The US dollar’s supremacy in international finance is an important factor in the Trump administration’s ability to pursue its highly divisive policies with impunity. But some have questioned whether these same policies will have the reverse effect of ending dollar supremacy.
Commentators, including Eswar Prasad and Edward Luce, have raised this possibility on the grounds that the dollar’s international position ultimately depends on foreign trust in the US, and that the Trump administration is seriously eroding that trust. The second part of this argument is surely right. But the first part is just as surely not.
The US dollar’s enduring strength is fundamental to why President Donald Trump is able to make some of the decisions he does. Its importance in the global economy is also why the US will be in a strong position whatever policy he introduces. Many fail to recognise this when critiquing the US president’s actions.
All understanding of what currently underpins dollar supremacy comes down to an understanding of bonds. As I outline in my new book, Commodity: The Global Commodity System in the 21st Century, bonds and equities are now not only different types of funding instruments but also different types of commodities. And they are valuable to the world’s large investors as assets that maintain their value. Once this is taken into account, it is possible to understand why the size of US capital markets will long continue to bind foreign investors to the dollar – because it will be some time before other capital markets will reach a comparable size.
The US is the world’s leading supplier of these securities, accounting for 43% of the US$92 trillion global bond volumes outstanding at the end of 2016. No other country comes close. Indeed, the gap is still substantial even when countries are grouped together into geographical regions or status categories. Thus the EU 28 countries could only account for 27% of global bond volumes in 2016 while all of the emerging market economies, China included, accounted for a mere 12%.
If bonds are only viewed as forms of debt, then the US’ disproportionate share of global bond supplies, taken in conjunction with its declining percentage share of world GDP and its persistent trade deficits, would seem to put the dollar’s supremacy at risk. This is because of the ability of investors to pull out of US bonds if they have fears of US solvency.
In today’s world economy, however, bonds also serve as an asset that can be invested in – they have a value storage function. Equities also have such a function, but bonds are safer in that they pay interest by law, while equities pay dividends on discretion. And government bonds are, on average, safer still in that the interests on them come out of taxes that vary less considerably over the business cycle than corporate profits.
This means that, while any one group of foreign investors may decide to pull out of US bonds for whatever reason, it is unlikely that all foreign investors will make this decision. This is simply because there are not enough alternative quantities of bonds where they can store their money.
This situation is not likely to change soon. There are two fundamental criteria that determine the extent to which a country can generate and maintain securities stocks. First, a large production base that ensures the ability of its borrowing organisations to return cash to investors. Second, a strong governance infrastructure that ensures the consistency with which cash is returned.
Judged against these criteria, the US is in a class of its own. Some countries have a large production base but weak governance institutions (such as China) and others have strong governance institutions but a small production base (such as the UK). Only the US meets both criteria in a way that allows it to carry the major burden of satisfying the global demand for bonds as safe assets.
The world’s investors may want the rule of law, stability and US global leadership – something the Trump presidency may seem to threaten. But they also want safe assets in the quantities that only the US can supply.
The launch of the euro in 1999 raised expectations that the eurozone would present real competition in safe asset supply, but these expectations have not been realised. Nor are they likely to be as long as many of Germany’s leading politicians and economists continue to treat government bonds as the archetypal debt instruments rather than safe assets too.
The situation looks even worse from a wider EU perspective in that the combined percentage contribution of the EU member states to global bond volumes is actually declining: from 35% in 2007, it had fallen to 27% in 2016, and it will fall even further following Brexit, given the UK’s substantive contribution to EU bond supplies.
This state of affairs is deeply worrying because it places the EU in a vulnerable position at a time when trade frictions between the US and its erstwhile allies, including the EU, are escalating.
The crux of the matter is that the large size asymmetry separating the US bond markets from the EU markets translates into an equally large size asymmetry in foreign currency needs. EU financial institutions are now far more heavily dependent on dollars to manage their US investments than are US institutions dependent on euros or British pounds to manage their EU investments.
For the time being, this asymmetry continues to be accommodated by the US Federal Reserve in its currency swap arrangements with the European Central Bank, the Bank of England and other European central banks. But what if this accommodation is terminated, or at the very least severely reduced? The Federal Reserve may have formal independence from political control, but if the trade war continues to intensify will Donald Trump be restrained by such a formality? There are serious grounds for believing the answer to be no.
Unpalatable as it is, the reality is that dollar supremacy is here to stay. It will not last forever because nothing lasts forever. But it will certainly outlast Trump’s presidency, even if this should run to a second term.