Currency wars go nuclear---draws in Russia and China.

Attendant to this crisis of fiscal legitimacy are increasing challenges to the primacy of the US dollar. The standing of the dollar allows the United States to shape the global economic and political system and offers it greater influence abroad, greater flexibility at home, and greater insulation from international crises.18 For those who would downplay the benefits of dollar dominance, the British experience is instructive. Prior to World War II, the British pound sterling was the primary international currency, thereby allowing Britain to finance military expenditures and manage its wartime debt. Once the sterling was eclipsed by the dollar in the postwar years, Britain was no longer able to finance its war debt, a problem that contributed to its economic decline and exacerbated persistent financial crises during the 1960s.19

The sustainability of the dollar as the leading global reserve currency has been a near constant concern since the 1960s. During this time, foreign dollar reserves began to outgrow US gold reserves, and many international actors began to question the United States' ability to convert dollars to gold at the fixed official rate specified by Bretton Woods. As this confidence declined, speculative attacks against the dollar abounded. The United States eventually abandoned the gold standard, but the dollar has retained its dominance ever since. Thus, anyone decrying the dollar's current strength risks crying wolf.

Nevertheless, in the wake of the Great Recession, there are convincing signs that we are headed for a restructuring of the international monetary system as faith in the dollar faltered. The reality is that countries are now questioning the wisdom of carrying debt obligations solely in dollars, and they are moving toward baskets of currencies and alternate trading conventions and currencies to reduce their reliance on the dollar. The portion of global reserves in dollars declined from approximately 72 percent in 2000 to 62 percent in 2012 as the rest of the world attempted to decouple from the US economy.

The Chinese have begun to use their own currency, the renminbi, and reserves in certain trading situations and with some partners with more frequency. China recently completed a $1.08 billion currency swap deal with Kazakhstan and has similar arrangements with Argentina, Belarus, Hong Kong, Indonesia, Malaysia, South Korea, Ireland, Argentina, and Iceland. China has also reached agreements with Russia and Brazil to gradually eliminate the dollar from bilateral trade. 20 All five of the BRICS (Brazil, Russia, India, China, and South Africa, all of which have large, rapidly growing economies) have taken significant steps toward trading in their own currencies, diversifying their foreign exchange reserves, and hedging their bets against the growing instability of the dollar and the euro.

Prior to the G8 summit of 2009, China, Russia, and India explicitly called for an end to dollar dominance. On January 7, 2011, the International Monetary Fund (IMF) produced a paper outlining a plan for replacing the dollar with Special Drawing Rights (SDRs)-IMFissued currency defined in terms of the weighted average of the dollar, euro, yen, and pound. The plan would create a liquid bond market for SDRs and thereby elevate the IMF to the de facto role of the world central bank. 21

This portends a world of multiple reserve currencies, one in which the dollar serves as the primary rudder, steering a steady course to prevent erratic devaluations, but in which the currents are more volatile than they have been for decades. In this scenario, the euro, the British pound, the Swiss franc, and the renminbi would play enhanced roles as regional currencies for Europe and Asia, thereby limiting US influence in these areas.

A more dangerous scenario is an intensification of what James Rickards has termed "Currency War III." According to Rickards, this war began in 2010 and involved competitive devaluations of the yuan, dollar, and euro. These concerns were echoed publicly in 2013 by finance ministries and central banks. It is important to note that the biggest threat is not that yuan devaluation directly damages the US economy. The true threat is systemic. The current China-US monetary relationship is unsustainable and brings the fragility of the entire international monetary system into sharp relief. As Rickards contended, by 2011 both countries were "locked in a trillion-dollar financial embrace, essentially a monetary powder keg that could be detonated by either side if the currency wars spiraled out of control."22 Economic historian Niall Ferguson has dubbed this presently symbiotic yet ultimately dysfunctional relationship "Chimerica." In order to maintain employment for its massive population, China must keep its exports attractive to American consumers and keep the yuan tied to the dollar. As such, China must continue to buy dollar assets and increase its account surpluses. It is caught in a "dollar trap." China's current exchange-rate policy thus ironically helps to preserve dollar dominance.23 Chimerica is, for Ferguson, highly unstable. A sudden deterioration in political relations, perhaps stemming from a clash over natural resources or Taiwan, could trigger a major war and a corresponding collapse of the international financial system. 24

Currently, China is the most competitive player in the so-called currency wars. Yet all major powers are attempting to influence the relative value of their currencies, a ruthless competition that places the entire global monetary system at risk. The currency war need not devolve into actual war for it to prove disastrous. A small but systemically critical event-such as the collapse of the Spanish bond market-could ignite a widespread loss of confidence in paper currencies and a massive transition to hard assets (gold) led by a shrewd and forward-leaning competitor state such as Russia or China.25

Even if one doubts the likelihood of such a crisis, China is nonetheless taking steps to internationalize the renminbi and thereby enhance its power relative to the dollar. This is happening in two ways. First, by purchasing sovereign debt of other Asian countries, China pushes up the value of these regional currencies and incentivizes its neighbors to reciprocate by buying Chinese debt in order to devalue their currencies against the yuan. The net result is a greater international role for the renminbi. Second, the Chinese government is finalizing programs that would allow select foreign financial institutions to invest their renminbi deposits in Chinese equity and bond markets. With increased stakes in renminbi-based businesses, these foreign firms will have more reasons to promote the renminbi so that they can reap the benefits of renminbi internationalization.26

Though the dollar remains superior for now and appears to be the currency of choice amid economic turmoil in Europe, it-along with American financial preeminence-is coming under direct assault.

Conclusion

In many ways, the United States has taught the world how to use financial power in the twenty-first century. The United States has deliberately leveraged US capital markets, the centrality of the dollar, and American ability to set global standards and mores to drive national security goals. The power of this paradigm is derived from the centrality and stability of New York as a global financial center, the importance of dollar-clearing transactions, and the demonstration effects of any regulatory or other steps taken by the United States or major US financial institutions in the broader international system. Our competitors have learned from our use of power, and our enemies have witnessed our vulnerabilities.

Countries such as Russia and China will continue to challenge the dominance of the US-led international system and the dollar itself. If such attacks succeed, they could weaken the ability of the United States to affect or move private sector decision making in line with national security interests, regardless of what other governments do. The advent of nuclear weapons forced scholars and policymakers to rethink their models and methods for advancing US national security. In a similar way, the coming financial wars will force the United States to adapt amid a new geo-economic order defined by globalization and the speed and ease of communication and transnational commerce. In the age of nuclear competition, the United States drew strength from its scientific and technological advantage; however, it is becoming increasingly clear that America is losing its competitive edge in the era of economic security. This development is particularly troubling in light of the unique advantages it possesses as the vanguard of the international trading and financial system and hub of innovation and collaboration.