The dethroning of the dollar

Is the dollar in danger?

On Thursday, President Trump finally followed through on his threats to impose tariffs on most steel and aluminum imports. He did so, he says, to promote what he characterizes as fairer relationships between the United States and its trading partners. "We've been treated so badly over the years by other countries," Trump said at Thursday's signing ceremony.

But one reason America runs persistent trade deficits is that the U.S. dollar is in high demand. This drives up the value of our currency, making our exports more expensive. And one reason the U.S. dollar is in high demand is that it serves as the world's premiere reserve currency. So to get the sort of trade relationships Trump wants, the U.S. dollar might have to be kicked from its throne.

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How could that happen?

There are a few possible ways, says Barry Eichengreen, an economics professor at the University of California, Berkeley and co-author of a book on the topic.

But before we get into the nitty-gritty, let’s unpack what a reserve currency means. Basically, whenever two countries trade goods and services, they inevitably trade currencies. But no country controls any currency but their own. That makes it useful to stockpile (i.e. reserve) other currencies for a rainy day (e.g. a financial shock rattles markets or an unforeseen trade crisis strikes).

In theory, everyone should trade in a whole bunch of different currencies. But thanks to many historical factors, most countries just trade with each other using U.S. dollars. Thus, they stockpile dollars, too. As of 2017, almost 64 percent of all foreign exchange reserves were American currency. The euro was in second place at a mere 20 percent. The Japanese yen was way back in third, with less than 5 percent. China's renminbi was just 1.1 percent.

"We talk about the secret sauce that makes for an international currency, with four ingredients," Eichengreen told The Week. "Size, stability, security, and liquidity."

Right now, there's no obvious contender for replacing the U.S. dollar.

Japan, for instance, probably lacks both the sheer scale of GDP and the political or military reach necessary to serve as a reserve currency. And neither of those things will change soon.

What about China? When it comes to size, the Chinese economy is big because of its huge population, not because of its income per person. China also recently scaled up its capital controls, which hurts its liquidity.

As for the eurozone, its economic growth just started picking up steam after years of stagnation. And the ongoing crisis over Greece, as well as the rise of ethno-nationalist parties across the continent, certainly doesn't make it look very stable.

But there are more immediate things China and the eurozone could do to improve the desirability of their currencies. China's recently announced push to invest in infrastructure projects around the world is an attempt to build international relations and geopolitical clout. But it would also make the renminbi more attractive as a reserve option. Work is also underway on a single capital market that would stretch across the European continent, which would certainly offer the world more liquidity in euro-denominated assets. The eurozone could also eventually figure out its various debt crises and internal money flow problem.

Meanwhile, the U.S. could wreck its standing.

That President Trump makes America look a bit less politically stable sort of goes without saying at this point. But the precariousness of the U.S. position is more specific than the president's tweets. Eichengreen and his co-authors looked through the historical data and found that geopolitical relationships — particularly military alliances — influence who uses what reserve currency. It's not just an economic calculation, but also a way of strengthening an alliance. "We find that military alliances boost the share of a currency in the partner's foreign exchange reserve portfolio by close to 30 percentage points," they concluded.

You can see how this might be worrying for the U.S. Trump could eventually make good on his "America First" rhetoric and pull the United States out of NATO. Or the president's ongoing feud with North Korean dictator Kim Jong Un could also destabilize the region. What if Japan and South Korea — who both likely hold around 80 percent of their foreign currency reserves in dollars — no longer see the U.S. as a reliable provider of stability and security? China could rush in to fill the breach.

This brings us back to Trump's tariffs. It's unlikely that increased duties on steel and aluminum could set off a tit-for-tat trade war that eventually encompasses a whole range of trade goods and services. But if they did, that would make the U.S. dollar look less attractive as well.

If any of these conflagrations do happen, Eichengreen and his co-authors think changing technology could be an accelerant. It's traditionally assumed that reserve currencies function similar to monopolies: Things like convenience and network effects push everyone to rely on one dominant currency. But with modern technology, massive reserve holdings can be instantaneously transferred between assets and between currencies. Digital technology allows everyone to comparison shop between different assets and currencies at the click of the button.

Eichengreen thinks this comes with two consequences.

First, we may not live in a monopoly reserve currency world after all. If China and the eurozone can get their acts together and America slips, the world could wind up with two or three global reserve currencies all tussling together.

Second, if the change does come, it could come fast. When America created the Federal Reserve system in 1913, for example, the U.S. dollar had virtually no international role. But the Fed and World War I changed things, and within a decade, the dollar had become one of the dominant reserve currencies. Depending on what China, the eurozone, the United States, and other players do, such a change could happen again. And with modern technology, it might be even swifter than last time.

But one thing that isn't likely to dethrone the U.S. dollar is the federal debt load. Even if you believe that some level of debt is unsustainable, it's a problem that's a decade or more away. And when you think through the dollar's role as a fiat currency (i.e. the government controls the supply) it's hard to see how a debt crisis could ever occur. Trump and the government could politically choose to default on the debt by breaching the debt ceiling, but recent deals pushed that possibility at least a few years into the future as well.

Finally, this debate gets into whether the U.S. losing its reserve currency status is a good or bad thing in and of itself. If the federal debt is a problem, being the world's reserve currency gives us an enormous cushion to finance that burden. On the flip side, being the dominant reserve currency does make trade deficits more likely. And all else being equal, trade deficits drain aggregate demand from our economy and make it harder to create jobs.

In other words, if you view this as a problem, Trump might wind up "fixing" it. But it will probably be by accident. And it won't be pretty.