Jul 4, 2022

Michael Dooley on the International Monetary System and Future of Global Dollar Dominance

In addition to supplying the world with safe assets, the dollar’s global dominance also provides a form of discipline for emerging market countries seeking foreign investors.
David Beckworth Senior Research Fellow , Michael Dooley

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Michael Dooley is a chief economist for Figure Technologies and a 20-year veteran of the Federal Reserve System and the IMF. Michael is also a professor emeritus in the department of economics at the University of California, Santa Cruz, and he joins Macro Musings to talk about the international monetary system and the future of the dollar. Specifically, David and Michael also discuss the original and revised Bretton Woods systems, the Fed’s role as a monetary superpower, and what this means for the US as a provider of safe and unsafe assets.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Michael, welcome to the show.

Michael Dooley: Thank you. Glad to be here.

Beckworth: Well, it's great to have you on. I read your work in the early to mid 2000s when a lot of the hot conversations surrounded the emergence of the Bretton Woods II system, and I'm sure you'll share with us how you guys, you and your co-authors actually coined that term. So it's a real delight to speak to someone who's coined such a prominent term in the international economics literature. And then most recently you had a paper that really caught my attention titled, *US Sanctions Reinforce the Dollar’s Dominance,* which goes against the narrative that many are putting out there that these sanctions are getting abused and may actually undermine the dollar's role in the world. So you have a paper that kind of makes the argument in a different direction. We'll get back to that later in the show. But before we get into all those fascinating topics, tell the listeners a little bit about yourself. I know you've written on the 1982 debt crisis, the emerging market crisis '97 '98, capital flows. You were the editor of a prominent journal. You've done a lot in your career. So guide us through that amazing journey you've been on.

Michael Dooley’s Professional Journey

Dooley: I tell people that I keep trying different things till I find something I'm good at. I started at the Federal Reserve Board of Governors in Washington in 1971. And I was there for 10 years. As you said, I worked for Arthur Burns, G. William Miller and Paul Volcker. So I saw the whole transition from ancient history to the modern Fed up close. And for the most part, I had jobs that put me in the boardroom once a week or once a month. So I wasn't really in research. I was more of a functional kind of guy. So I saw monetary policy being made up close for that interval. Toward the end of that, mostly I worked at that time on capital flows among industrial countries, US balance of payments, analysis, and that sort of thing. Toward the end of my time there, the Mexican debt crisis came along in '82. And since that was a bank crisis, most of the lending had been done by money center banks, including US banks.

Dooley: This was a big deal for the Fed because it's a regulatory issue. They have large losses. How large were the losses? Should we make them write them off? That sort of thing. So I did a research project and a paper which concluded pretty clearly that this was not a liquidity crisis, that these debts were going to have to be restructured and that the market prices at the time, which were down to 40 cents, were a realistic gauge of the value of the loans. This was a very unpopular view, both at the Fed and the Treasury and the IMF, because for the Fed's point of view, some of the big banks, at least one of the big banks, you would've legally had to close if you had marked those loans to market.

Dooley: Our work, and I did this with several other people at the Fed at the time, suggested that we were going to have to do something extraordinary to get these countries out of this situation. And of course, that crisis spread rapidly all around the world. And this led to the famous Volcker letter to the banks saying, "Don't worry, we're not going to enforce the rules. We're going to carry you." It was regulatory forbearance at its best in a long letter. Well, so I was feeling a little constrained, because that really got me interested in banking crises, and that sort of thing, which I had worked on before, but now this was up close and personal. And in '82, I got an opportunity to go to the IMF and I figured, "Well, if I go to the IMF, I can actually publish some of this stuff."

Dooley: Because I couldn't get the Fed. So I took a job at the IMF and I was there for 10 years and again, I did a variety of things. But for my own time, it was mostly on the need for debt restructuring and moving the IMF as an institution toward that conclusion. You probably remember at the time the US Treasury was extremely hostile to that point of view because they were claiming it was liquidity crisis. If these countries would just follow their policies, we'd get out of it and so on and so forth. And I was arguing no, that they could follow the best policies you guys could think of and they're not going to get out of this without some outside help. And I think actually there were a lot of people participated in that debate on both sides, but I think I helped move the institution toward the Brady plan, that was actually was named after the Treasury secretary, although he didn't... I don't think he even knew much about it. But it became his plan.

Dooley: That was a lot of fun. I got to go to the countries, I got to meet a lot of the people involved. But I wanted even more freedom to write about things. So I went to the University of California as a professor. And so in the '90s, I did a variety of things, both on the theory of crises and analysis of what had happened or at least my view of what had happened, what we should learn from it. A basic theme in the theoretical papers was that for the most part, the private capital inflows into dangerous markets, emerging markets, if you like, were insured in a way by the reserves of the country and by its power to lend after the crisis appeared.

Dooley: And I did just some statistical work showing that yeah, the private capital inflows, the integral of the private capital inflows was roughly equal in all of these cases to the resources that would be on hand on the day of the crisis to bail them out. This also was a pretty unpopular view because other people were talking about all kinds of first generation, second generation, third generation bottles of crisis. This was an extraordinarily simple first generation model that said, "You lend up until the point where the insurance is now unable to cover the marginal lender. And so everybody pulls out on the same day. You got to pull out on the same day because then everything's going to be gone if you wait." And so that was a 2000 paper that was published somewhere.

