The Dollar Dilemma

Toward the end of World War II in 1944, the United States and 43 of its allies held a conference at the luxury Mount Washington Hotel in Bretton Woods, New Hampshire, and established a new global monetary system. Alongside the United Nations and the General Agreement on Tariffs and Trade (GATT), which laid the initial foundation for the World Trade Organization, the Bretton Woods system aimed to more permanently stabilize global economic relations and rebuild war-torn economies in Europe and Asia. As part of these efforts, leaders at Bretton Woods sought to establish a system that would prevent persistent imbalances and competitive currency devaluations that were used in the interwar period to gain advantages over trading partners. While this system was successful in its initial aim of reconstructing world economies devastated by the war, its efforts to ensure long-term stability through monitoring balance of payments and currency manipulation faltered over time. 

During the Bretton Woods negotiations, the unparalleled geopolitical and economic strength of the United States at the time allowed it to establish the dollar, pegged to gold, as the world reserve currency, despite concerns voiced by other participants. The emergent system initially succeeded in restabilizing the global economy after the war, but its central structure ultimately collapsed in 1971 when the United States abandoned the gold standard to widen its fiscal flexibility. Ever since, the world has been left without a coherent monetary framework.

With global capital flows left unmoored, continued foreign demand for safe assets denominated in the world’s reserve currency has fueled chronic U.S. capital surpluses—the counterpoint to trade deficits in the national balance of payments. The absence of U.S. capital controls and the explosion of global financial markets have further deepened these imbalances, as foreign governments and investors increasingly recycle trade surpluses into U.S. stocks, bonds, and real estate, rather than purchasing U.S. goods in return. These conditions have resulted in a U.S. net international investment position of negative $26 trillion¹“International Investment Position,” U.S. Bureau of Economic Analysis, accessed November 16, 2025.—after the United States was a net lender for most of the 20th century—and have widened vulnerabilities in the U.S. economy.

The reasons for the monetary system’s failure run parallel to those driving the failure of the international trade system. Much as U.S. leaders thought trade deficits would be self-correcting, they assumed markets would correct currency overvaluations and capital imbalances over time. These leaders also assumed the peace and financial dividends of such policies were worth the risk of monetary distortions, much as they thought trade imbalances were an acceptable price to pay for global influence. As faith in openness and neutrality grew on the trade side under the GATT, a blind eye was also turned to imbalances driven by predatory monetary policy as capital began to flow as freely as goods. As policymakers seek to rebalance trade, it is essential to understand the role capital flows play in international markets.

Moreover, policymakers should recognize that the imbalances accumulated under the post-Bretton Woods system are a departure from both the U.S. historical norm and the explicit aims of that system’s architects. While the current international monetary system has supported American consumption, it has damaged U.S. production and increasingly appears unsustainable. Open capital markets and a free-floating dollar have distorted currency values, inflated U.S. asset prices, fueled U.S. debt, accelerated deindustrialization, and enhanced inequality. Given these realities, the dollar’s privileged position has begun to look more like a liability than a stable asset. The failed trading system thus provides only half of the picture of how the world economic system became so distorted. Understanding the history of the present monetary “non-system”—why it developed the way it did and why its current form overvalues the dollar and helps drive our trade imbalances—provides the other half. To restore a stronger and more balanced system, policymakers should further understand that, in the long run, a “strong dollar” of the sort beneficial to the national interest is one that is fairly valued, stable, and trusted; not one systematically overvalued to afford larger import volumes and inflated domestic asset prices.

The Rise and Fall of the Classical Gold Standard

The nineteenth century witnessed a surge in global economic integration, driven by the transformative technologies of the Industrial Revolution, including the railroad, telegraph, and steamship. As trade expanded and communication became faster and more reliable, those engaged in international trade sought more practical and standardized methods for conducting foreign transactions. Zooming out, every trade represents an exchange of value between two parties. In the modern economy, that value is reflected in the price of the good or service, measured in the currency used in the transaction. When the parties to trade are based in separate countries with separate currencies, some method must be used to assess the relative value of one currency to another. Gold, already a widely recognized store of value, offered a consistent benchmark for countries to set the value of their currencies against.²Antoni Estevadeordal, Brian Frantz, and Alan M. Taylor, “The Rise and Fall of World Trade, 1870–1939,” The Quarterly Journal of Economics 118, no. 2 (2003): 362. In 1821, the United Kingdom (UK), then the world’s leading colonial and economic power, formally adopted this system, also known as a “gold standard.” By the 1870s, most other advanced economies had followed suit.

Under a gold standard, countries set a fixed exchange rate between their currencies and a specific weight of gold. For example, the U.S. dollar was officially valued at $20.67 per troy ounce of gold from 1834 to 1933. This made trade easier because countries knew they could exchange each other’s currencies for a fixed amount of gold, which could then be exchanged for a nation’s own currency at a fixed amount. This kept the exchange rates among nations’ currencies more consistent and reliable, easing international trade. 

Unfortunately, the wonders of the integrated market³Edgar Crammond, “The Economic Relations of the British and German Empires,” Journal of the Royal Statistical Society 77, no. 8 (1914): 777–807. and increased trade flows⁴Estevadeordal, Frantz, and Taylor, “The Rise and Fall of World Trade,” 360-61. did nothing to forestall the outbreak of World War I among its participants, which quickly destabilized the entire system. Most European countries had to either take on enormous debts or finance their war spending in other ways, including by suspending their gold standards. This was accomplished by suspending or limiting the convertibility of currency into gold, which allowed a country to issue more paper currency without risking the depletion of its gold reserves. While this might temporarily facilitate higher spending and more transactions, a currency not ultimately redeemable for gold would lose confidence over time. When countries reintroduced convertibility, they often had to do so at a higher exchange rate because additional currency was circulating in the economy. 

