The Shultz Years: Toward Dollar Hegemony

George Shultz assumed office with two years of experience as Director of the Office of Management and Budget and almost a decade of experience as dean of the University of Chicago’s business school. He was intimately familiar with the political workings of the administration, a trusted adviser of President Nixon, and an adherent to the neoliberal economic thought associated with the University of Chicago. According to Volcker, his immediate subordinate at the Treasury, “Shultz had strong Friedmanite ideas” that guided his international monetary planning.⁴⁵ From a policy perspective, these views primarily included preferences for flexible exchange rates, free capital movement, and free trade but also extended to an ideological orientation against centralized market management, including at the international level.⁴⁶ Shultz’s objectives also aligned quite closely with the preservation of the dollar standard.

Shultz’s influence can be seen in the thinking of the OMB immediately after the closing of the gold window. A November 1971 OMB analysis of the dollar standard argued that, “the United States would be better off in an international monetary system in which it did not assume any specific obligations with respect to the settlement of outstanding dollar balances” – i.e., a world with a dollar standard and/or floating exchange rates.⁴⁷ The OMB report made three points about the benefits of a dollar standard: (1) it would lead to larger income from financial services, (2) it would allow the U.S. to run deficits without worrying about adjustment, and (3) it would force other countries to either freely float or absorb dollars to maintain a fixed parity. The OMB, in this remarkably prescient analysis, was correct in asserting that a dollar standard with floating exchange rates would force other countries to accept additional dollar liabilities if they wanted to maintain a fixed peg. This was the point missing from the CEA and Fed’s analysis of the issue and the point that ultimately afforded the U.S. much of the benefit of dollar hegemony thereafter.

Most importantly for Shultz, a dollar standard would make the U.S. an automatic focal point of international economic activity as long as restrictions on the movement of trade and capital were avoided.⁴⁸ He viewed the dollar standard as a means to promote global economic and financial integration, not an end in itself. Shultz saw the U.S. and the dollar as the natural center of global economic activity and viewed restrictions as an unnecessary impediment to this role. A dollar standard was simply a necessary component of the liberalized world he envisioned.

Just as Shultz was taking office, the Smithsonian Agreement began to unravel and the world veered toward international monetary chaos. International negotiations during this period took place in an environment characterized by three key facts: (1) the failure of the Smithsonian Agreement had let the system fall back to de facto floating exchange rates, (2) the world remained on a dollar standard, and (3) appetites for centralized international monetary authority were, for the first time since the Bretton Woods Agreement, diminishing.

The failure of the Smithsonian parities in late 1972 only worsened at the beginning of the following year. Between January 22 and February 6, 1973, the U.S. experienced a dollar outflow of $4.3 billion in response to the release of dismal 1972 balance of payments figures. These outflows put enormous pressure on international exchange rates, particularly the dollar/deutschemark rate as funds flooded into Germany and out of the U.S. In executive level meetings to plan the U.S. response, Shultz butted heads with Fed Chairman Arthur Burns in making his position clear. He advocated imminent removal of American capital controls (Burns wanted to do it over two to three years) and forcing a dollar devaluation on other countries by refusing to intervene in foreign exchange markets (Burns thought this would be taken as “economic belligerency”).⁴⁹

The evidence suggests that Shultz was far less concerned than his predecessors with even maintaining the facade of international cooperation. His aggressive outlook was motivated by both an ideological commitment to neoliberal policies and an extension of the unilateral self-interest that had come to characterize American international monetary policy. Shultz had been party to the group pushing hardest for the closing of the gold window on the grounds that it would restore American freedom to pursue domestic policies that had been sidelined in order to appease foreign governments.⁵⁰ Like Connally, he was not afraid to take an assertive stance to protect American interests, and it is worth remembering his response to foreign pleas for the U.S. to resume international exchange intervention after the closing of the gold window: “Santa Claus is dead.”⁵¹

Shultz’s interest in the liberalization of the international monetary system made the expansion of the dollar’s intervention and transactions role a primary objective of his time at the Treasury. The logic was simple: a common currency (the dollar) for international transactions and a world financial center (the United States) would ensure the smooth functioning of such a system by reducing transaction costs and uncertainty. On the private side, the banking community felt that the preservation of the dollar’s international role would benefit them by attracting additional transactions; one prominent banker noted that even without gold convertibility, the dollar was still “convertible” into U.S. goods and corporate stocks.⁵²

