Yves here. This James Galbraith article on the history and prospects for the dollar is a meaty read, so I hope you can find time for it. It’s an excellent piece but others might tell a different story with somewhat different emphasis.
For instance, Galbraith depicts the rise of financiers to influence as inevitable in a post-Bretton Woods world. Perhaps, but that was only because they got rescued when they got themselves in trouble in a world of volatile markets, particularly interest rates. Having the government repeatedly eat the industry’s tail risks amounted to a massive subsidy.
That pattern had started in 1970, even before the post-Bretton-Wood era, when the Fed bailed out the commercial paper market (and Goldman Sachs) when Penn Central declared bankruptcy. The savings & loan industry was going bust by the later 1970s, leading to two rounds of salvage operations, the second after the famed S&L crisis.
Another factor was when the US embraced a strong dollar policy, which was terrible for US manufactures but great for its multinationals and its banks. The US lobbied aggressively for financial services industry deregulation around the world and had the World Bank, through its International Finance Corporation, encouraging developing economies to set up capital markets. I saw first hand how destructive this was to Japan. The US had whipsawed Japan’s foreign exchange rate through the Paris and then the Louvre Accord. A high yen did dent Japanese exports to the US but did not lead to more Japanese purchases of American goods. But the economic effect was large enough that the Bank of Japan lowered interest rates, with the intent of increasing consumption. It instead fueled speculation, even at the retail level.
While that was happening, the US also pressed Japanese banks to deregulate. Mind you, Japanese banks were not terrible at running retail branches and corporate lending operations. But the scope and speed of deregulation was tantamount to telling a drayage company that it was really in the transportation business and giving it a 747 to fly.
These factors made Japan’s real estate and stock market bubbles even worse than they would otherwise have been. No wonder China has been very attentive to Japan’s sorry fate.
And speaking of China…its rise would have been delayed had the US not pressed for China to be allowed to join the WTO before it qualified.
By James K. Galbraith, Lloyd M. Bentsen Jr. Chair in Government and Business Relations, University of Texas at Austin. Originally published at the Institute for New Economic Thinking website
As Costabile (2022) points out, the dollar has by now been de facto the primary world reserve asset for over a hundred years, first because of US preeminence in the holding of gold and its creditor position with respect to the European belligerents in the Great War. In 1944 US military and industrial power, soon to be backed, in the shadows, by a monopoly over the atomic bomb, were the foundations of the gold-exchange standard established at Bretton Woods.
A Brief History of the Neoliberal Era
On August 15, 1971, the curtain came down on the gold-exchange standard, and it rose – though we did not know it yet and thought otherwise at the time – on the neoliberal era. Devaluation, export controls, the wage-price freeze, and fiscal stimulus à outrance – these were Keynesian and even wartime measures that seemed to signal a mass conversion of Richard Nixon’s coterie to full employment, price stability, and managed trade. My father, John Kenneth Galbraith, the World War Two price control chief, was called by The Washington Post for a comment. “I feel like the streetwalker,” he replied, “who has just been told that not only is her profession legal, but the highest form of municipal service.”
The impression held through the explosive growth year of 1972, ensuring Nixon’s re-election with full employment at the highest real median wage of all time. But it fell apart in 1973 when the stimulus ended, controls were weakened or lapsed, oil prices spiked, and the resulting general inflation was met by high interest rates, spurring a new slump in 1974. At that point pre-Keynesian dogmas re-emerged in an updated toga. The Phillips Curve was declared vertical, so that unemployment was fixed at a “natural” rate, while the central bank was vested (by academics, though not yet in practice) with control of prices through control of the money supply. The consequence of any attempt to improve real performance – except by removing “rigidities” such as union wage contracts, unemployment insurance, and welfare programs, would be hyperinflation and the collapse of the dollar. Capitalism was thus a child of beauty, natural health, and balance – but prone to fits of hysteria or depression if fed either slightly too much or slightly too little, by its monetary Momma.
