America First, Dollar Last
Since the start of this year, the US dollar has dropped by 10% against the euro; 9% against the British pound, and 6% against the yen. It has fared even worse against gold (-52%) and virtual currencies such as bitcoin (-30%). This weakness cannot be blamed on the surprise hike in import tariffs, which textbooks predict should strengthen the dollar. Rather, this article argues that the dollar’s slide results from an erosion of its role as the world’s reserve currency. Specifically, markets fear that a Trump-controlled Federal Reserve would no longer act as a reliable lender-of-last-resort.
To analyse this fear, I consider two competing theories on the ontology of money, but applied at the global level (ontology is the study of what exists). The standard view of money goes at least as far back as ancient Greece, but there is a more recent alternative, the so-called ‘credit theory’ of money.
The Crowning of ‘King’ Dollar
Non-Americans have conducted the majority of their cross-border transactions in US dollars ever since the 1920s, when it knocked the pound Sterling off its top spot, and the world economy today remains highly dollarized. More than half of global exports are paid for in US dollars, and two-thirds of central bank foreign reserves are held in dollar-denominated assets. In just two decades, ‘offshore’ dollar deposits held at non-US banks have trebled in value to twelve trillion (recall that modern money is defined as bank deposits plus currency).
To explain this pre-eminence we must ask; what is the nature of money? The ancient Greek philosopher Aristotle explained the existence of money in terms of the fulfilment of three roles or functions: a ‘means of exchange’ and a ‘both a measure and as store of value’. This approach, termed the ‘commodity’ theory of money, has dominated ever since, whether applied to Greek silver tetra drachmas, Italian gold florins, or the cowry shells used from Africa to East Asia for thousands of years. Throughout history, myriad objects have functioned as money simply because different peoples shared a belief that they would fulfil Aristotle’s three roles. Even in our age of electronic money, international finance is conducted only in those currencies that, it is believed, meet these standards, requiring a level of trust that transcends national borders and bridges yawning cultural chasms.
Keynes’s ‘Babylonian Madness’
The ‘commodity’ theory went unchallenged until an article appeared in 1913. It was written by a British diplomat, Alexander Mitchell Innes, in between postings from Egypt to Siam. Innes proposed that money should best be understood as circulating credit. In other words, it comes into existence as a transferable record of obligations. This ontological argument also has a strong empirical basis, as a loan can directly function as money when used to pay off another loan; for example, states regularly issue new bonds to pay existing debts. Indeed, modern money is brought into existence by credit, because when a bank makes a loan, it simultaneously creates a deposit on the liabilities side of its balance sheet. Even banknotes have a credit counterpart, and until 1963 the promise, “Will Pay Bearer on Demand” was inscribed on US dollar bills.
Innes’s theory caused a stir among Keynes and other contemporary economists, who scoured early Mesopotamian records for evidence that credit from the first state also created the first money - an exercise Keynes later dubbed his ‘Babylonian madness’.
Aristotle would probably not have agreed with Innes, as he was rather disdainful about credit. He drew a distinction between money used in economics (from Oikonomou, or household management) and in chrematistics (accumulating money for its own sake). He wrote, ‘currency came into existence merely as a means of exchange; usury tries to make it increase.’ He scorned interest as being ‘bred by money’, and admonished, ‘of all modes of acquisition, usury is the most unnatural’.
Today’s economics textbooks still favour the commodity theory over the credit theory at the national level. However, I argue that the credit theory can be usefully applied at the global level, where different currencies compete. It implies that the US dollar will continue to dominate international transactions only if it remains the first choice of borrowers and lenders. Here lies a problem. The twelve trillion dollars of offshore deposits mentioned previously are ‘backed’ by a similar amount of offshore dollar credit, roughly split between bank loans and tradable bonds; while an even larger volume of currency derivatives rests on top of this edifice. Non-American countries and companies have borrowed enormous sums in US dollars, presuming that in the future they will easily be able to obtain the currency to service this debt. Twice in recent years this presumption has been tested. Global financial markets suffered a severe dollar ‘funding squeeze’ in the financial crisis of 2008, and again during the COVID crisis of 2020. On both occasions, the US Federal Reserve bank provided over half a trillion dollars of emergency funds to nine major foreign central banks, with no strings attached. This liquidity was available to be on-lent to stressed international borrowers including banks. Unfortunately, the belief that in a crisis the Fed will always act impartially as a global ‘lender of last resort’ is now in jeopardy.
‘Lender of Last Resort’ meets ‘The Art of the Deal’
President Trump is explicitly seeking to gain control of the institutionally independent Federal Reserve. He has verbally and legally attacked the members of its governing Board, and will soon nominate the successor to Chair Powell. There is every reason to fear that the Fed will soon become another tool for ‘America First’ policies, for example using the threat of tariffs to extract promises of huge industrial investments from allies, with Japan coerced into investing $550 billion, and the European Union $600 billion. Central banks and international borrowers now worry that a Trump-controlled Fed will use its leverage to demand financial, political or diplomatic concessions as a quid pro quo for emergency liquidity during the next dollar funding squeeze.
With legitimate concerns over the integrity and neutrality of the dollar’s lender of last resort, foreigners will rationally diversify their borrowing into other currencies. Bond issuers may prefer euros, Swiss francs, and yen; and Chinese state banks now conduct all overseas lending in renminbi. Kenya recently accepted an offer to convert its Chinese ‘Belt and Road’ loans from US dollars into renminbi. If Innes was right about the ontology of global money, as the activity of borrowing migrates away from the US dollar, its role as the primary global money will also dwindle. Inevitably, the dollar’s exchange rate against other currencies will also decline. In fact, this is a stated objective of Stephen Miran, the first of Trump’s placemen on the Federal Reserve Board.
A Bang or a Whimper?
In his study of long-term debt cycles, billionaire hedge fund manager Ray Dalio identified an historical sequence of steps in the rise and fall of great powers. In the final stages, over-borrowing tends to be followed by money printing, internal political conflict and costly foreign wars. The loss of reserve currency status arrives almost at the end, partly because monetary customs become ingrained. Over the last twenty years, America’s net international investment position (its external liabilities) has plunged from -20% to -90% of GDP; while the Fed has rolled the printing presses twice. Domestic politics is starkly polarised, while the rising axis of China and Russia threatens US geopolitical hegemony. Still, as Dalio points out, there currently seems to be no obvious alternative reserve currency to the dollar, at least while China retains capital controls. Perhaps, then, the extinction of the dollar as our global money looks likely to be slow and painful - more like the dinosaur than the dodo.