Trump, humiliation and the future of reserve currencies

A reserve currency is not merely something central banks hold in their vaults. It is also the currency of international trade and its settlement, as well as the main form of international credit. It must be universally accepted, easily traded and based in a powerful politically stable country. At least more so than the alternatives.

Today, the US dollar accounts for around 59% of global foreign exchange reserves, down from 72% in 1999. This is often cited as evidence of decline but such a reading is too simple.

As we show in our work, the US sets about two-thirds of the world’s financial risk appetite. What happens in New York and Washington determines global investment, not Brussels or Beijing.

When macro volatility rises, we flee to the dollar. In crises, the Federal Reserve’s swap lines become a global lifeline as no other central bank can provide crisis liquidity at comparable speed or scale.

Those strengths appear to be eroding. Not only due to the continuing relative decline of the US economy but increasingly because of rapidly rising policy volatility within the US itself.

We might draw comfort from Churchill's quip, “You can always count on Americans to do the right thing — after they’ve tried everything else.” But does that still hold?

Events this week, not the least the US deliberately humiliating the EU in trade negotiations, reinforce the desire for a new reserve currency.

But desire is not destiny.

What would replace the dollar? Not the euro. The eurozone may be economically significant but its fragmented governance and lack of military force hampers the necessary monetary cohesion and trust. The renminbi is constrained by capital controls, shallow financial markets and limited transparency. Cryptocurrencies are too volatile, too limited and without sovereign backing. Stablecoins, by their very definition, are are just a derivative form of the underlying fiat currency, and so cannot be a reserve currency.

If wishes were horses, beggars would ride. A viable alternative must do more than reflect dissatisfaction with the incumbent.

Might we move to many reserve currencies? Not if history is a guide.

While the idea of a multipolar reserve system based on the dollar, euro, renminbi and perhaps even crypto sounds appealing, history and reality get in the way. Network effects have always favoured a single dominant reserve currency. A fragmented system would raise transaction costs, create confusion during crises and amplify exchange rate risks.

For better or worse, the dollar remains the only currency with the necessary scale, depth and crisis infrastructure to serve as a true global reserve.

The real question is not what replaces the dollar but how the world responds when it becomes a little less reliable and where all the resentment finds an outlet.

P.S.
I was reminded of this today when revising the FX slides in my Global Financial Systems master's course.