Dooley: And that was pretty much my involvement during the '90s in the whole crisis. Since I was at the university, I wasn't really firsthand observer of the Asian crisis, but I wrote a couple papers on it, that sort of thing. While I was at the university, I also went to Deutsche Bank for a couple years in 2002, 2004, or again that's where the Bretton Woods II idea was initially hatched. So Peter Garber and David Folkerts-Landau and myself were all working in Deutsche Bank's research department. David was running it, but Peter and I were working in it. And that again, well, we can talk about the substance of the argument. But that again got me involved in a more market-oriented view of how financial markets work and how financial markets fail, what happens. And again, an overriding theme of that is that contrary to the vast majority of the academic literature, credits are collateralized. I mean, it sounds ironic, but credit markets are not based on trust, not real credit markets. Credit markets are based on the idea that if you can't pay me, I can go and see something of yours. And so the joke, a good banker is not one that makes wise lending decisions. A good banker is one that gets out first.

It sounds ironic, but credit markets are not based on trust, not real credit markets. Credit markets are based on the idea that if you can't pay me, I can go and see something of yours. And so the joke, a good banker is not one that makes wise lending decisions. A good banker is one that gets out first.

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Beckworth: Right, right?

Dooley: So that's where the real rewards are in banking. And that struck me as an idea that was largely absent from the literature on crises. Again, going back to the idea that people don't go into dangerous countries unless they're insured one way or another.

Beckworth: So you have a rich experience there all the way from the 1980s debt crisis up till the... well, we've just talked through the early to mid 2000s. And I want to go back and just touch on a few things… so fascinating that you got to work with Arthur Burns and Paul Volcker. So I just have to ask this and if you don't feel comfortable answering, that's fine. But when you were there at the FOMC when Arthur Burns’ Fed was kind of more accommodative, at least in hindsight, retrospectively it looks like he's more accommodative than was warranted and contributed to the great inflation. I mean, in real time, was anyone uncomfortable? Were you uncomfortable? Did you have a sense that maybe we shouldn't be doing this? What was it like?

A Look Into the Arthur Burns Fed

Dooley: Yes. The younger staff people at the Fed who had been hired by Arthur Burns' directions… When Burns came to the Fed, the Board of Governors anyway didn't have much of a research staff. And Burns being a former professor and head of the NBER and all that, he hired a bunch of us. I mean, it was a blitz in the market. He hired people from everywhere, even Penn state where I came from. But he hired new PhDs from Chicago, from Yale, from... you name it. We had a great group there. And the younger people were quite concerned that... and we learned to our surprise, or at least I learned to my considerable surprise that a lot of the caution was based on two things. One was the senior staff was telling Burns, "You couldn't have sustained inflation with an unemployment rate above X, three and a half percent or 4%," whatever they thought it was at the time.

Dooley: They just said, "It's not possible," because they believed in cost push inflation. Right? So if you have slack in the labor market, you can't have inflation, period, full stop. That was the end of the argument. The other which surprised me a lot and I think in retrospect was even more important, was the Treasury was extremely concerned about financial fragility, about rolling over, what to them seemed at the time, was a very large federal debt. And that goes all the way back to the Korean War and World War II, that the main concern of the US Treasury following World War II, after say 1950, was their belief that they would have trouble rolling over the debt if there was a lot of price uncertainty in the markets. And so the Fed felt constrained about moving the federal funds rate too fast because they thought it would lead to a financial fragility, what we would call financial fragility now. So yeah, I went to a lot of briefings where inflation was blamed on rising prices.

Beckworth: Great circular reasoning.

Dooley: It was blamed on farmers. It was blamed on... you name it, labor unions. And actually we're seeing a lot of that now-

Beckworth: Yeah. It's interesting. We're coming full circle here.

The main concern of the US Treasury following World War II, after say 1950, was their belief that they would have trouble rolling over the debt if there was a lot of price uncertainty in the markets. And so the Fed felt constrained about moving the federal funds rate too fast because they thought it would lead to a financial fragility, what we would call financial fragility now. So yeah, I went to a lot of briefings where inflation was blamed on rising prices.

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Dooley: Yeah, yeah. Now it's supply chain disruptions, right, which is causing inflation.

Beckworth: Very fascinating.

Dooley: Yeah, so there was a lot of doubt at that time.

Beckworth: Yeah. So, wow. You could probably write an interesting book about this career of yours.

Dooley: I keep threatening to do it.

Beckworth: I would just mention that when I got out of grad school, I graduated in 2003. I went to work at the US Department of Treasury and one of the big things that we worked on and to be clear, I was in the Office of Western Hemisphere Affairs. So we dealt with Mexico. And that year, I believe it was that year they retired or they finished up their Brady Bonds. It was the last year for them to go through that. I remember that being a big deal for them. As well as I think during that year, their Peso yield curve finally hit 10 years. And they were very jubilant about that as well. But I remember very vividly getting the memo from the Department of Treasury, that wasn't in my department, that, "Hey, they're done. Their Brady bonds are finished." So interesting to talk to someone who was a part of that history and maybe, Mike, they should have called it the Dooley plan instead of the Brady plan since you pushed them in that direction.

Dooley: That's what my wife calls it.

