CHAPTER 1 INTRODUCTION

1.1 INTRODUCTION

The United States dollar (sign: $; code: USD; also abbreviated US$), also referred to as the
U.S. dollar or American dollar, is the official currency of the United States of America and its
overseas territories. It is divided into 100 smaller units called cents.

The U.S. dollar is the currency most used in international transactions and is one of the
world's dominant reserve currencies. Several countries use it as their official currency, and in
many others it is the de facto currency. It is also used as the sole currency in two British
Overseas Territories, the British Virgin Islands and the Turks and Caicos islands.

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1.2 OVERVIEW

The Constitution of the United States of America provides that the United States Congress shall
have the power "To coin money". Laws implementing this power are currently codified in
Section 5112 of Title 31 of the United States Code. Section 5112 prescribes the forms in which
the United States dollars shall be issued. Those coins are both designated in Section 5112 as
"legal tender" in payment of debts. The Sacagawea dollar is one example of the copper alloy
dollar. The pure silver dollar is known as the American Silver Eagle. Section 5112 also
provides for the minting and issuance of other coins, which have values ranging from one cent
to fifty dollars. These other coins are more fully described in Coins of the United States dollar.

The Constitution provides that "a regular Statement and Account of the Receipts and
Expenditures of all public Money shall be published from time to time". That provision of the
Constitution is made specific by Section 331 of Title 31 of the United States Code.

The sums of money reported in the "Statements" are currently being expressed in U.S. dollars
(for example, see the 2009 Financial Report of the United States Government). The U.S. dollar
may therefore be described as the unit of account of the United States.

The word "dollar" is one of the words in the first paragraph of Section 9 of Article 1 of the U.S.
Constitution. In that context, "dollars" is a reference to the Spanish milled dollar, a coin that
had a monetary value of 8 Spanish units of currency, or reales. In 1792 the U.S. Congress
adopted legislation titled An act establishing a mint, and regulating the Coins of the United
States. Section 9 of that act authorized the production of various coins, including "DOLLARS
OR UNITS—each to be of the value of a Spanish milled dollar as the same is now current, and
to contain three hundred and seventy-one grains and four sixteenth parts of a grain of pure, or
four hundred and sixteen grains of standard silver". Section 20 of the act provided, "That the
money of account of the United States shall be expressed in dollars, or units... and that all
accounts in the public offices and all proceedings

in the courts of the United States shall be kept and had in conformity to this regulation". In
other words, this act designated the United States dollar as the unit of currency of the United
States.

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The U.S. dollar bill uses the decimal system, consisting of 100 equal cents (symbol ¢). It is also
officially divided into 1,000 mills(symbol ₥) or ten dimes, while ten dollars is equal to an
eagle. However, only cents are in everyday use as divisions of the dollar; "dime" is used solely
as the name of the coin with the value of 10¢, while "eagle" and "mill" are largely unknown to
the general public, though mills are sometimes used in matters of tax levies, and gasoline prices
are usually in the form of $X.XX9 per gallon, e.g., $3.599, sometimes written as $3.599⁄10.
When currently issued in circulating form, denominations equal to or less than a dollar are
emitted asU.S. coins while denominations equal to or greater than a dollar are emitted as
Federal Reserve notes (with the exception of gold, silver and platinum coins valued up to $100
as legal tender, but worth far more as bullion). Both one-dollar coins and notes are produced
today, although the note form is significantly more common. In the past, "paper money" was
occasionally issued in denominations less than a dollar (fractional currency) and gold coins
were issued for circulation up to the value of $20 (known as the "double eagle," discontinued
in the 1930s).

The term eagle was used in the Coinage Act of 1792 for the denomination of ten dollars, and
subsequently was used in naming gold coins. Paper currency less than one dollar in
denomination, known as "fractional currency," was also sometimes pejoratively referred to as
"shinplasters." In 1854, James Guthrie, then Secretary of the Treasury, proposed creating $100,
$50 and $25 gold coins, which were referred to as a "Union," "Half Union," and "Quarter
Union," thus implying a denomination of 1 Union = $100. Series of 1917 $1 United States bill

Today, USD notes are made from cotton fiber paper, unlike most common paper, which is
made of wood fiber. U.S. coins are produced by the United States Mint. U.S. dollar banknotes
are printed by the Bureau of Engraving and Printing and, since 1914, have been issued by the
Federal Reserve. The "large-sized notes" issued before 1928 measured 7.42 inches (188 mm)
by 3.125 inches (79.4 mm); small-sized notes, introduced that year, measure 6.14 inches (156
mm) by 2.61 inches (66 mm) by 0.0043 inches (0.11 mm). When the current, smaller sized
U.S. currency was introduced it was referred to as Philippine-sized currency because the
Philippines had previously adopted the same size for its legal currency.

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 1.3 HISTORY

The first dollar coins issued by the United States Mint (founded 1792) were similar in size and
composition to the Spanish dollar. The Spanish, U.S. silver dollars, and Mexican silver pesos
circulated side by side in the United States, and the Spanish dollar and Mexican peso remained
legal tender until 1857. The coinage of various English colonies also circulated. The lion
dollarwas popular in the Dutch New Netherland Colony (New York), but the lion dollar also
circulated throughout the English colonies during the 17th century and early 18th century.
Examples circulating in the colonies were usually worn so that the design was not fully
distinguishable, thus they were sometimes referred to as "dog dollars".

The U.S. dollar was created by the Constitution and defined by the Coinage Act of 1792. It
specified a "dollar" to be based in the Spanish milled dollar and of 371 grains and 4 sixteenths
part of a grain of pure or 416 grains (27.0 g) of standard silver and an "eagle" to be 247 and 4
eighths of a grain or 270 grains (17 g) of gold (again depending on purity).

The choice of the value 371 grains arose from Alexander Hamilton's decision to base the new
American unit on the average weight of a selection of worn Spanish dollars. Hamilton got the
treasury to weigh a sample of Spanish dollars and the average weight came out to be 371 grains.
A new Spanish dollar was usually about 377 grains in weight, and so the new U.S. dollar was
at a slight discount in relation to the Spanish dollar.

The Coinage Act of 1792 set the value of an eagle at 10 dollars, and the dollar at 1/10 eagle. It
called for 90% silver alloy coins in denominations of 1, 1/2, 1/4, 1/10, and 1/20 dollars; it called
for 90% gold alloy coins in denominations of 1, 1/2, 1/4, and 1/10 eagles.

The value of gold or silver contained in the dollar was then converted into relative value in the
economy for the buying and selling of goods. This allowed the value of things to remain fairly
constant over time, except for the influx and out flux of gold and silver in the nation's economy.

The early currency of the USA did not exhibit faces of presidents, as is the custom now. In fact,
George Washington was against having his face on the currency, a practice he compared to the
policies of European monarchs. The currency as we know it today did not get the faces they
currently have until after the early 20th century; before that "heads" side of coinage used profile
faces and striding, seated, and standing figures from Greek and Roman mythology and
composite native Americans. The last coins to be converted to profiles of historic Americans
were the dime (1946) and the Dollar (1971).

