Can the World Survive Without Dollar Diplomacy?

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The Federal Reserve’s rescue of the global financial system one year ago prevented a public health crisis from degenerating into market chaos. When histories of the Covid-19 pandemic are written, it would be shortsighted to ignore this exercise in financial diplomacy that cemented the dollar’s role as a pillar of the world economy.

This flexing of monetary muscle raises big questions about the world’s dependence on the greenback and the moral hazard it implies. What if the U.S. decides it no longer wishes to shoulder the responsibilities that come with being a global lender of last resort? For all the allure of the America-in-decline narrative the world has few alternatives.

In late March 2020, the Fed dramatically expanded the supply of bucks to foreign central banks. It did this by opening dollar-liquidity swap lines with nine overseas monetary authorities, including those of Singapore, South Korea, Australia and New Zealand. (The Fed had existing deals with the U.K., euro zone, Japan, Canada and Switzerland.) It also established a program that allowed more countries to temporarily exchange U.S. Treasury notes for dollars.

Not acting would have been disastrous. The world stood on the precipice of a funding crisis, as my Bloomberg Opinion colleague Shuli Ren wrote here. The Bloomberg Dollar Spot Index soared the most since 2008. Yet the Fed’s measures worked: A dollar squeeze was eventually stymied. The MSCI Emerging Markets Currency Index bottomed on March 23 and enjoyed a strong rally for most of the past year.

Seven decades after the Bretton Woods agreement, which shaped the post-World War II financial architecture, the dollar’s influence has only grown. “Despite the widespread prediction that the world is evolving towards a more multipolar system, the U.S. dollar remains by far the most important anchor currency (or in the case of more flexible arrangements, reference currency), particularly when one considers the integration of China and former Soviet bloc in the global financial system,” wrote Ethan Ilzetski, Carmen Reinhart and Kenneth Rogoff in a 2019 paper.

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