Exchange rate theory in the 1970s, as the Smithsonian agreement enshrining floating took hold, generally complemented domestic doctrine. In an extension of David Hume’s specie-flow model, deficits would force devaluations and surpluses would bring appreciations. If the Marshall-Lerner conditions held, then the realignment of relative prices would bring the current account back into balance. And for a while, all seemed to follow the plan: US trade deficits brought the dollar down, corresponding surpluses drove the Deutschemark and the yen up.
But the Marshall-Lerner conditions did not hold, and trade balances did not return to equality of exports and imports. Instead, the US issued Treasury bonds, while Japan and Germany accumulated financial assets. And in the Third World, ex China and India, the balance depended largely on the presence or absence of oil. Demand for oil, it turned out, is notably invariant to price. So as prices went up, for producers it was the best of times. And so long as oil importers wished to grow, they were obliged to cover the bill with borrowings from commercial banks, on terms that the bankers controlled, and at rates governed in the final analysis by the policy of the Federal Reserve.
In this way the abolition of the Bretton Woods system set in motion the final defeat of New Deal banking law and of balanced international financial governance, in the end restoring the financiers to the center of American and world economic power. For forty years that genie had been bottled up, internally by regulation, deposit insurance, and the Glass-Steagall Act, so that in the 1940s, 1950s, and 1960s banks were largely adjuncts to the large industrial corporations and under the fairly-effective discipline of the state. There were, accordingly, no financial crises from 1934 to 1974, when Franklin National Bank failed, followed in 1975 by the “fiscal crisis” – really a bankers’ crisis – of the City of New York. On the international side, capital controls and the IMF had provided (in principle) a similar damper. After 1971 and especially 1973, the currency casinos were open again.
The 1970s were nevertheless an apparently prosperous time in much of the Third World for oil exporters and most importers alike; credit flowed on easy terms and the bills could still be paid. There was therefore no tendency, in either the global North or the global South, for trade imbalances to self-correct. And as balance sheets grew, banks also prospered, while a latent power built in the hands of the agency charged with managing the interest rate.
The specific conditions of the United States in the 1970s were of economic goals that were, if not intrinsically incompatible, then unachievable with the tools on hand in the circumstances of the moment. These goals included high employment in the face of industrial encroachments from – at the time – most notably Germany and Japan; reasonably stable prices in the face of peak domestic conventional oil production, rising imports, and rising prices; and a strong international dollar, central to the power, prestige, and worldview of the bankers. The choice, ultimately, was to sacrifice labor and industry, while breaking the back of commodity prices, industrial wages, and therefore prices, all the while driving the dollar back into the global driver’s seat. This choice was made by Paul A. Volcker, appointed chair of the Federal Reserve Board by President Carter in the summer of 1979.
The rest is, so to speak, history. Volcker’s actions, redoubled in 1981 with the arrival of President Reagan, achieved their purposes on inflation, wages, unions, and the dollar. Exorbitant privilege got a new lease on life, one that has yet to expire, notwithstanding the later advent of the euro. Autonomous development strategies in Latin America, Africa and Southeast Asia were forcibly abandoned; the new mantra was “export-led growth” and incorporation into global value chains, specifically the sweatshop element thereof. Books balanced, if at all, via austerity, unemployment, curtailed imports, and the sale of public assets and mineral rights. When Mexico went to the brink of default in 1982, the squeeze was relaxed but only slightly and only enough to ensure the survival of the money-center banks. In the aftermath they would rule, almost undisturbed, for twenty years. The opening of Eastern Europe in 1989 and the fall of the USSR in late 1991 cemented the new order.
In short, with the end of Bretton Woods and the associated abandonment of capital controls by most countries, exchange rates became, to an overwhelming degree, an artifact of capital flows, asset transactions and relative rates of return, and thus substantially under the influence if not the control of private financial power. A period of orthodoxy, confidence and capital inflow would bring on the simulacra of prosperity, accompanied by Dutch Disease and deindustrialization. Asymmetric bets, as against Mexico in 1994 and Thailand in 1997, could precipitate a crisis. When crises hit, funds would flee to the safety of US Treasury bonds, inefficiencies, excesses, and “crony capitalism” would be duly discovered, and the IMF would be called in with ritual purgatives. No longer concerned with exchange-rate stabilization, still less with financing a development plan, the Fund and Bank became enforcers of an austerian and neoliberal code of conduct – the “Washington Consensus.”