Beckworth: Okay, there you go. Well, we'll recognize it on this show at least. And all the listeners out there, we'll have a moment to reflect that the Brady plan could have been called the Dooley plan. Okay. So let's move on then to the mid-2000s. And that brings us up to the great financial crisis and two things I want to ask about that. Let me first start with this. So I was really energized and excited about this Bretton Woods II literature, which again, you and your co-authors coined, and a lot of people grabbed onto it. There's a lot of discussion about global imbalances, everything from multiple issues of The Economist magazine covered this to prominent economists [like] Ken Rogoff, Larry Summers, Paul Krugman.

Beckworth: I mean, big names were out there discussing this issue. And most everyone out there was making this claim that, "Man, yes, this is a neat idea. It's a great way of framing the international monetary system we have, now Bretton Woods II." However, it has a built in crisis. It's going to implode. And the big fear back then was there's going to be a big dollar crisis. The US can't sustain this huge current account deficit. It's not sustainable. It's basic economics. It's the inter-temporal constraint. You can't keep this going on. And you and your co-authors were one of the few who didn't make that point. Is that right?

Pushing Back Against Dollar Crisis Fears

Dooley: Well, we argued strongly against it for many years. In our original paper, we said that the Bretton Woods II system might last for 10 years or more. And immediately people came out with a blizzard literally of papers saying, "It might last another six months. But you guys are crazy. These imbalances can't go on for a long time because the system is inherently unstable." As years went by and the system survived quite nicely and quite successfully, people began to doubt it. But then as you mentioned 2008, there was one dandy of a crisis. First of all, I did not see that crisis coming. I should have. I had all the tools. I even had the information because a young researcher at Deutsche Bank when I was there, who studied these things, told us that the default rate on initial subprime mortgage packages was off the charts… that is, it was larger than anything she'd ever seen. And that was a very good predictor of what was going to happen later on. And I believe that. But I didn't know the scale of the subprime market. I don't think anybody else did it either. So we knew there was a problem. But I at least didn't have any idea how big it was, right? In our view, and it's still my view, is that that was a good old fashioned crisis caused by fraud and regulatory lax, if that's okay.

Beckworth: Sure.

Dooley: A failure to regulate, right? And that failure to regulate has started long before that in the early '90s, right? I mean, the regulatory structure in the US banking system was pretty much gutted by 2002, 2003. And so these really terrible loan things were put together, sold, given AAA ratings by rating institutions that use incredibly naive procedures. And so I said, "Look, there's no surprise to me," and we exported it. We not only generated the bad paper, we exported it all over the world, right? And then we insured it by one... then it was all "insured" by one guy who didn't have any money, right? This is a classic fraud credit crunch thing. And sure enough, there was a crisis and the system ended. But it was not what was predicted. The dollar actually appreciated during the crisis. Treasury yields actually fell during the crisis.

Dooley: If it was anything, it was orthogonal to the crisis that had been widely forecast or anticipated. But it did bring the system pretty much to a halt because the system depends on free flow of capital. The Bretton Wood II system depended on free flow of capital from the center to the periphery of China and other emerging markets. And that certainly was interrupted, right? So I certainly saw the 2008 crisis through the lens of all the other crises I'd looked at. But it really was a regulatory crisis. And a couple of other people took the same line eventually. I think if I pulled my colleagues at the NBER, most of them would still say it had something to do with imbalances, although they're not sure what it is.

I didn't know the scale of the subprime market. I don't think anybody else did it either. So we knew there was a problem. But I at least didn't have any idea how big it was, right? In our view, and it's still my view, is that that was a good old fashioned crisis caused by fraud...A failure to regulate...And that failure to regulate has started long before that in the early '90s.

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Beckworth: Well, that's great. And you touched on the second question I was going to make, or the comment I was going to make. And that is, I remember Paul Krugman, I don't know if it was during the crisis, or maybe soon after making the observation that for those people like himself and you and your colleagues who worked on financial crises in other parts of the world, this is easy to understand. You had the tools, you had the framework, it had a different origin, but it had a very similar framework. Whereas for many, maybe macroeconomists’ standard New Keynesian model, three equations... wasn't so clear. We're used to the great moderation, right? Things are predictable, stable. So it did come out of the blue for some, and kind of blindsided them. But you had a good sense at least of making sense of this. Well, let's go to the Bretton Woods system and I want to get to your Bretton Woods II system. And I think most of our listeners know what the first one was, but just to be thorough here, why don't you describe the original Bretton Woods system and then what it is you and your co-authors coined, Bretton Woods II?

Describing the Original Bretton Woods System

Dooley: Okay. Yeah. Very simply the Bretton Woods I is our interpretation of what its essence was. We had a Europe to rebuild and a Japan to rebuild, the US as a center had all the productive capacity, had all the lending capacity, had all the gold, had everything. And the strategy that both the Japanese and the Europeans used... again, this is our interpretation. The strategy they used was to significantly undervalue their exchange rates in real terms. And since there were no functioning financial markets in Europe or Japan following the war, they were able to do this. So their strategy was to undervalue and rapidly industrialize when the rest of Europe re-industrialized. And that was the key to their development strategy, was some people have called that mercantilism, some people have called it export led growth.

Dooley: Mercantilism at least in an economics profession has kind of a pejorative tone to it. But that's what it was in our view. Now the way they kept the exchange rate under value was through exchange control. That is, if you earn foreign exchange, you by law sold it to the central bank at the price they gave you. Period. And if you held it even, not even invested it, if you held it, you were prosecuted and you were thrown in jail. This was a very effective capital control. People don't like to go to jail for a couple basis points, right? And they kept the exchange rate undervalued through what economists call sterilized intervention, right? You buy the foreign exchange, but then you sell enough domestic bonds to soak up the increase in bank reserves, right?

