Picture a game of Jenga, with the U.S. dollar as the key piece holding the global monetary system together. Accounting for roughly 60% of global foreign exchange reserves, 40% of global trade, and 88% of global payments, the U.S. dollar is the most widely used and trusted currency worldwide. But what if that crucial piece starts to wobble? What if the credibility of the U.S. as the dollar’s issuer is undermined by economic, political, and geopolitical factors, causing other countries to lose confidence in the dollar and seek alternatives? This could have severe consequences for global monetary stability, such as price volatility, higher interest rates, currency wars, or financial crises.

To understand how this could transpire, we must delve into the fascinating history of the global monetary system, examining the critical transitions between Bretton Woods I and Bretton Woods II. In this article, we will explain how the collateral behind the global reserve currency shifted from commodity to credibility due to these two systems, how the erosion of this credibility can lead to price volatility and higher interest rates, the options for responding to a credibility crisis through austerity or stimulus measures, and historical examples and outcomes of these measures.

Bretton Woods I: The Gold-Dollar Standard

Bretton Woods I, established after World War II, was a system of fixed exchange rates founded on gold and the U.S. dollar, intended to foster international trade and collaboration. Countries agreed to peg their currencies to the dollar within a narrow fluctuation range, while the U.S. pledged to convert dollars into gold at a fixed rate of $35 per ounce for foreign governments and central banks. Consequently, the dollar was effectively gold-backed, with gold serving as the ultimate collateral for the global reserve currency.

For a time, this system functioned well, offering stability and predictability for international transactions. However, it also encountered challenges and limitations. For instance, countries had to relinquish some control over domestic economic policy to maintain their exchange rate pegs by adjusting interest rates and money supply. Additionally, this system created tension between the dollar’s domestic and international roles, requiring the U.S. to balance its own economic needs against its responsibilities as the reserve currency issuer.

This tension intensified in the 1960s and 1970s when the U.S. grappled with escalating balance of payments issues and inflation. As more dollars circulated overseas than gold reserves held domestically, foreign governments and central banks grew increasingly concerned about their dollar holdings’ value and sought more gold in return. This pressured the U.S. to either devalue the dollar or tighten its fiscal and monetary policy — both options with adverse domestic economic consequences.

Bretton Woods II: The Trust-Dollar Standard

Bretton Woods II refers to the floating exchange rate system based on trust in the U.S. dollar, which took shape after Bretton Woods I collapsed in 1971. In this system, countries let their currencies fluctuate according to market forces while still maintaining substantial dollar reserves. The U.S. no longer guaranteed dollar-to-gold conversion but relied on its economic prowess and political leadership to maintain currency confidence. As a result, the dollar was no longer gold-backed but instead anchored by trust in the U.S., making trust the primary collateral for the global reserve currency.

This system had its pros and cons. On the one hand, countries enjoyed greater flexibility and autonomy in their domestic economic policies, free from the constraints of fixed exchange rates. On the other hand, this system introduced increased uncertainty and volatility in international transactions, as exchange rates could shift unpredictably due to market forces or speculative attacks. Additionally, it fostered dependence on the U.S. as the reserve currency issuer, requiring countries to accept its economic policy decisions and political influence.

This dependence became more evident in recent years as challenges and criticisms weakened U.S. credibility. For instance, the 2008–2009 financial crisis triggered a global recession and revealed flaws in the U.S. regulatory system. The U.S. also implemented unconventional monetary policies like quantitative easing, flooding the world with inexpensive dollars and raising concerns about inflation and devaluation. Political instability and polarization hindered U.S. governance and leadership, while geopolitical competition and conflicts with countries like China and Russia challenged its hegemony and interests.

The Impact of Eroding Credibility on Price Volatility and Higher Interest Rates

These factors have led some countries to question the U.S. dollar’s dependability as a stable store of value and medium of exchange. Consequently, some countries are diversifying their reserves away from the dollar and exploring alternative reserve currencies or assets. For example, countries have increased their gold, cryptocurrency, or other commodity holdings as a hedge against dollar depreciation. Additionally, some countries are trading more in their own or regional currencies, such as the euro or the yuan. There have even been discussions surrounding the creation of a new, more stable and representative global reserve currency.

These actions could significantly impact global monetary stability. Reduced demand for and value of the dollar, coupled with heightened exchange rate volatility and uncertainty, could make international trade and investment more expensive and risky. This would affect global prices for goods and services. Furthermore, it could make it more difficult for the U.S. to finance its deficits and debt, potentially forcing it to raise interest rates to attract foreign capital. Consequently, this could hinder U.S. economic growth and recovery, impacting its ability to maintain global leadership and influence.