What Backed the Dollar-Based System?
Thus, one may say that after 1981 the US returned to the 1920s system, but without the backing of a stranglehold over gold or the industrial and military superiority of the early and mid 20thcentury. It was the pull of high interest rates, the debt vulnerability of the Global South, and the accelerating decay of the Global East that combined to establish the dollar-based system under which we have lived ever since. From 1989 and especially 1991, this position was reinforced by the ideological and political collapse of the USSR and its socialist allies, with no corresponding gain in the underlying strength of the US position. On the contrary, the US camouflaged the consequences of deindustrialization and the moral effects of its defeat in Vietnam with a series of minor wars against apparently trivial opponents – in which sustained victory nevertheless proved elusive.
As recent crises make clear, up to now the dollar-based order has been supported mainly by instability elsewhere and the lack of a credible alternative or compelling reason to create one, or where such reasons are felt, the ability to do so. With a large and liquid market for debt, the US Treasury bond remains the refuge of first resort even when a financial upheaval originates within the United States, as was the case with the sub-prime debacles of the 2000s and even today. The system has been held up, in short, by confidence in itself, and not, so far as one can see, by much of anything else. This however did not necessarily portend collapse on its own in the immediate or even foreseeable future.
Had neoliberal hegemony been entirely complete, the doctrine of TINA – “there is no alternative” – could never have been refuted. But in fact, even in the West the doctrine was never universally or fully applied, and differences in economic and social performance could be noted. Egalitarian Scandinavia, industrially-integrated Germany, Japan, and the Republic of Korea, generally speaking, liberalized less and performed better. In the US itself, the stabilization and social insurance programs of the New Deal and Great Society largely endured, and the country benefited from the compulsive Keynesianism of its political elites, of both parties when crises hit. However this pragmatism was obscured by a dogmatic rhetorical commitment to free-market doctrines, and the industrial base continued to wither while, in each crisis, first and foremost, the banks were saved.
The triumph of neoliberal capitalism, the global hegemony of the United States in a dollar-based monetary world, and the end of history itself were, therefore, not firmly founded. The illusion could persist only so long as there emerged no clearly different, functionally superior economic development model. Had the victory of the neoliberals been complete, they might have put off that day indefinitely. But it wasn’t. And they couldn’t. Enter China.
China’s Challenge to the Neoliberal World.
The “rise” of China is an uncontested fact. As such it poses a lethal threat to neoliberal ideology, even though the Chinese themselves have made little effort to brand their experience and none whatever to export it as a competing economic model. China simply is, and as such it poses an interpretive challenge that neoliberalism cannot handle.
Consider the options. According to one, once popular but somewhat fading in recent years, China has made a successful “transition to capitalism” and owes its success to having applied the principles of the free market. But if that were the case, how can the West complain? It is unsportsmanlike to kvetch if bested at one’s own game.
A fall-back is to assert that while China has indeed played the capitalist game, it has gained an unfair advantage by bending “the rules” – for instance by appropriating “intellectual property,” manipulating the RMB, or running a low-wage industrial system. But this claim merely exposes the rules for what they are: an effort to preserve the monopolies and privileges of the already-rich. Such rules have been broken by every rising power going back to the 17th century at least; in the 19th century the practice of systematic violation of “the rules” even had a name: “The American System.”
The third option, taken up avidly by voices as disparate as Mike Pompeo and Robert Kuttner, is to slime China as a “totalitarian” state, an aggressive economic power, ruthlessly driven forward by its Communist Party. But this solution amounts to conceding the superiority of communism and the inferiority of capitalism and of democracy in the economic sphere. It thus completely negates the triumphalist posing that gave neoliberalism its legitimacy forty years ago.
