A good academic paper is like an ancient Hindu spiritual text. The more you read it, the more it reveals hitherto unexplored dimensions. I would put Ronald McKinnon’s The Rules of the Game: International Money in Historical Perspective, published in 1993, in that category. It captures both the written and the mostly unwritten rules under which the various international exchange rate regimes—Bretton Woods onwards—were expected to operate.

Let us start with this:

Even the traumatic breakdown of the fixed exchange rates in 1971-73 did surprisingly little subsequently to disturb the conventions for using the dollar as international money for official and private purposes (McKinnon 1979). Under floating (as well as fixed) exchange rates, economies of scale are such that “the use of a currency as (international) money itself reinforces that currency’s usefulness" (Paul Krugman 1984). This reinforcing circularity makes displacement unlikely short of war, exchange controls, or massive inflation in the centre country.

Because of disruptions from World Wars I and II, the dollar eventually displaced sterling’s similarly entrenched international role (Benjamin Cohen 1971)—but not without fomenting disorganization in the international economy (Kindleberger 1973).

So, short of war, exchange controls and massive inflation, China cannot even contemplate the chance of displacing the dollar with its currency. America is a mighty military power. It is re-engaging East Asia. War will be calamitous for China. Greenspan and Bernanke have done their best to create inflation in the country. But, with US data improving lately, the chances of another quantitative easing are eroding, although it is difficult to rule out its chances completely as long as Bernanke is in office and as long as the Wall Street-US treasury-Federal Reserve connections remain strong.

America nearly squandered it in the late 1960s and early 1970s. The war efforts, the resulting rise in inflation and the anti-war protests dented America’s self-confidence. The Marshall Plan was too successful. Germany and Japan turned out to be post-War industrialization and economic growth success stories. Enlightened self-interest gave way to insecurity. American corporates wanted a weaker dollar.

One of the “rules of the game" of the post-War dollar standard that evolved was that America had to remain passive in the foreign exchange market. It was supposed to practise free trade with neither a balance-of-payments nor exchange-rate target. The country was neither required nor expected to hold significant official reserves of foreign exchange. It was also to maintain a net international credit position and limit fiscal deficits. In recent decades, America has strayed a long way from these conditions and that has been the cause of a lot of global booms and busts, exchange rate misalignments, etc.

McKinnon writes, “In 1970-71, facing the clamour for dollar devaluation and greater exchange rate flexibility, the schizophrenic American government would not disinflate the American economy in order to defend the most successful international monetary regime the world has ever seen."

Despite this big setback in the 1970s, the world has continued to operate on a dollar standard until today. The rest of the world expands money supply when America is doing, too, and weakening the dollar. Conversely, the rest of the world contracts money supply when the dollar is strengthening and America is contracting or growing its money supply. That is what happened in 2002-07.

There was a synchronous global credit and housing boom. The world economic system became unstable. All of them collapsed simultaneously and contracted in 2008. America again reinflated. Others followed. The world experienced a mini-boom in 2009-10. The cycles repeat, but with alarmingly shrinking intervals.

America managed to keep the world on a dollar standard in the 1970s despite the setbacks by targeting oil-exporting nations and making them adopt a dollar peg. It cemented the alliance in East Asia with the anti-communist Association of Southeast Asian Nations. Japan was a big ally in any case. In the new millennium, the economic crisis of 2008 was an even bigger threat to the dollar hegemony.

But, now as then, there are no alternatives to the dollar. America has either assisted or watched Europe’s fiscal and debt mess. The euro is precarious. Inertia, as mentioned earlier, is in favour of the dollar. But, with America abandoning all the rules of the game for a world dollar standard to be stable, we are in for recurring and more frequent bouts of global instability, unless America accepted that periodic disinflation was necessary to maintain domestic and global economic stability or the world found a replacement for the dollar. Both look very remote today.

V. Anantha Nageswaran is a senior economist with Asianomics. These are his personal views. Comments are welcome at baretalk@livemint.com

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