In many cases, countries that suspended their gold standards experienced massive inflation throughout the early 1920s. To restore price stability and international credibility, many of these countries attempted to re-anchor their currencies to gold, although often at discounted exchange rates. For example, before the war, France’s franc was valued at 0.29 grams of gold. After France suspended its gold standard in 1914 and printed additional currency to pay for its wartime expenses, it experienced significant inflation and decided to reintroduce the franc’s gold conversion rate at 0.066 grams in 1928 (a 77% devaluation). 

Recall that inflation is a monetary phenomenon caused by too many dollars chasing too few goods. In other words, it means a currency declines in value. Domestic consumers experience this as net price increases. But trading partners experience a country’s monetary devaluation in the opposite direction. This is because foreign consumers (importers) purchase goods with their own currency, which is exchanged for the exporting nation’s currency at a specific rate at some point before or after the transaction. Under a gold standard, if one nation’s currency falls in value relative to gold while another nation’s rises or stays the same, the country with the stronger currency has greater purchasing power in the country with the weaker currency and import prices from that country fall. In the country with the weaker currency, import prices rise, making domestic goods more competitive with foreign goods. From a trade perspective, then, a weaker currency advantages a nation’s exports and domestic industries while disadvantaging foreign imports.

Unlike France, Britain attempted to restore the pound to its pre-war exchange rate after the conflict. To do this, Britain had to withdraw money from its economy and lower prices on net (i.e., deflation). This was primarily accomplished by the Bank of England raising interest rates and the British government cutting spending. Higher interest rates make borrowing more expensive, which results in businesses and consumers spending less. This lowers aggregate demand, eventually leading to lower prices and wages. Lower government spending also results in less money circulating through the economy, which decreases demand and, in turn, prices. By strengthening the pound, these policies worsened Britain’s already flagging export competitiveness—driven partly by its earlier failed free trade posture⁵Graeme Thompson, “The End of Pax Britannica,” Engelsberg Ideas, September 10, 2025.—while intensifying unemployment and lowering wages. A year after these policies finally put Britain in a position to restore the gold standard in 1925, the 1926 General Strike nearly brought its economy to a standstill. Although the strike was called off after nine days, another wave of economic pain that threatened unrest after the Great Depression in 1929 led the UK to permanently abandon the gold standard in 1931. Other nations soon followed suit: Japan in 1931, the United States in 1933, and France in 1936. According to economic historian Douglas Irwin, Britain’s move created far more turmoil for world trade than the Smoot-Hawley tariff had a year earlier.⁶Douglas A. Irwin, Clashing Over Commerce: A History of US Trade Policy. Chicago: University of Chicago Press, 2017, p. 406.

The gold standard also helped ensure nations couldn’t run persistent deficits. As stated above, a gold standard meant each nation’s currency could be exchanged for gold at a set price. This meant that when a country (such as the United States) paid for foreign goods (from, say, France), France could exchange the dollars it earned from the sale of those goods for U.S. gold reserves, which could then be exchanged for francs at France’s gold exchange rate. If the United States ran a trade deficit, its gold reserves would diminish as France redeemed dollars for gold. This would effectively shrink the money supply because all dollars had to be backed by gold. If gold reserves were to shrink, U.S. banks would have less money to lend domestically and would likely respond by raising interest rates. Eventually, this would reduce lending and, as a result, domestic demand, causing prices and wages to fall; in turn, this would make U.S. exports more competitive and French imports less affordable. In time, this would balance trade between the two countries. But often, unemployment, bankruptcies, and social unrest during such adjustment periods made them politically intolerable, as many nations experienced during the Great Depression.

Faced with economic distress and freed from the gold standard, more than 70 nations⁷Kris James Mitchener and Kirsten Wandschneider, “Currency Wars and Trade,” Working Paper No. 33313 (National Bureau of Economic Research, December 2024), 2. devalued their currencies in the 1930s to boost exports and stimulate their economies at the expense of trading partners. This was done out of recognition that a weaker currency makes a nation’s goods relatively cheaper in foreign markets, thereby advantaging its exports and industries. These predatory currency policies were often accompanied by sweeping tariffs and other trade barriers, reflecting a deepening defensive posture among nations that frequently led to further retaliation.⁸Irwin, pp. 404-406. Economist Joan Robinson famously described these strategies, aimed at shifting economic pain onto other countries, as “beggar-thy-neighbor” policies.⁹Steven R. Weisman, “Whence Cometh Beggar-Thy-Neighbor,” Peterson Institute for International Economics (PIIE), February 10, 2009.

In short, two decades of economic crises during World War I and the Great Depression had reversed the earlier trend toward greater global integration and standardization (often termed globalization’s first wave¹⁰Laurence Chandy and Brina Seidel, Is Globalization’s Second Wave About to Break (Washington, D.C.: Brookings Institution, 2016), 2.). The abandonment of the classical gold standard during World War I and again during the Great Depression reflected the limits of the system’s appeal¹¹Michael McNair (@michaeljmcnair), “History is unambiguous that transitions between global monetary systems are inherently chaotic. During the interwar period, there were repeated failed attempts to restore global economic order, but countries couldn’t even agree on what caused the problems,” X, May 2, 2025.. Gold-fixed exchange rates did make trade easier and more reliable, but they also limited nations’ ability to respond to economic and geopolitical crises, as governments could not easily expand the money supply or extend credit during times of war or recession. Nations that did often faced years of painful inflation and economic disruption afterward. The harsh lessons of this period would inform the creation of a new monetary system after World War II.

The Bretton Woods Monetary System

While the United States returned to the gold standard in 1934, it did so at a devalued rate of $35 per ounce (up from $20.67). This effectively expanded the U.S. money supply by increasing the value (in dollar terms) of U.S. gold held in reserve. For example, if the United States had 100 million ounces of gold before the revaluation, those reserves would be worth $3.5 billion after the adjustment instead of $2.07 billion, creating more room for the Federal Reserve to lend at lower interest rates and stimulate the economy.

