Bank of England (AP Microstock)
Bank of England (AP Microstock)

Concerns that a continuing impasse over the medium-term direction of U.S. fiscal policy could have a negative impact on the international role of the dollar harken back to debates over the design of the post war international financial "architecture." The dollar was accorded a special role at Bretton Woods; one that imposed obligations on the U.S. as the issuer of the international reserve currency.

In the view of some, the Bretton Woods system collapsed as a result of U.S. failure to the pursue "sound" policies needed to support the dollar-gold system. Others argue, however, that responsibility is shared by those countries that benefited from the security umbrella provided by the U.S. By the late 1960's, countries that at war's end had suffered from destruction, dislocation and the risk of social and political collapse had recovered and were benefitting from the stability and open trading regime that the Bretton Woods system provided. Their refusal to shoulder the obligations, responsibilities, and costs of maintaining the system, some contend, is also to blame for the collapse of the system.

Regardless, the demise of Bretton Woods has had no discernible significant impact on the dollar. Indeed, in the years since the advent of flexible exchange rates, capital account liberalization and the rise of financial globalization has at times reinforced the role of the dollar as the world's safe haven asset. The financial maelstrom that swept through global financial markets following the Lehman shock was one such period.

What accounts for this remarkable resilience? Certainly, the U.S. legal framework —rule of law and independent judiciary — is a critical factor. Of course, other countries likewise have solid legal institutions; yet their currencies do not have reserve currency status. In this respect, the dollar undoubtedly enjoys an advantage of size: the U.S. economy remains the biggest market in the world. Moreover, the Bretton Woods system conferred another advantage given the dominant role it gave to the dollar. There is a positive feedback effect in media of exchange: people want to use an asset that they think other people will want to use. As a result, the more an asset is used, the more it is demanded by others.

Such effects give a currency an incumbent advantage — they do not make that role unassailable. In the 19th century, the U.K. pound arguably had a similar role to that of the dollar in the 20th century. But financially drained by two world wars and overtaken economically by the U.S., by the 1970s, the Pound was relegated to a much diminished role in global finance (as reflected, say, in the share of foreign exchange reserves denominated in pounds).

The decline in the role of the Pound didn't happen overnight. There was a long period of gradual decline, reflecting the changing shares of U.S. and U.K. economies in the global economy. But, arguably, the final denouement came with the unanticipated devaluation of the Pound in the late 1960s, which imposed losses on the holders of sterling-denominated assets. The Pound has since occupied a relatively minor role in global finance — albeit, thanks to the importance of London as an international financial centre, one larger than would be expected from consideration of size of the U.K. economy alone.

Of course, between the hegemony of the Pound in international finance circa, say, the late 1890s and the apex of dollar hegemony in the early 1960s, there was an international economic collapse and a decade of global stagnation. While many factors undoubtedly contributed to the disaster, the failure of key players to provide the international public good of financial stability was key. As Charles Kindleberger put it in his authoritative analysis of the 1930s: the Bank of England couldn't, and the Fed wouldn't, provide the public good of international financial stability.

Briefly, what Kindleberger argued was that because the U.K.'s financial position had deteriorated so significantly as a result of the First World War the Bank of England was incapable of "policing" the operation of inter-war gold standard, while the Fed — still a nascent institution and mindful of "foreign entanglements" — hadn't yet assumed its obligations as the rising new economic and financial power. The result was a dysfunctional inter-war gold standard that magnified, rather than dispersed, macroeconomic imbalances and the adoption of "beggar-thy-neighbour" that propagated and spread depression when the system was shocked.

So, what are the possible lessons of all this for the international financial architecture of the 21st century?

First, that the costs of providing the public good of international financial stability must be shared between those who benefit from it or appropriated by the hegemon that unilaterally provides stability.

Second, that the costs of providing that stability can be recouped through the privileges accorded to the hegemon's currency in the design of international monetary arrangements. In the early years of the Bretton Woods agreement, the U.S. was the only country capable of providing the stability that was needed to dispel the uncertainty that hung over the global economy. The preeminent role of dollar in the system allowed the use to reap benefits from the seigniorage flowing from the international use of the dollar.

Third, the tragic history of the 1930s teaches that the transition between international monetary regimes can entail great uncertainty and great disruption. In this respect, the Bretton Woods system bridged between the hegemony of the pound and the hegemony of the dollar.

Less clear, when viewed in the broad sweep of history, is the impact, if any, of the fiscal impasse in the U.S. on the evolution of international monetary arrangements. This is just one more outstanding issue in the new age of uncertainty.

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