The Dollar Reigns Supreme, by Default

• Author: Eswar Prasad
• Position: a professor in the Dyson School at Cornell University, a senior fellow at the Brookings Institution, and a research associate at the National Bureau of Economic Research.

The dollar has been the preeminent global reserve currency for most of the past century. Its status as the dominant world currency was cemented by the perception of international investors, including foreign central banks, that U.S. financial markets are a safe haven. That perception has ostensibly driven a significant portion of U.S. capital inflows, which have surged in the past two decades. Many believe that this dollar dominance has allowed the United States to live beyond its means, running sizable current account deficits financed by borrowing from the rest of the world at cheap interest rates. Some other countries have chafed at this “exorbitant privilege” enjoyed by the United States.Â

Moreover, the fact that a rich country like the United States has been a net importer of capital from middle-income countries like China has come to be seen as a prime example of global current account imbalances. Such uphill flows of capital—contrary to the prediction of standard economic models that capital should flow from richer to poorer countries—have led to calls for a restructuring of global finance and a reconsideration of the roles and relative importance of various reserve currencies.Â

The 2008–09 global financial crisis, whose aftershocks continue to reverberate through the world economy, led to heightened speculation about the dollar’s looming, if not imminent, displacement as the world’s leading currency.Â

Indeed there are indications that the dollar’s status should be in peril. The United States is beset by a high and rising level of public debt. Gross public (federal government) debt has risen to $16.8 trillion (see Chart 1), roughly equal to the nation’s annual output of goods and services. The aggressive use of unconventional monetary policies by the Federal Reserve, the U.S. central bank, has increased the supply of dollars and created risks in the financial system. Moreover, political gridlock has made U.S. policymaking ineffectual and, in some cases, counterproductive in driving the economic recovery. There are also serious concerns that recent fiscal tightening has constrained the government’s ability to undertake expenditures on items such as education and infrastructure that matter for long-term productivity growth.Â

All these factors should have set off an economic decline in the United States and hastened erosion of the dollar’s importance. But the reality is starkly different. The dominance of the dollar as a global reserve currency has been barely affected by the global financial crisis. Not only did the dollar’s share in global foreign currency reserves change only modestly in the decade before the crisis, it has held steady at about 62 percent since the crisis began (see Chart 2). Overall, foreigners have sharply increased their holdings of U.S. financial assets. Foreign investors now hold nearly $5.6 trillion in U.S. government securities (see Chart 3), up from $1 trillion in 2000. In fact, during and after the recent crisis...