How the West Was One

A world without the US dollar is a near impossible thought. But spurred on by the Russia–Ukraine conflict and the extension of sanctions, many now see a fast-growing challenge to the US dollar’s dominance from rival units such as the Chinese yuan.

Doubters point to the fall in the US dollar’s share of forex reserves from 73% in 2001 to under 59% today. Academics widely predict that the world is heading for a multipolar currency system. There is even a clamour to label these new configurations ‘Bretton Woods II’ or even ‘Bretton Woods III’, after the 1944 world monetary conference which set out the currency contours that underpin the international liberal order.

I disagree on most counts. As this article argues, Bretton Woods I effectively still exists and continues to drive Western economic supremacy. The error is to see Bretton Woods as an accounting system for world trade, with once fixed exchange rates. Whereas, in practice, Bretton Woods supports a $170 trillion global funding system, based around the US dollar, that allows capital to circulate worldwide.

It seems too extreme to consider the current international system a new variant, when the bulk of the original Bretton Woods structure and its very modus operandi remain largely intact. Indeed, apart from abandoning explicit currency pegs, little else has changed.

The US dollar retains its paramount role; the IMF and World Bank are still policing us, and the geopolitical agreements that underpinned the original deal not only continue to backstop the system, but they have lately reappeared in an updated guise as US dollar ‘swap lines’ that crucially discriminate ‘friend’ from ‘foe’.

Many argue that 15 August 1971, when US President Richard Nixon closed the ‘gold window’, was a key turning point because it removed the once explicit gold bullion guarantee of $35/oz for the US dollar. A move later epitomised in Treasury Secretary John Connally’s savage quip to Europeans that ‘it’s our currency, but it’s your problem!’. Yet, in the event, the ‘Nixon Shock’ was much more about domestic politics. It imposed tough wage and price controls plus a 10% import surcharge. Perhaps surprisingly, it included no immediate devaluation of the US dollar. Admittedly, the yen and eventually the deutsche mark were ‘floated’ in spring 1973, but, even then, this came with much reluctance.

If there was a systemic change, it lay in recognising the power of footloose private capital. Since the 1970s, global adjustment has increasingly depended on international private banks and cross-border capital flows, not official IMF loans, with the role of the US Federal Reserve formalised through its recent provision of swap lines, the de facto lender of last resort. Many politicians often preferred to borrow rather than devalue their currencies. The US dollar flourished as a funding currency by exploiting the greater freedom of capital and the growing pool of Eurodollars, fuelled by OPEC oil revenues and the Soviet Union’s hesitancy to hold on-shore US dollar deposits. In facilitating and hedging new loans, international banking capital expanded both sides of the financial sector balance sheet by rapidly growing their assets and liabilities. Not surprisingly, Wall Street and American finance became major beneficiaries of these capital flows. Capital mobility represented the new paradigm. Deficits no longer mattered, if they could be financed. This greater elasticity of international credit proved the crucial factor driving decades of Western economic growth.

Many of the plaudits here must go to Treasury Secretary William Simon who secretly persuaded Saudi Arabia in July 1973 and later OPEC, to not only price crude oil in US dollars, but also to invest their bloated US dollar oil revenues into US assets. In return, America supposedly guaranteed Saudi national security, explicitly linking currencies to geopolitics. The Bretton Woods’ gold anchor was effectively replaced with an anchor of ‘safe’ US Treasuries and a legal commitment by borrowers to repay US dollar-denominated loans, thus locking in a future demand for US currency. Despite the slowly grinding wheels of the SWIFT transfer system, by controlling international financial payments, settlement and clearing, the US was able to maintain the dollar’s long-held seigneurage advantage, the so-called ‘exorbitant privilege’.

Bretton Woods II is a headline-grabbing label pinned to the more stable currency arrangements that evolved after the 1997/98 Asian Financial Crisis. Yet, the US dollar remained central in the payments system throughout and the IMF was closely involved in managing the crisis.

So, what has changed? The Bretton Woods III idea is yet another eye-catching moniker that has been coined to popularise the idea that the ‘reserve asset’ of the international monetary system will shift again to a basket of physical commodities. However, commodity prices are notoriously volatile and hence a questionable store of value. Even gold itself has proved throughout history insufficiently stable to be used as a monetary commodity.

