LONDON (Reuters) - The world is getting an object lesson on the problems of having one dominant global currency and even the supposed prime beneficiary, the United States, can see the downside.
Alarming bouts of volatility in world financial markets over the past 12 months have been rooted in a fear of what happens when a world with its highest-ever peacetime debt pile faces even a hint of higher interest rates.
Despite a constant narrative about U.S. households and banks paying down debts ever since the global credit crash eight years ago, any 'deleveraging' that did happen was more than offset by higher government, corporate and personal debt around the globe in Europe, China and across emerging markets.
In fact, aggregate world debt is now far higher than it was before the 2007-08 crash.
"The saga of debt is far from over," says a report from Morgan Stanley. It goes on to explain why Morgan Stanley expects demographic-led shifts in savings and investment to soon push interest rates higher and transform that debt mountain into additional deadweight on world growth over next five years.
But the role of the U.S. dollar as the world's main reserve currency denominating large chunks of that debt pile is showing up as complicating factor that's added to risk of instability.
The first U.S. interest rate increase in almost a decade in December - just a quarter of a percentage point - was enough to trigger a convulsion in world markets that led to the worst start to a year for global stocks since World War Two.
Underlining 'cause and effect', the subsequent recovery only came about once the Federal Reserve hastily made clear it was pressing the pause button precisely because of seismic events in world finance.
Few doubt a growing U.S. economy that's near full employment can absorb some normalization of interest rates from near zero, and a higher dollar goes hand in hand with that.
But the rest of the world clearly can't.
The Bank for International Settlements estimates that while U.S. dollar dominance means it accounts for almost 90 percent of all foreign exchange transactions and some 60 percent of hard currency reserves. But crucially it also accounts for about 60 percent of all debts and assets outside the United States.
And if the rest of the world goes into shock because of the higher cost of servicing and paying back those dollar debts, the boomerang effect on U.S. exporters, commodity firms and the wider economy just ends up tying the Fed's hands in ways made crystal clear this year already.
No surprise, then, the U.S. central bank has no deep love for the dollar's prime reserve currency status - even though it's been described by Europeans and others over the years as an "exorbitant privilege" that ensures the world lends to the U.S. Treasury in its own currency at low interest rates regardless of dollar strength.
Speaking at an event in Zurich on Tuesday on the dollar's global status, New York Fed chief Bill Dudley said Americans should not be perturbed if other currencies such as the euro or China's yuan eventually eat into the dollar's share of reserves.
"If other countries' currencies emerge to gain stature as reserve currencies, it is not obvious to me that the United States loses," he said, as long as it "is being driven by their progress, rather than by the U.S. doing a poorer job."
While that's far from wishing away dollar hegemony, it speaks to the greater ambivalence among central bankers toward reserve status than their national treasury chiefs - given how widespread use of the currency can compromise domestic policy.
It's that tension that risks sowing instability everywhere.
If the Fed can't adjust monetary policy because of fears of transmitting a self-defeating shockwave around the world via the dollar, then there's understandable concern that artificially low Fed policy just stores up even more debt and international accounting imbalances and undermines the very currency that's supposed to play anchor.
At the same event in Zurich, Claudio Borio, head of the monetary and economic Department of the BIS, said the dollar's role could potentially exacerbate instability by allowing the United States to run larger and more persistent fiscal and current account deficits - and to run looser monetary policy for longer.
What's more, a resulting Fed easing bias spreads to developed and emerging economies as governments resist a weaker dollar for competitiveness or financial stability reasons, Borio added.
"Easing begets easing," he said.
For Morgan Stanley, this is just leads to ever-higher debt, and there are no painless ways out of a problem that will start to hurt significantly over the coming years - only a series of "less painful" options including the option of consolidating debts and making them permanent or perpetual.
In the meantime, the U.S. bank said, the dollar itself will most likely push higher again, if only because the U.S. economy is probably the only one that can absorb a rising exchange rate in this environment.
For Borio, a more 'pluralistic' system with many world currencies sharing the reserve role doesn't by itself solve any problem, either. There would then be no credible single anchor.
Hard-headed cooperation and joint decision making may be the only answer.
"This means not just putting one's house in order, but also putting our global village in order."
Additional reporting by Jamie McGeever and Jonathan Spicer. Editing by Larry King