__This policy study is based on the newly released book, by Brendan Brown and Philippe Simonnot, published by Palgrave Macmillan.__
One hundred years ago, the United States emerged from the First World War and its immediate aftermath, including the Spanish flu pandemic, as the global monetary hegemon, exercising immense power over the Old Continent. This new power quickly became the source of huge instability in Europe, culminating in the collapse of the Weimar Republic. After World War II, the Bretton Woods system set new contours for US monetary hegemony, ultimately resulting in the great economic crisis of 1973–75. This woeful history continues to the present day: Dollar hegemony has not been a force for good.
It could have been different. The United States and Europe would both have gained from a US hegemony based on sound money principle. Instead, the guiding characteristic of US monetary power has been inflation, especially around election time. According to the doctrine made notorious by Treasury Secretary John Connally, who served under President Nixon, “the dollar is our currency but your problem.”
The US monetary regime’s further lurch toward fundamental unsoundness during the COVID-19 pandemic is not getting the new century of US monetary hegemony off to a new start. The “known unknown” is whether forces will emerge in Europe that will again challenge US inflationary dominance, as occurred under Germany’s leadership in the 1970s. Could high inflation in the post-pandemic US economy cause US monetary hegemony over Europe to crumble?
The Origins of US Monetary Hegemony
Let us take a step back and define global monetary hegemony. Its essence is a country having considerable power to influence monetary conditions in the rest of the world. Hegemony is regional rather than global if that power extends only to a country’s neighbors.
The basis of hegemony is evident in the case of fixed exchange rates. Countries that peg their exchange rates to the US dollar are bound to follow US monetary policy. In contrast, where exchange rates are floating against the dollar, the basis of hegemonic power is more indirect. If countries choose not to follow inflationary US policies, their currencies rise against the US dollar. That may be very painful, particularly for their export industries, so such countries often decide to implement inflationary policies as well.
There was no monetary hegemon under the pre-1914 gold standard. The stock of above-ground gold supplies was the base money of the system, whose automatic mechanisms determined monetary conditions globally. All that changed during the First World War, when the European belligerents sequestered the gold that was backing their monies to pay for war expenditures. As the Europeans, mainly Great Britain and France, were selling gold in New York, the United States was amassing it. As a consequence, the newly created Federal Reserve System found itself with quantities of the yellow metal far in excess of the legal minimum that its founding act required for backing notes. The Fed could now follow a national monetary policy whose novel aims included stimulating the pace of economic recovery from recession. It forged a new tool to match: interest rate policy. Under the pre-1914 international gold standard, interest rates had been wholly determined by markets.
The Fed used its new powers in an inflationary way. Because it had received so much blame for the Great Recession of 1920–21, when wholesale prices had fallen steeply from their post-war peak, it resolved (unofficially) to pursue stable prices henceforth. It did so even though fantastic productivity growth (led by the second industrial revolution, including electrification and the assembly line), along with a glut of primary commodities, were driving non-monetary disinflation. The consequence was huge asset inflation domestically and in Germany, including a credit bubble in that country fueled by US lenders who sought high yields. In 1924, the Weimar Republic had effectively put its currency on a dollar standard, in accordance with the Dawes Plan, drawn up following the hyperinflation. This ushered in the first German economic miracle (Wirtschaftswunder). When this global asset inflation led to an economic bust, however, Germany was the epicenter of the storm, which culminated in a colossal banking crisis and the collapse of the Weimar Republic.
Germany’s Two Decades of Defying Dollar Hegemony
Germany was also at the receiving end of US monetary inflation in the mid-life and late life of the dollar standard after World War II. The basis of this standard was that the US currency would be convertible into gold for non-US citizens (and governments) at the fixed price of $35 per ounce. By the late 1960s, Germany was in full rebellion against this inflationary dollar hegemon; the Social Democratic Party (SPD) won the 1969 general election on a platform of revaluing the Deutsche Mark (DM) and thereby securing benefits in savings and purchasing power for the middle class.
The SPD had a strong ally in the Bundesbank, where Dr. Otmar Emminger pioneered the implementation of monetarist doctrine. Emminger advanced the view that Germany could in effect anchor its money independently by targeting a fixed low annual expansion in the German monetary base, once the DM was freed from its tie to the inflationary dollar—which finally occurred in March 1973. France under President Charles de Gaulle had also challenged dollar hegemony, but favored international monetary reform based on enhancing the role of gold.