Responding to a Credibility Crisis: Austerity vs Stimulus

The U.S. faces a critical decision in addressing its credibility crisis: whether to adopt austerity or stimulus measures. Austerity measures involve policies aimed at reducing government spending, increasing tax revenues, or both, in order to decrease budget deficits and debt levels. Conversely, stimulus measures involve policies designed to boost government spending, reduce tax revenues, or both, with the goal of increasing economic activity and job creation.

Proponents of austerity argue that reducing public debt is essential to restoring confidence in the U.S. dollar and economy, thus averting a sovereign debt crisis. They maintain that by cutting spending and raising taxes, fiscal discipline will improve, interest rates will decrease, and private investment will be encouraged. Austerity supporters also contend that such measures will have positive long-term effects on economic growth and competitiveness by minimizing distortions, inefficiencies, and crowding-out effects resulting from excessive government intervention.

On the other hand, advocates for stimulus measures assert that increased public spending is necessary to stimulate demand and output in a struggling economy and prevent a deflationary spiral. They claim that by increasing spending and lowering taxes, job creation, income growth, and multiplier effects will boost economic growth and tax revenues. Stimulus supporters also argue that such measures will positively impact long-term economic growth and potential by enhancing public investment in infrastructure, education, healthcare, and research.

Historical Examples of Austerity vs Stimulus

There are numerous historical examples of countries adopting either austerity or stimulus measures in response to economic crises or shocks. Some notable examples include:

1. The Great Depression of the 1930s: Initially, many countries pursued austerity policies, such as reducing public spending, raising taxes, and maintaining the gold standard after the stock market crash of 1929. These policies intensified the depression and led to social unrest and political instability. Later, some countries switched to stimulus policies, such as increasing public spending, lowering taxes, and devaluing their currencies after abandoning the gold standard, which helped them recover from the depression and prepare for World War II.
2. The Latin American Debt Crisis of the 1980s: During this period, many Latin American countries faced a debt crisis due to a sharp rise in interest rates and falling commodity prices. They were forced to adopt austerity policies as part of structural adjustment programs imposed by the International Monetary Fund (IMF) and other creditors. These policies led to worsening economic and social conditions and sparked widespread protests and resistance movements.
3. The Asian Financial Crisis of 1997–98: Following a sudden reversal of capital flows and a currency crisis, many Asian countries experienced a financial crisis. They were forced to adopt austerity policies as part of bailout packages offered by the IMF and other creditors. These policies exacerbated the economic and social impact of the crisis and led to widespread discontent and political change.
4. The Global Financial Crisis of 2008–09: During this crisis, many advanced countries initially pursued stimulus policies to rescue their financial sectors and support their economies. These policies included increasing public spending, lowering taxes, cutting interest rates, injecting liquidity, and providing guarantees and bailouts, which helped prevent a global depression and restore some economic growth and stability.
5. The European Debt Crisis of 2010 onwards: Some European countries faced a debt crisis following a surge in public debt and deficits after the global financial crisis and the eurozone crisis. They were forced to adopt austerity policies as part of rescue packages offered by the European Union (EU) and the IMF. These policies deepened the recession, increased unemployment and poverty, and led to social unrest and political fragmentation in these countries.

Conclusion

In conclusion, the dominance of the U.S. dollar as the global reserve currency is contingent on the credibility of the U.S. as the issuer of the dollar. Erosion of this credibility could lead to serious consequences for global monetary stability, such as price volatility and higher interest rates.

In response to its credibility crisis, the U.S. has two main options: austerity or stimulus. The choice between these options depends on the specific situation, but historical examples suggest that stimulus measures tend to be more effective and less harmful than austerity measures in times of economic crisis or shock. However, stimulus measures also come with drawbacks, such as higher inflation and interest rates, which could further erode U.S. credibility. It’s essentially a choice between the better of two unfavorable scenarios.

Stimulus measures can help restore confidence in the economy by creating jobs, increasing incomes, generating multiplier effects, and raising economic growth and tax revenues. Austerity measures, on the other hand, can undermine confidence in the economy by destroying jobs, reducing incomes, creating negative feedback loops, and lowering economic growth and tax revenues.

As such, it may be advisable for the U.S. to pursue stimulus measures rather than austerity measures in response to its credibility crisis. Achieving this will require a high degree of political will and cooperation among all stakeholders, which can be challenging in a complex and polarized environment. Nonetheless, it may be necessary in order to prevent a global monetary crisis that could have far-reaching effects on the U.S. and the world.