A perennial issue throughout my career has been how long the dollar can retain its status as the world’s principal currency. There have been numerous occasions when commentators declared an end to the dollar’s dominance only to be proven wrong.
The biggest test occurred in the 1970s when U.S. inflation soared to double digits and the Federal Reserve was behind the curve in raising interest rates. Lack of confidence in the dollar was manifested by efforts of European countries to link their currencies to one another and by the strength of the Japanese yen. The dollar ultimately prevailed when then Fed chair Paul Volcker tightened monetary policy to tackle inflation and restore confidence in the dollar, which he called the single most important price in the economy.
Since then, the dollar’s status has not been threatened for several reasons. First, the Japanese authorities were reluctant to permit the free flow of capital into and out of Japan, and its financial markets were not as deep or broad as the U.S. Second, while Europe succeeded in creating the European Monetary Union and a single currency, problems with countries such as Greece, Italy, Spain and Portugal threatened to break apart the euro-zone. Mario Draghi, the head of the ECB, averted a crisis 10 years ago when he declared he would do “whatever it takes” to save the euro, but it has not tested the dollar since then.
In the meantime, China’s government has sought to bolster the status of its currency, the yuan, in international markets. However, like Japan, it is reluctant to allow capital to flow freely and its financial markets are much less developed than the U.S. Consequently, China has made only limited progress in displacing the dollar. Based on data from SWIFT (Society for Worldwide Interbank Financial Telecommunications) nearly 85 percent of international transactions are settled in dollars versus only 2 percent for the yuan until recently.
Despite this, there is still considerable talk that the dollar’s role is likely to decline, which is being called “de-dollarization.” The main reason is geopolitical. The argument is that as the U.S. government sanctions countries with which it has conflicts, it lessens the appeal of the U.S. as a safe haven.
The most recent example is the sanctions on Russia in the wake of its invasion of Ukraine. During a visit by Xi Jinping to Moscow last month, Vladimir Putin pledged to use China’s currency for “payments between Russia and countries of Asia, Africa and Latin America” in an attempt to displace the dollar. According to press reports, Russia is now using the yuan more than the dollar in transactions and its share of international transactions has doubled to 4 percent.
Beyond this, there is talk that other countries may follow suit. China has pursued agreements with Russia, Iran and countries in Asia to use its currency for cross-border transactions. Last week, Brazilian President Lula da Silva met with Xi Jinping to deepen trade ties with China. In a speech at the New Development Bank in Shanghai, Lula called on developing countries to work towards replacing the dollar with their own currencies in international trade.
This message has been echoed by Jim O’Neill, the former Goldman Sachs economist who launched the “BRICs” acronym (short for Brazil, Russia, India and China). However, in a commentary for Project Syndicate, he acknowledged “until would-be challengers can find a credible alternative to the dollar for their own savings, the greenback’s dominance will not really be in doubt.”
Amid all the angst, what is unusual is that it is happening after a period of exceptional dollar strength. The dollar surged by more than 15 percent on a trade-weighted basis from mid-2021 to the end of last year as the Fed raised interest rates aggressively. Although it has given back some gains this year in anticipation that the Fed is about to pause, it is still very strong. Moreover, even though some regional U.S. banks have experienced deposit flight, the Fed played a key role in supplying dollars to European central banks during Credit Suisse’s funding problems.
So, why are people worrying about the dollar’s status now?
Paul Krugman tells the story about his mentor, Charles Kindleberger, who told his students, “anyone who spends too much time thinking about international money tends to go mad.” His message is that because the role of the dollar sounds important and mysterious, it is a natural subject for conspiracy theorists and catastrophic thinking. Krugman’s take is that the dollar’s role looks secure, with the major caveat that the U.S. government does not wind up defaulting on its debt.
My own take is that the real threat today is not the dollar but fissures in the global trading system. The risk is that it could be splintering into two blocs — the alliance of OECD members and outliers such as Russia, North Korea and Iran. The big unknown is how China will align itself. If it joins the outliers, it would mean a return to the world of the Cold War era, where the Soviet Union formed Comecon to trade with Eastern European satellites. As I have discussed in a previous commentary, this would represent a major setback for the post-war order that contributed to strong global growth.
Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including “Global Shocks: An Investor Guide for Turbulent Markets.”