Published March 1, 2021 by Jacob Eigner, Class of 2021 at Georgetown Law, IIEL Fellow.

I. Dumping the Dollar: A Call To Action

In 1944, the Bretton Woods Agreement pegged the currencies of the countries that made up the majority of the global economy to gold. Because the United States (U.S.) controlled most of the world’s gold at the time, the agreement effectively cemented the United States Dollar (USD) as the international reserve currency, the main currency the world uses to trade and save. This special role for the USD has long engendered enmity even amongst allies; most famously, French Finance Minister d’Estaing accused the U.S. of enjoying an “exorbitant privilege” due to the USD’s reserve status. And yet in 2021, thirty years after the end of the gold standard, the USD is still by far the most commonly held reserve currency and is considered the lingua franca of global trade.[1]

This status quo is immensely favorable to the U.S., but is at risk of weakening due to technological friction. The International Monetary Fund has reported that the USD share of total global reserves declined to a post-World War II low of 60.46% in 2020.[2] A combination of decreased demand for the USD, Quantitative Easing (QE), persistently low interest rates, and a higher inflation target by the Federal Reserve (“the Fed”) threatens to exacerbate the issue by raising fears of debasement of the USD. Both Goldman Sachs and Morgan Stanley cited these fears of debasement in their 2021 forecasts, which reflect a general bearish sentiment towards the USD in relation to other currencies.[3] Bitcoin and other cryptocurrencies (cryptos) represent an existential threat to analog currencies in general, and other major currencies are racing to digitize in order to maintain relevance and use.

Reserve currency status for the U.S. appears to be under pressure from all sides and demands action to rectify the situation. Most future projections for the Japanese Yen, the Chinese Yuan, and the Euro predict that they will strengthen significantly against the USD, signaling a trend towards a world with multi-polar reserve currencies rather than one dominated by the USD.^[4] In particular, European countries outside the Eurozone have recently increased reserves of the Euro, and Asian countries have dumped USD in favor of the Yen and the Yuan.[5] Perhaps even more worrisome, the technology of digitization and tokenization has proliferated in developing countries and increased the feasibility of cutting out the analog USD entirely. These trends have been enabled by the rapid and turbulent rise of Bitcoin and its crypto peers. The Fed should make digitizing the USD their highest priority to stay competitive in this rapidly changing landscape and to avoid a trend that would possibly lead to the decline of the USD as the world reserve currency. This brief examines the mixed blessing of reserve currency status and explains how a transition to a digital currency could reverse these downward pressures on global USD use and ownership.

II. “An Exorbitant Privilege” for American Business and Consumers

In light of the amazing advantages that reserve currency status brings, proposing solutions to mitigate the possibility of a multi-polar reserve system which supplants the dominant USD is particularly important. The status of the USD as the world’s reserve currency has improved quality of life domestically for several decades in important ways.[6] Benefits include reduced pain in running current account deficits, decreased foreign exchange risk for U.S.-based firms, and increased buying power for the American consumer despite low interest rates and QE. These benefits create significant incentives for the Fed to make any adjustments necessary to maintain the system as currently constituted.

From a macroeconomic standpoint, reserve currency status allows the U.S. to maintain current account deficits without commensurate consequences. The U.S. has run a current account deficit in the hundreds of billions of USD for at least the last twenty years since reliable data on the subject has been available.[7] Normally, this current account deficit would raise the cost of borrowing for the government and could be a significant contributing factor to forced austerity policies such as those of the Greek government during the 2008 debt crisis. Yet as other developed countries such as Greece have undergone strong fiscal reforms, forced austerity measures, and even humanitarian crises, in part due to their current account deficits, the American standard of living has consistently risen year-over-year. While America essentially lives beyond its means by far exceeding its income with expenditure, its special status in the global economy has propped up this major imbalance and demonstrates the exorbitant privilege of America due to the special status of the USD.[8]

More directly, the American consumer has enjoyed the unique status of the USD through increased buying power despite persistent QE and low interest rates, as reserve currency status has allowed the government to use these tools to strengthen the economy without incurring destabilizing inflation. The Fed has gone through several cycles of QE since the 2008 Financial Crisis, buying massive amounts of securities on the open market and thus increasing the supply of the USD.^[9] In addition, the effective federal funds interest rate has not risen above 2.41% since 2007, in comparison to historical rates of 12.92% (June 1974), 19.1% (July 1981), and 6.5% (September 2001), for example. This combination of trillions in Federal Balance Sheet expansion and low interest rates would normally cause a destabilizing level of inflation, as it has in Argentina.^[10] However, the relative value of the USD as of February 2021 is relatively unchanged in relation to other currencies compared to ten years earlier despite years of rock-bottom rates and intermittent trillions spent on QE. Consequently, American consumers have prospered by continuing to enjoy cheap imports and the stabilizing effect of low interest rates and QE on the economy simultaneously.