Facing the prospect of harsh recoveries after World War II, allied leaders began drafting plans for a new global monetary system that would enhance stability, support postwar reconstruction, and prevent the predatory devaluations seen during the interwar years. Leading the effort¹²Benn Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order (Princeton University Press, 2013). were Harry Dexter White, Assistant Secretary of the U.S. Treasury, and John Maynard Keynes, a chief advisor to the British Treasury.¹³American internationalists were embracing free trade at the same time economist John Maynard Keynes was turning against it. He writes in his 1936 book, The General Theory of Employment, Interest and Money, “Thus, the weight of my criticism is directed against the inadequacy of the theoretical foundations of the laissez-faire doctrine upon which I was brought up and which for many years I taught—against the notion that the rate of interest and the volume of investment are self-adjusting at the optimum level, so that preoccupation with the balance of trade is a waste of time. For we, the faculty of economists, prove to have been guilty of presumptuous error in treating as a puerile obsession what for centuries has been a prime object of practical statecraft.” John Maynard Keynes, The General Theory of Employment, Interest and Money (Macmillan and Co., 1936), 339. According to economic historian Douglas Irwin, Keynes was appalled by conditions on aid suggested by the U.S. State Department in 1941, which was led by free trade stalwart Cordell Hull at the time. These included commitments to non-discrimination in trade and exchange rate controls after the war. Irwin writes, “Keynes was shocked by the State Department proposals and privately dismissed the draft…as the ‘lunatic proposals of Mr. Hull.’ To him, the Americans seemed to believe in an outdated ideology of limited government intervention that ignored the new reality that governments would need extensive trade controls to ensure economic stability. Keynes rejected one State Department memo on trade as ‘a dogmatic statement of the virtues of laissez- faire in international trade along the lines familiar forty years ago, much of which is true, but without any attempt to state theoretically or to tackle practically the difficulties which both the theory and the history of the last twenty years [have] impressed on most modern minds.” (Irwin, p.458-9.) The American, White, advocated that all currencies be pegged to the dollar, which alone would be convertible to gold. This would place the USD at the center of the global financial system. Keynes offered a different plan. Concerned about potential trade and capital imbalances, he suggested creating an International Clearing Union (ICU) that would issue a supranational currency unit called the “bancor” for use in international transactions rather than anchoring the world market to a single nation’s currency. When countries traded, they would use bancor held in accounts at the ICU rather than accumulating foreign currencies or gold-backed dollars. The ICU would then pressure nations with significant deficits to devalue their currencies and tighten their fiscal policies, while penalizing nations with persistent surpluses. This symmetrical adjustment mechanism would discourage persistent imbalances on either side. 

Given the dominant position of the United States —which was providing massive amounts of aid to Britain and the Allies through its Lend-Lease program¹⁴Douglas Irwin notes, “Britain did not have the financial resources to pay for military and civilian supplies, but the president was determined to provide some form of assistance. The idea of making loans to Britain, as had been done during World War I, was rejected on the grounds that debt repayments had contributed to the instability of the interwar world economy.1 …Under Lend-Lease, the US government would purchase military supplies and provide them to the Allies under the fiction that they would be ‘returned’ after the war, thereby eliminating the need for repayment. After intense debate, Congress approved the Lend-Lease program in March 1941.” (pp. 455-6).—and the reluctance of other nations to accept penalties from an international authority, White’s proposal won out. The resulting Bretton Woods Agreement of 1944 cemented the U.S. dollar as the world’s reserve currency. However, the agreement retained some elements of Keynes’s proposal. European nations would be allowed to restrict private conversions of their currency into dollars for a period to retain higher dollar reserves.¹⁵Article VI, Section 3 of the IMF Charter allowed members to “exercise controls as are necessary to regulate international capital movements,” but no member could “restrict payments for current transactions, except as provided in Article VII, Section 3(b), and in Article XIV, Section 2.” Article VII, Section 3(b) allowed limited exemptions for cases of scarce currency holdings. Article XIV, Section 2 allowed members to “maintain and adapt to changing circumstances” during a “post-war transitional period.”  The Bretton Woods Agreements, San Diego State University Department of Political Science, accessed November 18, 2025. A few years later, an ICU-like intermediary also began managing currency exchanges in Europe,¹⁶“History – The BIS as a Forum for European Monetary Cooperation (1947-93),” Bank for International Settlements (BIS), accessed November 16, 2025. and European nations were allowed to maintain import quotas¹⁷General Agreement on Tariffs and Trade (GATT 1947), art. XII, World Trade Organization, accessed November 16, 2025. under the 1947 GATT to regain export competitiveness with the United States and correct their trade imbalances.¹⁸See also, Irwin p. 519.

Like the free trade paradigm established under the GATT, the international monetary system established at Bretton Woods sought world peace through greater economic coordination. White, the chief U.S. architect of the agreement, wrote in his plan for the system, “Just as the failure to develop an effective League of Nations has made possible two devastating wars within one generation, so the absence of a high degree of economic collaboration among the leading nations will, during the coming decade, inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale.”¹⁹International Monetary Fund, “The White Plan,” in IMF History Volume 3 (1945-1965), (USA: International Monetary Fund, 1996) accessed Nov 17, 2025. Aiming to “win the peace,” White further explained:

[T]he task of securing the defeat of the Axis powers would be made easier if the victims of aggression, actual and potential, could have more assurance that a victory by the United Nations will not mean in the economic sphere, a mere return to the pre-war pattern of every-country-for-itself, or inevitable depression, of possible widespread economic chaos with the weaker nations succumbing first under the law-of-the-jungle that characterized international economic practices of the pre-war decade… They must have assurance that methods and resources are being prepared to provide them with capital to help them rebuild their devastated areas, reconstruct their war-distorted economies, and help free them from the strangulating grasp of lost markets and depleted reserves. Finally, they must have assurance that the United States does not intend to desert the war-worn and impoverished nations after the war is won, but proposes to help them in the long and difficult task of economic reconstruction. To help them, not primarily for altruistic motives, but from recognition of the truth that prosperity, like peace, is indivisible.²⁰Ibid.