Dooley: So sterilized intervention doesn't change the monetary base. You could do that because you run the market and the banks for the most part. And you tell the banks, "Congratulations. You've just bought X number of bonds to sterilize the increase of the monetary base." And that worked beautifully. I mean, Europe and Japan did come back fast. It worked fine. But in that case, the success of the strategy led to its demise. As the strategy was successful, the industrial sector grew in strength and power and said, "Hey, we need a real financial market here. We don't want to go on like this." And the authorities, including the US authorities by the way, but mostly the European and Japanese authorities, loosened up on their exchange control.

Dooley: They made their currencies convertible. So that by roughly 1968, '69, the system was already crumbling because you can't sterilize huge private capital flows. And as soon as the capital account was open, this story is very familiar to economists. But maybe I hope other people that might be watching see the connection. So you can clean up a small mess, but you can't clean up a huge mess. And private capital flows became a huge mess. And so in the US and other places, we went off of the...and in fact the first of August, I was at the Fed. Nixon took us off of gold. And by 1974, we went to general floating. Okay. So in our view, that was the... the Bretton Wood system was still there, but it was no longer operating.

Dooley: These countries had moved from the periphery to the center. There was now a center which is an integrated floating exchange rate, free capital market center. And there was no real periphery. China, Soviet Union, they were completely outside. Move to 2002, and China actually joins the club. They join the GATT. They decide that maybe they can industrialize. And so they invite in direct investment. All you had to do was have a Chinese partner. You could go in, they put their exchange rate... when they liberalized in 2000, 2002, they set their exchange rate , initially, very low. They did that for a bunch of reasons. One is they didn't have any money. So if they set it too high, they couldn't finance the deficit. So they had to be sure, and nobody cared.

Dooley: Exports are about $12 a year. Who cares? You could have any exchange rate you want, we don't care. Well, people then saw a well educated, highly motivated industrial workforce of roughly 250 million people who were being paid one tenth to one twentieth what was being paid in Illinois. And so they said, "Well, maybe we should move some of our capital and some of our expertise there." The problem of course is that you're moving it to communist country who is very likely someday to steal your capital. And so you need some insurance. What was the insurance? Our argument was the insurance was to keep the exchange rate undervalued. They accumulated $3 trillion worth of reserves, assets. A lot of those reserves were held in places where the host government could seize them, a lot of it in the US Treasury. And so that's still my view, that was our main theoretical contribution or analytical contribution was that it was the reserves which were probably accumulated accidentally to keep the exchange rate undervalued that reassured foreign investors in putting their capital and technology into China and other emerging markets. Again, that idea among my colleagues was even less popular.

Beckworth: Yeah. And I want to come back to that. It's a great thought. We'll come back to it a little bit later when we get into your paper, because even today, it's probably not the most popular idea. But I do find it convincing in what you just mentioned, early 2000s, is a great data point that can be interpreted to support that claim. Well, let's talk about Bretton Woods II since that time. So you coined a term, back then you and your co-authors, it generally has been accepted I believe by the profession.

Dooley: Actually, we didn't coin the term.

Beckworth: You didn't?

Dooley: No, we called it the revived Bretton Woods system.

Our main theoretical contribution or analytical contribution was that it was the reserves which were probably accumulated accidentally to keep the exchange rate undervalued that reassured foreign investors in putting their capital and technology into China and other emerging markets.

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Beckworth: Okay. So you coined the revived Bretton Woods system.

Dooley: And everybody else called it Bretton Woods II.

Beckworth: Okay.

Dooley: So we got tired of correcting people. So we said, "Okay. It can be Bretton Woods II." But the revived part actually was important. The revived means that when countries move to the center, then that system is gone. But there could be a new periphery, right? So what happened, in our view, the Bretton Woods I system didn't collapse, it evolved. And then it was revived.

Beckworth: So you really stressed the revival part and then also the role that reserves or safe assets from the core country plays in disciplining the periphery, which we'll come back in a minute with your paper. But what you just said, your two big contributions. But let's talk a little bit more about the Bretton Woods system since then. So a couple things come to mind first. I'll just mention off the bat… So I have a friend, Ethan Ilzetzki, you may know him. He had a paper coauthored with Carmen Reinhart, Ken Rogoff. And the title was, *Exchange Arrangements Entering the 21st Century: Which Anchor Will Hold?* QJE, Quarterly Journal of Economics, 2019. But what they do is really fascinating, and the IMF does this exercise as well, but they go through and they look at every country and their exchange rate regime and they count the countries up or what I think is a more useful exercise is they take the percent of world GDP that's linked to other currencies. The dollar is a key thing here. And what they show, which is so striking, they have this great time series graph, that the share of world GDP that's linked in some form to the dollar is about where it was under the original Bretton Woods system. It hasn't really changed and is anywhere from 65 to 70%. I mean, it's huge. And it's very, very shocking, because you would think, "Well, Bretton Woods breaks down. So people go their separate ways." But as you said, it got revived. So any thoughts on that?

The Revived Bretton Woods System

Dooley: Yeah. I mean as the system evolves, the countries in the periphery have to adjust their exchange rate policy. They can't just peg wherever they want it. And that usually leads to some sort of basket intervention thing where the dollar has a big weight and where the other non dollar currencies in the basket also are related to the dollar in some sense. So it’s effectively a pretty much still a dollar weighted system. It is often a tradeoff... in China, for example, so I think 2015 was an important year to understand this. As the dollar appreciated dramatically against everybody, the Chinese government had since the very beginning equated domestic stability with a stable dollar renminbi exchange rate.

