Monetary policy

One of the turning points that defined the post-WWII period was the conference of allied nations in Bretton Woods, NH, in 1944 that redefined and largely reinvented the world financial system, with the dollar at its base.  This was not without cost to the US – essentially, we agreed to provide a stable reserve currency for the rest of the world, using dollars based on gold reserves.  This would allow all other currencies to be devalued against the dollar, giving other nations a trading advantage while they recovered from WWII.  It also meant we had to exercise considerable self-restraint in terms of currency stability.  The US ended the gold-standard in 1971, but the dollar remains the world’s reserve currency.

Having the dollar as the reserve currency provides a small, but steady subsidy for American businesses and the federal government, which has helped offset those costs as well as some of the costs to us of maintaining an expensive military capability.  We gain from every dollar held abroad as part of national reserves and we also gain by being able to borrow more cheaply than most nations would with our level of debts and political dysfunction.

The concern for many economists and government officials is that the decision to hold dollars, and to have international trade denominated largely in dollars, is entirely voluntary.  Each nation goes along with it because all the other nations do – it just makes sense to follow the crowd.  But this also means that the situation can change overnight.  Should we fail to put our economic house back in order, there will come a time when some nations see an opportunity to switch from the dollar to the euro, the yen, or maybe even the yuan, and it will make sense for everyone else to follow, just as the world switched from doing business in pounds sterling to dollars in the 1940s.

This would represent a major blow to the US economy as well as to US power and prestige.  If it happens, it will happen partly because we have allowed our economy and debt to deteriorate badly, but also because we have alienated other nations and lost their trust in our leadership.

 

Back to the Impact of Foreign Relations on the Economy

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