for the world as a whole was hit hard and for a time the global economy experienced cumulative deflation. But the funds withdrawn from Asia, Russia, Latin America, and later from Japan and Europe, did not vanish into the air; nor did people rush to convert it into gold and other precious metals. Most of it was actually held in the form of dollars, part of which then headed to financial markets in the United States. As a result, the US stock markets were able to continue their unprecedented boom (which turned out to be a mere bubble) and the US bond markets were able to maintain their already low rates of interest, except in the immediate aftermath of the LTCM debacle. In this sense, the global slump caused by the Asian currency crisis can be interpreted as a vote of confidence on the status of the US dollar as the key currency, and after a year or two of turmoil the global economy was able to resume its growth almost unscathed.
It must be obvious by now that it is a “dollar crisis” that represents the real crisis of global capitalism (in addition, of course, to the crises of global warming, energy depletion, food shortage, population explosion in developing countries, population aging in advanced countries, crashes of religions, global terrorism, etc.) The dollar crisis is nothing but a hyperinflation of the dollar as key currency—an unraveling of the bootstrapping process that has supported its key currency status independently of the real strength of the US economy.
If, for any reason whatever, people around the world begin to believe their dollar holdings to be excessive, they start to sell dollars against the other currencies in foreign exchange markets. As long as the resulting depreciation of the dollar is expected to be temporary, a dollar crisis will not develop. But once a large number of people come to fear that other people fear that the dollar will continue to depreciate, the situation reaches a tipping point. People start refusing to accept dollars as the means of settlement in their international transactions, further depreciating the value of the dollar and confirming their original fears. The flight from the dollar now sets off. Not only are dollars dumped on foreign exchange markets all over the world, but the bulk of those that have circulated outside the United States now rush back home, directly demanding the US products in their exchange. This will overheat aggregate demand within the US economy and plunge it into domestic hyperinflation. The dollar will be reduced not only to the mere national currency of the US just like all the other currencies but to one of the weaker ones, with a far smaller purchasing power than it used to have.
If such a dollar crisis were actually to occur, most of the trades and finances that have been made possible by the intermediation of the dollar as the key currency would become difficult to sustain. The world economy would split into a collection of numerous national economies, or more likely, would be divided into a few trading and/or financial blocks, each with its own local key currency. The final destiny is a breakdown, or at least a temporary breakdown, of global capitalism itself. Of course, the history of international monetary system has taught us that sooner or later a new key currency will emerge. But the same history also shows that it is much easier to destroy an existing bootstrapping process than to create a new one. In order for one currency to become a key currency there must already be a critical mass of people who expect a critical mass of other people to accept it as something like a key currency! In fact, it was during the long transition from the pound to the dollar as the key currency that the Great Depression erupted, and it was during the Great Depression that the world economy divided itself into blocks, which paved the way to WWII. 
Many will no doubt argue that the dethroning process would not be so violent in the case of the dollar. It would merely lead to a two-headed system, with the dollar and the euro peacefully sharing key currency status, or perhaps a three-headed one with the dollar coexisting with the euro and the yuan (or, if I am allowed to be a bit chauvinistic, the yen).  However, I do not, believe that such a dual or three-part key currency system would ever be stable, even if the rapid development of financial technology continues to reduce the cost of converting currencies. On the contrary, the easier it is to convert currencies, the easier it becomes to speculate in foreign exchange markets. This would be nothing but an invitation for professional speculators to participate in the easiest form of the Keynesian beauty contest. The essence of the Keynesian beauty contest is not a simple “winner-take-all” game, as it has sometimes been misunderstood to be. There are in fact two winners in the game—the face chosen as the prettiest and the voters who receive cash prizes for voting for her. Although the competition to be chosen as the prettiest is certainly a winner-take-all game, the voting process itself is a game where everyone becomes a winner simply by joining the majority. When the choice is among two or three, instead of a hundred, a small sign, even a false one, that one of them is getting more votes than the others will push everyone to vote for that face, especially when there is no or little cost in switching one’s vote.
 For instance, Korea, Thailand, and Malaysia use the dollar in invoicing more than 75 percent of their import transactions at the beginning of the 2000s, though the US share of their imports is 14% in Korea, 10% in Thailand, and 12% in Malaysia. Japan’s and Australia’s use of the dollar in import invoicing is 69% and 51%, though the US share of their imports is just 16% and 2% respectively. (Data on invoicing are from Linda S. Goldberg and Cédric Tille, “Vehicle Currency Use in International Trade,” Journal of International Economics 76 (2008), pp. 177‒192; data on import shares are taken from the IMF Direction of Trade.)
 According to IMF estimates of the Currency Composition of Official Foreign Exchange Reserves (COFER) in the fourth quarter of 2008, claims in US dollars made up 4,213,437 of total allocated reserves of 6,712,857 (million dollars), against 1,116,780 for the euro and 137,695 for the yen. (Unallocated reserves amounted to 2,499,419.)
 See, for instance, Alan Blinder, “The Role of the Dollar as an International Currency,” Eastern Economic Journal , 22, Spring 1996, pp.127–36.
 According to one estimate, the dollar share of foreign exchange reserves was 77.2% in 1970, 78.6% in 1972, 76.6% in 1976, 67.2% in 1980, and 65.8% in 1984. Akinari Horii, “The Evolution of Reserve Currency Diversification,” BIS Economic Papers , No. 18, Dec. 1986.
 A classic discussion of the advantages of a single currency serving as the key currency of the world economy is Charles P. Kindleberger, The Formation of Financial Centres: A Study in Comparative Economic History , Princeton Studies in International Finance, No. 36, 1974. He concluded that there are strong economies of scale associated with centralization in a single currency and single financial center in the world as a whole, due to the reduction of transaction costs, especially those of search. (This is precisely the raison d’être for the emergence of money demonstrated in my papers cited in notes 18 and 20.) See also his “Key Currencies and Financial Centres,” F. Machlup, G. Fels, and H. Müller-Groeling (eds) Reflections on a Troubled World Economy: Essays in Honour of Herbert Giersch , London: Macmillan, 1983, pp. 75-90; reprinted in Charles Kindlebeger, Keynesianism vs. Monetarism and Other Essays in Financial History , London: George Allen & Unwin, 1985, 155-167. Barry Eichengreen emphasized the role of network externality (roughly the same concept as what I have called the bootstrapping process) in Globalizing Capital, Princeton: Princeton University Press, 1996, esp. pp. 5-6. He, however, now questioned this bootstrapping logic and argued that several currencies have often shared the key currency role in the past and that the dollar and the euro are likely to share the key currency positions for the foreseeable future. (Barry Eichengreen, “Sterling’s Past, Dollar’s Future: Historical Perspectives on Reserve Currency Competition,” NBER Working Paper 11336, May 2005.)
 See, for instance, Barry Eichengreen, Globalizing Capital .
 One of the main theses of Charles Kindleberger in The World in Depression, 1929-1939 ( 2nd ed., Berkeley: University of California Press, 1986) is that the Great Depression turned into the greatest depression in history because Great Britain was no longer able, and the United States not yet ready, to act as the lender of the last resort. .
 For instance, Eichengreen suggested that the dollar and the euro are likely to share key currency status for the foreseeable future. However, he did not foresee the rise of the Chinese yuan to the status of a major international currency even 40 years from now. See his “Sterling’s Past, …”