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1.4 ORIGINS OF THE DOLLAR SIGN

The sign is first attested in business correspondence in the 1770s as a scribal abbreviation "ps",
referring to the Spanish American peso, that is, the "Spanish dollar" as it was known in British
North America. These late eighteenth- and early nineteenth-century manuscripts show that the
s gradually came to be written over the p developing a close equivalent to the "$" mark, and
this new symbol was retained to refer to the American dollar as well, once this currency was
adopted in 1785 by the United States.
An alternative theory states that the dollar sign ($) is directly borrowed from the sign used to
represent the Spanish peso, which is in fact a "$", and is said to come from a representation of
one of the Pillars of Hercules with a motto-ribbon as depicted in the Spanish Coat-of-Arms

1.5 ADOPTION BY THE UNITED STATES

By the American Revolution, Spanish dollars gained significance because they backed paper
money authorized by the individual colonies and the Continental Congress. Common in the
Thirteen Colonies, Spanish dollars were even legal tender in one colony, Virginia.

On April 2, 1792, U.S. Secretary of the Treasury Alexander Hamilton reported to Congress the
precise amount of silver found in Spanish milled dollar coins in common use in the States. As
a result, the United States dollar was defined as a unit of weight equaling 371 4/16th grains
(24.057 grams) of pure silver, or 416 grains of standard silver (standard silver being defined as
1,485 parts fine silver to being defined as 1,485 parts fine silver to 179 parts alloy). It was
specified that the "money of account" of the United States should be expressed in those same
"dollars" or parts thereof. Additionally, all lesserdenomination coins were defined as
percentages of the dollar coin, such that a halfdollar was to contain half as much silver as a
dollar, quarter-dollars would contain one-fourth as much, and so on.

In an act passed in January 1837, the dollar's alloy (amount of non-silver metal present) was
set at 15%. Subsequent coins would contain the same amount of pure silver as previously, but
were reduced in overall weight (to 412.25 grains). On February 21, 1853, the quantity of silver
in the lesser coins was reduced, with the effect that their denominations no longer represented
their silver content relative to dollar coins.

Various acts have subsequently been passed affecting the amount and type of metal in U.S.
coins, so that today there is no legal definition of the term "dollar" to be found in U.S. statute.
Currently the closest thing to a definition is found in United States Code Title 31, Section 5116,
paragraph b, subsection 2: "The Secretary [of the Treasury] shall sell silver under conditions
the Secretary considers appropriate for at least $1.292929292 a fine troy ounce."

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Silver was mostly removed from U.S. coinage by 1965 and the dollar became a freefloating
fiat currency without a commodity backing defined in terms of real gold or silver. The US Mint
continues to make silver $1-denomination coins, but these are not intended for general
circulation.

1.6 USAGE IN GREAT BRITAIN

There are many quotes in the plays of William Shakespeare referring to dollars as money. Coins
known as "Thistle dollars" were in use in Scotland during the 16th and 17th century, and use
of the English word, and perhaps even the use of the coin, may have begun at the University of
St Andrews. This might be supported by a reference to the sum of "ten thousand dollars" in
Macbeth (Act I, Scene II) (an anachronism because the real Macbeth, upon whom the play was
based, lived in the 11th century).

In 1804, a British five-shilling piece, or crown, was sometimes called "dollar". It was an over
struck Spanish 8 real coin (the famous 'piece of eight'), the original of which was known as a
Spanish dollar. Large numbers of these 8-real coins were captured during the Napoleonic Wars,
hence their re-use by the Bank of England. They remained in use until 1811. During World
War II, when the U.S. dollar was (approximately) valued at 5 shillings, the half crown (2s 6d)
became nicknamed a "half dollar" by US personnel in the UK.

1.7 USAGE ELSEWHERE

Chinese demand for silver in the 19th and early 20th centuries led several countries, notably
the United Kingdom, United States and Japan, to mint trade dollars, which were often of
slightly different weights from comparable domestic coinage. Silver dollars reaching China
(whether Spanish, Trade, or other) were often stamped with Chinese characters known as "chop
marks", which indicated that that particular coin had been assayed by a well-known merchant
and determined genuine.

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1.8 OTHER NATIONAL CURRENCIES CALLED “DOLLAR”

Prior to 1873, the silver dollar circulated in many parts of the world, with a value in relation to
the British gold sovereign of roughly $1 = 4s 2d (21p approx). As a result of the decision of
the German Empire to stop minting silver thaler coins in 1871, in the wake of the Franco-
Prussian war, the worldwide price of silver began to fall. This resulted in the US Coinage Act
(1873) which put the United States on to a 'de facto' gold standard. Canada and Newfoundland
were already on the gold standard, and the result was that the value of the dollar in North
America increased in relation to silver dollars being used elsewhere, particularly Latin America
and the Far East. By 1900, value of silver dollars had fallen to 50 percent of gold dollars.
Following abandonment of the gold standard by Canada in 1931, the Canadian dollar began to
drift away from parity with the U.S. dollar. It returned to parity a few times, but since the end
of the Bretton Woods system of fixed exchange rates that was agreed in 1944, the Canadian
dollar has been floating against the US dollar. The silver dollars of Latin America and South
East Asia began to diverge from each other as well during the course of the 20th century. The
Straits dollar adopted a gold exchange standard in 1906 after it had been forced to rise in value
against other silver dollars in the region. Hence, by 1935, when China and Hong Kong came
off the silver standard, the Straits dollar was worth 2s 4d (11.5p approx) sterling, whereas the
Hong Kong dollar was worth only 1s 3d sterling (6p approx).

The term "dollar" has also been adopted by other countries for currencies which do not share a
common history with other dollars. Many of these currencies adopted the name after moving
from a £sd-based to a decimalized monetary system. Examples include the Australian dollar,
the New Zealand dollar, the Jamaican dollar, the Cayman Islands dollar, the Fiji dollar, the
Namibian dollar, the Rhodesian dollar, the Zimbabwe dollar, and the Solomon Islands dollar.

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 CHAPTER 2

EMERGENCE OF DOLLAR AS INTERNATIONAL

CURRENCY

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2.1 US DOLLAR BECAME WORLD CURRENCY 65 YEARS AGO

The historic conference in Bretton Woods ended on July 22, 65 years ago. The members of the
conference agreed to establish a system of payment based on the US dollar and established the
dollar peg with gold. The conference also resulted with the establishment of the International
Monetary Fund and the World Bank.

The Bretton Woods currency system, which set the dollar-based financial rules in the post-war
world, has proved to be justifiable. However, the system has changed a lot since then and
continues changing, Dmitry Pankin, an official with Russia’s Finance Ministry believes.

―The present world currency system is completely different. The USA unilaterally terminated
the convertibility of the dollar to gold during the 1960s. Secondly, all countries practice the
peg-free floating currency rate nowadays. As a matter of fact, we are living in a different world,‖
the official said in an interview with RIA Novosti news agency.

―There were no major collapses in the international payment system. The system was
working, the structure of international currency relations was clear to everyone, and the
countries were observing the rules of the game. The international payment system works at this
point,‖ Pankin said.

On the other hand, the official added, the system is unable to prevent economic difficulties.
―A crisis always lies in the beginning of any economy. A crisis may occur in any system that
man can create,‖ he said.