American commercial interests also enjoy the exorbitant privilege of the USD. Because commodities, loans, and global investment opportunities are usually denominated in USD, firms in the United States enjoy lower exchange rate risk than firms in any other country. As volatility rises, so does exchange rate risk.[11] Consequently, firms based in the United States can limit risk by scaling back international operations more easily than foreign firms. This gives U.S.-based firms a particular advantage during periods of upheaval such as the coronavirus pandemic and the 2008 global financial crisis, as evidenced by significantly higher U.S. stock market performance during those periods and overall.[12] Relatedly, U.S. firms also get easier access to capital because of the USD’s reserve status, specifically due to increased ease of pricing loans and assets internationally.[13] The advantages of foreseeability and access to readily valued capital have resulted in years of consistent outperformance by American firms when compared to their foreign counterparts.

III. Transitioning to a Central Bank Digital Currency Will Strengthen the USD’s Status as the World’s Reserve Currency

America is behind its peers in transitioning from an analog USD to Central Bank Digital Currency (CBDC). Perhaps recognizing the opportunity to redirect aspects of the exorbitant privilege to themselves, other central banks have aggressively pursued the digitization of their currency while publicly pushing for debate on an eventual shift away from the USD.[14] Specifically, efforts by China to digitize the Yuan through real-world testing are already underway, Japan has sponsored a pilot test of the digital Yen, and the E.U. has targeted mid-2021 to institute plans for a digital Euro.[15] While the Fed already issues digital money to commercial banks, there are currently no official plans to shift to a CBDC for consumers or to test this concept in real-world conditions. The first major currency to transition from analog currency to a CBDC will likely enjoy a significant first-mover advantage and greater currency use, as citizens of less developed countries face less barriers to converting their currencies into the more stable tokenized foreign currency.[16] This potential for greater use of another currency relative to the USD, when combined with preexisting pressure from other developed countries to explore other avenues, underscores the urgent priority of digitizing the USD in order to negate any first-mover advantage by another country. If no action is taken, digitization and automation threaten to create global systems of exchange that for the first time since 1944 can cut out the analog USD entirely.^[17]

Digitizing the currency will also likely blunt competition from Bitcoin and other cryptos, which represent an existential threat to analog currencies. Bitcoin was incepted only 12 years ago, yet has quickly become a heavyweight. Self-reported crypto use has skyrocketed to over 10% of the population in much of the developing world and at least 5% in the United States.[18] As the trend towards crypto use has quickened, it has become apparent these currencies pose a significant threat to the USD’s dominance, and both the public and private sectors have taken note.[19] Payment services such as PayPal, Visa, and Square as well as consumer goods companies like Tesla have recognized the rapid rise of crypto both as a speculative asset and as a medium of exchange that could replace the analog USD, and have started to accept them as payment.[20] Meanwhile, the mayor of Miami has proposed allowing local tax payments in Bitcoin and converting portions of the city’s treasury into crypto assets.[21] Furthermore, the proliferation of crypto options in the 8.2 trillion 401(k) Defined Contribution market promises to further normalize use and investment in assets such as Bitcoin.[22] Rapid inflows and widespread acceptance underscore how cryptos are quickly proliferating the global financial system, and represent an existential threat to analog currencies that fail to transition to a CBDC.

Transition to a CBDC would help to solve the issues of other developed countries digitizing their currencies and the proliferation of cryptos. Digitizing the USD would effectively blunt any first-mover advantage enjoyed by the Yen, the Yuan, or the Euro.[23] Additionally, a CBDC backed by the U.S. government will immediately undercut many of the selling points of cryptos. A tokenized USD would share many of the advantages that attract the global consumer to Bitcoin, such as secure transactions and no need for payment processing services, but would also be much more stable when compared to the wild volatility of Bitcoin.[24] By staving off these threats, the transition to a CBDC can help to avoid a precipitous drop off in use and demand for the USD and defy widespread expectations for debasement, thus cementing reserve currency status.