The China that one sees with trained but unfiltered eyes does not so easily fit into these simple boxes. It has the following key characteristics:
The Chinese model has succeeded, by trial and error, over a bit less than 50 years, in eliminating mass poverty, in creating an urban world that is largely secure, with an educated, healthy population. In 2020 it succeeded in mobilizing that population to defeat the Covid-19 pandemic – so far, anyway – as no Western society, except New Zealand, was able to do. It now offers its engineering services as an export to the developing world on favorable financial terms and with no ideological or diplomatic baggage. It has no need of advertising this; the success of the model and the appeal of the offerings speak for themselves. For this reason, the public-relations counteroffensive from the West focused on flaws and allegations both real and imaginary, is necessarily intense.
Will the Chinese engine, now increasingly tied to a reconstructed Russia and the gravitational pull of the world’s largest demographic, productive, and trading region – the emerging Eurasian Economic Union and Shanghai Cooperation Organization – spell the end of the end of Bretton Woods? Is the writing on the wall, at long last, for the dollar-based international order?
The answer to this question depends not only on the size, productivity, and technical development of the Chinese nation and its economy but also on the role of Chinese financial assets in the world at large, in relation to the incumbent role of the financial assets of the United States, Europe, and other “Western” nations and international institutions, including the IMF.
China is now the world’s largest economy by purchasing power measures. It is the world’s greatest trading nation. But it plays neither the global financial nor the security role and has no evident ambitions to do so. Indeed, one may argue that to take on such roles would be antithetical to the Chinese development model, which rests on construction and production rather than finance, and which is entirely defensive militarily and reliant on international institutions, law, and cooperation for the preservation of world peace. China moreover protects its internal assets and limits the external reach of its economic actors with capital controls; it does not run current account deficits that would make obligatory the large-scale expatriation of financial claims, and to do so would be quite incompatible with its position in the structure of world production systems, and risk leading to internal instabilities that the Chinese state cannot afford. Finally, China holds over a trillion dollars in US government bonds, and cannot easily divest these, even if it wished to do so, without affecting either the price of the bonds or the exchange rate of the dollar, and so devaluing its own holdings.
What China can do, over time, is to take two steps that are evidently on the agenda. First, it can arrange for bilateral or multilateral payment mechanisms, with willing partners, that bypass the conventional medium of the US dollar. It can for example pay in RMB for Iranian oil and accept them back for Chinese goods. This works so long as trade in the non-dollar sector is reasonably balanced, so that the partner in the surplus position does not end up with large holdings of a financial asset it may not want, entirely trust, or be able to use in other transactions. But when trade is unbalanced for an extended period, one party or another may find themselves with financial assets denominated in units that are perceived to be insufficiently stable or liquid. And so the question of an alternative to the dollar-denominated reserve asset is, inevitably, raised.
The evident solution to this problem lies in a common reserve asset for the emerging non-dollar trading area. This is the historical role, of course, of gold bullion. In the modern world, gold is unlikely to play this role in full, given the extreme instability of its market price, while other commodities are subject to depletion through use as well as to speculative instabilities originating in activities outside the common reserve zone. The logical approach is therefore an international financial asset, comprised of a weighted set of the national bonds of the participating countries, as in recent schemes for a Eurobond, backed by the joint commitments, in proportion to size and capacity, of China, Russia, Iran and other participating countries, such as Kazakhstan and Belarus. In the realities of Eurasia, this means a predominantly RMB-based bond backed predominantly by China. The durability of such an instrument against the US Treasury bond can only be tested over time.
These are the basic conditions for the emergence of a non-dollar financial zone. It is easy to see that they are quite stringent. Efforts by one country or another to move in this direction may be deterred by the threat of sanctions, or thwarted (as in the case of Iraq in 2003) by war. Big changes in the world financial order appear to happen only under extreme circumstances.
