A pivotal element of the global economy is whether the international monetary system engineers credit creation or operates by credit transfer. In the first case, credit is available and countries can finance deficits on their current account. Imbalances are not addressed. Creditors maintain their propensity to save and debtors continue to spend. This leads to higher global growth. In the second case, creditors limit the amount of credit available. This forces debtors to apply tight fiscal and monetary policies. Global imbalances are addressed, but debtors’ efforts to suppress demand stifle global growth.

Between 1870-1914, Britain managed to control credit creation through the limits set by the gold standard, which made all sterling bank notes convertible into gold. The system did not get its strength from gold, but from the role of Britain’s economy. In every decade since 1870, Britain ran a current account surplus. The trade balance showed a small deficit in the 1890s and 1900s, with balance in the 1880s and small surpluses in the 1870s and between 1910-14. Britain loaned to the world and in return the world bought British goods and services.

Things changed at the 1944 Bretton Woods conference when Britain, exhausted by its efforts in the second world war, pleaded for credit creation. The US rejected this, fearing the rest of the world would use US credit to buy goods and services without any prospect of the loans being paid back. The US won, as creditors normally do. Limited credit transfers kept financing low, forcing the rest of the world to address imbalances – Britain depreciated sterling by 30% in 1949 – which put a lid on global growth.

In the early 1960s, the outstanding amount of dollars rose so much that the unilateral commitment to redeem dollars into gold lost credibility. Between 1971-73 the US renounced the gold standard and switched to credit creation by printing dollars without restrictions. The money printed by the Federal Reserve System underpinned expansion in emerging markets. It also undermined the domestic economy by laying the foundation for a spectacular consumption boom.

After staying steady for decades at around 62%, private consumption’s share of US GDP has risen to 69% in 2018. Unlike Britain, which was both banker and supplier of goods and services, the US has become just the banker and sacrificed its role as a major manufacturer. The result is an inherently unstable system with glaring global imbalances where the US runs permanent current account deficits and creditors run permanent surpluses.

The first line of defence when the gold standard crisis began in 1971 was to offer a higher yield on 10-year Treasury bonds. Yield rose to almost 8% in August 1971 from around 4% in 1962. That worked for a short time. But by the end of 1972 the yield had not fallen; in fact, it was on an upward trajectory. What creditors wanted was a depreciation of the dollar, and they got it. In early 1973, President Richard Nixon’s administration negotiated a coordinated depreciation of the dollar against other major currencies.

This illustrates what happens when a reserve currency is overstretched. First, creditors ask for a rise in yields. When that proves insufficient, they move to the second stage and ask the administration to make it cheaper to buy the reserve country’s goods and services. There is a considerable risk that this will happen to the dollar.

Yields on 10-year Treasury bonds have started to rise significantly. Creditors may hold dollars for a while, but are likely to move to the second stage soon, engineering a fall in the real effective exchange rate. They may demand both a permanently higher yield and a depreciation in exchange for not unloading dollars. If the US continues to pump dollars into the global economy, the yield will go up and the dollar down. In the light of Donald Trump’s views on international negotiations, it is hard to imagine a repetition of the Nixon administration’s skilful handling of such a crisis.

Joergen Oerstroem Moeller is Senior Research Fellow, ISEAS Yusof Ishak Institute, and a former State Secretary at the Danish foreign ministry. This is the first of two articles on the future of the dollar. The second will be published on X June.