The frightening world without the dollar

This was the week we were supposed to find out what tariffs the US was going to charge importers after tearing up the global trade rule book. But my colleague Alan Beattie has already said everything that can be sensibly said about President Donald Trump’s trade policy: Nobody. Knows. Anything.

The only thing I would add is that other countries’ leaders must learn to stop aiming for the best possible outcome for their economies. There will be no “outcome”. The chaos of Trump surprises, U-turns and postponements is all there is, and all there will remain: a definitive policy is an illusion. The task for others is simply to figure out how best to inure their economies, whether by ignoring Trump’s antics and let exporters get by as best they can, or by actively scaling down their trade integration with the US and compensate by deepening trade elsewhere.

Since that exhausts what I can contribute about this week in trade policy, I will turn my focus instead to a different front in the global economic conflict. That is the monetary front, and what will happen to the role of the US dollar. It is well known that, since April, the greenback has behaved a bit like an emerging market currency rather than the world economy’s monetary anchor, and there are plenty of reports that international investors are looking to move out of the dollar. But if the dollar’s reign is actually coming to an end, what comes next?

The risks to the dollar’s pre-eminence are easy enough to grasp. I highly recommend my colleague Martin Wolf’s podcast with Kenneth Rogoff from a few months ago, about the latter’s recent book on the rise and decline of the dollar’s global pre-eminence. This is the direction Rogoff sees things going: “I certainly see a world where the dollar is on top, but less, much less than it was . . . The rest of the world is going to reroute trade, reroute finance, and try to depend less on the dollar.”

And what then? The questions I have been trying to ponder are these: if the global economy does lose its US dollar anchor, what does the new monetary world look like? And how, precisely, does this de-anchoring happen? The standard story is of dollar asset holders becoming weary and trying to get out of their investments, but the dollar is also the key global invoicing currency, funding currency, foreign exchange matching currency (ie most currency trades are between the dollar and another currency), and the most important currency for central bank swap lines (emergency facilities when other countries’ central banks need dollars). What are the mechanics by which a degraded reserve status makes people abandon the dollar for these other uses? 

When I got in touch with Rogoff to ask him for some follow-up enlightenment, this was what he told me:

We are absolutely at the biggest inflection point in the global currency system since the Nixon shock to end the last vestige of the gold standard . . . Into the foreseeable future, the dollar is likely to lose market share, mainly to [the renminbi] but also the euro; crypto is already taking market share from the dollar in the underground economy. This was happening for a decade before Trump (mainly because the renminbi was becoming more flexible against the dollar and China has been working on developing alternative settlement systems). Trump is an accelerant.

More than a new global monetary hegemon, then, we may be facing global monetary warlordism, with the euro, the renminbi, crypto — and we could add gold — vying for position. The same multi-polar future is traced out by Danny Leipziger in a piece that points out the challenges for pretenders to dethrone the dollar, and foresees “a combination of currencies in central bank coffers, but as of now, a continuing reliance on actions of the Federal Reserve with respect to global interest rates and the trends in US bond markets”.

So what will happen to those rates and trends if we go from one to many monetary poles? I contacted Barry Eichengreen, the eminent economic historian, who reminded me that

firms, banks and other investors hold dollars so they can execute cross-border transactions relatively safely and conveniently at low cost. There being no substitute for these functions of the greenback, were firms, banks and other investors to grow more reluctant to hold and use dollars, obtaining the liquidity to conduct those cross-border transactions would become more expensive. There would be fewer cross-border transactions of all kinds. There would be less of what we have come to call globalisation.

I don’t think this has sunk in very widely: that a loss of the dollar’s status means everything globalised will become more expensive. A stark essay by Jean-Pierre Landau imagining a world without a safe asset points out a paradox we rarely think about:

[A] total disappearance of safe assets would be fundamentally different from a shortage. In a shortage scenario, a reference asset remains as a risk-free anchor. In a world with no safe asset, there is no such risk-free rate on which agents coordinate for asset pricing. Investors must rely on private signals and relative valuations, leading to heightened volatility, increased dispersion in beliefs, and structurally higher risk premia. While a safe asset shortage reduces interest rates, total disappearance will, on the contrary, increase them. 

Since safe assets have money-like properties — they function as means of payment and stores of value — not only credit but also liquidity will be more expensive. So here is one possible mechanism by which lost reserve status contaminates other uses of the dollar: higher dollar interest rates and volatility make dollar funding less attractive, and make it harder to commit US dollar-denominated working capital. As a result, invoicing and paying in dollars become less attractive.

Of course, frictions in the dollar system have repercussions for the whole global monetary system. Rogoff predicts that

In the likely coming tri-polar world, the dollar will still be on top, but come down a couple of notches, reducing exorbitant privilege . . . raising dollar interest rates . . . making sanctions much less effective. If there is a debt crisis in the US (which would express itself in a burst of inflation or financial repression, or both), then it will lead to a period of much higher volatility in interest rates and exchange rates, and possibly financial crises.

Not everyone agrees that currency multi-polarity needs to be less stable. Karthik Sankaran makes a strong case for the opposite here and in a shorter version in a letter to the FT. A multi-polar currency system could be more stable, he thinks, because it would align regions’ financial cycles with their real economic cycles rather than, as today, having to accept financial conditions that suit the US. I am sceptical — if the advantage of this outweighed those of a common anchor currency, we would not have got unipolarity in the first place. So even if economies sort themselves into different dominant currency areas (some of which may be crypto- or gold-based), that could well be a distant second best.

Either way, the onus will be on policymakers to protect populations from economic uncertainty. That means pressure on finance ministries and central banks to “take back control” in some way or other. The result, argues Landau, would be to “respond by reversing course on capital account liberalisation, thus reducing their exposure to shocks and the need for reserves” (and, as I argued last week, embrace “financial repression” or state direction of financial flows):

A new international monetary system would emerge — one in which cross-border interactions are driven primarily by trade in goods and services, and where international money is defined by its role as a medium of exchange rather than a store of value.

This would resemble the system that prevailed in the decades following WWII. However, the world would not revert exactly to that earlier configuration. Money is increasingly used in digital form. Technology would interact with geopolitics to draw the international monetary map. In this environment, countries will derive monetary influence not from their ability to issue safe assets, but from their capacity to build, govern, and expand digital networks based on new forms of money, such as stablecoins. We might see the rise of ‘digital currency areas’ . . . structured around technological interconnectedness rather than a shared store of value.

None of this sounds particularly good for anyone. The many critics of financial globalisation may come to regret what they wished for. At the same time, the deeply unsatisfactory future that some of these thinkers are pointing to means that there will be a demand for someone to fulfil the functions the US dollar has provided until now. Neither of the two candidates — the euro and the renminbi — is prepared to take on all the duties that come with that job at the moment. (Read my colleague Katie Martin’s excellent column on the Eurozone fretting about a stronger exchange rate from the modest tilt in asset allocations into the euro. If the dollar falls, you ain’t seen nothing yet!)

But should somebody step up to the task, they’ll find a world jumping at the offer. As Thomas Hobbes suggested nearly 400 years ago, hegemony beats warlordism — at least in the monetary space.

Other readables

● How stablecoins are entering the financial mainstream — an FT explainer.

● Is natural gas really a “transition fuel” for the carbon transition? New research says it may reduce emissions in the short run but increase them in the long run.

● Emma Jacobs investigates how to get children reading again.

● Traditionally carbon-heavy Poland now generates more power from renewables than from coal.