Like Cordell Hull’s arguments for a free trade system, White’s arguments extended beyond immediate practical considerations and emphasized a more theoretical case for lasting peace under a new integrated international order. Much of the cost of erecting this new order, as implied by the statement above, would be borne by the United States.

By signing the Bretton Woods Agreement, 44 Allied nations agreed to fix their exchange rates to the U.S. dollar, which remained convertible into gold at a rate of $35/oz. This system aimed to restore the stability of the gold standard while providing additional flexibility. For example, in cases of “fundamental disequilibrium”²¹Atish Rex Ghosh, “From the History Books: The Rethinking of the International Monetary System,” IMF Blog, August 16, 2021. in a nation’s balance-of-payments (i.e., persistent trade deficits), the International Monetary Fund (IMF), created under the system, was permitted to adjust currency exchange rates. A forerunner to the World Bank was also established to fund post-war reconstruction in Europe and, eventually, to support global development. 

Beyond promoting global cooperation, the stated purposes listed in Article I of the IMF’s charter were: 

[T]o facilitate the expansion and balanced growth of international trade and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy… to promote exchange stability…and to avoid competitive exchange depreciation… [and] in according with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.²²Articles of Agreement, art. I(ii), (USA: International Monetary Fund, 2011) accessed Nov 17, 2025.

Thus, the authors of the system plainly recognized the systemic risk that persistent trade imbalances pose to monetary stability and set balanced trade and capital flows as a benchmark for ensuring stable prices, employment, income, and resource development across nations.

This system worked well for the first two decades as Europe and Asia slowly recovered from the war. But by the 1960s, according to IMF historian Atish Rex Ghosh,

“Governments of deficit countries with overvalued currencies often delayed necessary devaluations for fear of the political repercussions. Meanwhile, surplus countries, which were enjoying a trade competitiveness advantage, had no incentive to revalue their currencies… The rise of private capital flows meant that any whiff of a possible devaluation would send billions of dollars out of a deficit country—thus precipitating the devaluation—and into surplus countries that would struggle to contain the inflationary consequences of the capital inflows.”²³Ghosh, “From the History Books.”

By 1971, the United States had come down from its post-war economic high. Rapid expansion of federal spending on Great Society social programs and the Vietnam War led to growing budget deficits. America’s once-formidable trade surplus during the war had eroded, and the U.S. saw its first trade deficit in nearly 100 years. Confidence in the dollar weakened as foreign nations, led by France, began demanding gold in exchange for their dollar reserves. Because the dollar was the world reserve currency under the system, it could not be devalued against other currencies (as was still possible under the classical gold standard),²⁴Irwin, p. 542-546. and the United States was obligated to provide gold in exchange for dollars on demand. Facing a run on its gold reserves, President Richard Nixon ended the dollar’s direct convertibility into gold in August 1971. Instead of cutting spending and accepting painful deflation under higher interest rates, the Nixon administration chose to ease the pressure. As a result, the United States would experience inflation, much like the nations that suspended gold convertibility after World War I. Instead of being tied to a specific amount of gold, the dollar’s value would fluctuate based on supply and demand in international currency markets. In other words, the dollar’s value would rise based on the Federal Reserve’s interest rate decisions and demand for dollars by foreign governments and investors relative to other currencies. As a result, the United States no longer faced immediate pressure to endure deflation or wage cuts to correct deficits, but the system also lost the inherent discipline that gold had demanded.

Post Bretton-Woods: The “Monetary Non-System”

While eliminating the gold standard gave the United States additional budget flexibility, it also eliminated the mechanism for ensuring balanced trade and capital flows, thereby opening the door for much greater trade imbalances. As Douglas Irwin explains,

“In previous decades, trade imbalances had been small because the Bretton Woods system of fixed exchange rates involved government restrictions on the international movement of capital. When countries could only buy and sell goods with each other, exports and imports had to be roughly balanced. When the fixed exchange-rate system finally collapsed in 1973, and countries adopted floating exchange rates, these capital controls were no longer necessary. As governments began to permit greater international capital movements, investors in different countries were able to buy one another’s assets as well. Consequently, financial flows between countries increased enormously. The increase in capital movements between countries allowed large trade imbalances to emerge. In the US case, other countries wanted to use the dollars they earned exporting to the United States to buy US assets rather than American-made goods. As a result, the dollar appreciated in value and exports began to fall short of imports as foreign investment in the United States surged.”

Alongside oil shocks and the Federal Reserve’s failure to adjust U.S. monetary policy to these changing conditions, the United States saw a surge in inflation in the 1970s. Adding fuel to the fire, the U.S. printed more dollars—now backed by trust rather than gold—whose relative value declined against foreign currencies and commodities. To end the inflation crisis, Federal Reserve Chairman Paul Volcker raised interest rates to over 20%, triggering a recession. The Federal Reserve now had to step in to raise interest rates to slow lending, whereas rates would have risen naturally as reserves depleted under the gold standard. 

