Since World War II’s end, the US dollar has beenused to invoice most global trade, serving as the intermediary currency forclearing international payments among banks and dominating officialforeign-exchange reserves. This arrangement has often been criticized, but isthere any viable alternative?

The problem for post-WWII Europe,mired in depression and inflation, was that it lacked foreign reserves, whichmeant that trade carried a high opportunity cost. To facilitate trade withoutrequiring payment after each transaction, the Organization for EuropeanEconomic Cooperation created the European Payments Union in 1950. Supported bya dollar-denominated line of credit, the EPU’s 15 Western European memberstates established exact dollar exchange-rate parities as a prelude toanchoring their domestic price levels and removing all currency restrictions onintra-European trade. This formed the keystone of the hugely successfulEuropean Recovery Program (the Marshall Plan), through which the US helped torebuild Europe’s economies.

Today, mostdeveloping economies, with the exception of a few Eastern European countries,still choose to anchor their domestic macroeconomic arrangements by stabilizingtheir exchange rates against the dollar, at least intermittently. Meanwhile, toavoid exchange-rate conflict, the US Federal Reserve typically stays out of thecurrency markets.

But the dollar’s roleas international anchor is beginning to falter, as emerging markets everywheregrow increasingly frustrated by the Fed’s near-zero interest-rate policy, whichhas caused a flood of “hot” capital inflows from the US. That, in turn, hasfueled sharp exchange-rate appreciation and a loss of internationalcompetitiveness – unless the affected central banks intervene to buy dollars.

Indeed, since late2003, when the Fed first cut interest rates to 1%, triggering the US housingbubble, dollar reserves in emerging markets have increased six-fold, reaching$7 trillion by 2011. The resulting expansion in emerging markets’ monetary basehas led to much higher inflation in these countries than in the US, and toglobal commodity-price bubbles, particularly for oil and staple foods.

But the US is alsounhappy with the way the dollar standard is functioning. Whereas othercountries can choose to intervene in order to stabilize their exchange rateswith the world’s principal reserve currency, the US, in order to maintainconsistency in rate setting, does not have the option to intervene, and lacksits own exchange-rate policy.

Moreover, the USprotests other countries’ exchange-rate policies. Two decades ago, the USpressed the Japanese to allow the yen to strengthen against the dollar,claiming that Japan’s unfair exchange-rate policies were responsible forAmerica’s ballooning bilateral trade deficit. Likewise, today’s “China-bashing”in the US – which has intensified as China’s contribution to America’s tradedeficit has soared – is intended to force the Chinese authorities to allowfaster renminbi appreciation.

Herein lies the great paradox. Although no one likes the dollar standard,governments and private market participants still consider it the best option.

In fact, US trade deficits are primarily the result of insufficient,mainly government, saving – not a misalignedexchange rate, as economists have led policymakers to believe. Large US budgetdeficits during Ronald Reagan’s presidency generated the famous twin fiscal and trade deficits of the 1980’s. This,not an undervalued yen, caused the bilateral deficit with Japan to widen in the1980’s and 1990’s.
The much larger US fiscal deficits of the new millennium, courtesy of Presidents George W. Bush and BarackObama, portend large – and indefinite – tradedeficits. But American policymakers continue to blame China, claiming that therenminbi has been undervalued for the last decade.
The claim that exchange-rate appreciation will reduce acountry’s trade surplus is false, because, in globally integrated economies,domestic investment falls when the exchange rate appreciates. So the ill willthat China-bashing is generating is for nothing. Worse, it detracts political attention from America’s hugefiscal deficit – $1.2 trillion (7.7% of GDP) in 2012 – and thus impedes any serious effort to rein in future spendingfor entitlements, such as health care and pensions.
Some contend that large fiscal deficits do not matter ifthe US can exploit its central position under the dollar standard –& thatis, if it finances its deficits by selling Treasury bonds to foreign centralbanks at near-zero interest rates. But America’s ongoing trade deficits withhighly industrialized countries, particularly in Asia, are acceleratingde-industrialization in the US, while providing fodderfor American protectionists.
Indeed, America’s trade deficit in manufactures is roughlyequal to its current-account deficit (the amount by which domestic investmentexceeds domestic saving). So those concerned with job losses in USmanufacturing should join the chorus lobbyingfor a much smaller fiscal deficit.
Can large US fiscal deficits and near-zero interest ratesbe justified because they help to revive domestic economic growth and jobcreation? Five years after the credit crunch of2007-2008, it seems that they cannot. And, without even that justification, thelatest wave of criticism of the US dollar standard appears set to rise further– and to stimulate the search for a “new” arrangement.
Butthe best new arrangement – and possibly the only feasible one – would follow anold formula: as in the 1950’s and 1960’s, the US would set moderately positiveand stable interest rates, with sufficient domestic saving to generate a(small) trade surplus. The cooperation of China, now the world’s largestexporter and US creditor, is essential for easing and encouraging thetransition to this nirvana. Apart from theongoing euro crisis, a stable renminbi/dollar exchange rate is the key torenewed (dollar) exchange-rate stability throughout Asia and Latin America – asenvisaged in the original 1944 Bretton WoodsAgreement.