Dooley: That's the communist party. I mean, the people in charge said, "Our objective is to keep a stable dollar because that's what our people understand." So when the dollar went up against everybody else, China went with the dollar and it caused remarkable real appreciation of the renminbi, even bigger than the dollar’s, because all their competitors didn't go with the dollar. They let it go up and they still had a basket currency. But the dollar had a much smaller weight. Korea is probably the best example of a country that just allowed the dollar to go its way. So in a sense, that was effectively the end of Bretton Woods II. But because one of the keys, the undervalued currency, just disappeared more or less voluntarily. Now, since then the Chinese have moved more to a basket.

Dooley: The basket is apparently 98% dollars. So not sure that has changed a lot. I think that work of looking at what countries do instead of what they say is very important. I think it's absolutely the right way to go. But you still have to look behind and say, "Okay, why did the government of China allow the renminbi to appreciate so much just because the dollar did?" And I think that was a financial stability argument and since then, I mean, for the other emerging markets, especially the east Asia, their capital markets have become much more integrated and much more a part of the center although there's still income differences. There's not a lot of ability to manage exchange rates now. And in our terms, there is almost no periphery right now.

Beckworth: So you just said a few minutes ago, which surprised me, that Bretton Woods II ended in 2015 with China's-

Dooley: Effectively.

Beckworth: Okay. Effectively.

Dooley: I mean, the system is still there, but it's not used.

Beckworth: The system is still there. And when you say the system, you mean the periphery versus center kind of arrangement? Yeah?

Dooley: Yeah, yeah. It's the development strategy which we find most important. This is the only development strategy that's ever worked, which, when you think about it, is pretty amazing. It actually worked. I mean, we never thought initially that it would work. But it did. It worked in Europe and it worked from 2000 to 2015. Remarkable.

Beckworth: So just to help clarify this in my mind, at least, so there's the Bretton Woods II system, it's related, but it's also very distinct from the issue of dollar dominance, who provides the main safe assets to the world. That there's some overlap, but the key points you're stressing effectively are not binding right now, the periphery versus core points. But the entanglement may be left over from that or the connections are still there. Is that fair?

Dooley: Yeah. In terms of just analyzing the system, I would say China is almost part of the center, very close. So the difference between say Europe and China and the United States in terms of financial markets... I mean, there's still huge differences. But they are no longer this very easily identified separate entity pursuing a strategy to catch up with the center. Unfortunately from their point of view, they didn't quite make it before they came over. And by the way, my co-authors don't like this, but I think it was 98% an accident, right? I think they accidentally set their exchange rate undervalued. They accidentally allowed in foreign direct investment. They accidentally built up these reserves. It worked and then they kind of backed away from it.

Beckworth: So sometimes it pays to be lucky rather than good, huh?

It's the development strategy which we find most important. This is the only development strategy that's ever worked, which, when you think about it, is pretty amazing. It actually worked. I mean, we never thought initially that it would work. But it did. It worked in Europe and it worked from 2000 to 2015.

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Dooley: Yes.

Beckworth: Okay. And that applies to international monetary systems as well. So then if Bretton Woods II is effectively over, what would you call this kind of current global monetary system? And we'll flesh that out in a minute, what it currently is. But do you have another clever name for it? Have you thought of anything like that or...

Dooley: No, it's still the Bretton Woods system. It's just changed a lot.

Beckworth: So it's still the Bretton Woods system. Fair enough.

Dooley: Except everybody's in the center.

Beckworth: Okay. Well, let's talk about some of those changing dynamics. And one of the papers I found interesting and we'll get to your hot paper here in a minute. In fact, when you were mentioning in the early 2000s and how your paper was very provocative and the argument you made that, this is actually going to last a decade, Bretton Woods II. And everyone was like, "No." I was just thinking, "Man, if Twitter had been around back then,” and Mike, had you been on Twitter, that would've been a hot take and it would've gotten a lot of interaction on Twitter. And it's unfortunate that hot take wasn't possible back then. But you had the hot take that went the more traditional route, you had it in journal articles and conferences and stuff. But we're going to make it a hot take here.

Beckworth: And your article in a minute will be a very hot take. But one of the articles that speaks, I think, to elements of what we currently have, that I've really appreciated was Helene Rey's global financial cycle paper. And she had one in 2013. And I see she had one just last year, but she paints this story that there's this... if you look at the global financial cycle, there's some common factors that are shaping it everywhere. And it looks like in her findings and other related literature, it's the Federal Reserve, it's the US, it's the dollar. And whatever happens here, has this bearing everywhere else around the world. You mentioned China in 2015, for example, the dollar appreciates in part because the Fed was tightening, wanting to lift off and get back to normal and had a bearing. And you could trace that to China. You could trace it to the slowdown in commodity prices in 2016. So what is your thought about this? Is there this global financial cycle and is the Fed basically a monetary superpower [with] outsized reach?

Global Financial Cycles and the Fed as a Monetary Superpower

Dooley: Yes. I mean the logic of the center is that it's an integrated financial market which will be dominated by the most economically and most open economy. And I guess my view is we've simply added countries to this more or less. I mean, the way I think about it is that if you're a candidate, if your market is completely open, you are completely a part of the United States. You're just the 13th Federal Reserve district.