The dollar will remain the international reserve currency, but the world will be aiming towards
the multi-currency system of payment.
―There has been no indication of the decline of the dollar in the international payment system
during the recent two decades. However, it is clear that the world will be making steps towards
the multi-currency international payment system,‖ Dmitry Pankin said.

For example, the influence of the European currency in the system has been growing steadily.
The Brazilian real and the Chinese yuan will most likely be strengthening their positions too.

―Yet, it is hard to say that the system of currencies will change drastically in 10 or 15 years,‖
Pankin concluded.

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2.2 THE INTERNATIONAL DOLLAR STANDARD
Bretton Woods

In the aftermath of World War II, the relatively stable-valued US dollar was the only major
currency in which international exchange could freely take place. The dollar's role was
formalized under the Bretton Woods monetary agreement of 1944. Other nations set official
exchange rates against the dollar, while the US agreed to exchange dollars for gold at a fixed
price on demand by central banks.

This system functioned well for a brief period. However by about 1958 the initial worldwide
dollar shortage had turned into an overabundance. With the too rapid growth of dollar credits
around the world, gold backing of the dollar proved unsustainable. The Bretton Woods
agreement collapsed in 1973, but it enthroned the dollar as the international medium of
exchange. This unique role of the dollar continues to the present day.

How the Dollar Grew

The rapid growth of the industrialized economies after World War II created a growing demand
for dollar balances around the world. The more of its own currency a central bank issued the
more dollars it wanted as underpinning for its currency.

During the Bretton Woods period, the US ran large current account surpluses. That would have
drained dollars from abroad, but long-term capital outflows in the form of grants and direct
investments by the US were greater than its current surpluses. The result was a buildup of
dollar assets by foreign firms and central banks. In effect, the US was lending long more than
it was borrowing short, thereby satisfying the world’s growing demand for dollar liquidity,
even while it remained a net creditor.

The Dollar Today

Today over half of all dollar notes in circulation are held outside the borders of the US. About
half of US Treasury securities are owned by foreigners, mainly held as reserves by foreign
central banks. The dollar is the main currency in international capital flows, as well as the
currency of invoice for commodities and for many manufactured goods and services. All
countries that trade directly with the US invoice both imports and exports in US dollars.
Eurodollars often trade without any involvement by US participants.
Advantages for the U.S.

With the dollar as the world standard, the US is free to conduct its monetary policy independent
of exchange rate fluctuations. In this respect, other countries operate at a disadvantage. They
are reluctant to see their own currencies depreciate against the dollar because of the domestic
inflationary threat that presents. They are also reluctant to allow a substantial appreciation of
their currency against the dollar for fear of losing competitiveness in world markets.
Consequently they sometimes subordinate their domestic monetary policies in order to stabilize
their currencies against the dollar.

A Useful Analogy

The international dollar is analogous to the fiat money that a central bank issues within its own
monetary domain. Central banks do so by purchasing assets from those who want to hold their
currency as a store of value or for use in trade. There is little or no need for a central bank to
concern itself with redeeming its own currency.

Likewise the US can issue dollar-denominated claims to the rest of the world which may never
have to be redeemed so long as it maintains the domestic purchasing power of the dollar. While
this gives the US a unique advantage in terms of borrowing in its own currency, the existence
of a safe reserve asset is a great convenience to other countries. Only a serious loss of
confidence in the dollar could depose it as the primary medium of international exchange, such
as might be due to a prolonged major inflation in the US.

2.3 DOLLARIZATION

Dollarization means adopting the US dollar as the currency of choice in a foreign country.
Many countries today are already dollarized unofficially. Where the purchasing power of the
local currency has been volatile, as in Latin America and in the former Soviet Union, people
often hold dollars as a store of value. In those cases the domestic currency is commonly used
in small transactions, but the dollar is preferred in large transactions and in savings.

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Official Dollarization

In some countries, using the dollar in transactions is perfectly legal, in others it is not. In a
very few, the US dollar is the official currency, mostly in small or developing countries.
Panama has been officially dollarized since 1904. Other countries have on occasion
considered moving to an official dollarized system.

Under official dollarization the local currency is completely replaced by the dollar, with the
possible exception of coinage. That means domestic banks only accept dollar checking
accounts and issue dollar loans. Federal Reserve notes are legal tender and the only form of
paper money recognized by the government.

Before its latest political and economic crisis, Argentina operated under a currency
boardsystem that maintained an exchange rate of 1:1 between the dollar and the peso. That
required holding sufficient dollar reserves to fully back the pesos in circulation. The dollar
was recognized as legal tender along with the peso. Argentina has since abandoned the peg
to the dollar and gone to a floating exchange rate for the peso.

In the wake of the Asian and Brazilian economic crisis, Ecuador was unable to avoid a deep
recession and banking crisis. In March 1999 the government froze deposits in the entire
banking system as the value of the sucre dropped. A year later, after much political turmoil,
and with the help of the IMF in structuring its financial system, Ecuador adopted the US
dollar as its official currency. This will be an important test of dollarization under very
difficult conditions.
The US Position

There is nothing to prevent a country from unilaterally moving to an official dollarized

currency, although the Fed has recommended that it be consulted in advance. At the very
least, the Fed would need advance notification of the extra notes that it would have to make
available.

The Fed has stated that under no conditions would it act as a lender of last resort to foreign
banks, nor would its monetary policy be contrary to the best interests of the US. So far, US
officials have taken a neutral position, neither encouraging nor discouraging dollarization.
However there are many issues, pro and con, for the US and a dollarizing country that deserve
careful consideration. Here are a few:

A Stabilizing Factor

A country with its own currency, typically issued by a central bank, can exercise its own
monetary policy. In theory this enables it to manage its money supply, interest rates, and to
some extent the exchange rates solely in its own self-interest. In practice however many
developing countries have experienced serious problems in their monetary affairs, lacking the
institutions and experience needed. It is likely that official dollarization would significantly
improve price stability in those countries with a history of monetary problems.

Loss of Independent Monetary Policy

On the other hand dollarization means that the country can no longer tailor its monetary policy
to suit its own needs. Unless its economy closely tracks the US economy, that can be a serious
limitation at times. Nevertheless the discipline required might be worth the loss of flexibility.
The added stability should offer a better environment for planning business expansion and new
enterprise. Under dollarization the central bank would no longer be able to create money, but
it would still retain the important task of administering banking system regulations and
ensuring sound banking practices.
Seigniorage Effects

The US gains added seigniorage benefits as countries increase the use of dollar currency. The
annual cost to the US of creating and servicing its currency is now less than 0.1% of the face
value of currency outstanding. The notes however are sold at face value. Thus notes that are
purchased for use overseas are the equivalent of nearly cost-free imports of goods and services
to the US.

If the US wished to encourage certain countries to officially dollarize their economies, it could
easily afford to share some of the seigniorage benefits. That seems a reasonable tradeoff, since
dollarization would enhance trade with those countries, to the advantage of both.

