Jesús Fernández-Villaverde
Why does the dollar dominate international trade and finance? The usual answer involves some combination of the Bretton Woods system, the size of the US economy, and deep financial markets.
All true, but unsatisfying. Britain’s economy was already smaller than America’s by 1900, yet sterling remained the world’s dominant currency until the 1940s (and, in some regions, until the 1967 devaluation). If size and fundamentals were all that mattered, the transition should have occurred much more quickly.
What keeps a dominant currency in place long after the fundamentals have shifted?
In a recent paper, “International Currency Dominance,” with Joe Abadi and Daniel Sanches, we argue that the answer is coordination.
Consider a Thai exporter deciding whether to accept dollars. Her choice depends on whether she can spend those dollars later, which depends on whether her suppliers in Vietnam and Germany accept them. Their choices, in turn, depend on their own trading partners. Once the world coordinates on the dollar, no individual wants to deviate, because deviating means holding a currency that fewer people accept.
We formalize this intuition in a model in which agents incur a small cost to recognize foreign currencies. The cost is realistic, just a few basis points of trade value, but it creates powerful strategic complementarities. When more people hold dollars, accepting them becomes more valuable, which in turn increases the number of people willing to hold them. The feedback loop is self-reinforcing.
Thus, we can prove that three types of international monetary regimes can emerge. In the “classical” regime, everyone holds a diversified portfolio: dollars to buy American goods, euros to buy European goods, and so on. In a “dominant currency” regime, one currency circulates everywhere, even in transactions unrelated to its home country. In a “multipolar” regime, several currencies coexist as international media of exchange.
The central theoretical result is that the classical regime is unstable. Any small perturbation tips the system toward either dominance or multipolarity. But once a dominant currency emerges, it becomes very hard to dislodge. The equilibrium is stable precisely because coordination is self-reinforcing. This is why currency dominance persists for decades: not because fundamentals are unchanging, but because the coordination equilibrium exhibits inertia.
Governments can try to internationalize their currencies by offering higher real returns on their debt. But large economies have a natural advantage. Foreigners expect more opportunities to trade with agents from a large economy, so they are more willing to hold its currency even at lower returns. Size begets dominance, and dominance begets persistence.
We calibrate the model and explore counterfactuals. Could a trade war dethrone the dollar? We find that even permanent and reciprocal 30 percent tariffs between the US and the rest of the world are insufficient. Trade with America declines, but the rest of the world continues to settle transactions in dollars because that is what everyone else uses. History supports this: the dollar and sterling survived the protectionism of the interwar period.
Could China’s rise reshape the system? Capital account liberalization alone is not enough. However, if China aggressively expands its payment infrastructure and competes on interest rates, the renminbi could become a secondary international currency, relevant but not dominant. The incumbent’s coordination advantage is simply too strong.
One finding may disappoint those who emphasize the “exorbitant privilege.” The liquidity premium we estimate is modest, at less than 50 basis points. This finances a stream of imports that is at most 0.25 percent of GDP. Real, but not the bonanza sometimes imagined.
The bottom line is that currency dominance is a coordination equilibrium. Fundamentals set the stage, but history picks the outcome, and once picked, it is sticky. The dollar will remain dominant until a shock large enough to break the coordination. Neither tariffs nor Chinese competition, at current magnitudes, is that shock.
