The US dollar has long enjoyed preferential status as the world’s dominant medium of exchange, unit of account and store of value. US President Donald Trump’s erratic leadership and his readiness to violate long-established political norms, including the independence of the US Federal Reserve, could threaten that status. In the event of a sudden erosion of the dollar’s role, the abrupt repricing of US dollar assets on which the global financial system is based could entail severe financial volatility that threatens global growth.
Though this is a low-probability outcome, it is one that nevertheless warrants consideration. More likely is a gradual shift out of US assets by international investors — including central banks — looking to reduce their exposure to possible policy shocks, particularly the higher inflation that could result from the dismissal of the current Fed chair, Jerome Powell, and the appointment of an individual more yielding to Trump’s whims.
The likelihood and impact of these scenarios hinge on the international role of the dollar. The greenback’s dominance reflects several factors, including its historical role as anchor currency in the post-Second World War international monetary arrangements established in 1945. That dominance is sustained by investors’ confidence in sound, stable policy frameworks and strong, independent institutions. For the past eight decades, confidence in those frameworks and institutions has meant that in times of global crisis, international investors have sheltered in the “safe haven” of US dollar assets.
That is only one of the benefits the United States reaps from its financial exceptionalism, however. The United States also earns seigniorage on foreign use of the dollar — in effect, it can issue currency at zero cost and gain command over real resources. In addition, financial market constraints on the United States are more elastic given the critical role US treasuries perform in global finance; that is to say, the market’s implicit threshold on US debt, above which risk premia would rise, is probably higher than the thresholds of other sovereign borrowers. Moreover, the “exorbitant privilege” historically accorded to the dollar given its role in international monetary arrangements has allowed the United States to run larger current account deficits for longer, which can shift the burden of balance of payments adjustment to other countries.
As former US treasury secretary John Connelly observed to his international counterparts 60 years ago with respect to US current account deficits: “It may be our dollar, but it’s your problem.” The fixed exchange rates of that earlier period are long gone, but to some extent Connelly’s adage remains relevant.
Most troubling from an economic perspective, however, are Trump’s past attacks on the Fed, which he has falsely claimed is politically biased against him.
All these benefits may now be at risk.
In his first administration, Trump’s violations of long-standing political, legal and economic norms ranged from the willful disregard of presidential decorum, to questioning the integrity and competence of key federal law enforcement and intelligence agencies. He undermined the independence of the judiciary and rule of law and, at his worst, incited a failed insurrection.
In the wake of his re-election, he has become more bombastic and divisive, publicly musing about the possible use of military force to acquire Greenland and retake control of the Panama Canal and threatening to use punitive tariffs to coerce Canada into becoming the “fifty-first state.”
Even if his bluster is dissembling designed to enhance the US bargaining position in international negotiations, it could have dire unintended consequences for the rules-based international order. Worryingly, the Republican-controlled Congress shows little inclination to act as the constitutional “check and balance” on the executive branch envisioned by the founding fathers.
Most troubling from an economic perspective, however, are Trump’s past attacks on the Fed, which he has falsely claimed is politically biased against him, designed to get the Fed to lower interest rates. Presidential criticism of the Fed is not unprecedented; presidents Lyndon B. Johnson and Richard Nixon both pressured the Fed to hold interest rates down.
What differentiates Trump from them is his lack of self-restraint, on the one hand, and his compulsion to pursue his own self-interest above anything else, on the other. In the current environment, with a compliant Congress, his attacks could erode confidence in the operational independence of the key institution on which American financial exceptionalism is based. Worryingly, a recent executive order would, if not successfully challenged in the courts, impinge on the Fed’s authority to independently write and enforce financial regulations. Should markets view this latest attack on the Fed’s independence as a possible precursor to political oversight of interest rate decisions, the consequences could be serious.
At risk is the preferential status of the dollar, the loss of which could harm the United States, with the global economy becoming collateral damage. These effects would arise because US dollar assets, especially US treasuries, form the bulk of international reserve assets. They are held, in part, for the liquidity they provide, which is partly due to the shared expectation that the dollar will remain a stable store of value and the belief that others will hold them. A shift in these expectations and beliefs that leads reserve managers to sharply decrease the share of dollar assets could trigger a scramble for a replacement asset, likely gold. The resulting simultaneous contraction in global demand, as central banks build gold reserves, and wild fluctuations in exchange rates could push the global economy into recession.
Financial markets would also react to the loss of US financial exceptionalism. In the first instance, bond markets would be much more vigilant of slippages in policy frameworks. This increased focus could become problematic given the probable path of US fiscal policy over the next year. It seems likely that tax cuts enacted in Trump’s first administration will be extended. Together with proposed spending increases and the inevitable shortfall in savings from the much-hyped but poorly conceived review of federal spending, the extension of these tax cuts will produce a sharp deterioration in long-term public finances, putting the United States one step closer to the slippery slope of unstable debt dynamics. In these circumstances, and the Fed’s commitment to price stability possibly in doubt, bond markets would begin to price-in risk premia, resulting in higher long-term interest rates even if the White House succeeds in pressuring the Fed to defer short-term rate hikes. These higher bond yields would accelerate fiscal deterioration and strain highly levered corporate balance sheets, with attendant risks to the economy.
At the same time, because US treasuries constitute the bulk of the collateral on which the global financial system is based, an abrupt repricing of them could represent a potentially catastrophic shock to international financial stability. In a sense, the system resembles a huge inverted triangle with a large trapezoid of securitized assets balancing precariously on a much smaller triangle of leveraged and re-hypothecated US treasuries. The structure is fragile given that it rests on expectations and beliefs, and an unexpected write-down of treasuries could entail a sudden and dramatic credit contraction reminiscent of the 2008 Lehman Brothers shock. Should it unfold, this would be the most disruptive effect of the loss of the dollar’s dominant role.
These effects are not inevitable, however, and to better assess their likelihood, it is helpful to review two factors that support the dollar.
First, and most important, is the currency’s continuing role as global medium of exchange and unit of account and the absence — to this point at least — of a viable alternative to the dollar as a global reserve asset. Transactions costs are minimized by limiting the number of currencies used to invoice contracts and settle transactions; once a currency has pre-eminent status in those functions, it is less likely to be displaced. In this respect, the fact that the United States has had the world’s largest economy for the past century has given it an added advantage.
Second, the checks and balances provided by US political, economic and legal institutions remain in place, though weakened by the hyper-partisanship that has infected the US body politic. Meanwhile, market reactions (such as rising bond yields or stock price volatility that results from ill-considered policy) can provide a check on Trump’s disruptive inclinations. Market-based constraints are indeed likely to play an increased role, just as they did in the early years of the first Clinton administration.
These factors provide some grounds for optimism. But this optimism is curbed by the fact that while the size of the US economy remains a key consideration, it is declining in importance over time given the increasing economic weight of China. Similarly, in a scenario in which the United States becomes viewed as a rogue actor, the euro could, in theory, assume a larger share of the dollar’s role as reserve asset. Moreover, even if market adjustment is an effective check on reckless policy making, it is not always smooth and gradual; adjustment is frequently delayed, allowing imbalances to build until some seemingly minor event triggers an immediate and highly disruptive adjustment.
So while there are grounds for optimism, it would be folly to rule out the possible loss of financial exceptionalism. And as the 2008 financial crisis amply demonstrated, financial markets can leverage a small risk (such as problems in a relatively insignificant segment of the mortgage market) into a catastrophic meltdown of global financial markets. In this respect, though the risk of this scenario is speculative and uncertain, what is apparent and certain is that Trump constitutes a threat to the institutions and policy frameworks on which American financial exceptionalism rests.