Political Considerations

An important political issue is the effect on national pride. Most people see their currency as
a symbol of national sovereignty. Losing their own currency could be difficult for many to
accept. It could foster the 'imperialist Yankee' reaction, particularly when some incident strains
relations. Also their politicians could find it convenient to lay the blame for their own
mismanagement and poor economic conditions on US monetary policy. These, rather than
purely monetary issues, appear to be of primary concern to the US.
2.4 DOLLAR OVERTAKES STERLING AS THE LEADING
INTERNATIONAL CURRENCY

The global economic and financial crisis has lent new impetus to discussions of the future of
the international monetary and financial system. Some advocate moving to a multipolar system
in which the US dollar shares its international currency role with the euro, the Chinese renminbi
and/or the IMF’s Special Drawing Rights. At the Cannes Summit of November 2011, G20
Leaders committed to taking ―concrete steps‖ to ensure that the international monetary system
reflects ―the changing equilibrium and the emergence of new international currencies‖.

Some observers expect this change to develop spontaneously, as a natural consequence of the
declining economic and financial dominance of the US and the increasingly multipolar nature
of the global economy, together with the advent of the euro and gradual internationalisation of
the renminbi. Sceptics object that the prospect of a shift to a multipolar monetary and financial
system is remote. If it occurs, they insist, such a transition would take many decades to
complete.

The view that a shift to a multipolar system is unlikely to occur rapidly is rooted in theoretical
models where international currency status is characterised by network externalities (see for
example Krugman 1980 and 1984; Matsuyama et al. 1993; Zhou 1997; Hartmann 1998; and
Rey 2001). These give rise to lock-in and inertia effects, which benefit the incumbent.

Such models rest, in turn, on a conventional historical narrative, epitomised by Triffin (1960),
according to which it took between 30 and 70 years, depending on the aspects of economic and
international currency status considered, from when the US overtook Britain as the leading
economic and commercial power and when the dollar overtook sterling as the dominant
international currency. Allegedly, sterling remained the dominant international currency
throughout the interwar years and even for a time after the Second World War.
Recent studies (Eichengreen and Flandreau 2009 and 2010) have challenged this conventional
account, showing that the dollar in fact overtook sterling already in the mid-1920s as lead
currency for financing and settling trade and the leading form of international reserves. This
―new view‖, to paraphrase Frankel (2011), also challenges broader implications of the
conventional narrative. It suggests that inertia and the advantages of incumbency are not all
they are cracked up to be. It challenges the notion that there is room for only one international
currency in the global system, as well as the presumption that dominance, once lost, is gone
forever.

In a recent paper (Chiţu et al. 2012), we reexamine the role of international currencies as
vehicles and currencies of denomination for foreign investment. Specifically, we analyse the
currency denomination of foreign public debt for 33 countries in the period 1914-1946. The
results lend further support to the new view‖.

First, while network externalities, first-mover advantages and inertia matter, they do not lock
in international currency status to the extent previously thought. Abstracting from the
Commonwealth countries, whose allegiance to sterling was special, we show that the dollar
overtook sterling already in 1929, at least 15 years prior to the date cited in previous accounts
(see Figure 1). And even when the Commonwealth countries are included, we find that the
dollar was already within hailing distance of sterling as a currency of denomination for
international bonds by the late 1920s.

Second, our evidence challenges the presumption that monetary leadership once lost is gone
forever. Although sterling lost its leadership in the 1920s, it recovered after 1933 and was again
running neck and neck with the dollar at the end of the decade.

Third, our findings challenge the presumption that there is room for only one dominant
international currency due to strong network externalities and economies of scope. This is true
even if one takes into account the Commonwealth countries, which were heavily oriented
towards sterling for institutional and political reasons.
A regression analysis of the determinants of vehicle currency choice points to the development
of American financial markets as the main factor that helped the dollar overcome sterling’s
first-mover advantage. Financial deepening was the most important contributor to the increase
in the share of the dollar in global foreign public debt between 1918 and 1932 (see Figure 2).
In the case of the UK, economic stagnation, i.e., declining relative economic size, was the most
important factor accounting for sterling’s declining share over the period.

These findings have important implications for the future of the international monetary system.
They suggest that a shift from a unipolar dollar-based system to a multipolar system is entirely
possible; that it could occur sooner than often believed; and that further financial deepening
and integration will be a key determinant of the ability of currencies other than the dollar to
strengthen their international currency status.

The international status of a currency will only rest on solid foundations, however, if financial
deepening in the issuing country is sustainable, and not if financial innovation and liberalisation
simply cause a boom that eventually goes bust. The impact of finance on international currency
shares in global debt markets worked both ways in the interwar period. Our findings underscore
this point as well, insofar as the collapse of the US banking system and subsequent financial
retrenchment was the most important factor contributing to the decline in the share of the dollar
in global foreign public debt between 1932 and 1939.

This underscores that the compass guiding the pace and scope of financial sector reform should
always point to the direction of medium-term sustainability. In turn, this highlights the
important role that macro-prudential policies and tools will play in shaping the international
status of currencies in the new millennium.
Figure 1. Global foreign public debt – Selected currency shares (As a % of total; at current exchange
rates)

Figure 2. Estimated contributions to the change in the share of the US dollar in global foreign public
debt between 1918 and 1932 (in percentage points)
2.5 THE DOLLAR WILL REMAIN THE GLOBAL CURRENCY

People's Bank of China governor Zhou Xiaochuan recently sparked a new round of debate
regarding the international monetary regime with his call for a new international reserve
currency. While the dollar was not specifically mentioned, it is clear that the proposed new
international currency is meant to replace the role that the US currency currently plays. When
a senior official of a government that holds about 10% of the US government's marketable debt
makes such a statement, people take notice. There also appears to be some international support
for governor Zhou's idea, although the U.S. is understandably less enthusiastic. So will we see
the U.S. dollar lose its international preeminence anytime soon?

An evaluation of this question must begin with an understanding of why the U.S. dollar is so
well regarded globally in the first place. There are four main reasons for this. One, it has, at
least until now, been a reliable store of value. Two, it is the most widely accepted means of
international payment for goods and services. Third, large, deep, and liquid dollar financial
markets exist for savers to invest their money in. And finally, a long period of dominance has
allowed the currency to become a part of the international financial trading infrastructure.

The U.S. dollar is the most frequently used currency in international trade today. The fact that
the U.S. is the world's largest trading nation is only part of the reason. The value of international
trade that is invoiced in dollars is much larger than the total trade conducted by the U.S. and
countries with currencies linked to the greenback. This is particularly true in Asia, where many
countries bill more than 80% of their exports in dollars.
Large international savers such as the Persian Gulf states and East Asian exporters also find
U.S. financial markets most attractive. Partly, this is because Gulf oil exports are paid for in
dollars and because it is the most convenient currency with which to intervene in foreign
exchange markets for Asian central banks. But more importantly, the U.S. financial markets
remain the most efficient place to intermediate global funds. In these markets, particularly the
U.S. Treasury market, large amounts of financial assets can be bought and sold without causing
large movements in market price. Moreover, due to the narrow differences between buying and
selling prices, the costs of transacting in these assets are lower than in any other market.
Investing in U.S. financial markets, and also through the dollar in other financial markets,
therefore, lowers costs and increases the flexibility of portfolio decisions.

The previous two reasons also give rise to a third factor that keeps the U.S. dollar as the world's
currency. The dollar has become an integral part of international financial and commodity
markets because it is so frequently used in international trade and investment. In quoting
exchange rates, the value of a currency is most commonly stated in terms of the U.S. dollar.
Even in actual exchange, the dollar's role is important. A company wishing to exchange Thai
baht for New Zealand dollars typically buys U.S. dollars first, before converting them into New
Zealand dollars. As a result, the U.S. dollar is involved in one leg in close to 90% of all foreign
exchange transactions, compared with less than 40% for the euro and 16% for the Japanese
yen.