Beckworth: Wow. Which is fair though. Think of the currency swap lines. I wrote an article where I said in jest, I think this was last year, that the Federal Reserve effectively opened its branch offices in 2020. And you're making the same point here. Effectively it is part of the dollar.

Dooley: Right. As you move away from that to countries that are more closed financially, are not as sophisticated internally, one of the things I believe and I've emphasized throughout my career is it's mostly the development of the domestic financial system which leads to international capital mobility. Once you've got a sophisticated domestic system, they are going to move the money. So it's not the country. So the US or Europe never decided to open their capital account, just the opposite. They fought it tooth and nail. But once the private guys became more and more sophisticated and more and more powerful, they just overwhelmed you. So right now we've got countries, China, for example, is I would say maybe 30% along the way toward that.

Dooley: So they're a part of the center, but they're a part which is still somewhat insulated, let's put it that way for the... but countries where the financial markets are quite clearly extremely integrated, yeah, it's the... and the Fed is simply the dominant central bank. And the dollar is still the dominant currency. There are lots of reasons for that. But I think it has to do with GNP. I think it's because we're a big old country and it is remarkable. For example, I think even most macro economists don't realize how integrated equity markets are around the world. If S&P closes up 1% today, or it looks like it's going to close down 1%, wherever it closes, Europe will open it at that same amount down the next day. I mean, it's one market. And the bond markets are the same. They're really very, very, very integrated. So, Helene's finding, it doesn't surprise me at all. I mean, we've always thought of the center as the difference between the weighted average, which is sort of the center and the US, which is a big part of the weighted average is very small.

The logic of the center is that it's an integrated financial market which will be dominated by the most economically and most open economy. And I guess my view is we've simply added countries to this more or less. I mean, the way I think about it is that if you're a candidate, if your market is completely open, you are completely a part of the United States. You're just the 13th Federal Reserve district.

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Beckworth: Well, let me put a plug in then for another reason the dollar's dominance that I like. And this appeals to my monetary theorist heart, and that is network effects. The more it's used, the more it grows, maybe call it a first mover advantage. I think that plays a huge role and I've had guests on here before talking about this. And usually this point is made that, well, banks overseas are issuing dollars. They're benefiting as well. So you can think seigniorage flows that might come back to the US because of this advantage, the exorbitant privilege, but a lot of private firms capture that too. It's not just the US government that captures it. But I would argue, even if there's private firms capturing it in the US or overseas even, if there's banks in England who are capturing some of the seigniorage flow from dollar issuance, it still reinforces the dollar network. On the margin, if you get another user, even if they're capturing some of the benefits, it on the margin increases the demand for dollar assets globally and indirectly, it still benefits the US and the US government. And I just think network effects are just so powerful. And anyway, I just put a plug in for that story too.

Dooley: Actually, I think that the models I've seen of exactly that, are the best things I've seen about why the dollar maintains its dominance. I agree with you, that's powerful stuff. There are some good theory papers. But they're pretty dense.

Beckworth: Yeah. Going back to a comment I made earlier, I think the Fed stepping in and backstopping the global dollar system in 2008 and then 2020 is only reinforcing those network effects. So I think it would really take something big and dramatic to end the dollar's role in the global economy. Something we haven't seen yet, but before we go into your paper and that's next thing we're going to do, I want to throw out an argument I've made by China and the yuan will unlikely play that role. And you're the real deal. So you get to assess me and tell me whether this makes sense. I've said it a few times recently on the podcast, but you're a real international economist, lots of experience and wisdom.

Beckworth: So I make this argument why I don't think the Chinese yuan will never ever see the dominance. And I've already touched kind of on the network effect. But for China to do that, three things have to happen. One, China would have to fully open up its capital account. And that just isn't something China wants to do, lose control over policy, capital flows in and out like you mentioned, it goes on the whim of the market. Secondly, in addition to fully opening its capital account, it would need to run sustained current account deficits. It would need to build up its financial liabilities to the world.

Beckworth: You want the world to hold yuan denominated assets, you got to run sustained current account deficits. Again, that just doesn't seem to be the model of growth that Chinese communist officials have in mind. And then finally, you would want to begin to trust the state and institutions. And we've seen in the past few years, back and forth in tech policy, back and forth on different industries, real estate. So I just see so many hurdles to China ever making a serious advance in becoming a dominant currency. But what do you think?

Dooley: I agree with that, all three points. To me, the most powerful one is the probability that they would generate a lot of trust among other people, that they wouldn't be treated arbitrarily. That also seems to be a long shot. Just as an aside, you can take this out, but one of the things I refused to work on at the IMF was the future of the SDR. The executive board of the IMF insisted on two papers a year on the future of the SDR. And I said, "I can write this paper very quickly. It has none, zero." And one ED once joked in a session that instead of issuing SDRs, we issue papers.

Beckworth: There you go. They must have loved you there at the IMF.

Dooley: Some of them did. Some of them didn't.

Beckworth: Well, I enjoy your sense of humor that you bring to bear on these topics. So it's great to have a guest like you on the show. So let's move to the big deal, the reason I really wanted to get you on, all of this has been fascinating, but I really want to get to kind of a very topical kind of at this moment paper that you wrote. And the paper is titled, *US Sanctions Reinforce the Dollar’s Dominance.* And it's with your colleagues who you wrote with before, David Folkerts-Landau and Peter Garber, you wrote the Bretton Woods papers with. And let me just read a couple excerpts, and then you can expound upon this because I found it very provocative, very interesting. And I hadn't thought through this argument, although it was in your earlier work. But here we go.