IV. The Path Forward

Reserve currency status for the USD confers the U.S. exorbitant privilege which the Fed should protect. Built-in demand for the USD allows the U.S. to persistently run current account deficits, avoid foreign exchange risk for U.S.-based firms, and keep the value of the USD stable despite low interest rates and QE. This reserve currency status is currently facing two strong pressures: other developed countries attempting to create a first-mover advantage by transitioning to a CBDC before the USD, and the rise of Bitcoin and other cryptos. These two pressures have the potential to diffuse and negate the great advantages that the USD currently enjoys without decisive action by the Fed. Potential action items include running real-world tests of a digital USD similar to those being conducted in the Chinese cities of Beijing, Shenzhen and Sozhou with the Yuan.[25] The results of these tests in America can be used to transition to a digital USD quickly and efficiently in an effort to maintain the exorbitant privilege conferred by reserve currency status.

In November 2019, Fed Chairman Jerome Powell said that the central bank is “carefully analyzing” the idea of transitioning to a CBDC.[26] Although this is encouraging, the time for reasoned deliberation is at its end. The transition to a tokenized USD is now unavoidable and urgent. If the USD remains in its analog format, the exorbitant privilege that American corporations and citizens have enjoyed since 1944 due to reserve currency status will likely become attenuated.

Thank you to IIEL’s Prof. Chris Brummer, Marie Kasperek, and Meha Jain for their contributions.

Sources:

[1] Anashu Siripurapu, The Dollar: The World’s Currency, Council on Foreign Relations, Updated September 29, 2020. https://www.cfr.org/backgrounder/dollar-worlds-currency.

[2] International Monetary Fund, Currency Composition of Official Foreign Exchange Reserves, Updated December 23, 2020. https://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4.

[3] International Banker, Is the US Dollar’s Role as the World’s Reserve Currency Under Threat? September 30, 2020. https://internationalbanker.com/finance/is-the-us-dollars-role-as-the-worlds-reserve-currency-under-threat/.

[4] Stephen Roach, How the Coming Crash in the Dollar will Unfold, Bloomberg, June 14, 2020, https://www.bloomberg.com/opinion/articles/2020-06-14/dollar-crash-how-will-it-unfold.

[5] Frances Coppola, Could the Dollar be Replaced as the World’s Reserve Currency? American Express, https://www.americanexpress.com/us/foreign-exchange/articles/could-dollar-be-replaced-as-world-reserve-currency/.

[6] Bob McTeer, Reserve Currency Status—A Mixed Blessing, Forbes, September 5, 2013. https://www.forbes.com/sites/bobmcteer/2013/09/05/reserve-currency-status-a-mixed-blessing/?sh=1a3f8b9a4e59.

[7] Federal Reserve Bank of St. Louis, Balance on Current Account, Updated June 19, 2020, https://fred.stlouisfed.org/series/IEABCA.

[8] Sebastian Edwards, America’s Unsustainable Current Account Deficit, National Bureau of Economic Research, March 2006, https://www.nber.org/digest/mar06/americas-unsustainable-current-account-deficit#:~:text=The%20U.S.%20current%20account%20deficit%20essentially%20is%20a%20reflection%20of,inflows%20of%20money%20from%20abroad.

[9] Cheng, Powell, Skidmore & Wessel, What’s the Fed doing in response to the COVID-19 Crisis? What more Could it Do?, Brookings Institution, January 25, 2021. https://www.brookings.edu/research/fed-response-to-covid19/.

[10] Antonia Oprita, Argentina shows the bad side of Quantitative Easing, Market Moving, http://www.marketmoving.info/argentina-shows-bad-side-quantitative-easing/.

[11] Paul Krugman, International Economics: Theory and Policy,https://saylordotorg.github.io/text_international-economics-theory-and-policy/index.html.

[12] Ryan Frydenlund, A Fresh Look at U.S. vs. International Equity, Raffa Investment Advisers, September 9, 2020. https://raffawealth.com/us-international-equity/.

[13] Nick Bunker, Being the reserve currency has its privileges and costs, Washington Center for Equitable Growth. https://equitablegrowth.org/reserve-currency-privileges-costs/.

[14] Carbaugh & Hedrick, Will the Dollar be Dethroned as the Main Reserve Currency? Global Economy Journal, 2009, https://www.researchgate.net/publication/46555000_Will_the_Dollar_be_Dethroned_as_the_Main_Reserve_Currency/.

