Goodbye, Mr Greenback?

The key question to ask as one navigates the turbulent sea of global risks is whether we have a reached the turning point at which the dollar begins to lose its status as a reserve or safe-haven currency.

The starting point would be to focus of President Donald Trump’s hard macroeconomic challenges over the next four years. The elephant in the White House’s oval office is clearly the Federal Government’s enormous fiscal deficit (about 7% of its GDP) and the overhang of government debt (estimated at over $36 trillion or 124% of GDP as of December) that seems well-nigh impossible to service.

Viewed through a non-ideological lens, the Trump administration’s seemingly ruthless attempts to shut down long established agencies such as the Department of Education or USAID and reduce government is an attempt at rapid fiscal compression. The increase in tariffs comes from the pages of a long-abandoned playbook of “tax substitution” in which the US effectively taxes other countries to accommodate a gap in its own tax revenues. Finally, by making imports more expensive tariffs would reduce the trade gap.  Since a trade deficit is a drag on aggregate income, reducing it would help US GDP.

The risks to this strategy should be blindingly obvious. For one, it assumes that the US can do all this while the rest of the world stays passive. The sharp retaliation it has triggered from its trading partners has put paid to this assumption. The demand for US products is far from inelastic. When China and the US rattled their tariff sabres during the first Trump presidency, US soyabean farmers lost large fractions of their market share in their biggest buyer, China. 

The tariff argument is curiously self-contradictory. While it discourages American consumers from buying abroad, it assumes that import volumes will remain strong enough to rake in the revenues needed to substitute for domestic taxes. The consensus among fiscal experts is that the recent attempts to reduce the size of government will barely make a dent – deep cuts to military spending is the only way out.

Some economists might point to a deeper problem. The flip-side of a trade deficit is capital inflows. If it buys more than it sells, foreign money flows will have to fill the gap to ensure the “balance” in the balance of payments. The US needs foreign investors to buy its government bonds. Too rapid a compression of the trade deficit would reduce these flows. The result – soaring US interest rates and the possibility of debt default. 

Thus, the conditions for sharp shift away from the dollar in international reserve and safe-haven holdings might be in place. Europe might well be getting its act together. Germany’s decision to exempt defence and infrastructure spending from its fiscal strictures and allocating 500 billion euro for this is a historic move. It might mark the beginning of a pan-European military-industrial complex that could map out a whole new trajectory for growth and the euro. 

After decades, Japan is seeing reflationary pressures and that augurs well for the yen. China seems to have toned down its anti-business stance and is pulling rabbits out of its technology hat, be it in AI or green tech. Thus, safe haven and reserve flows might seek out the euro, yen, yuan and a couple of other like the Swiss franc. 

For long, the status of the US dollar has given the US the “exorbitant privilege” of being unconstrained by its external balances. This meant that the rest of the world was willing to hold the US bonds at much lower yields than it paid on its own bonds resulting in a neat spread on the US’ external investments. 

It also brought the comfort that high trade deficits - that the US has run for over four decades now - would not precipitate a crisis that other economies typically face. If that indeed changes central banks, investors and businesses will have to rework their strategies from the very basics. The demise of the dollar will certainly hurt the US but leave unprecedented turbulence across the global economy in its wake.   

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