I was at George Mason University this week, presenting my paper, “The Treasury Standard: Causes and Consequences.” Thus, I thought that I would spend this week summarizing the argument of that paper. The summary is below, but you can also listen to me talk about the paper on David Beckworth’s Macro Musings podcast.
The U.S. dollar is the global reserve currency and the U.S. Treasury security is the global reserve asset. I will refer to this as the "Treasury Standard.” What I try to do in my paper is explain how that system emerged as part of an evolutionary process related to the state’s desire for emergency finance. That sounds like a lot (it is, it’s a long paper!), but hopefully I can summarize the main arguments and interested readers can read the complete paper for more details.
The basic theme that runs throughout the paper is that a monopoly over money provides a unique ability for the state. If we understand this role and the commitments required of the state, we can better understand the evolution of the monetary system over time.
A basic place to start is to consider the fact that the sale of monopoly privileges was once a source of revenue for the state and various state monopolies have come and gone. Yet, the monopoly over money has been quite durable. So what is unique about money?
In the paper, I argue that the state’s desire for a monopoly over money is driven by the need to raise large sums of revenue in a short period of time during national emergencies, like war. Debasement, devaluation, and inflation provide the state with the ability to satisfy this demand for revenue. However, this is only possible if the state maintains a credible commitment to stabilize the purchasing power of money over the long run. In the absence of this commitment, continued use of debasement, devaluation, and inflation will reduce the demand for money and thus the “tax base” for seigniorage.
If this idea is correct, then one would expect to see the state monopoly over money driven the needs to finance war. Successful exploitation of the monopoly should correspond with a commitment to price stability (and one should be able to predict who can commit to price stability based on the expected durability of rule). Furthermore, changes in political, economic, and military constraints faced by the state should change the nature of the monetary system.
This seems to be generally true. A.R. Burns argues that ancient monopolies over the mint were motivated by war finance. George Selgin and Larry White point at the prerogative over coinage fluctuated with the borders of the realm in the Middle Ages. And even back then, there is evidence from Ancient Greece and the Middle Ages in England that rulers understood that exploiting the monopoly required periodic recoinage to restore the metallic content (and thus the purchasing power) of the currency.
In thinking about the modern world, I argue that a significant change in military constraints occurred in conjunction with the "Military Revolution" — the shift to gunpowder, cannons, trained infantry, and complex fortifications that made warfare vastly more expensive.
I illustrate the importance of this shift by contrasting the fiscal approaches of England and Sweden during this period. England used the Bank of England to borrow heavily during warfare. They combined their wartime money printing with a commitment to revert to the original gold parity once peace was restored. This anchored long-term money demand and enabled large-scale deficit spending that ultimately bankrolled English military triumphs.
Sweden, on the other hand, lost its Baltic empire. The Riksbank wasn’t legally permitted to issue notes. Thus, it lacked institutional capacity to suspend convertibility while credibly recommitting to a future peg, causing funding woes that ultimately led to defeat in the Great Northern War.
This tool used by the Bank of England spread across Europe. States could monetize wartime budget deficits through convertibility suspensions. Despite short-run inflation, credible resumption commitments preserved long-run money demand could facilitate a large amount of borrowing.
By World War I, it was commonplace to suspend gold convertibility and commit to restoration. However, in the aftermath of World War I, countries sought to avoid the postwar deflation, but lacked a credible commitment for cooperation. The result was an international scramble for gold, which resulted in deflation and depression. Those chaotic interwar years convinced policymakers that there was a new monetary paradigm.
Enter Bretton Woods. The dollar was formally made the global reserve currency at a fixed gold parity. This meant that other states could settle imbalances in U.S. currency rather than draining American gold coffers. The logic was that since dollars were redeemable for gold, the Fed could create more dollars. A scramble for gold would be unnecessary in that system since the dollar and gold were perfect substitutes. And since the Federal Reserve could create more dollars, the world could avoid deflation.
The flaw in that system is that perfect substitutability cannot be determined by edict. It is a market outcome.
The expansionary fiscal policy and expansionary monetary policy of the 1960s put pressure on that substitutability. American policymakers responded with agreements to redeem dollars for U.S. Treasury securities rather than gold and what might politely be described as diplomatic arm-twisting. When the final collapse proved inevitable, Nixon closed the gold window. Nixon’s advisers had advocated this as a tool to motivate U.S. allies to come to an agreement about revaluations of their currencies. But the gold window was never re-opened. This paved the way for the Treasury Standard.
In the aftermath of the Nixon shock, U.S. policymakers took deliberate steps to keep the U.S. dollar as the global reserve currency. In the wake of oil shocks, the U.S. used it veto power to sideline efforts by the IMF to deal with the corresponding payment imbalances. The U.S. also made a secret agreement with the Saudi Arabian government for the Saudis to use their surplus dollars to purchase U.S. Treasury securities.
The subsequent reduction in inflation and commitment to low, stable rates of inflation by the Federal Reserve, combined with the Fed’s independence created the commitment mechanism required for emergency finance. Furthermore, given that the reserve asset is a debt instrument of the U.S. government, emergency financing temporarily increase those reserves. But the expectation that emergencies are temporary implies that the effect on the cost of borrowing is minimal. In addition, the Treasury Standard creates a tool of foreign policy of the U.S., since the U.S. can use dollar-based sanctions against foreign adversaries. In each sense, the current international monetary system resembles monetary systems of the past.
But this system is potentially fragile. As the world economy grows, the demand for reserves grows along with it. All else equal, this tends to drive down yields and incentivize policymakers to increase debt in conjunction with the increase in the demand. As long as debt remains sufficiently low, this is fine. However, if debt reaches a critically high level, people might expect that the U.S. is incapable of repaying the debt and will resort to inflation. These expectations can be self-fulfilling. In addition, the increased weaponization of the dollar as a tool of foreign policy is also a threat to the system. Excessive sanctions may drive targeted states towards establishing dollar alternatives.
This theory, history, and discussion should hopefully give one a better idea of how we got here, why we got here, and what the threats to the future of the system are. Despite the potential fragility of the system, I will stop short of forecasting the future of the dollar. Nonetheless, hopefully this post does a good job of explaining why the dollar is a source of U.S. hegemony and the inherent trade-offs associated with that. It should also hopefully give the reader a sense of how the U.S. is likely to respond if it sees this hegemony threatened. And if you’d like to read more, there’s always the paper.