Political Economy Review writer Daniel Burge writes on the hegemony of the US dollar in the global economy and its implications.
US dollar hegemony poses a difficult trade-off for the world’s economies. Increasingly exposed to exchange rate fluctuations and shifting trade patterns, a broad spectrum of countries will have to accept persistent inflation or risk painful recessions. The US’s historic and contemporary economic dominance has perpetuated outsized importance in the world economy, with the vast majority of global trade, investment, and credit all valued in dollar terms.
Commercial banks use the dollar as an intermediary and a benchmark when exchanging most currencies, while central banks in developing countries hold a large proportion of their foreign reserves in USD to prevent domestic currency fluctuations. Often, international companies not only borrow and lend in dollars, but settle trade contracts in dollar terms. As US interest rates rise, the USD’s unique position may force smaller economies to choose: continuing inflation, or stunted growth?
After a period of high inflation, the US Federal Reserve has begun to tighten monetary policy by sharply raising interest rates. This is at a pace exceeding that of most other central banks, such as the ECB. Consequently, smaller economies must respond in kind to avoid large dollar appreciations and subsequent relative increases in the cost of US imports, dollar-denominated liabilities, and dollar-denominated asset values.
Compared to an index of world currencies, the USD has already appreciated to historic highs. For smaller economies, permitting this change in exchange rates risks further fuelling inflation and increasing borrowing costs to unsustainable levels. However, aggressively raising interest rates to mitigate currency depreciations and reduce inflationary pressures risks stifling domestic prosperity.
Central banks must strike a delicate balance between various macroeconomic objectives: easing inflation, maintaining growth and employment levels, and maintaining a stable exchange rate vis-a-vis the US. Finding the optimal policy requires reliable forecasts of inflation, growth, and unemployment. Unfortunately, the post-pandemic – and now embattled – world economy is increasingly unpredictable. The persistence of inflation has wrought chaos, and forecasters, including central banks themselves, have seen their macroeconomic projections fail repeatedly.
The Hedgemon; the Hawk
The US holds a unique position with regards to inflation. The US dollar is the most important currency in the world, serving as a means of interaction with the world’s largest economy. Moreover, the strength and reliability of the US economy anchors international markets. Subsequently, the dollar functions not only as a powerful means of exchange, but also as a benchmark of value. A large proportion of trade is, and other countries’ foreign reserve holdings are, made in dollar terms. This reinforces the US’ position as hegemon: the reliability and usefulness of the dollar ensures its use, and its use compounds its importance.
The dollar’s position consequently self-perpetuates. As world crises occur or seem imminent, USD denominated assets form a ‘safe haven’ for international and institutional investors, exemplified by the increasing value of US treasuries in times of turbulence. This is a rational tendency, as the strength of the US economy makes it a reliable store of value but is also fuelled by contagious investor sentiment. When domestic governmental policy seems unreliable, or a nation seems poorly prepared to face economic shocks, investors tend to flee en masse to a more dependable market. This often magnifies what would be a limited market response to domestic events.
Moreover, increasingly hawkish US Federal Reserve policy is likely to strengthen the dollar further. Responding to historically high inflation, the Fed has begun to move towards higher interest rates, hoping to reel in remaining demand-driven inflation. The Fed is now a leader in raising interest rates in the developed world, with the Bank of England and many European central banks mimicking US rate rises. Similarly, nations with stringent pegs to the dollar, such as Saudi Arabia and Vietnam, must also copy US monetary policy to maintain their exchange rate regimes.
The combination of interest rate rises and investor sentiment, and how these reliably interact to propagate USD hegemony, reinforces the expectation that US assets will always be reliable and fare well in the future. This may lead to further US-bound investment, coupled with progressive dollar appreciation. This perpetuates the problem: the world is forced to react to a powerful dollar, whether it is macroeconomically beneficial or not.
Trade and debt
If trade partners decide not to mimic US interest rate hikes, the dollar will be relatively strong, making trade in dollar terms nominally more expensive for them. Simultaneously, the dollar would command greater purchasing power abroad. US inflation would fall as imports become cheaper. Importing US goods would become more expensive, driving inflation higher for trade partners. This complicates the industrialisation of developing nations, dependent as they are upon imports of Western manufacturing technology. Energy trade, undertaken globally in dollar terms, would become increasingly expensive for importing countries, while producing nations – the US included – would generate a windfall from the exchange rate changes. This threatens further inflationary pressure as necessary imports become more expensive.
Without intervention, sovereign debt burdens would also be magnified by US rate rises. American-provided loans are denominated in dollars and many foreign investors often expect national debt repayments in dollars. An appreciating dollar threatens to increase the real repayment burden of nominally valued loans, as the cost of exchanging a now weaker domestic currency for dollars implies a premium to interest repayments which had not existed when the loan was agreed. This is especially relevant after the expansion of sovereign debt overhangs throughout the Covid-19 pandemic and may forewarn of national debt defaults in the future if federal reserve rates are not responded to.
Follow the leader?
So why should other economies not raise their interest rates, considering their effectiveness in curbing inflation? The answer lies in inflation composition. Tightening monetary policy in the US is likely to reign in the strong post-pandemic economy. However, in economies where demand is less of a factor, and cost-push factors are more prevalent, it is hard to see how interest rate rises will be truly curative to inflation. As monetary tightening does little to influence the cost-push causes of inflationary pressures, it appears it would simply signal central bank action. However, the real economic effects would be more consequential.
Tightening monetary policy would drive up mortgage repayment costs, forcing those who are on variable rates to tighten further. Those paying for energy with loans will see rates rise for these also. Defaults may then follow, decreasing the value of mortgages and debt more generally. The subsequent fall in asset prices may well reverberate across international housing and debt markets. Firms, forced to service higher interest repayments, may be required to postpone expansions and even downsize. This would be reflected in increasing unemployment and stunted consumer/investor confidence. Inflation would remain high, but economic activity would stagnate.
A likely result is stagflation. While there is some macabre hope that asset prices could be depressed enough to mitigate inflationary pressures, driving destructive deflationary effects, this appears misguided. By failing to account for the true cause of inflation, depressing the economy would likely worsen short-term economic outcomes for the poorest in societies, while ignoring the long-term solutions necessary for bottlenecks and other cost-push factors to be remedied. Moreover, stunted growth would provide fewer opportunities for interventions, while draining public revenues when they are most needed to reduce the human impacts of energy-price pressures. Many economies, in following the dollar, may sign themselves into recession, at no true benefit to price stability.
No easy answer
These relationships, and their potential outcomes, are worth reflecting upon. Europe’s reliance on Russian energy has thrown into stark relief the dangers of interdependency, especially with nations which do not share otherwise commonly held values. Yet the world’s dependence on the dollar provides another example of poisoned connectedness in a completely different context. In struggling to respond to the new era of instability, countries may find themselves trapped by their connections not only to a belligerent Russia, but to an indifferent dollar as well.
This does not have to be the case: if the US Federal Reserve were to better cooperate with other central banks before setting monetary policy, the shock factor of US rate rises could be removed. The problems inherent in these rate rises would remain, but monetary policymakers would be better able to organise to assist one another with the effects. Whether this is likely is uncertain: part of the appeal of surprising rate rises is that the shock factor reiterates the seriousness of the task. If consumers and investors are convinced the Fed will do everything, they can in order to reduce inflation, reserve policy will be more effective. Shock and awe as a policy instrument may be too tempting to abandon, foreign economies be damned.
This article is published in partnership with “The Political Economy Review”. You can find the full article here.