The Long Reign of King Dollar

It has been almost a decade and a half since Chinese banker Luo Ping described the hate-hug joining Chinese financial interests to U.S. financial interests: “We hate you guys.” Why? Washington’s profligacy in the issuance of government debt, which, as fundamental economics would have it, must eventually lead to a reduction in the value of the dollar—something of keen interest in China, where much of the savings, both private and government, is in dollars and dollar-denominated assets. As Luo observed, those investments could be expected to start losing value “once you start issuing $1 trillion to $2 trillion” in debt a year. 

Well. 

In 2022, new U.S. government debt totaled about $1.4 trillion, or 5.5 percent of GDP, a deficit that was about 40 percent more in GDP terms than the 50-year average. The deficit is projected to hit $1.4 trillion again this year and then get worse, averaging $2 trillion from 2024 to 2033, according to the Congressional Budget Office, right where Beijing was afraid it would be. “So,” Luo said in 2009, “we hate you guys. But there is nothing much we can do.” 

Why was that? 

Luo again: “Except for U.S. Treasuries, what can you hold? Gold? You don’t hold Japanese government bonds or U.K. bonds. U.S. Treasuries are the safe haven. For everyone, including China, it is the only option.”

That was the view in 2009. Is it still the case? 

You may have heard that the dollar is the “world’s reserve currency” or the world’s preferred “settlement currency.” 

What “reserve currency” means is that big institutional savers, including central banks, prefer to keep much or most of their savings in dollars, because the dollar historically has been stable, a solid store of value. The dollar has suffered from inflation, but it had been–until recently–mostly slow and predictable inflation. There are currencies in the world that are even more solid than the dollar, such as the Swiss franc, but there aren’t a lot of Swiss francs out there, Switzerland being a small country with a sub-$1 trillion economy. (Amazon and CVS combined have annual revenues about equal to Swiss GDP.) In reality, there aren’t very many currencies out there that are big enough and stable enough to do what the dollar does—the euro is the closest real competitor. 

What “settlement currency” means is that a great many transnational contracts are negotiated in dollars and paid in dollars. So if you are a gasoline importer in Mexico (despite being a big oil producer, Mexico is the world’s largest importer of gasoline), you probably are going to have to pay for that gasoline in dollars rather than in pesos. That’s because people are interested in holding dollars or investing in dollar-denominated assets, and they don’t want to take on the hassle and expense of converting pesos into dollars. There is also risk in accepting second- or third-tier currencies: Everybody knows what a peso is worth today, but there are historical reasons to be at least a little skeptical that a peso will be worth what we might expect it to be worth six months from now. (That is “currency risk” or “foreign-exchange risk.”) A sum of pesos worth $1 billion today might be worth only $700 million in a year–or a month. Nobody is signing $1 billion contracts payable five years down the road in Argentine pesos or Zimbabwean dollars. 

You may also have heard of something called the “quantity theory of money,” an idea associated with Milton Friedman but dating back as far as Copernicus. Simplifying for my fellow English majors, what QTM basically says is that the usual laws of supply and demand apply to money just as they apply to any other good. (There are some complications here, including monetary “velocity” and “sticky” prices, but we don’t need those for this discussion.) If you have an economy in which the quantity of money is growing more quickly than is the production of goods and services, then there will be more money relative to goods and services, which should cause the value of that money to decline, either in absolute terms or relative to what it would have been without the growth in the money supply. (Strictly speaking, that excess growth in the money supply is what “inflation” actually is; rising prices are an effect of inflation, not inflation itself.) And what QTM predicts is roughly what we typically see in most cases with most currencies. 

But the U.S. dollar is different. Markets are shaped by both supply and demand. There is very little demand for Mexican pesos outside of the Mexican economy itself. But there is tremendous demand for dollars outside of the U.S. economy. When Chinese oil importers pay Saudi exporters, they use dollars, which creates demand for the U.S. currency that is exogenous to the U.S. economy itself. In the simplest terms, that allows Washington to borrow more money without dire consequences for the dollar than otherwise would be the case. (For our purposes here, government borrowing in the bond markets and creating new money are economically pretty much the same thing.) For years, Washington has been able to issue bonds at relatively low interest rates simply because there is so much worldwide demand for them. 

The unique position of the dollar gives the United States some economic benefits, but it also confers certain political powers on Washington. U.S. economic sanctions matter in a way that Indian economic sanctions do not because, even though India is the world’s sixth-largest economy, getting cut off from the dollar is a much more serious thing for most firms and institutions than getting cut off from the rupee. For reasons that are easy to understand, would-be U.S. rivals—including China and its very junior partner, Russia—would prefer that the United States not occupy that position of economic and political power. 