Similarly, commodities, such as oil and copper, usually have their quotes and their trades
executed in U.S. dollars. This prevalence also means that the dollar derivative markets are the
most developed for anyone wishing to hedge currency and commodity price risks.
The common factor crucial for the continued validity of the above support for the dollar's
international status is confidence in the stability of its purchasing power and confidence in the
government to honor its debts. Whether one is a trader or an investor, there is a need to hold
the currency on an ongoing basis. People have to believe that it is a good store of value, in that
the real effective exchange rate of the dollar is not expected to see large declines over the short
to medium term. This belief rests on the strength of the U.S. economy, the independence and
checks inherent in key institutions, as well as the prudence and coherence of its policies. If even
a significant minority of external creditors has doubts that these factors are no longer true, then
the U.S. dollar money and capital markets will become unstable. Real interest rates and equity
premiums will rise sharply and the dollar will fall precipitously against other major currencies.

The reason for governor Zhou's proposal is that recent developments have the potential to
weaken confidence in the dollar. As the U.S. has the largest trade deficit in dollar terms, its
vibrant economy as well as responsible fiscal and monetary policies have supported the value
of its currency. These conditions make investments in U.S.-based companies attractive and
the government's debt a safe asset to hold. As a result, the U.S. has managed to attract
international capital to help maintain its international balance of payments.

This foundation is looking shaky now that the economy has suffered serious damage, budget
deficits are expected to rise sharply, and the Federal Reserve is pursuing quantitative easing.
Not only have growth prospects dimmed, but inflation risk over the medium term has risen.
U.S. policymakers pursuing measures that deal with domestic problems, however, have
affected confidence over the longer-term attractiveness of the dollar. But it is still too early to
call the end of the pole position of the dollar. And even if it isn't, it is not clear that Zhou's
proposed use of the Standard Drawing Rights (SDR) is the right answer anytime in the next
few years.
The SDR is an accounting unit that represents a basket of currencies: U.S. dollars (44%), euros
(34%), yen and sterling (both 11%). It is neither used in physical nor financial trading, only in
the internal accounting of the International Monetary Fund. There is no economic need and,
therefore, demand for the unit. It will be difficult to persuade major financial institutions to
make expensive investments to change their systems for such trading. It will also be of little
use to international savers since it will take a long time, if at all, for SDR financial markets to
grow to a reasonable size. Finally, companies involved in international trade will find it
difficult to hedge the SDR against the domestic currencies that determine their costs of
production.

A more natural alternative to the U.S. dollar is a currency that is already widely used today.
Perhaps this is the reason China has signed currency swap agreements with a number of
countries recently. However, the yuan is hardly ready for a major international role anytime
soon. China's strict capital controls and restrictions on currency convertibility currently prevent
such a development. And in the next few years, it is unlikely that policy makers will have
sufficient confidence in the Chinese banks to subject them to the large international currency
flows that come with an internationalized yuan.

The most likely candidates for an alternative international currency are the euro and Japanese
yen. In recent years, however, the growth in the use of the euro has slowed significantly. In
terms of use in international trade and international debt issuance, the share of the euro has
stabilized. While its use in Europe is naturally widespread, the currency's influence outside the
region has remained small. The Japanese government's push to internationalize its currency in
the late 1990s met with no success. Also, while the U.S. economy has weakened recently, the
European and Japanese economies hardly seem in better shape.
Even more than the U.S., both Europe and Japan face serious demographic challenges that are
likely to bring down their medium- to long-term growth. Over a longer horizon, as long as
fundamental U.S. economic policies are not changed, the U.S. will continue to have better
growth prospects. The truth is that, in the near term, there appears to be no good alternative to
the U.S. dollar as an international currency.

It's also far from certain that current conditions in the U.S. economy are sufficiently serious for
the world to doubt the stability of the worth of its currency. Even counting a few years of
exceptionally large fiscal deficits, it is unlikely that the U.S. government debt will reach that
of the Japanese government in relation to their respective GDP. Yet, domestic confidence in
the Japanese government's creditworthiness is so strong that it can continue to borrow long
term at among the lowest interest rates in the world. These rates are achieved despite
maintaining an open capital account that has enabled the Japanese private sector to become one
of the world's largest external creditors. Meanwhile, the U.S. government experienced a far
higher debt burden than it has now, just after the Second World War. Yet, the dollar continued
to grow in international importance at that time.

And the dollar has survived other serious tests as well. In the early 1970s, there was a significant
loss of confidence in the U.S. currency, which eventually led to the dollar floating freely against
gold. Stagflation in the 1970s also called into question the preeminence of the U.S. economy
and the role of the dollar. In both episodes, however, the innovation and flexibility of the
country's open economy helped it to return to strong growth, which sparked renewed
confidence in the dollar as well.
What could prevent a similar revival are policy mistakes by the U.S. government. The
economic position of the U.S. will not emerge unscathed from this financial turmoil. In the near
to medium term, we believe some weakening of the dollar's dominance is likely. Only a
permanently less-vibrant U.S. economy, however, will ensure a trend decline in the dollar's
international importance. If that happens, it will most likely come from a structural shift in U.S.
economic policy, for example, if we were to see a much more protectionist international trade
regime or excessive regulation of businesses.

These risks could materialize. The rise of unemployment in the country, coupled with the
government's weakened finances, has led to rising pressures to put American firms and workers
first. The recent U.S. stimulus package, for instance, came with a "Buy American" clause.
Meanwhile, public discontent with executive compensation and increased state control over the
economy could lead to restrictive policies that could ultimately introduce excessive risk-
aversion in firms. Policy mistakes could lead to a period of price instability. Factors such as
these could diminish America's growth prospects and the long-term international status of the
dollar. But if that day arrives, we believe it will likely stem from developments in the U.S.
rather than from efforts abroad.
 CHAPTER – 3

THE INTERNATIONAL ROLE AND DECLINING STATUS OF THE DOLLAR

3.1 INTRODUCTION

The U.S. dollar is always in the news. This is not surprising, given the role of the United States
in the world economy and the role of the dollar in transactions around the world. During the
Great Recession, the strong dollar funding reliance of banks in some markets outside the United
States was not viewed as particularly noteworthy until balance sheet funding was disrupted.
Some of the news articles speculated on pending changes to the global financial system. As
one example, an article in the Financial Times (June 28, 2011) discussed a likely shift from
the dollar as the dominant reserve currency to a portfolio of currencies, based on a survey of
over 80 central bank reserve managers, sovereign wealth funds, and multinational institutions.
There is an expectation that there will be an associated evolution of the international financial
architecture. Of course, it is already the case that the U.S. dollar is not the only international
currency. The euro also is extensively used, and there are international roles for other
currencies including the pound sterling, the Swiss franc, and the Japanese yen.

