Jeffrey Cleveland, Chief Economist, Payden & Rygel writes that with topics like “de-dollarisation” gaining mindshare, some investors have expected the dollar to be displaced. But quitting the dollar is difficult. Arguably, the dollar matters more than ever, he says.
Bold forecasts that miss the mark are often quickly forgotten or swept under the rug by misfiring prognosticators.
Two years ago, we heard forecasts of “a 30–40 per cent decline in the U.S. dollar.” But as everyone now knows, the drop in the dollar didn’t happen. Compared to other developed countries’ currencies, such as the Japanese yen, the dollar is up more than 30 per cent since 2022. Further, since 2011, the dollar is up almost 40 per cent compared to a broad basket of currencies!
So why were the dollar bears so wrong? Popular misconceptions about the dollar’s role in the global financial system mislead investors and policymakers alike. These misconceptions never seem to die. We detail our favorite mistakes so that, hopefully, you won’t repeat them.
The result of human action not design
For much of its early history, the United States had nothing like a universal currency The US followed a bimetallic standard (linked to gold and silver), and paper money was shunned. However, the Panic of 1907 prompted Congress to create the Federal Reserve (Fed).
The Fed later issued “Federal Reserve notes,” lent to banks when liquidity dried up, and enforced “par” settlements for checks across the Federal Reserve System.
Then came a series of crises and some luck. The US’s favourable geographic location during the First and Second World Wars (far removed from most battlefields) allowed it to become the “centre of the global financial system.”Owning about 40 per cent of global gold reserves allowed the US to be one of the only countries that did not suspend convertibility throughout the wars.
But wasn’t the dollar system designed by policymakers at Bretton Woods after the Second World War? In reality, delegates ruled out competing plans as infeasible. In short, the dollar was just the best and easiest option.
In addition, the dollar’s reign had already gone global. The Euro-dollar market was born in the 1920s and was revived in the 1950s because London banks started accepting dollar (and other currencies) deposits and making dollar loans to third parties.
Modern-day crises have only further cemented the dollar’s global reign. During the global financial crisis, the Fed lent USD10 trillion in raw swap amounts to its major foreign counterparties, and again during Covid-19—a sign of just how vital the dollar is to the global economy.
The dollar will soon be displaced by a rival
The dollar is the most dominant currency, and its status has waned little in recent decades. According to the international currency index constructed by the Fed, the dollar has remained a steady leader in forex reserves, transaction volume, foreign currency debt issuance, and international banking claims for as long as data is available.
As for second place? It’s not even close. The Euro scores 23 on the index, one-third of the US level, though greater than the sum of the next three currencies combined – Japanese yen (JPY), British pounds (GBP), and Chinese renminbi (RMB).
Further, in 2015 countries with currencies anchored to the dollar (not counting the United States) accounted for 50 per cent of world GDP. In contrast, euro-linked economies accounted for just 5 per cent (not counting the euro area).
The world is de-dollarising.
The latest dollar bear fad is “de-dollarisation.” The argument is that major economies will prefer to use other currencies to avoid the ire of US policymakers keen to “weaponise” the dollar using sanctions.
De-dollarisation is catchy and alliterative. But it’s also wrong.
First sanctions are common and have been used for a long time. As early as 1935, the US-led League of Nations (predecessor to the United Nations) sanctioned Italy for its invasion of Ethiopia, banning loans and military equipment. In modern times, for military purposes, the US has frozen assets tied to the governments of Libya (2011), Iran (2012), Venezuela (2019), and most recently, Russia (2022).
Second, the benefits of “dollarisation” far outweigh the perceived risk reduction from de-dollarisation. Using the dollar allows you to reach 80 per cent of the buyers and sellers in global trade activity and the deepest and most liquid financial markets in the world.
While instituting sanctions dissuades some countries from holding Treasuries as reserves, it’s unlikely the bulk of dollar reserve holders will dump the dollar. In fact, overseas governments with military ties to the US own nearly three-quarters of the total US debt held by foreign governments.
In short, the benefits of operating in dollars far outweigh the costs of de-dollarisation.
Debt overhang will sink the Dollar
Another common misconception is that the dollar is (always) on the brink of collapse due to excessive debt burden. Headlines often tout the “USD27 trillion in marketable debt outstanding.”
From a first approximation, we find this view tedious. For the last 30 years, one could have said the same thing every day of every month in every quarter of every year. So far, the predictive value is nil, for the cumulation of national debt has yet to lead to higher yields or a debt default.
The debt issue is overstated. The average cost (yield) of US debt is only 3.4 per cent as of July 2024, still much lower than most of the country’s recent history, thanks to the dollar’s status as the global reserve currency and decades of price stability since the 1990s. Unless the Fed funds rate stays above 5 per cent for a few more years, we’d argue that the current trajectory of the US debt burden remains manageable.
Dollar doubters beware
Contrary to popular belief, there are no viable rivals to the dollar. De-dollarisation may occur to a limited extent and be led by bad actors in the global financial system. Still, users of the dollar system overwhelmingly benefit from trading, borrowing, and saving in dollars. Further, debt burdens do not yet threaten the dollar system’s stability, with debt service costs manageable and dollar debt buyers more eager than ever to hold greenbacks.