Beckworth: I want to read the first paragraph and a paragraph later on in the paper. And this is an NBER working paper. Listeners, we'll provide a link to it so that you will be able to see it for yourself. But you and your co-authors begin, "The freezing of Russia's dollar foreign exchange reserves has driven warnings that the dollar may lose its dominant status. But providing a relatively safe asset is not the only function of a reserve currency. In a series of papers started in 2004, we have argued that the willingness and ability to engage in comprehensive financial asset seizure is part of the job description for a reserve currency.

Beckworth: Such potential seizures were the foundation to the massive expansion of net and gross capital flows between rich and poor countries over the past 30 years. Moreover, for good reasons, the US was and is the country most trusted to fulfill this responsibility." Let me jump down later on in your paper, you put, "An influential academic theory for persistently depressed real interest rates in the center is that the US supplies safe assets to the rest of the world. This is only part of the story. The US also produces assets that are unsafe to those who misbehave." So expound for us on this point and what it means in this current moment.

The US as a Provider of Safe and Unsafe Assets

Dooley: Okay. So in order for an asset to behave, or as a function  as collateral against bad behavior, basically seizure of foreign assets, you need several things in place. And let me talk about regular collateral first, because people often take it too literally. So regular collateral is pretty straightforward. You put up the value of a thing. If you don't pay, the lender has an almost certain payment. So there's literally no credit risk. And there's a well defined court that you can go to get the collateral. There's a well defined price for the collateral. There's a well defined amount of increase in collateral that you have to have if the collateral value is injured. And we call that private collateral.

Dooley: That's really good stuff. Now what we call international collateral, reserve assets and other things, only share one of those. Seizure that hurts the person that seizes, or the bad behavior, because they lose the asset. But you're not guaranteed as an individual investor to benefit from it. And a lot of people argued early on that, well, the collateral analogy is not useful because... well, for example, not all of the direct investment into China or into Russia was by US residents. A lot of it was by other residents. And we don't believe the US will actually seize the collateral. We don't believe the US Treasury would ever do such a crazy thing as default on a Treasury bond in order to punish that. That simply can't happen. And so the argument didn't go very far.

Dooley: Our argument is that, although public collateral is not as good, it does share the one really important function. And that is that it injures the interest of the person who's going to do the bad behavior. Now you may or may not get compensated as an investor. But I always turned that argument on his head. I said, "Well, that just means you need a lot of it." The fact that it's not as good as regular collateral means, well, maybe you need two or three times as much. But our conjecture is that it's an effective constraint. The Russian experience is really, really, really fascinating. It does all kinds of things to this. Number one, it shows that an important country chose to suffer the costs for reasons which appear to us at least to be irrational.

Our argument is that, although public collateral is not as good, it does share the one really important function. And that is that it injures the interest of the person who's going to do the bad behavior.

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Dooley: So that changes the nature of the game. Now we see that, well, okay. It may be a deterrent, but at least one country in one circumstance has chose to do it. The second thing it showed was that the US and its partners were remarkably good or aggressive and effective in collecting not only Treasury bills, but all kinds of other stuff, boats, trains, planes, you name it. So the stock of collateral is actually much larger than we conjectured. And I must admit that particularly not just the US Treasury, but the US allies have [inaudible] again, surprisingly aggressive. That also makes the collateral more effective in some sense. In fact, just today the Russians had to default on a bond not because they don't have money, but because they can't make a payment.

Dooley: If you had asked even me six months ago what I thought that was, I would say no. That there's no way we would get enough people to go along with us to tie up the financial system. Now, the people at your former employer, the Treasury, they've been kind of assuring us informally, very informally that... yeah, they can really do a lot. That you should not underestimate... and a lot of that, my understanding has had to do with the drug payment thing. The US Treasury's become quite good at tracing payments around the world. Doesn't matter. So maybe it shouldn't surprise me, but I think this experience has taught us a number of things. One is that even with this deterrent, a country has chosen to exercise its right to... not its right, it's prerogative, whatever we want to call it… has for reasons which would've surprised us, chosen to default on this stuff. Two, the center, if you like, has been remarkably cohesive in imposing sanctions. Three, a lot more stuff is at risk than we thought.

Dooley: So we have a little bit of discussion. Going forward, why do we think this happens? Well, one is a lot of how this evolves from here is obviously pure speculation, but the key is whether China goes along with Russia and chooses to drop out of the system. I think it very unlikely. But if they did, then that would create, certainly, a new international financial system. Two very separate... because it's not what we had with the Soviet Union, right? [The] former Soviet Union, like everybody else, believe it or not, they had a system. They had an international system within the Soviet Union of credits and all that kind of stuff. So that would have to evolve separately. That would be a big deal.

Beckworth: This is so fascinating on so many levels. I have a lot of questions here. I'll try to get to them. So first, just to restate the theory that you proposed in this paper and actually in earlier papers is that providing safe assets to the world's not just about providing some safe store of value, it's providing an asset that can be seized and therefore it encourages, it reassures foreign investors going into some emerging market that there's going to be some kind of discipline. And in fact, I was thinking, this could almost be a form of the government fixing a market failure. You mentioned these two characteristics of collateral, and one that's missing is you can't seize an asset from a foreign government. Well, yes, you can if it happens to be a US Treasury security and as you said, even more than that now. And so it's kind of a market failure story. You could tell that the US government is going to serve, or plug a hole that the market can't provide, and that is seize collateral when needed. And in order to do that, it needs to be the main provider of those safe assets and have the network and infrastructure. So that's fascinating. It seems to be validated with this Russia example. You also gave the example of China, though, in 2002, when China opened... so maybe you could tell us that data point, how does China shed light on this understanding?