For a currency, its international roles include serving as: a store of value and a unit of exchange;
a medium of exchange; an anchor currency in exchange rate regimes; a primary currency in
official foreign exchange reserves; a transaction currency in foreign exchange and international
capital markets; and an invoicing and settlement currency in international trade. As a preview
of main findings on currency status, we show that the dollar maintains a dominant role in all
key functions. However, there also are some areas where dollar dominance has declined.

The discussion of an evolving role of the dollar is not new. For example, in the past decade
there had been ample discussion of the euro overtaking the dollar as the key international
currency, or at least having a more balanced allocation of international activity across these
two currencies.

Much of the discussion, even from the academic side, focused on the role of the dollar in the
international reserve holdings of central banks. Chinn and Frankel (2008) is one example of
the reasoning behind evolving roles. They project that the dollar status has been based mainly
on the growth trajectories of different regions and argue that, in the next decade, the euro could
potentially rival or surpass the dollar. Likewise, Eichengreen (2011) forcefully argues that the
world is evolving toward a multicurrency regime, without the continuing dominance of the
U.S. dollar.
Most discussions of an expanding role of the euro have paused in the aftermath of the Great
Recession and during the period of European sovereign debt stresses. Instead, more recent
discussions have turned towards speculating about some the future roles for China’s currency,
the renminbi. In part, and following on the Chinn and Frankel arguments about country size,
this potential is due to because of the spectacular economic growth of China over the past two
decades. The argument holds that China’s historic rise as a global economic and trading power
will continue to profoundly reshape the global economic system. China’s promotion of RMB
internationalization in recent a time is viewed as having the potential to accelerate the removal
of China’s restrictions on international capital flows. I will not take a stand on projections for
the role of the dollar, euro, RMB, or any other currency. And, throughout this chapter, the
views are my own, and not those of the Federal Reserve Bank of New York or the Federal
Reserve System.

In this article I focus on a few main themes. I begin with a brief review of the main international
roles of currencies, and then present data on the status of the dollar in these roles, updating
Goldberg (2010). I next turn to three questions. First, from the vantage point of the United
States, what are the potential consequences of a change in the international role of the dollar?
Second, I note how my own research agenda addresses related questions. And finally, I discuss
what types of research questions are open and beckoning economic researchers in this area of
analysis.

As I turn specifically to the question of whether a potential decline in the international role of
the dollar or a rise in the roles of other currencies would be a concern, a key caveat prevails:
the contexts surrounding such changes are important. International currency usage is a market-
driven decision. The roles of currencies are not exclusively defined by the relative size of
countries and their country’s presence in international markets. Indeed, in the early part of the
20th century, the United States had surpassed the United Kingdom in size, but size alone was
not enough to unseat the pound sterling. Official and private sector agents have strong financial
incentives to ―vote with their feet‖ and use currencies that satisfy high standards of liquidity
and convertibility. Many dimensions influence such currency choice outcomes, including
country size, openness in international trade and international capital flows, creditworthiness,
and institutional and policy soundness and stability. The dollar’s primacy in international
economic transactions is a historical artifact that reflects the fact that the United States satisfied
these criteria following the ravages of World War II. Its status was institutionalized within the
Bretton Woods system and has been retained even as other economies, including the euro area
and China, have grown in strength. Size, openness, creditworthiness, and institutions and
policies have reinforced the status during this period.
Whether the rise of other currencies presents more negative or positive consequences for the
United States is closely linked to conditions within the United States. If the United States
maintains the strong economic fundamentals and the types of institutional strengths that have
supported the dollar’s international roles, the consequences of a reduced dollar role may not be
a large concern. Indeed, the emergence of plausible alternatives to the dollar could signal
strength in other economies and serve as a positive source of discipline on U.S. decisions. A
decline of dollar’s international primacy in such an environment is not to be regarded as a
significant threat to U.S. economic well-being when this decline arises in the context of strong
U.S. growth and institutional fundamentals.

However, if poor U.S. policy decisions undermine U.S. economic fundamentals and
institutional strengths, the reduced international role of the dollar could be one component of a
broader decline. The changes described below could have more adverse effects if the reduced
dollar role is associated with less auspicious U.S. policy and institutions.

A second caveat also applies to the discussion. While the exposition has a focus on the roles
of currencies, this is a somewhat distinct issue from a focus on the exchange value of
currencies. Exchange rates can move substantially, without immediately having bearing on the
international roles of currencies.
3.2 THE CURRENT STATUS OF THE DOLLAR IN ITS INTERNATIONAL ROLES

In policy discussions, two of the most frequently discussed roles of the dollar are as a central
currency in the exchange rate arrangements of many countries and in country international
reserves. While a historical perspective is provided in Goldberg (2010), up-to-date
information on the status of the dollar in these roles is provided.

Currency arrangements are grouped according to whether countries have dollarized or have
formed currency boards using the dollar, have a pegged exchange rate against the dollar, or
maintain managed floats with the dollar as a reference currency. The table shows statistics of
1995, 2000, 2005, and 2010. The statistics show numbers of countries with each exchange rate
regime status out of a total of 207 reporters. There also are statistics presented on the share of
GDP of all of these countries in the dollarlinked regime. As of 2010, eight countries are
dollarized or have currency boards using the dollar, and ninety have a pegged exchange rate
against the dollar. There is little evidence here that the dollar role as an anchor has changed to
date. Indeed, the share of global GDP for countries with exchange rate regimes tied to the dollar
has increased over time.

Country foreign currency reserves are another focal point of analyses and policy discussions.
Cross country data show that foreign exchange reserve holdings grew sharply over the recent
decade. While reserves dipped during the great recession, they have since resumed their climb,
nearing $10trillion in the beginning of 2011. In particular, reserves growth is dominated by,
but not limited to, developing countries. Within foreign exchange reserve portfolios, the dollars
denominated assets continue to account for the majority of reserves held by both industrialized
and developing countries, whether these assets are valued at current exchange rates or at
constant exchange rates. This distinction is useful as it abstracts from changes in portfolio
shares that might be passive and due to evolving currency values. These charts show that there
appears to have been some recent diversification away from dollars by developing countries.
Yet, overall and despite recent years of market turbulence, various crises, and including
movements toward greater internationalization of the RMB by China, the dollar has not
declined in prominence either as a central currency for exchange rate arrangements or as an
international reserve currency.
The next international currency role is as a transaction currency. A range of evidence shows
that the dollar continues to be the leading transaction currency in the foreign exchange markets
and a key invoicing currency in international trade. With an 85 percent share of foreign
exchange transaction volume--more than twice the share of next leading currency, the euro--
the dollar dominates these markets. Yet, this dominance has declined somewhat in the past
decade, even as volumes of currency transactions have more than doubled.

The dollar’s leading role in foreign exchange transactions also is reinforced by this currency’s
widespread use in the invoicing of international trade. Cross-country evidence in Goldberg and
Tille (2008), and the extended evidence in Kamps (2006), present some of the more
comprehensive views based on data at the level of country exports and imports. More recently,
the ECB report on The International Role of the Euro details currency use in imports and
exports of European Union countries. In general, the euro’s role rose in the years following the
advent of the euro, before stabilizing. More recent evidence on direction of changes in euro
and dollar shares is mixed across counties. In other recent work using Canadian Customs data
(Goldberg and Tille 2010), I document relatively stable use of the dollar, euro, and other key
currencies in invoicing international trade over the past decade.

