Empire of Dollars 6
Part 6: The dollar weapon (1 of 2)
The Gauls used the double-edged long sword to advance through modern-day Italy to overrun the Roman army and sack the city of Rome. The British had the Maxim gun and the Enfield rifle which allowed them to conquer vast swathes of the globe. Genghis Kahn’s Mongol bow allowed the Mongols to establish the largest contiguous land empire in history; from the Sea of Japan to the Carpathian Basin and the Danube River. But for the world’s current reigning superpower, the United States of America, its most potent weapon is an entirely different one altogether. It is one that travels across borders with ease, it fits into your pocket and wallet too, but it can cause regional economic crises leaving untold devastation in its path. However, this is not something designed by Lockheed Martin or Raytheon. I am, of course, talking about the U.S. dollar itself: America’s most important export and its most potent weapon.
This instalment of Empire of Dollars will be split into two parts. The reader should allow for some overlap as many of the points crossover with one another.
Devaluation against the dollar
As the world reserve currency, the dollar’s valuation is very important and it depends on a range of factors, including: central bank monetary policy, interest rates, market conditions, monetary cycles, geopolitical considerations and more.
As a weapon, the dollar is something akin to a doubled-edged sword. If it appreciates (rises) in value then other currencies simultaneously devalue, countries are then forced to invest in yet more dollar reserves (usually U.S. government-backed Treasury bonds) to defend their currency and potentially raising the value of the dollar even more. A strong dollar is good for the U.S.: for the U.S. government, for American corporations, investors and American citizens their dollars will fetch more in global markets.* The other end of the sword is that if the dollar depreciates then the U.S. can inflate away its own debt and countries will see their dollar-denominated assets decline in value.
Let’s unpack this a bit more. As other currencies devalue against a strong dollar that forces those countries to bring in more dollars to meet the shortfall created by the devaluation (either for oil or other commodity purchases, for their central bank holdings, for payment of existing dollar-denominated debts, for a whole variety of other obligations) and to protect their currency from devaluing further.[1] When this occurs, the demand for the dollar increases, the additional trade in U.S. dollars that results increases its liquidity and raises its value, reinforcing the dollar system as a result.[2] Central banks must acquire and hold dollar reserves in corresponding amounts to their own currencies in circulation, letting it fluctuate only to levels that are sustainable, if this equilibrium is broken then it can cause tremendous problems. Another structural problem to consider is that when the dollar rises in value then the debt that countries have rises as well therefore it is essential that countries with large dollar-denominated debts maintain parity with the U.S. dollar.[3] Conversely, when the dollar devalues then this can negatively affect exports as it means fewer goods and services heading for the U.S. (and potentially elsewhere), damaging the economies and industries of nations who rely heavily on their trade with the United States. So in a sense, the U.S. is covered in both instances: a strong dollar means other countries have to acquire more dollars to cover the devaluation of their own currencies and it gives the U.S. a greater advantage across global markets; however, a weak dollar reduces Washington’s debt burden.
Generally, however, as the author Barry Eichengreen explains, a weak dollar is something of a unicorn so to speak as whenever the dollar is weak investors rush to purchase more dollars pushing its value up as a result. The dollar is like good fortune; you can never have enough of it.[4]
Commodities and a fluctuating dollar
The dollar is the benchmark pricing mechanism for global commodities meaning that commodities are priced and traded in dollars. When commodities rise in value the demand for the dollar rises as well so the U.S. is, to a large degree, walled off from the consequences of commodity shocks. This is exactly what happened during the second oil crisis in the late 70s: when the price of oil increased in the wake of the Iranian Revolution so did the demand for dollars. However, for emerging market economies, when the dollar rises in value commodities become more expensive, this can reduce overall demand as a consequence and this is bad for countries whose economies are dominated by trade in commodities. This process destabilises world trade making many countries poorer as a result.[5]
Commodity price surges can also happen when money in developed countries is rendered artificially cheap (through low interest rates and quantitative easing policies) as excess money in developed countries is invested into the purchase of commodities causing their value to rise and leading to problems in emerging market economies especially.[6] This will be covered in more detail in part two.
Volcker shock and interest rates
When the Federal Reserve raises interest rates the consequences can be devastating. In 1980, Paul Volcker, then the Chairman of the Federal Reserve, raised interest rates to 21 percent in a bid to end America’s long-term battle with inflation.[7] Named ‘the Volcker shock’, the Fed Chairman’s actions contributed greatly to the Latin American debt crisis in the early 1980s. The collateral effects of Volcker shock meant that countries with large dollar-denominated debts saw the interest on their existing debts skyrocket as a result of Volcker’s actions, causing chaos across the region. Countries such as Brazil, Argentina, Mexico, and Venezuela all experienced severe problems to do with hyperinflation, currency devaluation, capital flight and debt. In Mexico, the peso shrunk by almost 50 percent against the dollar. By 1986 Mexico’s foreign debt amounted to 78 percent of GDP while inflation exceeded 100%. The 1980s is known in Mexico as La Década Perdida, “the lost decade”.
