Everybody hates the dollar.

• Author: McKinnon, Ronald

But there's no alternative. The solution is to stabilize the dollar-renminbi relationship.

The United States emerged from World War II as the only major industrial country with an intact and highly developed domestic financial system without exchange controls. Foreigners were free (if they could escape their own currency restrictions) to take positions in dollars: to hold dollar bank accounts or buy and sell U.S. Treasury bonds, and so on. The dollar then quickly became generally accepted as "international money." With the advantage of economies of scale from having just one key currency, the dollar remains so in 2014--even though other industrial economies have now opened their financial systems.

Since 1945, the dollar standard has played a dual role in the world economy--for facilitating private international commerce, and for domestic macroeconomic control by governments. These two roles are natural complements in such a key currency regime.

First, the dollar facilitates international trade by providing a common invoice currency for exports of primary commodities worldwide, and even for the manufactured exports of developing countries such as China. Outside Europe, the dollar both spot and forward is the vehicle currency used by banks to greatly reduce the private costs of making foreign exchange payments multilaterally.

Second, insofar as foreign governments have pegged their exchange rates to the dollar as has China, the dollar acts as a nominal anchor for their price levels--sometimes in the context of major domestic financial stabilizations.

For more than twenty-five years after World War II, U.S. government policy ensured that both the first and second roles held. The stable U.S. price level anchored price levels in the Western European and Japanese economies whose dollar exchange rates were more or less fixed. In recovering from the war, these industrial economies enjoyed very high trade-led growth in their real GDPs--reminiscent of China's growth in recent years. As the world's de facto central banker, the U.S. Federal Reserve behaved appropriately. In the 1950s and 1960s, the United States did not run with fiscal or trade deficits: it made substantial net direct investments abroad.

THE WEAK DOLLAR SYNDROME

But starting in the 1970s and continuing to the present day, an unfortunate confluence of economic circumstances began to undermine the second role--the dollar's anchoring role in the world economy. U.S. saving rates, both private and government, began to fall somewhat endogenously. Private saving edged downward, but public saving, in the form of federal fiscal deficits, fell quite sharply on occasion. In the 1980s, President Reagan presided over a large military buildup that was not tax-financed--and which led to the famous "twin" deficits of fiscal and trade. Although there were the usual dire warnings that such fiscal deficits would harm the economy, U.S. interest rates actually fell in the course of the Reagan "boom" in the late 1980s.

While generally unrecognized by politicians and most economists, it was (and is) the United States' central position within the world dollar standard that allowed it to borrow very cheaply by selling U.S. Treasury bonds and other financial assets to foreigners--mainly central banks in West Germany and Japan in the 1980s. Having learned a false lesson that deficits did not matter, this has emboldened American politicians--Keynesians to be more Keynesian in targeting unemployment with massive fiscal deficits during the 2008 downturn and disappointingly slow recovery, and supply-siders (sometimes called the Club for Growth) to become ever more reckless in their demands to cut taxes, or to refuse tax reforms to raise more revenue, or to provide tax revenues for needed public goods such as highways.

Since 2000, emerging...