The World Crisis and the Financial Future
The world crisis that erupted on February 24, 2022, with the outbreak of open warfare between Russia and Ukraine has already radically reorganized trade and financial relations. In short order Russian banks were disconnected from SWIFT and withdrew from Europe, many Western firms withdrew from Russia, NordStream 2 was “suspended,” airspace was closed, and the NATO countries froze Russian central bank assets while moving to confiscate the private property of Russian nationals alleged to be close to the Russian state. The freezing of central bank reserves constitutes, in effect, a technical default of the West toward Russia, even if interest on the blocked assets will continue to accrue. At first, the ruble fell and the dollar rose, as did the prices of oil and gas, Russia’s major, and continuing, export commodities.
In this test of wills and power, Russia starts from a strong position. She is nearly self-sufficient in every essential, including energy, food, heavy machinery, and weapons. The loss of familiar Western consumer goods and services can be made up through local initiative – not lacking in today’s Russia, compared to Soviet times – or from China. Russia’s financial assets greatly exceed her debts, even after the loss of foreign-held reserves. In reaction to the blocking of Russian banks, Russia set up ruble accounts in those banks, to which Russian debtors could make payments to Western creditors – who would thus be blocked from accessing those payments, not by Russia, but by the action of their own governments. This gives Russia’s commercial creditors at least a modest vested interest in the stability of the ruble. This interest has been bolstered by the Russian decision to demand payment for gas in rubles, effectively forcing Europe to work around its own sanctions or forego up to forty percent of its gas supply. So far, Hungary, Slovakia, and Austria have agreed to pay in rubles, and Germany seems headed to the same decision. The ruble, at current writing, is trading above pre-war values.
The strategy of the United States was to pressure the Russian government through its oligarchs, Westernized elites, and urban upper classes, hoping to affect the internal politics of the Russian state. This approach appears based on a view of Russia formed in the Yeltsin era, and a view of the attractions of the liberal West to powerful Russians, that is quite remote from the present realities, both social and political, and from the balance of power inside Russia. The departure in late March of Anatoly Chubais from his last official post and from Russia is a clear sign of this fact. The apparent failure of US officials to grasp this point in recent years has to rank among the greatest intelligence disasters of modern times.
In short, Russia has been effectively excluded from the world of Western global finance, in ways that do not affect the foundations of her economy in very serious ways and are sure to strengthen the industrial-military elements of her political order. The driving force for this new division of the world is not Russia herself, but the asymmetric, mostly financial/economic response of the NATO powers to Russian actions in Ukraine. Russia has therefore been obliged to take steps that the Western-oriented elements of her own government, notably at the central bank, would not have otherwise contemplated. With the backing of China, Iran, Belarus, Kazakhstan, and the studied neutrality of India, a new international financial system is in the process of being created. It is the creation in a real sense, not of Russia herself, but of top policymakers and strategic thinkers in the United States.
That said, Russia’s global economic reach is limited. Her whole population is only a quarter of that of the United States and the European Union, her GDP (a measure that is not appropriate to the current test of strength) is much smaller, and her currency is historically unstable. So while Russia’s military position is very strong, her contribution to a new financial order on the world stage is secondary to that of China – which as we have seen, remains and wishes to remain an integral part of the world economy and a large trading partner of both Russia and of the United States and Europe. While aligned with Russia in support of the latter’s security goals, China is not yet trading its existing dollar reserves in bulk for something less prone to political interference but at the same time less liquid and less stable. India, parts of Africa, and Latin America will, no doubt, find ways to cooperate with the new system, but with exceptions such as Venezuela and Nicaragua (as well as Cuba), this is unlikely to bring on a breach of their existing relationships to the dollar and the euro.
Conclusion: A Dual System Has Arrived
A tentative conclusion is that the dollar-based financial system, with the euro acting as a junior partner, is likely to survive for now. But there will be a significant non-dollar, non-eurozone carved out for those countries considered adversaries by the United States and the European Union, of which Russia is by far the present leading example – and for their trading partners. China will act as a bridge between the two systems – the fixed-point of multi-polarity. Should similar harsh decisions be taken with respect to China, then a true split of the world into mutually-isolated blocs, akin to the coldest years of the Cold War, would become a possibility. However the consequences for the Western economies in their current state of dependence on Eurasian resources and Chinese production capacity would be exceptionally dire, so it seems unlikely (though who knows?) that policy-makers in the West would push matters that far.