By focusing on the denomination of trade flows rather than the source and destination of capital flows, the idea of Bretton Woods III is a non-starter. Put another way, even with commodity-backing for a currency, whose banks are going to lend against this collateral?

Rather, the international monetary system is best seen as a US dollar-based global funding system. The world needs somewhere acceptable to place its surplus capital, while the flip side requires an asset market that is willing to absorb these inflows – the US dollar and Wall Street.

The US Federal Reserve directs US dollar liquidity via control of its balance sheet and through its swap lines. In fact, the current set-up parallels the 19th-century sterling-based financial system where London’s capital markets fulfilled the same role for the British pound then as New York does for the US dollar today. 150 years ago, the international ‘safe asset’ was the ‘bill on London’ – now it is the US Treasury note. Simply changing the currency denomination of trade flows away from the US dollar, say into yuan, and imposing sanctions against certain countries, namely Russia and Iran, will chip away at US dollar usage, but they will not displace the US dollar unless they challenge this funding system.

The Chinese yuan is unlikely to fulfil a future funding role without an equivalent network of international banks, without sourcing a ‘safe asset’ and given China’s existing capital controls. Nonetheless, I noted in Capital Wars that China has a clear goal. In a speech from 2015, a People’s Liberation Army major general Qiao Liang argued that China ‘should promote the renminbi to be the primary currency of Asia, just as the US dollar first became the currency of North America and then the currency of the world’.

China is already trying to fulfil its currency ambitions in a number of ways. First, it is increasingly redenominating its trade in yuan and developing a yuan-based trade credit market operated by Chinese banks. Second, by opening up its domestic bond market to foreign capital to establish a ‘safe asset’. Third, by introducing a digital-yuan, or e-CNY, that along with CIPS, China’s rival to SWIFT, can be used to make trusted peer-to-peer transfers. While there has been significant progress, the fact remains that China’s financial system is comparatively underdeveloped, given its huge economic size and paradoxically it still remains hooked on the US dollar.

What is more, although China’s capital controls may be less stringent than in the past, they still constrain off-shore liquidity and the international circulation of the yuan. Relaxing capital controls proved disastrous for China in 2015/16 as domestic money fled. This led to a hasty reversal and to heightened surveillance of its citizens. It now seems too radical for China to backtrack. In addition, China’s still nascent domestic financial system is kept on a tight leash by the People’s Bank and is less likely to both innovate and supply risk-taking capital to foreigners. In contrast to the US Federal Reserve, there is no evidence that the Chinese authorities would be prepared to support foreign banks with emergency cash in crises. At best, the yuan will gain ground as a vehicle currency in trade, but it is miles away from becoming a funding currency in capital markets. This means that China will only slowly be able to wean itself off the US dollar, which again will have implications that will limit its geopolitical ambitions.

Despite counter-claims for a Bretton Woods III, Russia cannot mirror the success of the US’s petrodollar arrangements by tying the rouble to energy payments. Not only is there unlikely to be any future significant offshore market in roubles, equivalent to the Eurodollar markets, but why should investors trust the Russian unit, not least when the country’s polity lacks transparency and the Russians have a costly war to pay for?

Part of the solution to the 2008/09 global financial crisis explicitly recognised what I dubbed ‘capital wars’. The US Federal Reserve created and deployed swap lines that very clearly demarcate ‘friend’ from ‘foe’. Since the financial crisis, the Federal Reserve now exercises greater control over the US dollar supply compared to the off-shore markets, which have lately suffered from capital repatriation following US tax changes and tighter controls on transnational banks through larger capital requirements, money-laundering checks and counterterrorism regulation. These capital wars will prove bruising. Russia has recently adopted discriminatory tactics, similar to those used by the US, for its energy payments, while China itself has a history of sanctioning countries that speak out against it, such as Australia. Exactly which camp, friend or foe, each national economy now chooses matters a lot.

Clipping the wings of the US dollar funding system is very different from successfully building a rival. Bretton Woods may be explicitly turning into a ‘friend’s club’, but it remains central to the West’s liberal order.