Inflation eventually stabilized, but the value of the dollar surged by over 50% between 1980 and 1985²⁵“U.S. Dollar Index (DXY/USDX) Chart Development from January 1973 to November 10, 2025,” Statista, accessed November 17, 2025.—driven in large part by Japanese purchases of U.S. assets²⁶Irwin, p. 566-7.—putting upward pressure on the U.S. trade deficit.²⁷A relatively stronger dollar can purchase more foreign goods, but it also means foreign currencies are relatively weaker and can therefore purchase fewer U.S. goods. This advantages foreign imports in the U.S. market and disadvantages U.S. exports in foreign markets, making trade deficits more likely. By 1983, the U.S. had become a net importer of manufactured goods after decades of dominating the sector globally.²⁸Irwin, p. 568. Financial deregulation,²⁹Matthew Sherman, A Short History of Financial Deregulation in the United States (Washington, D.C.: Center for Economic and Policy Research, 2009), 1, 9. the widespread elimination of capital controls,³⁰Christopher J. Neely, “An Introduction to Capital Controls,” Review (Federal Reserve Bank of St. Louis) 81, no. 6 (1999): 13-14. and the reduction or elimination of financial transaction taxes and fees³¹Chris Griswold, No Need to Speculate: The Empirical Case for a Financial Transaction Tax (Washington, D.C.: American Compass, 2021), 6.—alongside Congress’s refusal to lower budget deficits³²Irwin, p. 599.—continued to help drive up foreign capital flows into the United States. In contrast to earlier economic eras, when capital flows closely tracked the financing of goods and services trade, the newly financialized economy created a geometric increase in avenues for foreign capital. “By the early 2000s,” according to financial analyst Michael McNair, “daily trading volume in global foreign exchange markets had grown to more than 100 times larger than daily international merchandise trade.”³³Michael McNair, “The Dollar’s Dilemma: America’s Coming Policy Shift,” Michael’s Substack, December 10, 2024.

Much like China in the 2000s, Japan and West Germany saw a corresponding surge in their trade surpluses in the 1980s. In theory, this should have caused the currencies in those surplus countries to appreciate in tandem with the increased demand from the U.S.³⁴Michael McNair, “The Sovereign Wealth Effect: America’s New Tool for Rebalancing the Global Trading System,” Medium, February 13, 2025. As their currencies strengthened, both production costs and household purchasing power should have increased, leading to relatively more consumption and relatively less savings. When this did not happen and the U.S. trade deficit continued to grow, the U.S. pressured those nations (along with France and the U.K.) to sign the Plaza Accords in 1986. Together, these nations agreed to appreciate their currencies against the U.S. dollar (USD) by selling the dollars they held in reserve to buy back their own currencies. This increased the supply of dollars in circulation while lowering demand, allowing the dollar to depreciate. Conversely, the supply of foreign currencies in circulation fell, while demand rose, driving their valuations higher. The need for this ad hoc agreement was an early indication that a free-floating dollar would not readily adjust to trade imbalances.

As foreign currencies strengthened against the dollar under the Plaza Accords, U.S. trading partners expanded their purchases of U.S. exports, while a weaker dollar resulted in relatively weaker import growth. As a result, the trade deficit receded through the end of the decade, plummeting from $144.8 billion in 1985 to $28.6 billion in 1991.³⁵“U.S. Trade Balance,” Macrotrends, accessed November 17, 2025. Outside of the Great Recession in 2007 and the brief COVID recession in 2020—neither of which was driven by intentional policy—this was the last period in which the U.S. trade deficit saw a significant decline. 

But a few years later, the U.S. passed the North American Free Trade Agreement (NAFTA) in 1993 and the WTO agreements in 1994. Lawmakers in both parties began pushing to permanently grant China normal trade relations, which it had already received on an annual basis since 1980.³⁶Mark A. DiPlacido, Chris Griswold, and Trevor Jones, Disfavored Nation (Washington, D.C.: American Compass, 2024), 5. Meanwhile, China also began³⁷Julius Krein, “What A Mar-a-Lago Accord Can and Cannot Do,” The American Conservative, April 7, 2025. managing its exchange rates and devaluing its currency in 1994,³⁸“Dollar Yuan Exchange Rate (1981-2025),” Macrotrends, accessed November 17, 2025. a strategy other Asian exporters followed³⁹Russell Napier, “America, China, and the Death of the International Monetary Non-System,” American Affairs 8, no. 4 (2024): 3-15. after the Asian Financial Crisis in 1997. Between 1991 and China’s admission to the WTO in 2001, the U.S. trade deficit skyrocketed from around $30 billion to $346 billion. This more than doubled (again) to $763.6 billion by 2006.

Demand for dollar-denominated assets continued to grow at this time. Without restrictions on capital flows, a gold standard, or a bancor-style adjustment mechanism, foreign nations were able to accumulate previously unimaginable levels of U.S. currency reserves. These dollar acquisitions increased substantially in the 1990s after the effects of the Plaza Accords dissipated, then skyrocketed again after the financial crisis and the COVID-19 pandemic. According to economist Ehsan Soltani: 

“By Q1 2025, U.S. currency held abroad reached $1.05 trillion, representing 45% of all U.S. currency in circulation. From 1970 to 2025, foreign-held U.S. banknotes grew at a 10.1% annual rate, rising from just $5.4 billion to more than a trillion, compared with 7.2% annual growth for total U.S. currency in circulation. The sharpest surge occurred between 2008 and 2021, when overseas holdings jumped by $700 billion. The historical peak came during the 2020 COVID-19 pandemic, with an unprecedented $121 billion (15%) increase in a single year. Since 2022, however, foreign demand for U.S. banknotes has plateaued, showing little change through 2025—a shift partly reflecting the rise of digital payment systems and cryptocurrencies.”⁴⁰Ehsan Soltani (@Soltani), “U.S. Exports of Dollar Banknotes (1970-2025),” Voronoi, October 9, 2025.