International debt and loan markets are yet another area in which currency roles can be
compared. The ECB has compiled comprehensive data which show the shares of euro’s,
dollars, yen and other currencies in all outstanding debt securities, issued anywhere in the
world. The growth of debt issuance within European economies, including internal markets of
the euro area, has been associated with a declining dollar share in all debt securities. Another
key gauge of presence in international finance is the dollar-denominated share of all securities
sold outside the issuing country and in a currency different from that of the issuer’s country.
Within this narrower type of debt issuance -- termed ―international debt securities‖ -- the dollar
role continues to expand. Currently, dollars account for nearly half of all debt when borrowers
turn to external markets and foreign currency financing. It also is the dominant currency in
liabilities extended to both nonbank and bank counterparties. The dollar share in loans to bank
and non-bank customers has remained around 60 percent. The dollar also plays an important
role in the growing volumes of cross-border loans of banks.
3.3 CONSEQUENCES OF THE U.S. DUE TO DECLINING DOLLAR STATUS

It is sometimes argued that the United States extracts large benefits from the privileged
international status of the dollar. It is less frequently asked what could be the consequences of
a decline in this status. We examine the potential consequences in five areas: seignorage
returns, funding costs, transaction costs, U.S. insulation to foreign shocks, dollar valuation,
and U.S. global influence. These consequences are summarized discussed in more detail below:

➢ Seignorage revenues:

Seignorage gains on currency outstanding can be approximated by the difference between

interest earned on securities acquired in exchange for bank notes and the costs of producing
and distributing those notes. Total seignorage returns to the United States are estimated to be
moderate, despite roughly $1 trillion in cash dollars in circulation. In a low interest rate
environment seignorage gains can be relatively small, with an upper bound of around $2.5
billion per year if calculated at 25 basis points, or $20 billion if calculated at an interest rate of
2 percent. By some estimates, in excess of 60 percent of U.S. dollar notes are outside of the
United States. Clearly, changes in volumes of dollar cash holdings that are outside of the United
States would alter these gains proportionately.
 ➢ Funding costs:

It sometimes argued that one reflection of the ―exorbitant privilege‖ afforded the United States
due to the dollar’s international status is evidenced in the lower funding costs facing U.S.
borrowers on dollar liabilities. This point has been at the center of heated debate. While U.S.
entities have had higher rates of return on outward investments compared with what is paid to
foreign investors on U.S. inward capital flows, the evidence for exorbitant privilege per se is
disputed. Careful empirical investigation by Curcuru, Thomas and Warnock (CTW 2011)
shows that most of the differential in funding costs on U.S. borrowing roles versus those on
U.S. investments is attributable to the different composition of outward and inward capital
flows. In Particular, U.S. outward investment is more heavily focused on higher return foreign
direct investment. While there remains a small advantage on average for the United States
compared to other countries in official and bond financing, this is not relative to all countries.
Also, recent studies attribute the lower rates charged the United States on its debt to country
risk premia, differences in tax rates, and the relative stability of investment returns across
nationalities, rather than to the dollar’s international role per se. There is a conceptual counter
argument provided by Gourinchas and Rey (2011), in which there is effectively an insurance
premium paid by the rest of the world to the United States for its exorbitant duty in giving the
world a stable anchor and for providing other countries lender of last resort resources. This
argument does not refute the CTW evidence, but does raise interesting questions about the role
of currencies and volumes of flows Vis a Vis the United States during crises.

Regardless of one’s stance in this exorbitant privilege debate, it is certainly possible that
funding costs could rise on U.S. government borrowing if the assets of other countries emerge
as stronger alternative investment vehicles to U.S. Treasuries, or if the safe haven role of the
dollar is perceived as eroded. This could potentially reduce the demand for U.S. government
debt relative to the non dollar denominated assets purchased by private and official sector
investors. A reduced demand for U.S. official sector debts could increase the debt financing
costs for the United States, having as a consequence a higher fiscal burden of U.S. debt and
perhaps an increasing crowding out of domestic public and private sector spending. A reduced
demand for the U.S. assets also could lead to U.S. dollar depreciation.
 ➢ US insulation from foreign shocks:

The dollar’s role in invoicing international trade and its predominance in international
borrowing and lending activity have traditionally provided the United States with a degree of
insulation from shocks that originate in foreign markets. This type of insulation is discussed in
Goldberg and Tille (2006). The relatively low sensitivity of U.S. import prices to exchange rate
changes results in less expenditure switching between home and foreign goods when the dollar
value changes. The low import price sensitivity is partially attributable to the use of dollars in
trade invoicing. With increased use of other currencies in invoicing trade and in borrowing and
lending activity, the insulation could decline. In particular, reduced dollar invoicing of
international trade and use of dollars in international borrowing and lending activity could raise
exchange rate pass-through into domestic import prices, and ultimately make U.S. prices more
sensitive to foreign fluctuations. Thus, when the dollar exchange rate moves, more of the
expenditure switching burden is felt in the United States and less by our foreign trading
partners. Greater invoicing in other currencies could shift the adjustment burden more to the
United States. On the financial side, the global predominance of the dollar has enabled U.S.
entities to issue their debt in U.S. dollars, helping the U.S. government and private entities
avoid the ―original sin‖ of large currency mismatch risks on their balance sheets.

Overall, the increased use of other currencies in place of the dollar in international roles such
as trade invoicing and lending and borrowing activity could lead to a directional rebalancing
of international transmission of shocks and stimuli. The United States could be influenced
more by the policy decisions and economic cycles of foreign markets, and increasingly take
these into account in a range of policy decisions made in the domestic economy.
 ➢ Dollar valuation:

A currency’s value is supported by its status as the primary global reserve currency to the extent
that U.S. dollar assets are demanded by public and private sector entities worldwide. If, for
example, there was a withdrawal of foreign exchange reserve demand for U.S. dollars, this
occurrence could be associated with a depreciated U.S. dollar relative to whichever currency
gets an enhanced role. The potential economic consequences of a weaker dollar are mixed. The
U.S. debt burden does not increase in dollar terms since U.S. liabilities are denominated in
dollars, regardless of the size of external debt of the United States. However, higher costs of
carrying the debt could arise if further dollar depreciation is expected and compensation for
that risk is required by investors. Changes in the value of the dollar also are associated with
well-established facts on competitiveness of U.S. exporters and importers. Countries that use
the dollar on their international trade with other (non-U.S.) counterparties also may be affected
(Goldberg and Tille 2009).

US global influence:

Less quantifiable but potentially more significant could be a loss of global prestige and policy
influence for the United States resulting from a shift towards a multi-polar currency world.
One key channel of U.S. global influence in the modern economic system has been its influence
on the institutions, such as the IMF and World Bank that undergird the current international
economic and financial order. A second avenue by which U.S. influence may be impacted by
growing international use of other currencies in international negotiations and transactions.
This could further strengthen the reach of other countries in ways that could differ from U.S.
preferences and interests.
3.4 THE WORLD'S CURRENCY: THE U.S. DOLLAR AND ITS FUTURE STRUGGLE
FOR SUPREMACY

The US dollar is used at the reserve currency for the rest of the world, but much like the English
Pounds Sterling, that dominance might not last forever. With the dollar as the world's reserve
currency, the US is insulated from foreign supply shocks, reduces transaction costs in trade,
and contributes to the international transmission of US monetary policies. The dollar is likely
to continue its global dominance of the currency markets in the near term; however, there are
significant pointing towards a reduction in the dollar's world market share.

