An End to the Dollar's Reign?

June 12, 2019


A couple weeks ago, the Wall Street Journal ran an editorial piece titled The Dollar May Be Knocked Off Its Pedestal which discussed, among other things, how the US dollar is losing its preeminent standing in world markets and could one day cease to be the world’s reserve currency. The article's logic followed that, because other major currencies have increased their trading volume relative to the dollar, the dollar will lose out in the coming market cycle as investors look to diversify their currency holdings.


Now the fact that the Editorial Board ran the piece—in the paper edition no less—surprised me a little, as this is a very myopic way of valuing currency strength. But for you contrarians that regularly read The Demand Side and enjoy challenging the consensus view, why shouldn't you question the notion that one day the dollar will meet its demise as the world’s reserve currency? It seems possible.


And most of the time I would encourage such thought; I mean a single currency can’t dominate forever, right? But what is important to note is that while the dollar’s comparative value against other currencies has fluctuated throughout the post war period, it has remained a ubiquitous and persistent force on the global stage. But how? How can a currency lose value yet remain so dominant? The answer is because currency influence extends beyond simple market power. And to fully appreciate the features that affect a currency's international standing, one needs to consider its market, instrumental, and geopolitical influences.


The instrumental approach (as it relates to our currency discussion) posits that public institutions, not market factors, dictate a currency's fate. And in this regard, there is a strong case for continued dollar dominance. Almost two-thirds of the world’s countries either formally or informally peg their currency to the dollar and reap vast benefits for doing so. A good example is Saudi Arabia. Saudi Arabia relies heavily on oil revenues to fund their economic agenda—as do many in the gulf region, but because economic success in this region is often tied to oil prices, they've had a tough time maintaining monetary stability. However, since pegging the riyal to the dollar in 2003, they no longer have to worry that changes in oil prices will impact their monetary credibility. Another is China. Year after year, China strategically undervalues their currency against the dollar as a method  of guaranteeing themselves a steady stream of exports and establishing a GDP floor to work off of. The US knows China is doing this but doesn't care because it guarantees low cost goods for US consumers.


Now I personally believe the instrumental approach provides sufficient evidence for the dollar's continued supremacy, but the geopolitical approach offers a supplement that may be more theoretically grounded. By highlighting the way states use political power to support non-political agendas, the geopolitical argument posits that a country can use its political power to achieve its currency goals since currency strength is merely a byproduct of the state's political standing. Evidence of this can be seen in the US's economic relationships with Japan, South Korea, and other allies that lack military strength. The US provides military support to these nations and in turn expects these states to support the US's economic agenda.


But if you don't think these are valid arguments or are skeptical for other reasons, let me close with four market factors that reinforce the notion that it's unlikely the dollar will falter anytime soon.


1.) All purchases of US Treasuries require US dollars. Any government, business, or individual interested in purchasing treasury bills, notes, and bonds must purchase said securities with US dollars. This means that buyers either hold dollars initially or exchange currency for dollars before bidding in the next Treasury auction. Because of this, and because treasuries are the safest asset on the planet and in near-constant demand, it is not surprising that the dollar makes up around 65% of the world's foreign exchange reserves and is used in almost 90% of all foreign exchange transactions. 


2.) Recessions—even US recessions—increase the demand for dollars. Time and time again, governments and investors seek the stability of the US dollar during recessions as a way to limit downside volatility. Even during recessions where the US is vulnerable, like that of 2008, foreign entities flock to exchanges to convert their currency to dollars. 


3.) Circular causation leads to prolonged currency dominance. What this means is that the more omnipresent a currency, the more inertia it will experience as consumers find benefit in using a currency that is used by others. Because of this, if the dollar were to decline, it would be a gradual decline over many decades like that of the Pound Sterling in the twentieth century.       


4.) There is no alternative. This is what I would consider to be the most robust argument for the dollar’s supremacy. As there is no international reserve currency designated by the G-20, UN, and others, by default, the dollar has taken on this role. And while there was speculation in the mid-2000's that the Euro would supplant the dollar, these claims proved ill-founded as Europe’s perpetual crises underscore the structural deficiencies of having a singular monetary regime without a corresponding fiscal union.   


So while some believe the dollar's end is near, there is simply too much working in its favor to support such a claim.



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