But it isn’t just the Evil League of Evil that is interested in what is sometimes called “de-dollarization,” a term that, unfortunately, exaggerates what it is we are really talking about. Most notably, President Emmanuel Macron of France has called for the European Union to resist the “extraterritoriality of the U.S. dollar,” the power of which threatens to make “vassals” of European countries. Macron talks in terms of “strategic autonomy,” an inescapable bit of voguish Brussels-speak that indicates the European Union’s desire to have the political will and the practical resources to see to its own interests with or without U.S. support and cooperation. The European Union in general has come to see the United States as a troublesome and unreliable ally—not without good reason—and France in particular is bitter at its repeated mistreatment by the Biden administration, which has been positively contemptuous of America’s oldest ally. That contempt has been notable in the matter of AUKUS, the new U.S.-UK-Australian trilateral security pact that was sprung on our European allies with immediate and unwelcome economic consequences for France. (France lost a lucrative contract to build nuclear submarines for the Australians; a subsequent arrangement, recently announced, brought France back into the deal in a reduced position.) But the Biden administration also ignored European concerns in the Afghanistan withdrawal, a major military move undertaken with almost no consultation with European allies that have been directly involved in that campaign. “Buy American” provisions in the grievously misnamed Inflation Reduction Act have further aggravated our European allies. When Macron insists that Europe must “avoid the trap, to be caught in the crises which are not ours”—which is to say: Good luck with Taiwan, President Biden—that is the context. 

Macron envisions the European Union as a third superpower in a world otherwise dominated by the U.S.-China rivalry. But in a dollar-dominated world, the European Union—which does not have the capacity to compete militarily with the United States and is unlikely to develop such a capacity—will find it difficult to stand as an equal to the United States. But while the Chinese renminbi is for many reasons unlikely to replace the dollar on the world economic scene, the euro is nicely positioned to play a much larger role. The United States remains significantly wealthier than the European Union (U.S. GDP per capita is about 50 percent higher than that of the European Union), but with a $17 trillion total economy, a desirable currency, sophisticated export powers such as Germany, and a high and rising standard of living, the European Union is well positioned to play a larger role in global affairs, if not quite ready to operate at the level of the United States. 

There is a lot of Chicken Little talk about de-dollarization. And there are good reasons to be skeptical of the apocalyptic talk. For one thing, de-dollarization, if it happens, will be a process, not an event, and if a few central banks reshuffle their currency reserves or a few more international contracts are made payable in yen or euros, that is not the end of the world. (Please keep in mind that your favorite talk-radio host makes a considerable part of his living selling freeze-dried apocalypse lasagna and other end-of-days goods.) That kind of development might even be a good thing in the long term for the United States if it nudges Washington out of its habitual complacency. Beyond that, the world already has very accessible and efficient foreign-exchange markets, which means that there is nobody holding dollars today who doesn’t want to be holding dollars. The words “reserve currency” do not create some kind of magical condition that obliges Beijing to hold a lot of dollars—the terminology is derived from the facts on the ground, not the other way around. Opinions can change quickly, and economic stampedes are a real thing, but the reason the world wants dollars is because the world wants dollars, and that is not very likely to change overnight. The world economy is a complicated and complex interrelated system. For example: Do you know which U.S. firm is the nation’s largest automobile exporter? It is a South Carolina-based firm called BMW. The guys in Spartanburg are not going to start getting paid in renminbi or euros or even good ol’ Swiss francs. 

And Beijing is not very likely to crater its own balance sheet in a fit of pique, launching an attack on the very dollars it holds. It is not as though Beijing can unwind its dollar position all at once without anybody’s noticing. The people who run China are cruel and vicious, but they are not, generally speaking, stupid. Yes, they hate us, just as Luo said, but they would hate being broke a lot more. If there is a very bad recession in the United States, Joe Biden gets sent back to Delaware; if there is a very bad recession in China, Xi Jinping gets eaten. 

But if Washington wants to preserve the benefits associated with the dollar’s current enviable position, then it is going to have to enjoy those benefits a little bit less for a while, getting borrowing and spending under control and putting the federal government on a more sustainable fiscal basis. That means entitlement reform, limits on discretionary spending, and rationalization of the tax system. These are things you want to do before you are in a fiscal crisis rather than in the midst of one. The United States remains in a strong economic position, with lots of options and lots of resources to throw at our long-term fiscal problems. But that position will not last forever if we remain on our current course. It may not be suddenly evaporated, but it will be steadily eroded.