In the present crisis, political leaders in the West have been under the most extreme pressure to wield powers that they do not have, in order to display a resolve that they may not feel. Their reactions must be judged through the prism of this pressure and the requirements of political survival. They have, so far, managed to refrain from taking fatal military risks, while deploying the full force of information-war assets, and concentrating on a sanctions regime that is part of a well-worn toolkit, demonstrably more costly in the Russian case to its designers than to its target. The evolution of political pressures is difficult to predict, and a catastrophic turn, leading toward general war, would not be without precedent. Threats to Transnistria or, even more, to Russia proper at Kaliningrad, are portents of the catastrophic possibilities.
But, for sake of argument, let’s assume that the end of the world does not happen, and that relative restraint prevails until the fighting dies away in Ukraine. It appears that the next turn of the global financial screw will occur in Europe, most notably in Germany, as the implications of high energy prices and perpetually short supplies become clear. Germany’s competitiveness is tied to Russian resources and Chinese markets; its politics and financial links are with the Atlantic alliance. Though stranger things have been known, it is hard to believe that Germany would permanently subordinate itsindustry, technology, commerce, and general welfare to Washington and Wall Street, even for the sake of the high principles now being so eloquently stated by her politicians and press. The tension between economic and political forces can only grow over time, leading either toward deindustrialization or toward a new relationship with the Eurasian East – a new Ostpolitik, so to speak. The advocates of this approach on the German Left have been crushed, which means that the policy itself can be taken up, after an interval – perhaps quite short – in some other part of the political spectrum.
That being so, while the dollar/euro-based global financial order is unlikely to fall immediately or in a single cataclysm, it seems plausible that it will lose exclusive hold over at least one more major participant and her economic satellites – perhaps sooner rather than later. And then there is another, in the background, ever-quiet, that almost-forgotten third-largest economy in the world, Japan. While anti-Russian sentimentthere appears strong, what will happen, as time moves on, is anyone’s guess.
Can the United States survive the rise of a multi-polar world? The question is absurd: of course it can. But not without a political upheaval, spurred by inflation and recession and a falling stock market in the short term and eventually by demands for a realistic strategy consonant with the actual global balance of power. The ultimate threat is not to the living possibilities of the country so much as to its political elites, based as they are on global financial rents and domestic arms contracts. A world moving away from exclusive reliance on the dollar will clip the wings of US finance. A multi-polar world requires multi-lateral security arrangements, incompatible with the present extent of US military power projection; adding more money to a dysfunctional force structure will not make the country safe or secure, and it will make inflation worse. On the other hand, a lower dollar would help revive domestic self-reliance on critical goods, an industrial strategy can begin the necessary process of reconstruction, while investments in infrastructure and new technologies can work to offset the impact of higher energy costs. The latter are necessary, in any case, to combat climate change, so that what is necessary for adjustment in the short run aligns, for once, with what is necessary for survival later on.
Multi-polarity, in short, could be bad for oligarchy but good for democracy, sustainability, and public purpose. From these points of view, it would come not a moment too soon.
Costabile, Lilia, 2022. “Continuity and Change in the International Monetary System: The Dollar Standard and Capital Mobility,” Review of Political Economy, published online March 10, https://doi.org/10.1080/09538259.2022.2038438
James K. Galbraith holds the Lloyd M. Bentsen Jr, chair in Government/Business Relations at the Lyndon B. Johnson School of Public Affairs at The University of Texas at Austin. He drafted the first legislative plan to rescue New York City in 1975 and served as Chief Technical Adviser for Macroeconomic Reform to the State Planning Commission of the People’s Republic of China from 1993 to 1997.
This paper will appear in a special issue of the International Journal of Political Economy. Adapted and used here by permission.