There’s a paradox at the heart of global finance. The U.S. share of the world economy has drifted lower for decades, and now President Trump is retreating from the American chief executive’s traditional role as Leader of the Free World. Yet the U.S. dollar remains, as the saying goes, almighty. “American exceptionalism has never been this stark,” Ruchir Sharma, head of emerging markets and chief global strategist for Morgan Stanley Investment Management, said at a Council on Foreign Relations symposium on Sept. 24.
By the latest tally of the European Central Bank, America’s currency makes up two-thirds of international debt and a like share of global reserve holdings. Oil and gold are priced in dollars, not euros or yen. When Somali pirates hold up ships at sea, it’s dollars they demand. And threats to be cut off from the dollar-based global payments system strike terror into the likes of Iran, North Korea, and Russia. It’s no exaggeration to say that the dollar’s primacy is at least as valuable to the U.S. as a couple of aircraft carrier strike groups.
Now the dollar paradox shows signs of unraveling. Political leaders who once accepted the dollar’s hegemony, grudgingly or otherwise, are pushing back. Jean-Claude Juncker, the president of the European Commission, said in September that it’s “absurd” that European companies buy European planes in the American currency instead of their own. In March, China challenged the dollar’s dominance in the global energy markets with a yuan-denominated crude oil futures contract. Russia slashed its dollar holdings this year, claiming (inaccurately) that the greenback is “becoming a risky instrument in international settlements.” And French Finance Minister Bruno Le Maire told reporters in August that he wants financing instruments that are “totally independent” of the U.S., saying, “I want Europe to be a sovereign continent, not a vassal.”
This disturbance in the force isn’t good news for the U.S. The dollar’s preeminent role in global finance is an “exorbitant privilege,” as Valéry Giscard d’Estaing, then France’s finance minister, said in 1965. If the dollar loses its central role—to be sure, not an imminent threat—the U.S. will be more vulnerable when there’s a loss of investor confidence. The Federal Reserve might even have to do what other nations do when global investors panic: jack up interest rates to painful levels to keep speculative money from flowing out. As it is now, when trouble breaks out, investors flood into U.S. markets seeking refuge, oddly enough even when the U.S. itself is the source of the problem, as it was in last decade’s global financial crisis.
A slippage in the dollar could also be viewed as a symptom of U.S. isolationism. “In a hypothetical scenario where the U.S. withdraws from the world,” damage to the dollar’s standing could cause average U.S. interest rates to rise by 0.8 percentage point, according to a December paper by Barry Eichengreen of the University of California at Berkeley and two researchers from the European Central Bank.
While any serious erosion of the dollar’s status would take years, the U.S. can’t take its preeminence for granted, says Eichengreen: “Being the incumbent international currency is an advantage, but it’s not the only thing that matters.”
The most immediate risk to the dollar is that the U.S. will overplay its hand on financial sanctions, particularly those against Iran and countries that do business with Iran. In May the Trump administration withdrew from the 2015 deal that eased sanctions on Iran in exchange for that country’s promise to stop certain nuclear activities. The U.S. will reimpose sanctions on Nov. 4 and is successfully pressuring companies outside the U.S. not to do business with Tehran. European companies and banks could be punished by the U.S. if they inadvertently transact with sanctioned Iranian groups such as the Islamic Revolutionary Guard Corps.
European leaders, in response to what they perceive as an infringement on their sovereignty, are openly working on a payments system that would enable their companies to do business with Iran without getting snagged by the U.S. Treasury Department and its powerful Office of Foreign Assets Control. One idea is to set up a government-funded organization, which would be less vulnerable to U.S. actions than a private company or bank, to arrange exchanges of Iranian oil for products from Europe and possibly Russia and China as well. French officials say the transactions might be structured as barter to avoid involving banks. “We cannot accept as Europeans that others, even our closest allies and friends, determine who we can do business with,” Federica Mogherini, the European Union’s foreign policy chief, said at the Bloomberg Global Business Forum on Sept. 26.