The Demise of Dollar Diplomacy


October 17, 2017

The Demise of Dollar Diplomacy

by Barry Eichengreen*

http://www.project-syndicate.org

Pundits have been saying last rites for the dollar’s global dominance since the 1960s – that is, for more than half a century now. But the pundits may finally be right, because the greenback’s dominance has been sustained by geopolitical alliances that are now fraying badly.

WASHINGTON, DC – Mark Twain never actually said “Reports of my death have been greatly exaggerated.” But the misquote is too delicious to die a natural death of its own. And nowhere is the idea behind it more relevant than in discussions of the dollar’s international role.

Pundits have been saying last rites for the dollar’s global dominance since the 1960s – that is, for more than a half-century now. The point can be shown by occurrences of the phrase “demise of the dollar” in all English-language publications catalogued by Google.

The frequency of such mentions, adjusted for the number of printed pages per year, first jumped in 1969, following the collapse of the London Gold Pool, an arrangement in which eight central banks cooperated to support the dollar’s peg to gold. Use of the phrase soared in the 1970s, following the collapse of the Bretton Woods system, of which the dollar was the linchpin, and in response to the high inflation that accompanied the presidencies of Richard Nixon, Gerald Ford, and Jimmy Carter in the 1970s.

But even that spike was dwarfed by the increase in mentions and corresponding worries about the dollar starting in 2001, reflecting the shock of the terrorist attacks that September, the mushrooming growth of the US trade deficit, and then the global financial crisis of 2008.

Yet through all of this, the dollar’s international role has endured. As my coauthors and I show in a new book, the share of dollars in the foreign-currency reserves held by central banks and governments worldwide hardly budged in the face of these events. The greenback remains the dominant currency traded in foreign-exchange markets. It is still the unit in which petroleum is priced and traded worldwide, Venezuelan leaders’ complaints about the “tyranny of the dollar” notwithstanding.

To the consternation of many currency traders, the value of the dollar fluctuates widely, as its rise, fall, and recovery in the course of the last year have shown. But this does little to erode the attractiveness of the dollar in international markets.

Image result for The Future of the Dollar

America First–Then What is Future of the US Dollar in the Trumpian Era?

Central banks still hold US Treasury bonds because the market for them is the single most liquid financial market in the world. And Treasury bonds are secure: the federal government has not fallen into arrears on its debt since the disastrous War of 1812.

In addition, US diplomatic and military links encourage America’s allies to hold dollars. States with their own nuclear weapons hold fewer dollars than countries that depend on the US for their security needs. Being in a military alliance with a reserve-currency-issuing country boosts the share of the partner’s foreign-exchange reserves held in that currency by roughly 30 percentage points. The evidence thus suggests that the share of reserves held in dollars would fall appreciably in the absence of this effect.

This under-appreciated link between geopolitical alliances and international currency choice reflects a combination of factors. Governments have reason to be confident that the reserve-currency country will make servicing debt held by its allies a high priority. In return, those allies, by holding its liabilities, can help to lower the issuer’s borrowing costs.

Here, then, and not in another imbroglio over the federal debt ceiling this coming December, is where the real threat to the dollar’s international dominance lies. As one anonymous US State Department official put it, President Donald Trump “does not seem to care about alliances and therefore does not care about diplomacy.”

South Korea and Japan are thought to hold about 80% of their international reserves in dollars. One can imagine that the financial behavior of these and other countries would change dramatically, with adverse implications for the dollar’s exchange rate and US borrowing costs, were America’s close military alliances with its allies to fray.

Nor is it hard to imagine how this fraying could come about. President Donald Trump has painted himself into a strategic corner: he needs a concession from North Korea on the nuclear-weapons issue in order to save face with his base, not to mention with the global community. And, for all of Trump’s aggressive rhetoric and posturing, the only feasible way to secure such a concession is through negotiation. Ironically, the most plausible outcome of that process is an inspections regime not unlike the one negotiated by Barack Obama’s administration with Iran.

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Visualizing the Size of the U.S. National Debt

How big is the U.S. National Debt?

The best way to understand these large numbers? We believe it is to represent them visually, by plotting the data with comparable numbers that are easier to grasp.

Today’s data visualization plots the U.S. National Debt against everything from the assets managed by the world’s largest money managers, to the annual value of gold production.

1. The U.S. national debt is larger than the 500 largest public companies in America.
The S&P 500 is a stock market index that tracks the value of the 500 largest U.S. companies by market capitalization. It includes giant companies like Apple, Exxon Mobil, Microsoft, Alphabet, Facebook, Johnson & Johnson, and many others. In summer of 2016, the value of all of these 500 companies together added to $19.1 trillion – just short of the debt total.

2. The U.S. national debt is larger than all assets managed by the world’s top seven money managers.
The world’s largest money managers – companies like Blackrock, Vanguard, or Fidelity – manage trillions of investor assets in stocks, bonds, mutual funds, ETFs, and more. However, if we take the top seven of these companies and add all of their assets under management (AUM) together, it adds up to only $18.9 trillion.

3. The U.S. national debt is 25x larger than all global oil exports in 2015.
Yes, countries such as Saudi Arabia, Kuwait, and Russia make a killing off of selling their oil around the world. However, the numbers behind these exports are paltry in comparison to the debt. For example, you’d need the Saudis to donate the next 146 years of revenue from their oil exports to fully pay down the debt.

4. The U.S. national debt is 155x larger than all gold mined globally in a year.
Gold has symbolized money and wealth for a long time – but even the world’s annual production of roughly 3,000 tonnes (96 million oz) of the yellow metal barely puts a dent in the debt total. At market prices today, you’d need to somehow mine 155 years worth of gold at today’s rate to equal the debt.

