When the 2008 financial crisis happened, there was a lot of loose talk about the end of the dollar as the world’s reserve currency (i.e., the one currency that everyone from central banks to criminals holds and uses). There were also a lot more sober analyses suggesting the same thing. I was on the other side of the fence during that debate, arguing in both short-form and long-form that the dollar was going to be around for a while.
Why am I bringing this up now? Because while I still believe the dollar is not going anywhere anytime soon, I am less confident than I used to be.
My reasons for confidence have not changed. To create a true challenger to the dollar, any actor needed to meet two necessary conditions: opportunity and willingness. Another actor must be both able and willing to provide a substitute (and not a complement) to the greenback. The dollar functions as the reserve currency because of (a) deep and liquid U.S. capital markets and (b) transparent and reliable monetary authorities. Challengers to the dollar remain deficient in their ability to offer a viable substitute. If China wanted the renminbi to rival the dollar, it would have to radically improve both the availability of RMB-denominated securities and the transparency of its regulators. The eurozone economies would have to persuade investors of the long-term viability of a stateless currency.
It is also less than clear if either China or the eurozone really wants to assume the responsibilities of managing a top reserve currency. Although the issuer of a reserve currency accrues economic benefits through seigniorage and other positive externalities, it also reduces the competitiveness of the issuing economy. The currency tends to be a bit overvalued, weakening export competitiveness. Neither China nor Germany seems to be willing to disrupt its domestic political economy with the added burden of managing a reserve currency.
Furthermore, the United States just displayed its command over the dollar yet again, by forcing SWIFT — the Belgium-based network responsible for the cross-border payments system between banks — to comply with unilateral U.S. sanctions against Iran. If the Trump administration could coerce SWIFT into compliance despite the European Union’s desire for them not to comply, why should I worry now about the dollar’s future?
There are two parts to this answer. The first is that in ratcheting up the use of financial statecraft and trade sanctions on trading partners, the Trump administration has incentivized active efforts to develop the necessary financial architecture to challenge the dollar. The Iran case was particularly problematic because it is the first time that Washington applied this kind of pressure with its European allies in active opposition. If China, Russia and the European Union develop joint efforts to develop alternative payments systems to the dollar, it lays the groundwork for greater non-American coordination to come. While this might be costly to these countries, a belligerent Trump administration will increase the likelihood that these actors will be willing to bear the cost. Little wonder that sanctions experts are repeatedly sounding the alarm about U.S. abuse of the dollar’s position in the international monetary system.
If the United States cannot credibly commit to not abusing the dollar’s exorbitant privilege, eventually other countries in the system will become willing to shoulder the burdens of transitioning away from the dollar. On Iran, we have seen U.S. partners Turkey and India announce that they will trade in local currencies to bypass the dollar. The E.U., China and Russia are cobbling together an alternative payments system to bypass SWIFT as well.
Iran is still going to feel the sting of sanctions. But think of these measures as hedges against future U.S. sanctions. Speaking of the future, the second reason this time might be different is the ever-worsening U.S. fiscal picture. This year alone, according to the Treasury Department, the federal government will have to issue $1.3 trillion in new debt. This is coming with an economy generating full employment and more than 3 percent economic growth. If the economy were to spiral into a recession, or if the Federal Reserve raises interest rates further, the debt picture would deteriorate further.
Who buys U.S. debt? Americans, mostly, but foreigners buy about 30 percent of it. If foreign purchasers start to doubt the long-term viability of the U.S. debt picture, they might start demanding that the United States denominate its debt in a different currency (yes, there is precedent for this). If that becomes a thing, the prospects of the dollar remaining the top currency start to dim.
One last thought: If any of this happens, it can happen very quickly. The network effects of a single reserve currency are pretty strong. For now, that is good for the dollar, as all the market incentives favor a continuation of the status quo. If an alternative to the dollar emerges and is agreed upon, however, financial actors could move very quickly to offload dollars and buy up the new reserve currency. Which means that the end of the dollar’s privileged status will start slowly, and then accelerate quite rapidly.