The dollar gives the Treasury extraordinary power over global finance. It should not be used lightly
WHAT is America’s greatest source of power? Its military might is unparalleled. Its market is vast. Alongside these assets stands the dollar. The world depends on America’s currency, and hence on access to dollar payments systems and the banks America has effective control over. Greenbacks fuel trade everywhere. On average, countries’ dollar imports are worth five times what they buy from America. More than half of all global cross-border debt is dollar-denominated. Dollars make up nearly two-thirds of central-bank reserves. That gives the Treasury a veto over much of global commerce.
Most presidents have used the dollar-weapon sparingly. In recent weeks the Trump administration has imposed tough financial sanctions against Russia. Having withdrawn from the nuclear deal, America is acting against Iran and European firms that trade with it. In 2017 the administration’s “blacklist” gained roughly 1,000 new entries, almost 30% more than Barack Obama added in his last year.
There are times when it is wholly appropriate for America to use its clout. But the country risks choosing quick wins regardless of the long-term and less visible costs. Using the dollar as a bludgeon has already led to capricious and arbitrary decision-making. It also risks destabilising global finance. Eventually, it may hasten the demise of the dominant dollar.
Start with unpredictable decision-making. America’s financial power is so great that its application is hard to calibrate. After the Treasury sharpened sanctions against Russia in April, Rusal, a large aluminium producer, was frozen out of financial markets even though it does little of its business in America. Its shares fell by more than half. Perhaps awed by its own might, America backtracked, offering the firm a partial reprieve.
Calibration problems are exacerbated by inconsistency. In April the Commerce Department banned American firms from doing business with ZTE, a Chinese telecoms giant which violated sanctions against Iran and North Korea. The firm immediately foundered. President Donald Trump now seems to want to trade ZTE’s survival as part of a larger trade deal with China. As a result the administration is sending contradictory messages: first that Iran is beyond the pale, and second that sanctions violations involving it may be negotiable. As the number of sanctions multiplies, so will the exemptions, contradictions and unintended consequences. If that happens, sanctions’ effectiveness will fall accordingly.
Abrupt shifts in policy cause uncertainty for companies and risk financial turmoil (see article). That is because the corollary of dollar dominance is dollar dependence. At the end of 2007 the financial crisis went global when large European banks ran short of currency with which to service their dollar debts. The Federal Reserve stepped in to provide foreign central banks with liquidity. Since the crisis the offshore dollar financial system has grown, especially in Asia. A clumsily antagonistic move, such as cutting off a big Chinese bank—a move which some American officials may have contemplated—could create havoc. This time, though, it would be harder for the Fed to fight the fire, because the system is bigger and more dispersed. Even large non-financial firms could destabilise offshore finance if they defaulted on dollar debt.
One reserve, no substitute
Just as serious are the long-term risks for America. There is no obvious substitute for the dollar (see Free exchange). The euro zone has yet to recover from its crisis. China does not have a stable banking system or an open capital account. Only America can provide the safe, global asset needed to keep trade and finance flowing. But the dollar is unlikely to dominate for ever. As America’s share of world output shrinks, a shift to a mix of reserve currencies is, eventually, probable.
How orderly that transition is will depend in part on how America is perceived by its allies as well as its adversaries. European countries wish to continue honouring the Iran nuclear deal, for example, from which Mr Trump unilaterally withdrew earlier this month. But faced with the threat of being cut off from American markets and banks, European firms probably have little choice but to follow America’s lead.
That will surely be chalked up as a win by the White House. But it carries long-run costs. The dollar reigns supreme in part because foreigners trust American institutions and because its friends think that their interests coincide with America’s. If alliances become chiefly transactional, efforts by others to wean themselves off the dollar will intensify—and inevitably spill over into military and intelligence relationships. For there is another answer to the question of what gives America power: its commitment to a rules-based system.