Some argue that trade deficits are a product of government budget deficits, but the 1990s saw a surge in the dollar and U.S. trade deficit alongside balanced budgets.⁴¹Mark A. DiPlacido, Fiscal Conservatives Should Care About Trade Deficits (Washington, D.C.: American Compass, 2024). If budget deficits were the sole driver of trade deficits, the trade deficit would have declined in the late ‘90s and early 2000s as U.S. budget deficits declined. Instead, the U.S. trade deficit accelerated as NAFTA and China’s entry into the WTO drove massive offshoring. A growing trade deficit should have also put downward pressure on the dollar; however, consistent demand for U.S. assets held the dollar steady until January 2002, when the euro began circulating for the first time. 

Trade deficits must be covered somehow—America does not receive imports for free even when they are undervalued. As the United States balanced its budget and sales of the U.S. Treasuries declined, foreign investors with earnings from their trade surpluses sought to purchase other private dollar-denominated assets on the U.S. open market.⁴²DiPlacido, Fiscal Conservatives Should Care About Trade Deficits. The first wave of these investments helped drive the “dot-com bubble” that burst in 2000. The second wave in the early 2000s saw a massive surge in purchases of U.S. mortgage-backed securities, which ultimately helped drive the 2008 financial crisis that triggered the Great Recession.⁴³David P. Goldman, “A Path Out of the Trade and Savings Trap,” American Affairs 1, no. 3 (2017): 31-44.

Today, we are likely resting on another significant bubble. Analysts ranging from the Coalition for a Prosperous America⁴⁴Andrew Rechenberg, “Currency Misalignment Monitor, October 2024,” Coalition for a Prosperous America, October 1, 2024. to J.P. Morgan⁴⁵Samuel Zief, Madison Faller, and Harry Downie, “Is This the Downfall of the U.S. Dollar,” J.P. Morgan Private Bank, April 25, 2025. estimate that the U.S. dollar is overvalued by anywhere from 15 to 20%. Financial analyst Russell Napier has also pointed to several other troubling trends, arguing that since the 1990s: 

Credit to the U.S. nonfinancial corporate sector rose from 56 percent of GDP to a new all-time high of 87 percent, and U.S. Government debt rose from 60 percent of GDP to a recent high of 106 percent, very near the peak level recorded during World War II. The valuation of U.S. equities rose from a cyclically adjusted price-to-earnings ratio (CAPE) of 15x to the current level of 34x, having reached [an] all-time high of 44x in 2000. U.S. tangible investment declined from 7 percent of GDP to as low as just 1 percent of GDP, a level only previously recorded in the Great Depression and briefly in the hiatus of investment after World War II.⁴⁶Napier, “America, China, and the Death of the International Monetary Non-System.”

In short, both public and private debt have risen in the United States, while asset prices, such as stocks, have far outpaced corporate earnings. At the same time, corporate investments in physical assets that support production are at historically low levels.⁴⁷Oren Cass, The Corporate Erosion of Capitalism (Washington, D.C.: American Compass 2021), 2, 4. Despite these factors, the twin trade and budget deficits and the failure of U.S. GDP⁴⁸“U.S. GDP Growth Rate,” Macrotrends, accessed November 17, 2025. to reach its historical average growth rate of 3.2%⁴⁹“GDP-Real Growth by Decade,” Crestmont Research, accessed November 17, 2025. since 2005, foreign demand for USD-denominated assets remains strong, particularly⁵⁰John Sindreu, “Will America’s Unbalanced Trade Doom the Dollar?,” Wall Street Journal, June 9, 2025. for higher-yielding private assets such as U.S. stocks⁵¹Brad Setser (@Brad_Setser), “And since most investors — China’s SAFE excepted — have rebalanced their US equity holdings to keep their US holdings from rising the US share of their portfolio, foreign exposure to the US market is big (debt = heading toward 20% of WGDP, stocks = 8% of WGDP),” Twitter (now X), March 31, 2025. and corporate acquisitions. However, cracks are beginning to show. As interest payments on U.S. federal debt now exceed both the defense budget and Medicare,⁵²“Interest Costs Surpass National Defense and Medicare Spending,” House Budget Committee, May 16, 2024. total domestic non-financial debt reaches 257% of GDP,⁵³“Financial Accounts of the United States – Z.1: Recent Developments,” Federal Reserve, last updated September 11, 2025. and BRICS nations express interest⁵⁴Melissa Pistilli, “How Would a New BRICS Currency Affect the US Dollar?,” Investing News Network, September 10, 2025. in moving beyond⁵⁵Philip Pilkington, “The End of Dollar Hegemony?,” American Affairs, March 22, 2022. dollar supremacy, a free-floating currency without any trade adjustment mechanisms looks increasingly unreliable.

Capital Account Exposure as a Trade Deficit Driver

Examining trade in an accounting context, balances of trade in goods and services are reflected in the current account, which can run a surplus or a deficit. The other side of accounting identity is the capital account,⁵⁶Alicia Tuovila, “Capital Account Explained: How It Works and Why It’s Important,” Investopedia, September 3, 2024. which reflects the currency and assets exchanged for goods and services. The capital account is primarily comprised of three parts: foreign direct investment (FDI), foreign security investments and bank deposits, and a nation’s reserve account. By definition, a nation’s current account and capital account must balance, an identity also known as the “balance of payments.” In other words, as the United States runs a larger current account (trade) deficit, it must also run a larger capital account surplus. 

In a U.S. trade context, it is helpful to think of the capital account as tracking what foreign nations do with the dollars they receive from sales to U.S. consumers. In the case of contemporary U.S. surpluses, these dollars are most often used to purchase U.S. assets, including corporate shares, physical assets such as real estate and production facilities, intangible assets like intellectual property rights, and U.S. debt. Sometimes they are also held as reserves in savings accounts and by foreign banks. Perhaps counterintuitively, then, a higher U.S. capital account surplus often means the United States is selling off more of its assets and increasing its liabilities.⁵⁷“Capital” in this sense is better thought of as representing continued foreign demand for U.S. dollars and the U.S. assets such dollars can buy, rather than a measure of U.S. dollars the United States “owns” or “has in the bank.” The capital account is not a measure of U.S. assets—it explicitly includes U.S. liabilities. As discussed further below, this concept is further confused by differences between the economic and common sense definition of “investment.” The economic use of “investment,” as in the case of “capital accounts,” does not account for ownership; it merely tracks the deployment of capital.

