"Providing reserves and exchanges for the whole world is too much for one country and one currency to bear."
- Henry H. Fowler
U.S. Secretary of the Treasury
The US Dollars as the global reserve currency
The history of world wars evidenced that the US had not been a part of bloodshed wars, had not suffered political dominance and diplomacy and had not encountered any severe economic maladies barring the great depression. A few years before, Keynes introduced a worldwide currency in the name of Bancor. Since Britain faced huge debts with America, dollars were suggested to become the common currency. Considering the country’s political and economic stability, the Bretton Woods (BW) Conference in the year 1944, pronounced the US Dollars as the global reserve currency pegged against the bullion. Hence, the US Dollars superseded British Pounds becoming global money. The agreement primarily assured that the trade activities could happen in US dollars regardless of the US being one among the trading partners. In this way, the US engaged in immense imports to spray the dollars around the world and, led to the accumulation of excess US dollars in other countries. Bretton Woods Agreement authorised the participating nations to exchange US dollars for gold to discourage the behaviour of incessant trade and deficits.
The US did not experience any impact from continuous trade operations and gold-dollar exchange rates until 1960. By 1961, the US accorded to London Gold pool’s system of fixing the gold price at $35 per ounce. Instead of gold, countries began accumulating US dollars and invested in US securities. To finance the Vietnam War and Great Society domestic programs, the US performed deficit spending through printing paper money. The demand for treasury securities and the unstable dollar concerned other countries. As a result, France in the year 1968, demanded gold in exchange for dollars and withdrew from the London Gold Pool. Fearing that other countries would follow France, in 1971, Richard Nixon terminated the convertibility system to protect the remains of the gold with the US. Following this, the BWA cancelled, and from then on, the US dollar is treated as a floating currency without the discipline imposed upon it by gold convertibility.
Tracing the Triffin Paradox
Robert Triffin, a Belgian-American Economist, foresaw this problem where Nixon suspended the gold convertibility and virtually the abandonment of the Bretton Woods Agreement. In 1960, he talked about the repercussions of the exorbitant privilege in his book titled “Gold and the Dollar Crisis: The Future of Convertibility”. Valéry Giscard d'Estaing coined the term exorbitant privilege to signify the asymmetry of the international reserve system that fetched the subsidised lavish lifestyle for the US. Triffin reasoned that the boundless opportunity of being the global reserve currency would ultimately bring a hefty penalty for the US. It was later known as the Triffin Paradox.
What Triffin predicted?
Triffin pointed out that the US must maintain the reserve status, which requires a substantial percentage of world trade to occur in US dollars. For this to happen, the U.S. must supply the world with U.S. dollars; that eventually, makes the U.S. fall into persistent trade deficits and the devaluation of the dollar. In order to minimise the financial shocks and international uncertainty, foreign countries hold excess dollar reserves. Most of these reserves are invested in the US denominated securities considering it as the safest assets. With the expansion of the global economy and the development in trade, the US continued to satisfy the need for extra dollars.
Following this, the US interest rates lowered and remained low for several years, thanks to the accumulation of dollar reserves in foreign nations. With the US facing overwhelming debt burdens, its reliance on low-interest rates spurred debt-driven consumption further. Countries other than the US benefited, as the manufacturing haven moved to their counties from the US and boomed with improved prosperity of their respective citizens. While consumer capitalism, free-spending of funds, money supply through printing fiat currency mired the US economy; the rest of the world became her creditor as their debts are at the ticking point. That is what Robert Triffin explained in 1960 that ever-accumulating trade deficits, the flaw of hosting the reserve currency and the result of Bretton Woods Agreement may help economic growth in the short run but would kill it in the long run.
Prevalence of Dollar in the present
In the US, from 2009, the aggregate amount of federal debt outpaced the cumulative amount of GDP growth as shown below. Said differently, if it were not for a significant and consistent federal deficit, GDP would have been negative every year since the 2008 financial crisis.
Despite the financial crisis, the dollar is involved in 87% of overall foreign exchange trades, and more than 60% of foreign exchange reserves are still held in dollars. Moreover, dollars exert a gravitational force on other currencies and Forex reserves. The regression analysis of euro and yen as reference currencies and GDP weights predicted that the weighted dollar zone comprised 60 per cent. Also, the dollar-denominated debt lent to non-banks outside the US increased (2009-15) irrespective of macro-financial risks.
Triffin Dilemma: Myth?
Several studies were undertaken to find the relevance for Triffin Dilemma. The hypothesis that the US dollars played a significant impact on the Current Account Deficits (CAD) was not an easy task as for the empirical theorists and statisticians. Hence, they considered various practical approaches to test the link between the reserve role of the dollar and current accounts.
Fratianni (2012), in his study, found that the US current account deficits increased the US liabilities to foreign officials, which was opposite to the general theory. In an empirical study, Steiner (2014) demonstrated that reserve currency status systematically lowered US current account balance. Bayoumi et al. (2015) the fitted parameters suggested that 2.6 percentage points of GDP of the US current account deficit in 2007 owed to reserve accumulation elsewhere.
Most of the research papers studied the aptness of the Triffin Dilemma. Suppose the US external accounts are on an unsustainable trajectory. In that case, it is not clear whether the dollar’s role, the size of the US economy or the breadth, depth and liquidity of its financial markets is to be blamed. The Triffin-style arguments have never faded, as studies invoke the issues arising from one country supplying most of the world’s reserve currency.
1.Bordo and McCauley. Triffin: Dilemma or Myth? BIS Working Papers No 684. Monetary and Economic Department, December 2017.
2.Ito and McCauley. A key currency view of global imbalances. BIS Working Papers No 762. Monetary and Economic Department, December 2018.