Why the US Is the Center of the Global Monetary System

Stabilizing relative to the dollar rather than the Swiss franc or the Danish crown may allow these countries to lower their interest rate and increase capital accumulation, research suggests. An economic model developed by Chicago Booth’s Tarek Alexander Hassan, Thomas Mertens of the Federal Reserve Bank of San Francisco, and Chicago Booth PhD candidate Tony Zhang explains the dollar’s dominance and other dynamics of the currency trade.

The researchers build on a host of work that suggests that differences in interest rates across countries are a function of differing levels of economic risk in each country—and they hypothesize that a country can use currency to manage this risk.

By stabilizing its currency to another, a country can effectively assume much of the risk profile of the target currency, according to the researchers. Doing this relative to the largest economy in the world, a country can lower its interest rate, raise capital efficiency, and create higher wages for domestic workers.

And as its currency moves with the US dollar, the country can step in when there’s high demand for goods and generate extra production capacity. In this role, it can generate extra profits that more than offset the costs of the manipulation.

This works for smaller economies, the research finds, but not for larger ones. For bigger economies, it becomes more difficult to stabilize a currency without selling large amounts of the target reserves, creating net outflows. The costs of stabilizing are lowest when the difference in size between the risky and the stable economies is largest.

Thus the model also predicts that, because the costs are higher for them, larger economies will either stabilize to a basket of currencies or allow the value of their own currency to float freely. Indeed, in reality, large economies either stabilize their currencies to established baskets (as Germany did before adopting the euro) or float their currencies.

One of the most provocative conclusions from the research is that a large economy that stabilizes its exchange rate relative to a still-larger economy diverts capital from the target country and boosts its own citizens’ wages while simultaneously lowering the wages of the workers in the target economy. As China’s renminbi has been mostly stabilized to the US dollar since 1994, the dynamic the researchers describe may partially explain the observed stagnation in US workers’ incomes over the past few decades, as well as the massive rush of foreign investment money into China and the brisk rise in salaries of Chinese workers.