The United States has pursued a policy of open capital markets alongside its embrace of free trade. This approach—especially given the upward pressures on the dollar driven by its world reserve status,⁵⁸Around 57.7% of the world’s official foreign currency reserves are in dollars. “Currency Composition of Official Foreign Exchange Reserves,” International Monetary Fund, accessed November 17, 2025. According to the Atlantic Council, 54% of all export invoices are denominated in dollars, as well as 60% of international loans and deposits, and 70% of international bonds. Alisha Chhangani and Lize de Kruijf, “Dollar Dominance Monitor,” Atlantic Council, accessed November 17, 2025. See also Carol Bertaut, Bastian von Beschwitz, and Stephanie Curcuru, “‘The International Role of the U.S. Dollar’ Post-COVID Edition,” FEDS Notes, June 23, 2023. Dollars are used in 88% of foreign exchange transactions and nearly half of the $2 trillion in physical banknotes in circulation are held by foreigners. Chhangani and Kruijf, “Dollar Dominance Monitor”; Christopher J. Neely, “The Innocent Greenbacks Abroad: U.S. Currency Held Internationally,” Federal Reserve Bank of St. Louis: On the Economy (Blog), October 18, 2022. With that said, Michael Pettis argues that foreign nations holding U.S. dollars for transaction purposes should not in and of itself drive dollar overvaluation, noting that the Euro has seen similar rates of foreign use without becoming overvalued or devastating Europe’s industrial base. Michael Pettis (@michaelxpettis), “Europe, in other words, benefits almost as much from seigniorage as the US, without the cost of an overvalued currency and a weaker industrial base. The idea that this benefit, as small as it is, is part of some US dollar exorbitant privilege makes no sense.” Twitter (now X), May 4, 2025. and the escalation of that pressure after the United States abandoned the gold standard—reflected the same flawed assumptions about openness and non-discrimination that shaped multilateral trade under the GATT. With no stable benchmark for currency exchanges, unrestricted capital flows have allowed other nations to manipulate their exchange rates and distort trade balances through large-scale purchases of U.S. dollars and financial assets.⁵⁹Trade surplus countries produce more than they consume, which results in savings, often in the form of foreign currency reserves. Alternatively, countries can issue currency to buy foreign reserves first, which weakens their currencies against the foreign currency and makes their exports more competitive, resulting in a trade surplus. Those purchases help ensure continued foreign trade surpluses because they are purchased instead of U.S. goods and services, further weakening demand for U.S. exports. As Keynes and Article I of the IMF Charter recognized, chronic and excessive trade deficits are a key indicator of currency misalignment. 

Over-reliance on foreign capital has contributed to chronic budget deficits,⁶⁰Mark A. DiPlacido, “Gross Domestic Problems,” Commonplace, June 19, 2025. asset inflation, and dollar vulnerability.⁶¹A deficit country must have some form of capital to pay for its goods and services. If that capital is not generated by the sale of its own goods and services, it must come from capital lent by other nations. While this should put pressure on the currency of surplus nations to rise, many surplus countries devalue currency exchange rates and manage capital flows to keep out foreign investment while continuing to keep large reserves of U.S. dollars and assets. This prevents the exchange rate from adjusting, so surplus nation currencies remain weak against the dollar, despite their increased demand for U.S. assets. This helps ensure such nations remain net exporters. According to Apollo Chief Economist Torsten Slok, foreign entities now hold roughly $18.5 trillion in U.S. equities (~20% of total), $7.2 trillion in Treasury securities (30%), and $4.6 trillion in corporate debt (30%).⁶²Torsten Sløk, “Foreign Ownership of US Equities, Treasuries, and US Credits,” Apollo Academy: The Daily Spark, April 10, 2025. Foreign governments hold around 44% of foreign-held treasuries, while private foreign investors own the rest.⁶³Marc Labonte and Ben Leubsdorf, Foreign Holdings of Federal Debt, RS2233, Congressional Research Service,  (2025), 4. Note that China has obscured more of its U.S. treasury purchases in recent years. ACEMAXX ANALYTICS (@acemaxx), “A big part of #China’s UST portfolio is those held by offshore custodians, and it started precisely when the US started producing detailed monthly data of overseas foreign holdings in 2011, chart @JPMorganAM,” Twitter (now X), May 3, 2025. For perspective, foreign investors owned less than 6% of U.S. stocks in 1994.⁶⁴Torsten Sløk, “Record-High Foreign Ownership of the US Equity Market,” Apollo Academy: The Daily Spark, June 18, 2025. Foreign holdings of U.S. treasuries stood at only 1.2% in 1945, jumping to 20% in 1972 and reaching a high of 56.5% in 2008.⁶⁵Labonte and Leubsdorf, Foreign Holdings of Federal Debt, 2. Foreign-owned corporate debt securities climbed from a mere $7 billion (1.6%) in 1978 to $190 billion (12.7%) in 1989 to $572 billion (19.4%) in 1997.⁶⁶“Summary of Report on Foreign Portfolio Investments in the United States,” U.S. Department of the Treasury, accessed November 17, 2025. As of Q2 2024, foreign holdings of long-term U.S. corporate debt totaled over $4.2 trillion (30.6%).⁶⁷“Table 2 (preliminary data, February 28, 2025): Foreign Portfolio Holdings of U.S. Long-Term Debt Securities as of June 30, 2024,” U.S. Department of the Treasury, accessed November 17, 2025. “Nonfinancial Corporate Business; Debt Securities and Loans; Liability, Level (BCNSDODNS),” FRED (Federal Reserve Bank of St. Louis), updated September 12, 2025. It is worth noting that foreign investors earn interest and appreciation on these investments, rather than U.S. citizens, which further diminishes the relative wealth of the United States.