A lot of how this evolves from here is obviously pure speculation, but the key is whether China goes along with Russia and chooses to drop out of the system. I think it very unlikely. But if they did, then that would create, certainly, a new international financial system.

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Dooley: Well, China started out with no international assets, no foreign assets, no foreign exchange, even. So it maybe a probably made up story about the Chinese delegation coming to negotiate the GATT, they didn't have enough money to pay their hotel bill. They didn't have enough dollars to pay the hotel bill. They had no reserves, zero. And so to them, building up reserves was really crucial. I mean, they really needed the safety, the shock absorber. And I don't think they had in mind at the time that that would act as collateral for foreign investment, but it did. That said, the collateral is just as effective regardless of why you accumulated it. In fact, I would almost go the other way, an accidental increase in reserves or an increase in reserves in China for other reasons provided the incentive for the capital inflow. And I don't think anybody else has put those two things together.

Beckworth: Yeah. That is so remarkable. So here we have, two theories of yours have been validated. One for sure, the earlier point you made that the Bretton Woods system would survive the crisis in the mid 2000s. And it did. So you were validated then. And it looks like this theory is now beginning to become validated as well from what we're observing. We have the China experience. We got Russia. I mean, just simple observations, the dollar doesn't seem to be getting any weaker, it got stronger through this crisis. Even though Treasury yields are up, they're up just a little bit, 3%. I mean in the grand scheme of things, it's still pretty remarkable. The dollar center is holding. So this is just such a fascinating paper. I'm dying to hear from you since you're connected to the NBER and all your colleagues and your network, what has been the response to this kind of very hot take, but I think convincing one?

Dooley: Well, we don't have face to face meetings anymore. So I haven't presented it. I haven't presented the paper anywhere.

Beckworth: Well, this is it. This is it. We have thousands of listeners and many of them are senior Fed officials. We got economists, we got journalists, academics. So it will be interesting to hear from you listeners, what you think about this paper. But I found it very convincing. I'm assuming it will get many citations moving forward.

Dooley: If history is a judge, it will take on, but slowly. As you know, there's billions of papers on the dollar's dominance and that sort of thing. And so you're not going to move this literature overnight, but it might catch on, I don't know. I mean, I'm retired. So I-

Beckworth: Well, you're having fun in your retirement, that's for sure, writing papers like this. So let me end on a question here. Our time is running out, but it's been great to chat with you. The Federal Reserve, as we mentioned, is effectively this monetary superpower. It sets policy, it has a domestic mandate, the US economy, and it really only cares about the global economy to the extent the global economy comes back and affects the US economy. But the problem is the Fed's reach is global. It's a superpower. Is there any way to... I don't know, reconcile this tension? I mean, we have the global financial cycle. Everyone bears the burden of Fed policy of a strong dollar. And yet the US sometimes, we view ourselves as an island. We just do what's best for us.

And so the standard Fed line, which I think is correct, is that...the Fed can do for other people is to regulate the US economy properly. If we do that, we're doing more than enough. We're doing as much as we can possibly do for other people.

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Beckworth: And it's understandable. It's politics. I remember, 2019, Mark Carney gave a talk at Jackson Hole where he was presenting a pretty bold idea, how to get out of it was to create this synthetic hegemonic currency where it would become the new dollar. But it was really way out there, way too ambitious, but it was coming from a good place, I think. And there's been a lot of ideas on how to deal with this, but I think what we've said is it's going to be hard, not impossible, to get away from the dollar. So is there a way for the Fed to do monetary policy that minimizes global disruptions, but still fulfills a domestic mandate?

Can the Fed Walk the Fine Line Between Domestic and Global Policy?

Dooley: No.

Beckworth: Okay. Well, there you go folks. We're stuck in this endless loop of a global financial cycle. Michael Dooley has spoken. So shall it be. Okay.

Dooley: So I think the answer is pretty clearly no. But look, given the gap between what's happened in the last year or so in Fed forecasts… again, a story you probably want to take out is that for a long time, I gave the final briefing on the weekly economic update for the Board of Governors. And l it was the real economy, the financial markets, money supply, and then international was in. So I was just doing a foreign exchange thing. I don't think it was me, but by the time we got through three of those briefings, a lot of the governors were nodding off or had left.

Beckworth: Nice.

Dooley: International. And they would say quite rightly, and I would think to myself, "My God. How can what I say, possibly have any measurable effect on what they've already heard?" And so I would do my thing. But it’s just… it's unrealistic to think they could take the objectives of other governments into play simply because they have so much hidden within their own objectives. And so the standard Fed line, which I think is correct, is that... and I wrote it many times because it was the company line, is that the best the Fed can do for other people is to regulate the US economy properly. If we do that, we're doing more than enough. We're doing as much as we can possibly do for other people. I actually think that's right.

Beckworth: Well, on that positive note, our time is up. Our guest today has been Michael Dooley. Mike, thanks so much for coming on and making a good show.

Dooley: Pleasure.

Photo by Luis Robayo via Getty Images

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