Through the 1970s and 1980s, the existence of the hard DM as the number two international money did constrain the destructive power of the inflationary US monetary hegemon. Indeed, in 1978, the dollar’s crash against the DM may well have been a key catalyst in the Carter administration’s calling on Federal Reserve chairman Paul Volcker to launch a monetarist experiment in the United States. If so, that was the summit of the DM’s challenge. When the Fed under Volcker collaborated with Treasury Secretary James Baker to launch a dollar devaluation in autumn 1985, it unleashed a new episode of US monetary inflation, and Germany’s power to resist began to crack. Chancellor Helmut Kohl, whose party’s weak finances depended on contributions from large exporters, balked at the Bundesbank under Otto Poehl continuing its hard DM policy, and Germany boarded the train to the European Economic and Monetary Union (EMU).
The EMU has reinforced the hegemony of the inflationary dollar. Virtually from the start of the European Central Bank (ECB) in 1999, the ECB embraced the same 2 per cent inflation standard to which the Fed was harnessing US monetary policy and turned its back on the monetarist principles espoused by the Bundesbank in its heyday. As a result, the great asset inflation of 1998–2007 and the subsequent bust were even more spectacular in Europe than in the United States. In response to the ensuing European sovereign debt and banking crisis, the ECB in fact moved ahead of the Federal Reserve in monetary radicalism, adopting in particular a regime of negative interest rates and direct subsidized lending to weak banks (especially in Italy).
How the Pandemic Could Undermine US Monetary Hegemony—For Better and for Worse
The pandemic has triggered a further radicalization of US monetary policy. Europe has moved in the same direction as the United States, but for its own reasons, among which the most pressing has been staving off a bankruptcy of the Italian state and banking system.
If the result is high inflation, first in the United States, in the aftermath of the pandemic, the US dollar hegemon might suffer at least a temporary lessening of its power. Critical here would be how German public opinion develops—in response to the threat that high US inflation could spread to Europe, and to the reality that German savers are being forced to pay for massive transfers via the ECB into the EMU’s weak members. Perhaps the ECB, in response to German pressure, would for some time navigate a less inflationary course than the United States.
We could also imagine a scenario where high inflation in the United States galvanizes political forces into demanding a sound dollar. Ultimately, Washington stands to gain more from hegemony based on a sound dollar than an unsound one.
The United States, under a sound money regime, would attract a wide group of countries that would put their currencies on a dollar standard. The benefits for these economies would include virtually eliminating exchange risk from the viewpoint of exporters and investors—whilst also enjoying the benefits of a now sound money regime including prominently the absence of monetary inflation. The United States, as the core country of the dollar standard, would have the lowest cost of capital, a real advantage not brought about transitorily by Fed manipulations. This would also spare the United States those periodic great busts and recessions whose impact is magnified by the simultaneous crashes in foreign countries that have been following the inflationary US lead.
From both the US and European perspectives, Europe is not just another “foreign country” to consider in such a cost-benefit analysis of joining a sound dollar zone. Envy and admiration of a sound US money regime could drive Germany and several of its small neighbors, such as Holland and Austria, to demand the same. Sound money in the context of Europe’s present monetary union would mean bringing to a halt, in particular, the gravy train from Germany into Italy, fueled both at the front and back doors of the ECB. This is made up of carriages filled with asset purchase programs for Italian state debt and negative interest loans to Italian banks. No gravy train would mean that the EMU would collapse amidst an Italian bankruptcy. Under those circumstances Germany could take the lead in salvaging a smaller union founded on hard money. It is implausible that the German-centered union, having just liberated itself from the EMU, would join the dollar standard. The new money would not obviously sparkle brightly against a sound dollar, a dull outcome that would be pleasant for German exporters.
The bottom line is that high inflation in the United States in the wake of the pandemic could mean a lessening of US monetary hegemony with respect to Europe but might well fail to shake the European monetary establishment. Though the possibility seems remote today, if sound money forces ultimately emerged victorious in the United States—most likely due to popular resentment against the impoverishment wrought by unsound money—this would bring swifter and more powerful monetary reform in Europe. This would be in the context of a small, hard-money union centered around Germany that emerges to replace the EMU.