This thinking led Shultz and the Treasury to use the failure of the Smithsonian Agreement to let the international monetary system lapse into liberalization through neglect. It is important to remember that it was this failure of international coordination that gave Shultz the window he needed to push the world toward a more liberal system. He was not the first member of the Nixon Administration to support such policies but, rather, the first with a legitimate opportunity to implement them. In the lead up to the Smithsonian Agreement, Secretary Connally told President Nixon that the U.S. should be willing to compromise on exchange rate flexibility and capital liberalization in order to avoid a breakdown of negotiations, despite that fact that this might not be in the U.S.’s interest.⁵³ The U.S. did in fact compromise on both issues, committing to several years of capital controls under the Smithsonian Agreement. While the tense negotiating environment of 1971 limited the U.S.’s freedom to pursue a liberalization agenda, the decline of cooperation over the next year and acclimation of the world to the floating/dollar standard system mitigated these concerns for Shultz.

In 1972, Shultz told the world that the U.S. would not take on any obligation to intervene to adjust the dollar’s exchange rate and was recalcitrant in his dealings with foreign finance ministers on the subject of reform.⁵⁴ When it came time negotiate in March of 1973, he had the opportunity he needed. As Shultz himself put it, “The Smithsonian Agreement didn’t work. So when I became Secretary, in concert with my colleagues, we designed a different system and proposed it at the IMF meeting [in 1973], and that turned into the system of managed flexibility that we now have.”⁵⁵ The world community reluctantly agreed, given that the U.S. had functionally given them no other option, and Germany, France, Belgium, the Netherlands, Denmark, and Luxembourg began floating their currencies.⁵⁶ Without the need to balance multilateralism with American interests, Shultz was free to finally pursue the floating exchange rates he had wanted for so long.⁵⁷

The question of capital controls is a bit more complex. Although Shultz was a staunch supporter of eliminating capital controls from the outset, the U.S.’s ability to force other countries to follow suit was much more limited than it was for exchange rate flexibility. This did not stop him from announcing the unilateral end of American capital controls on February 12, 1973⁵⁸ and – after pushing for the go-ahead from President Nixon for almost a year – finally removing all controls in January 1974.⁵⁹ Although Shultz was able to rid the U.S. of capital controls on his own, his vision of a liberal payments and trading system would require action on the part of most major developed countries to come to full fruition.

In his account of global financial liberalization, Rawi Abdelal argues that the U.S. took an inward-looking approach to liberalization that emphasized unilateral choices and ad hoc measures rather than the more genuinely liberal approach he attributes to Europe. According to Abdelal, the U.S.’s hegemonic interest led it to pursue only piecemeal liberalization, while the truly revolutionary and liberal features of the current international financial system emerged from European initiatives in the European Union and OECD in the 1980s.⁶⁰

This view, however, is somewhat questionable in light of documentary evidence from the Treasury. Abdelal’s contention that the U.S. shied away from multilateral liberalization efforts ignores evidence that the U.S. feared that the IMF’s institutional interest in preserving its own relevance would lead it to sidetrack multilateral negotiations and get in the way of liberalizing reforms.⁶¹ While Abdelal is correct that the American approach to liberalization neglected the role of the international institutions, this was precisely because Shultz’s version of liberalism was far more trusting of the market than international bodies. Similarly, his argument that full liberalization only happened once the Europeans became involved misses earlier European involvement that stymied such efforts. In 1973, for example, the Nixon Administration met pushback from French President Georges Pompidou, who maintained that capital controls were necessary to fight short-term capital movements.⁶² While Abdelal is correct that European efforts were essential to the dismantling of global capital controls, this had long been a part of Shultz’s liberalizing project.

By 1974, it was clear that international monetary reform was stalled and the world was still stuck on the dollar standard. The only progress made toward reform had been the tacit adoption of Shultz’s program of managed floating and somewhat liberalized capital movement, securing the dollar’s intervention and transactions role. All that remained in the development of dollar hegemony was to ensure the preservation of the dollar’s reserve currency role, a task made far easier by Shultz’s reforms and the failure of international coordination.