However, the core problem is that this “investment” most often takes the form of acquiring existing assets rather than making capital investments to create new ones. Genuine greenfield FDI would create new assets on which foreigners could earn returns, but in the process, the U.S. economy would also benefit, as new production and jobs are created. Of course, this is what people envision when they hear that the rest of the world “wants to invest in the United States.” Instead, foreign investment looks more like what Warren Buffett once described when he said the United States has “day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.”⁶⁸Warren E. Buffett, “America’s Growing Trade Deficit Is Selling the Nation Out From Under Us. Here’s a Way to Fix the Problem—And We Need to Do It Now,” Fortune, November 10, 2003.

The persistent and substantial demand for U.S. assets has enabled the U.S. trade deficit to continue reaching record highs. As the current chairman of President Trump’s Council of Economic Advisors, Stephen Miran, has argued, “The root of the economic imbalances lies in persistent dollar overvaluation that prevents the balancing of international trade, and this overvaluation is driven by inelastic demand for reserve assets.”⁶⁹Stephen Miran, A User’s Guide to Restructuring the Global Trading System (Greenwich, C.T.: Hudson Bay Capital, 2024), Executive Summary. McNair further argues that the United States is the only nation in history to have run trade deficits for 40 years while seeing its currency appreciate by 350%.⁷⁰Michael McNair, “Of Trade and Capital: A Tale of Two Strategies,” Commonplace, May 13, 2025. In theory, these deficits should have caused the dollar to depreciate instead, eventually bringing trade into balance.

Holding all else equal, foreign demand for U.S. assets and U.S. demand for foreign goods both put downward pressure on the current (trade) account.⁷¹McNair, “The Sovereign Wealth Effect.” However, if foreign demand for U.S. assets primarily drives the transaction, foreign nations would need to sell more goods to fund the asset purchases, which would result in lower relative prices of their goods and a weakening of their currencies against the dollar. If U.S. demand for foreign goods were the primary driver of the deficit, the U.S. would have to start paying more for those goods over time and see its dollar decline relative to foreign currencies. In aggregate, the U.S. would find it more challenging to acquire foreign capital and its assets would decline in value. 

So far, the first scenario is a better description of reality, as the U.S. dollar has remained strong despite its chronic trade (and budget) deficits.⁷²“Dollar Yuan Exchange Rate (1981-2025),” Macrotrends. On a practical level, consumer demand for foreign goods will continue as long as prices remain competitive; however, those prices only remain so because foreign producers are willing to accept U.S. dollars, debt, and assets in return, rather than U.S. goods. In Washington, deficits are tolerated because multinational corporations can profit more from offshoring than from producing goods in the United States.⁷³Mark A. Diplacido, “Make American Companies American Again,” Commonplace, October 16, 2025. But if U.S. assets cannot eventually be redeemed for goods and services, their worth will inevitably be questioned. Continuing to indiscriminately expose the U.S. economy to open capital and trade markets will not indefinitely permit U.S. overconsumption and underinvestment, nor foreign overinvestment and underconsumption.⁷⁴Mark A. DiPlacido, Mutual Disadvantage (Washington, D.C.: American Compass, 2025). Without a system to gradually correct imbalances, the next correction is more likely to resemble the Great Recession—or worse—than the relatively stable period following the Plaza Accords.

Balancing Payments: How to Understand Trade and Capital Flows

With all of that said, the importance of trade in goods remains essential. Maintaining advanced production capacity and a significant global market share in critical sectors offers numerous advantages, including positive contributions to growth, high-quality employment, innovation, and national security. Furthermore, dollars become useless if they cannot eventually be used to purchase goods and services, a reality made manifest in periods of inflation, major defaults, and asset bubble deflations.

Recently, U.S. leaders have begun to ask whether the status of the dollar is an exorbitant privilege or an exorbitant burden.⁷⁵“CEA Chairman Steve Miran Hudson Institute Event Remarks,” The White House, April 7, 2025. While there are upsides to demand for one’s currency, especially for those who profit from foreign investments, there are clear risks and downsides when the dollar fails to adjust in response to chronic and ever-increasing trade and budget deficits. Furthermore, if the dollar remains strong against foreign currencies, some tariffs may not have the desired effect of reshoring production—especially if foreign nations deliberately devalue their currencies in response to a stronger U.S. trade posture.

Understanding the role of currency and capital flows is thus key to understanding chronic U.S. trade imbalances. It may be challenging to discuss the downsides of holding the world’s reserve currency, but policymakers should acknowledge that all policies have tradeoffs and should continue to weigh and contextualize the costs and benefits of all policies over time. A “strong” dollar may sound like an inherently desirable goal, but there are significant risks and tradeoffs involved when the dollar becomes overvalued, especially when the global monetary system contains no standard correction mechanism. While an overpriced dollar might benefit those who process foreign asset purchases and manufacture products abroad to sell domestically at higher margins, it ultimately harms the long-term health of the entire economy and the immediate opportunities available to working-class Americans. With this in mind, considerations of the capital side of the balance of payments should once again inform bilateral and multilateral negotiations among world leaders seeking more balanced trade agreements. Policymakers should also consider tools to ensure the dollar is valued fairly based on the U.S. trade balances, and better manage capital flows to restabilize our balance of payments—as was envisioned by those at Bretton Woods who had learned the lessons of vast imbalances in the interwar period.