[15] Giancarlo & Gorfine, The future of money should be cashless — with a digital dollar giving faster, easier and cheaper access to your savings, MarketWatch, November 5, 2020. https://www.marketwatch.com/story/the-future-of-money-should-be-cashless-with-a-digital-dollar-giving-quicker-easier-and-cheaper-access-to-your-savings-2020-11-05; Patrick Thompson, A digital yen will be piloted in 2021, CoinGeek, November 19, 2020. https://coingeek.com/a-digital-yen-will-be-piloted-in-2021/.

[16] Michaels & Vigna, The Coming Currency War: Digital Money vs. The Dollar, The Wall Street Journal, September 22, 2019. https://www.wsj.com/articles/the-coming-currency-war-digital-money-vs-the-dollar-11569204540/.

[17] Accenture Digital Dollar Foundation, The Digital Dollar Project: Exploring a US CBDC, May 2020, https://static1.squarespace.com/static/5e16627eb901b656f2c174ca/t/5f0c5d052d6235002637d0f6/1594645769165/Digital-Dollar-Project-Whitepaper_vF_7_13_20.pdf.

[18] Michaels & Vigna, The Coming Currency War: Digital Money vs. The Dollar, The Wall Street Journal, September 22, 2019. https://www.wsj.com/articles/the-coming-currency-war-digital-money-vs-the-dollar-11569204540/.

[19] Ruchir Sharma, Will Bitcoin End the Dollar’s Reign?, The Financial Times, December 8, 2020. https://www.ft.com/content/ea33b688-12e0-459c-80c5-2efba58e6f1a.

[20] Hannah Murphy, Facebook’s Libra currency to launch next year in limited format, The Financial Times, November 27, 2020. https://www.ft.com/content/cfe4ca11-139a-4d4e-8a65-b3be3a0166be; Balogh and Obaze, Visa Launches Pilot Program to help fintechs offer crypto trading, February 3, 2021; Steve Kovach, Tesla Buys 1.5 Billion in Bicoin, Plans to Accept it as Payment, CNBC, February 8, 2021. https://www.cnbc.com/2021/02/08/tesla-buys-1point5-billion-in-bitcoin.html; Balogh & Oblaze, Visa Launches Crypto Trading Pilot Program, February 3, 2021. https://www.businessinsider.com/visa-launches-pilot-program-crypto-trading-api-fintechs-first-boulevard-2021-2.

[21] Leeor Shimron, Miami Mayor Francis Suarez Talks Bitcoin & Building a Tech Innovation Hub, Forbes, February 7, 2021. https://www.forbes.com/sites/leeorshimron/2021/02/07/miami-mayor-francis-suarez-talks-bitcoin–building-a-tech-innovation-hub/?sh=16d1aac11a53/.

[22] Brian Anderson, Bitwage Launches World’s First Bitcoin 401k Plan, 401k Specialist Magazine, May 27, 2020.  https://401kspecialistmag.com/bitwage-launches-worlds-first-bitcoin-401k-plan/#:~:text=Contributions%20to%20the%20Bitcoin%20401k,the%20cryptocurrency%20each%20pay%20period.&text=What’s%20being%20touted%20as%20the,companies%20to%20offer%20to%20employees.&text=Employees%20will%20be%20able%20to,Bitcoin%20as%20they%20see%20fit.

[23] Tatiana Koffman, Senate Moves Closer to Digital Dollar, Forbes, July 1, 2020. https://www.forbes.com/sites/tatianakoffman/2020/07/01/senate-moves-closer-to-digital-dollar/?sh=5b22d33f7279.

[24] Hannah Lang, A Fed digital currency looks inevitable. So do the problems. American Banker, November 4, 2020. https://www.americanbanker.com/podcast/a-fed-digital-currency-looks-inevitable-so-do-the-problems.

[25] Evelyn Chang, China plans to hand out 1.5 million in a digital currency test during the Lunar New Year, CNBC, February 8, 2021, https://www.cnbc.com/2021/02/08/china-to-hand-out-1point5-million-in-lunar-new-year-digital-currency.

[26] Nikhilesh De, The Federal Reserve is Experimenting with a Digital Dollar, Coindesk, August 13, 2020. https://www.coindesk.com/the-federal-reserve-is-experimenting-with-a-digital-dollar.