From 1974 onward, the dollar’s role was more or less secure, and the final steps in the development of dollar hegemony were merely finishing touches. The failure of the Committee of Twenty, the IMF’s chief negotiating forum for international monetary reform, left a coordinated effort to replace the dollar as the key currency highly unlikely. Of course, the U.S. left little to chance, taking a series of actions to secure the dollar’s role in international oil trading and stymie its only plausible rival, IMF Special Drawing Rights.

The move to protect the dollar’s role as the invoicing currency for international oil transactions arose from the development of OPEC’s massive surpluses after the 1973 oil crisis.

After a doubling in U.S. demand for oil between 1971 and 1973⁶³ and OPEC’s quadrupling of prices, in 1973 the Treasury estimated that the OPEC countries would finish 1974 with a $55 billion surplus for investment.⁶⁴ At the outset, most oil was priced in dollars and dollar securities received the greatest portion of these surpluses. The Treasury estimated that roughly 25 percent of the 1974 surplus was invested in the U.S. (with the greatest share going to Treasury securities) and an additional 45 percent went into the Euro-dollar market. The Euro-dollar market was a logical destination for OPEC funds, given its plethora of dollar-denominated banking and investment options. With the unrivaled scale of dollar-denominated markets, there was little risk that a substantial portion of these funds would flow to a non-dollar financial market, a fact the U.S. knew quite well.⁶⁵ The question was whether the U.S. wanted OPEC (and mostly Saudi) funds to flow through the Euro-dollar market or into the domestic capital market.

The brilliant answer came from Shultz’s replacement as Treasury Secretary, William Simon. In a January 1975 statement before the Senate Committee on Finance, Secretary Simon noted that although the federal deficit was rising and the Treasury would need roughly $70 billion in capital markets borrowing in 1975, “The strains could be relieved…if the OPEC nations put a larger amount of their accumulated funds into investment in this country.”⁶⁶ Simon noted what would later become of a hallmark of American spending and deficit management: if countries exporting goods to the U.S. could be convinced to reinvest their dollar surpluses into American financial markets, particularly U.S. government debt, it would allow the U.S. to borrow indefinitely at low interest rates. Thus, the petrodollar recycling solution was born.

In July 1974, Simon had visited Saudi Arabia and proposed an “add-on arrangement” that would allow them to purchase Treasury debt outside the normal auction facility. The add-on arrangement was completed in December 1974 and met quick success. From 1976 to 1977, the proportion of Middle Eastern (especially Saudi) investments in Treasury debt jumped from 43 percent of total new investments to 65 percent.⁶⁷ The Treasury had succeeded in drawing OPEC funds into the U.S. Treasury bond market and secured a substantial amount of coveted deficit spending flexibility.

The Treasury also made sure to lock in the dollar’s role as OPEC’s preferred invoicing currency. OPEC’s denomination of oil sales in dollars left them with enormous surpluses of petrodollars that needed to be invested in dollar-denominated assets. However, after OPEC threats to switch to SDRs for the denomination of oil sales in 1975 and 1978, the American security establishment began to worry about the future of the dollar and the hegemonic benefits that came with it. As Assistant Secretary of State Julius Katz wrote in 1978, “Inaction by the Administration to check a steep decline in the dollar would have disastrous consequences for our foreign policy. The pressure on OPEC to raise oil prices directly or by denominating oil prices in SDRs would be irresistible.”⁶⁸ The economic risks were even greater than the foreign policy ones. The National Security Council, CEA, and Treasury all agreed that a move by OPEC to price oil in another currency could trigger a massive sell-off of the dollar and undermine its broader international role.⁶⁹ As a consequence, the U.S. took decisive action to undercut the SDR. The U.S. engaged in intense bilateral diplomacy with Saudi Arabia, the OPEC nation with the most sway over the invoicing decision via its market share, and in 1978 agreed to a deal that would give Saudi Arabia increased voting power in the IMF in exchange for Saudi opposition to SDR use.⁷⁰

In ensuring the dollar’s continued role as the denominating currency for international oil transactions, the U.S. put up a lasting defense of dollar hegemony. By facilitating the oil-producing nations’ acquisition of substantial dollar holdings, the U.S. created a strong incentive for them to maintain the dollar’s role and continue investing in American debt to stabilize the value of their holdings.