The transition in the computer industry from one dominant operating system to a few dominant
operating systems is comparable to what is occurring in the currency markets today. 10 years
ago when you purchased a computer you did not have the option of an operating system, you
only got Windows. Now a person buying a new computer has many options to choose from.
Like the computer industry in the past, advances in foreign technology and portability have set
the stage for three major currencies to duke it out over the next ten years. The Chinese renminbi,
the euro and the US dollar are all trying to dominate the global currency market.
The dollar has to overcome a few fiscal challenges if it wants to stay the major currency in the
markets. As you can see from the graph of UUP, a fund which tracks the dollar's value, there
has been a significant decline recently. US debt is approaching 75% of the national income,
which is significant given that the US only raises approximately 19% of national income from
taxes.

If this debt continues to increase, foreign users of the dollar will conclude that the US's only
way out of debt is by inflating the debt away. If this conclusion is reached by foreign leaders,
bankers, businesses and investors then a major collapse in the value of the dollar would occur.
Based upon current US fiscal trends, some experts have warned this collapse could occur within
the next 3 years.
The Chinese government is currently working very hard to make the renminbi an international
currency. A recent and public display of these actions can be observed by the Bank of China
offering foreign exchange services to American citizens. The Chinese have many more
significant steps to accomplish before the renminbi is truly an international currency, but the
Chinese government has shown a strong will to accomplish their fiscal goals.

Simply because the US government ignores the national debt does not mean that the rest of the
world will also turn a blind eye. If the US debt continues to increase, there will reach a point
when foreign investors, both public and private, will turn their backs on the dollar. Foreigners
will conclude that massive inflation is coming, and they will sell the dollar in droves. When
the smoke clears, the dollar will have lost the trust of the world, and the exorbitant privilege
which comes with being the world's currency.

3.5 US DOLLAR TO REMAIN DOMINANT GLOBAL CURRENCY DESPITE ITS

ECONOMIC TRAVAILS

History shows that the global economic system has often been based on an asymmetric
relationship of an anchor economy - currently the US - that runs persistent current account
deficits even as it provides liquidity to the rest of the world. This leads to a symbiotic
relationship where the anchor country gets cheap financing and the rest of the world gets the
monetary liquidity needed to lubricate economic activity.

Unfortunately, history shows this system eventually breaks down because the anchor country
needs to run continuous current account deficits in order to provide more and more liquidity
needed by an expanding world economy, making it increasingly indebted over time. In turn,
this undermines the very credibility on which the monetary system is based. This scenario was
first described in the 1950s in relation to the Bretton Woods system by Robert Triffin and has
since become known as Triffin's Dilemma.
During the Roman times, the world economic system was underpinned by booming trade
between the Roman empire and India. The problem with Indo-Roman trade, however, was that
India ran a large trade surplus with the empire. This deficit meant that there was a continuous
drain in gold and silver coins that, in turn, created shortages of these metals in Rome (in modern
terms, this was a monetary squeeze).

The Romans unsuccessfully tried to impose restrictions on imports but eventually resorted to
reducing the gold/silver content of imperial coins (the ancient equivalent of printing money).
Yet, frequent findings of Roman coins in India suggest that Roman coinage continued to be
accepted for a long time after it was obvious that the gold/silver content had fallen.

Spain was the world's dominant power in the 16th century but expensive wars caused it to run
continuous deficits and eventually default. Yet, Spanish silver coins continued to be the key
currency used in world trade right up to the American Revolution. In fact, they remained legal
tender in the US till 1857 - long after Spain itself had ceased to be a major power.

In fact, the only clear historical solution to Triffin's dilemma can be seen with the 'triangular
trade' system between Britain, India and China in the 19th century. Under this arrangement, the
British sold manufactured goods to the Indians and purchased opium. The opium was then sold
to the Chinese in exchange for goods that were then sold back in Europe.
Britain did not bleed gold in order to keep the system flowing. This system was stable in the
sense that it did not suffer from Triffin's Dilemma but functioned because the East India
Company was militarily able to impose its will. Chinese attempts to close down the opium trade
resulted in the Opium Wars of 1839-42 and 1856-60. In other words, Triffin's dilemma was
circumvented through war, colonisation and drugrunning.

By the 1870s, the world had shifted to a gold standard underpinned by the Bank of England's
willingness to convert sterling into gold on demand. However, Britain's economy was
surpassed by the US in 1890 and the Gold Standard was abandoned due to the shocks of WW1
and the Great Depression. The pound sterling however, continued to be a world currency till
after WW2. Even in 1950, 55% of foreign exchange reserves were held in sterling and many
countries continued to peg their currencies to it.

Under the Bretton Woods system after WW2, the US dollar became the anchor currency with
an explicit gold peg. Yet again, the need to run deficits to supply the Europe with liquidity
undermined the gold peg and the Bretton Woods system collapsed in 1971. Or did it? Over the
next few decades, Asian currencies pegged themselves to the dollar and pursued exported-
oriented growth strategies.

The system allowed the peripheral economy (say, China) to grow rapidly even as the anchor
economy (US) enjoyed cheap financing. Note how the relative rise of China did not diminish
the role of the US dollar and may even have enhanced it. Indeed, like the Japanese during their
period of high growth, the Chinese resisted the internationalisation of the Chinese yuan till
recently and even now are proceeding very cautiously.
So, should we expect the demise of the US dollar? The best sign of the resilience of the dollar-
based system is that its trade-weighted index has been stable since the crisis began - hardly a
sign that it is being abandoned. Far from it, the world appears to be willing to finance the US
at very low interest rates.

History shows that once an anchor currency has established itself, it can be very resilient and
often outlasts the economic and geo-political dominance of the country of origin. It is possible
(albeit not certain) that China will replace the US as the world's largest economy within a
decade, but we feel that US dollar will remain the dominant global currency for a long time
afterwards.
 CONCLUSION

The international role of the dollar remains substantial a decade after the introduction of the
euro, and despite changes in the value of the dollar and the fi nancial turmoil that began in
2007. Use of the currency abroad continues to have a range of consequences for the United
States. In general, it helps insulate the U.S. economy from foreign shocks, reduces transaction
costs in trade and finance, and extends the international transmission of U.S. policy. For non-
U.S. economies, broad use of the currency in reserves and in international transactions is
typically associated with greater sensitivity of trade, inflation, and asset values to international
movements in the value of the dollar.

As the size and structure of the global economy change, international currency use may change
as well. Despite evidence of the dollar’s vitality, the currency’s preeminence could diminish in
the future. Indeed, historical precedent exists for the rise and fall of the international status of
currencies. In the fi rst half of the twentieth century, for example, the dollar overtook the pound
sterling as the dominant reserve currency.

Changes to the global economy could have major implications for the international
transmission of shocks, the value of the dollar, and welfare across economies. Accordingly, it
seems important for policymakers to monitor use of the dollar in international economic
activity and to understand the potential causes and consequences of the dollar’s changing
international role.
 BIBLIOGRAPHY
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