When Trish Regan asks me a question, it makes me think. This morning’s question was no exception. She asked if I had seen Ray Dalio’s comments on the possible demise of the reserve status of the U.S. Dollar and did I have any thoughts on the matter? (Trish for her part believes there’s really no other game in town…and thus, we shouldn’t fear a declining dollar.) As I thought about it…I decided to approach her question from the standpoint of whether, at present, there are any viable alternatives waiting in the wings.
Let me first say, given Mr. Dalio’s rather impressive track record, his investing advice is usually worth taking. He has been concerned about the US Dollar for quite some time…and he raises some very real issues; he suggests that fiscal spending and monetary injections are debasing the currency perhaps past the point of no return. He points out “[t]here is so much debt production and debt monetization.” And, to be honest, I have also worried about the consequences of such behavior, particularly vis-à-vis our government’s reckless spending, for a long time. Having said that, the question is whether fiscal spending and indebtedness, particularly relative to GDP, is sufficient to remove the U.S. currency from its exalted position.
The U.S. Dollar’s “Magic Potion”
First, I asked myself what goes into the magic potion that makes the Dollar so special. I came up with a lot of really good reasons, so many that I am not sure I can even rank them. There is certainly the primacy of the American economic system including its overall size, the size and depth of its capital markets, its respected central bank (here I tend to have reservations), its remarkable financial institutions, its liquidity, and its place in the global hierarchy. There is also overall solvency, its stable and predictable political and legal systems, and the longstanding position of trust and reliability. And, perhaps, just as important, there is the backing of an amazing military that has helped project, promulgate and protect a stable and relatively peaceful world for nearly a century.
And, by the way, just because there is a lot of outstanding debt issued by the American treasury, it is not necessarily a negative. In many cases, size, liquidity, and presence go hand in hand. A significant portion of global debt is dollarized because capital and trade are conducted in dollars, investment is driven by dollars and hedging and other features of liquidity are easiest done in dollars too. Having plenty of the US currency and treasuries floating around is actually part of the process. Only if the negatives begin to outweigh the positives will the dollar really be at risk of being cut adrift?
Now, as I pointed out above, there is a flip side to the question. Even if the United States is doing things that put the dollar’s status at risk, the process of losing that status is somewhat dependent on an alternative. Not that the dollar can’t find its own level of isolated mediocrity, but the positives will make that shift, slower and more difficult. So, let’s consider the alternatives.
The Euro Will Not Replace the Dollar… Unless?
Many people point to the Euro as the logical successor. The EU economy is actually larger in size than the American; it has depth and breadth; it has evolved financial and legal systems; the ECB is an independent central bank with real power, and the currency and debt markets are deep and liquid. It is also a major participant in global trade.
Nevertheless, there are real structural issues with the Union starting with the fact that it is a union of sovereigns as opposed to a sovereign union. The withdrawal of the UK highlights this point. By the way, in this regard most market participants have sought a fiscal union; I think that is insufficient. In my view, only a singular sovereign entity will allow the EU to realize its full potential. The American colonies learned long ago that the Articles of Confederation, essentially the European model, had structural flaws. The competing interests of the various states, and requirements of unanimity have served as real impediments to the EU challenging the US for currency supremacy. (It reminds me of the cooking show Iron Chef, “who will reign supreme?”)
China Seeks Status As World’s Dominant Currency
If not the Euro, the only other alternative is the Chinese Yuan. In fact, if China met many of the criteria I outlined above, the Yuan could well give the US Dollar a run for its’ money over time. China, however, comes up short in many of the ingredients that I list above. Their legal system is arcane, unpredictable, and often, a tool of the government. The Chinese political model lacks many individual freedoms deemed essential by other countries. The economic system is domestically biased and participation by foreign entities comes with real risk and cost. The Trump Administration has elevated concerns like theft of intellectual property and staggering trade surpluses to the priority they should have been accorded long ago. In fact, if the US dollar has suffered some reputational risk, Chinese policy bias may have played a role. Such behavior lowers the level of trust that is a prerequisite to achieving reserve status.
There are other issues. The banking system is still developing and has a staggering problem with bad debts. The Central Bank is not considered to have the same level of credibility as other major central banks like the Fed, the ECB, or the BOE. And the Chinese military has taken an aggressive posture with respect to its’ neighbors that makes other countries uncomfortable and causes them to worry about a reserve Yuan being used as a tool of global conflict.
With all of that being said, the American government has certainly done damage to the Dollar over time, and the trend may not be easy to reverse. However, I do not see any real pretenders to the throne which should serve to insulate the Dollar for the time being. The ingredients of a reserve currency I list above still remain, and I think it is important to keep pay attention. Even if there is not another currency waiting in the wings, slow and steady erosion of the Dollar will not be good for this country in the long run. Growing reliance on fiscal spending and exponential increases in government debt is not a good thing. In that regard, I am in full agreement with Mr. Dalio. Something else that is NOT good is the reliance on the Federal Reserve to artificially suppress interest rates and inflate asset prices. From that perspective, in fact, I believe the Fed is doing significant damage to the long-term strength of the economy and, as a consequence, to the position of the Dollar. As I frequently point out, the Fed is the enemy of the rational.
But, in answer to Trish’s theoretical question on whether the dollar could be replaced in the near future; she and I agree. The dollar is still the prettiest girl at the dance.