Despite the success of this objective, though, the development of dollar hegemony was still not fully complete. Although the U.S. had succeeded in preventing OPEC’s transition to SDR-denominated oil pricing, the SDR remained a potential (even if unlikely) challenger to the dollar’s future. American “support” for the SDR during the late 1960s and early 1970s had always been contingent on its role as a buttress for the dollar’s role rather than a challenge to it.⁷¹ U.S. support for an expanded role for the SDR in the early 1970s (generally as the numeraire and a source of liquidity creation) was premised on the fact that it could provide orderly and cooperative growth in liquidity within a dollar-based system.⁷² Most of the Nixon Administration’s economic policymakers felt that reducing the balance of payments deficit was their primary objective after the gold window was closed; without American deficits, SDRs were presumed necessary to augment dollar liabilities as a source of global liquidity. However, the development of OPEC surpluses and their recycling through the Euro-currency market created an excess of liquidity that undermined the raison d’être for the SDR. Without this need, American support evaporated, as well.

Although history has shown that the SDR was never a true rival given its lack of consistent supporters, nonexistent private market, and lack of a clear purpose after the closing of the gold window, this did not stop the U.S. from taking steps to undermine it. To start, in 1973 the Treasury argued that the SDR should carry a very low interest rate on the grounds that it would avoid incentivizing countries to run surpluses.⁷³ Although this proposal seems innocuous enough, the response from Charles Siegman of the Federal Reserve is illustrative of the Treasury’s track record. In his response memorandum to this proposal, Siegman pointedly asserted that the Treasury’s view might have been born from a desire to allow the U.S. to fund its deficits by increasing its dollar liabilities. With lower interest on the SDR than dollar securities, foreign financial institutions would likely find holding dollars more attractive.⁷⁴ Officials outside the agency worried that Treasury was up to its old tricks, fighting to preserve any measure of deficit spending flexibility associated with the dollar’s role. Given the trajectory of the SDR, they may have been right. Although the SDR was formally recognized as the numeraire in the IMF’s Jamaica Agreement of 1976, it never caught on as a major reserve asset in the way the agreement envisioned.⁷⁵ At least in part because of its low interest rate, the SDR remained a monetary oddity and never gained broad acceptance among central banks or private financial actors. The Treasury also used its close relationship with Saudi Arabia to make sure that OPEC would never back the SDR as a major reserve currency. Without the support of the U.S., the world’s largest economy, or OPEC, the world’s largest surplus holders, the SDR lost its chance at ever becoming a major international reserve asset.

By 1979 the U.S. had finally arrived at what had been only a distant aspiration for the Volcker Group, full-fledged dollar hegemony comprised of a global dollar standard and a liberal payments and exchange system built around the dollar. This system facilitated easy financing for American deficits, which would become a staple of post-1980 American governance, and ensured a dominant economic role for the United States. The dollar had no peer competitors and was so entrenched in the world economic system as to be practically untouchable.
Conclusion

My argument has been that the rise of dollar hegemony was the result of a concerted strategy by American economic policymakers to defend and extend the dollar’s role as the international key currency. Although the dollar benefited from favorable conditions – including repeated breakdowns of international coordination, limited support for alternatives, and the size and attractiveness of American financial markets – the transition of the dollar’s role from one of constrained privilege to unrivaled hegemony was unmistakably the product of hegemonic strategy and American policy intervention.

Prior to the global financial crisis, the academic community was buzzing with talk of a potential end to dollar hegemony. The euro, backed by a host of sympathetic countries from the Eurozone and Asia, was seen as a likely successor to the dollar.⁷⁶ Today, such predictions seem laughable in light of the Eurozone crisis beginning in 2009. The more the world relies on the dollar, as it did as a source of liquidity and stability during the global financial crisis, the harder it will be to move away from it.⁷⁷ The fact that it took two world wars to dislodge the pound from its privileged position should give us pause when we hear predictions of the dollar’s demise. Although its day of reckoning will come eventually, for the foreseeable future dollar hegemony is here to stay.

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