Brazil’s debt doubled from $50 billion to $100 billion at the height of the debt crisis as the country battled rising deficits, high interest repayments, capital flight and soaring inflation throughout the decade.[8] By the time the IMF had stepped in, Brazil was practically left without any foreign currency reserves at all. Argentina saw their debt climb to $65 billion as the Latin American debt crisis plunged the nation into political and economic turmoil from which it has arguably never recovered.[9] Raul Alfonsin was forced to introduce a new currency.[10] By 1985, inflation was so bad that President Hyperinflation would set in by which time food riots had broken out.[11] Argentina’s problems continued long into the 1990s.
In a rather ironic twist of fate, the Latin American debt crisis lead to an exodus of people from Mexico and Central America north into the United States, a problem that continues to this day, now colloquially known as the ‘border crisis’ in the U.S. its true origins are today very much obscured beneath the noise of everyday, partisan political discourse.[12] What is important to understand here is that when the interest rate rises the size of the existing debt stock rises as well and debts become more expensive to service as a result, this is exactly what happened during the Latin American debt crisis as debt in the region soared to $315 billion and this, dear reader, is the network effect of the dollar weapon.
Another side effect of raising interest rates is that it makes borrowing more expensive, this can have a devastating effect on the global economy reducing demand and causing problems in global markets as a result. When the Fed raises interest rates this leads to something called capital flight, this is when capital leaves emerging market economies and flows into developed countries in search of higher returns. When capital flight occurs, this can be incredibly destabilising for emerging market economies and lesser developed countries; with less foreign currency reserves and no deep capital markets to call upon these countries are left exposed to volatile capital flows and speculation. Many countries have implemented strict capital controls as a means of reducing their exposure to this volatility. Capital flow volatility leads to the previously aforementioned problems to do with price surges and currency devaluation.[13]
Returning to commodities, when interest rate hikes occur this can lead to what is called a "price shock". A price shock is when the price of a commodity drops by 10 percent or more causing chaos in global markets. It causes chaos because countries with dollar-denominated debts (often either with the World Bank or large U.S. banks and investment firms) disproportionately tend to be located in the global south and trade in commodities. So for example, as a result of the Volcker shock, commodity markets experienced over a 150 of these shocks between 1981 and 1987.[14] Commodity markets are held hostage by the dollar system (in the case of currency movements) and Federal Reserve monetary policy (in the case of interest rates), distorting the global economy and often pushing exporting countries further into debt.
Part two will look at sanctions, swap lines and what happens when the Federal Reserve floods the global economy with cheap money.
Notes
[1] Prasad, E. S. (2014). The Dollar Trap. Princeton University Press. p.xxi
* it should be added though that is not good for American manufacturers as the price of American goods becomes more expensive and thus less competitive as a result.
[2] Prasad, E. S. (2014). The Dollar Trap. Princeton University Press. p.12
[3] Prasad, E. S. (2014). The Dollar Trap. Princeton University Press. p.52
[4] Eichengreen, B. (2012) Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. Reprint. Oxford University Press.
[5] https://www.reuters.com/plus/how-a-strong-dollar-affects-international-currencies-and-commodities
[6] Prasad, E. S. (2014). The Dollar Trap. Princeton University Press. p.142
[7] Harvey, B. D. (2022). A Brief History of Neoliberalism Oxford University Press, USA,2007] [Paperback] (1st (First) edition). Oxford University Press, USA.
[8] [9] Klein, N. (2008). The Shock Doctrine: The Rise of Disaster Capitalism. New York, Picador. p.199
[10] Klein, N. (2008). The Shock Doctrine: The Rise of Disaster Capitalism. New York, Picador. P.201
[11] Wolff, M. (2018) Bretton Woods Institutions & Neoliberalism: Historical Critique of Policies, Structures, & Governance of the International Monetary Fund & the World Bank, with Case Studies.Amsterdam University Press. p.66
[12] Klein, N. (2008). The Shock Doctrine: The Rise of Disaster Capitalism. New York, Picador. P.205-206
[13] Prasad, E. S. (2014). The Dollar Trap. Princeton University Press. p.189
[14] Klein, N. (2008). The Shock Doctrine: The Rise of Disaster Capitalism. New York, Picador. p.199