5. In fact, the national debt is larger than all of the world’s physical currency, gold, silver, and bitcoin combined.

That’s right, if you rounded up every single dollar, euro, yen, pound, yuan, and any other global physical currency note or coin in existence, it only amounts to a measly $5 trillion. Adding the world’s physical gold ($7.7 trillion), silver ($20 billion), and cryptocurrencies ($11 billion) on top of that, you get to a total of $12.73 trillion. That’s equal to about 65% of the U.S. national debt.

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To get there, Trump’s administration will have to offer something in return. The most obvious bargaining chip that could be offered to make the North Korean regime feel more secure is a reduction in US troop levels on the Korean Peninsula and in Asia in general, With that, the US security guarantee for Asia will weaken, in turn providing China an opportunity to step into the geopolitical breach.

And where China leads geopolitically, its currency, the renminbi, is likely to follow.

*Barry Eichengreen is Professor of Economics at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His latest book is Hall of Mirrors:The Great Depression, the Great Recession, and the Uses – and Misuses – of History.

2 thoughts on “The Demise of Dollar Diplomacy

  1. LaMoy and CLF,

    Trump is in dreamland. He needs friends and alliances and that is where diplomacy kicks in. America first policy is not good for the US Dollar since it can antagonize holders of US dollar bonds and reserves like China. America’s debt is rising rapidly and other nations are held at ransom. So if America catches a cold, the rest of the world is down with a flu. Najib thinks Malaysia is America and so he can do as he pleases by running our national debt sky high. –Din Merican

  2. Din:

    Remember the words of Nixon-era US Treasury Secretary John Connally: “The dollar is our currency, but it’s your problem”? These words today are developing new resonance for Asian central bankers.

    During the past couple of years it’s been difficult to pick up a newspaper without glimpsing a headline decrying China’s unfair competition, denouncing the undervalued renminbi and thus emboldening yet another expedition of politicians flying to Beijing for a photo op and some great food. Further, many market pundits have argued that, given America’s economic woes and multiple imbalances, a dramatic decline of the US dollar is once again nigh – especially so against the renminbi, as well as the yen and other Asian currencies.

    Currently, the US and several mercantilist Asian countries, which closely manage their currencies against the greenback, with the Asian current account surpluses recycled to provide cheap financing for the structural US current account deficit. A succinct interpretation is provided by Paul Krugman: “Americans make a living selling each other houses, paid for with money borrowed from the Chinese.” Given its fundamental flaws, the collapse of Bretton Woods II is inevitable and will certainly lead to a dramatic decline in the USD.

    The USD is basically a petrodollar. So the issue is – with the decline of oil, will USD also decline? Recent developments in technology and geopolitics have already ignited a process to bring an end to the financial system predicated on petrodollars, which will have a profound impact on global financial markets. Technology is affecting the energy markets dramatically, and this impact is growing exponentially. In the transportation sector, the global penetration of electric vehicles, or EVs, should lead to an automobile market that primarily consists of EVs soon, reducing gasoline demand and international oil revenue to a degree that today would seem unfathomable to the linear-thinking mind.

    Yes, the world is changing – rapidly. Alternative energy sources – solar power, wind, and such – also are well into their exponential growth curves, and are even ahead of EVs in this regard. Based on growth curves of other recent technologies, and due to similar growth rates in battery technology and pricing, it’s likely that solar power will supplant petroleum in a vast portion of non-transportation sectors in about a decade. This is real change. The growth of US oil production due to new technologies such as hydraulic fracturing and horizontal drilling has both reduced the US need for foreign sources of oil and led to lower global oil prices. With the US economy more self-reliant for its oil consumption, reduced purchases of foreign oil have led to a drop in the revenues of oil-producing nations and by extension, lower international demand for Treasuries and US dollars.

    Another major secular change that’s under way in the oil market comes from the geopolitical arena. China, now the world’s largest importer of oil, is no longer comfortable purchasing oil in a currency over which it’s no control, and has taken steps that allow it to circumvent the use of the USD. As an example of China’s newfound power to influence oil exporters, China has agreed with Russia to purchase Russian oil and natural gas in yuan; China has persuaded Angola (the world’s second-largest oil exporter to China) to accept the yuan as legal tender; and very recently Venezuela has agreed to sell oil to China in yuan. This is evidence of efforts made by Beijing to speed up internationalization of the yuan. The incredible growth rates of the Chinese economy and its thirst for oil have endowed it with tremendous negotiating strength that’s led, and will lead, other countries to cater to China’s needs at the expense of their historical client – the US. China is set to launch an oil exchange by the end of the year that’s to be settled in yuan. Note that in conjunction with the existing Shanghai Gold Exchange, also denominated in yuan, any country will now be able to trade and hedge oil, circumventing USD transactions, with the flexibility to take payment in yuan or gold, or exchange gold into any global currency.

    As China further forges relationships through its BRI, it’ll surely pull other exporters into its orbit to secure a reliable flow of supplies from multiple sources, while pressuring the terms of the trade to exclude the USD. The world’s second-largest oil exporter, Russia, is currently under sanctions imposed by the US and European Union, and has made clear moves toward circumventing the dollar in oil and international trade. In addition to agreeing to sell oil and natural gas to China in exchange for yuan, Russia recently announced that all financial transactions conducted in Russian seaports will now be made in rubles, replacing dollars. There’s a concerted effort from the East to reset the economic world order.

    All of these developments leave global financial markets vulnerable to a paradigm shift that has recently begun. I’ve absolutely no idea if anyone in the Trump administration saw this paradigm shift coming. I’m totally in the dark what the Federal Reserve is going to do about it. But one thing I’m sure of – you’ll never see a greenback with Trump’s head on it.

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