The US dollar is different to every other currency. The dollar is the global reserve asset, and its dominant status means dollar strength has important global spillovers. Paul and Luke discuss why the dollar has been appreciating recently, why this matters, how the dollar became so important, the benefits and drawbacks this brings to the US, and why a potential second Trump presidency could drop the US’s long-standing commitment to a strong dollar.  
Paul Diggle
Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle. 

Luke Bartholomew
And I'm Luke Bartholomew.

Paul Diggle
And this week we are talking about the US dollar; we're going to ask why the dollar has been appreciating recently. Why moves in the dollar are unlike moves in any other currency, how the dollar  came to have a dominant role in the global financial system, and how the US’s approach to the dollar could potentially change under a second Trump presidency. So there's lots to discuss, let's get straight into it. The dollar is pretty strong at the moment, the so-called DXY measure of the dollar, which is a cross against a basket of other major currencies, has appreciated by about 5% since the start of the year. Against the Japanese yen in particular, the dollar is up more like 10% this year. And various models which draw on ideas of an equilibrium exchange rate of fair value for the dollar seemed to point to a degree of modest overvaluation. So why is the dollar strong? Well, it largely comes down to interest rate differentials versus the rest of the world. The Fed funds rate is five and a quarter to five and a half percent at the moment. It's higher than policy rates in the UK, Europe and Japan. Market rates such as 10-year treasury yields are higher in the US, four and a half percent in the US versus 4.2%. In the UK, two and a half percent in Germany around 1% in Japan. And rate differentials matter for currencies because they make returns on capital in the dollar higher than elsewhere. That tends to attract capital inflows into the US away from other currencies and that means higher demand for dollars and therefore pushes up the price of the dollar - i.e. the dollar appreciates and rate differentials in turn reflect differences about the economy, the strength of US growth, higher, more persistent inflation in the US as well. And these differences, this divergence, in the economic outlook therefore affecting the exchange rate apply none more so than versus Japan, where the policy rate is barely positive 10-year bond yields are as I’ve said about 1%, and the speed of yen depreciation against the dollar has prompted the Ministry of Finance in Japan to intervene to stem the pace of yen depreciation. The Bank of Japan has also spoken about the possible need for further interest rate hikes to close some of the interest rate differential. 

Luke Bartholomew
And the key point is that the dollar isn't like other currencies.  Its relative strength against the rest of the world has important implications impacting global growth, inflation, and trade. And the reason for that goes beyond the simple fact that the US economy is huge and so movements in the currency of a huge economy are bound to have implications but because the dollar is in quite a precise way, the dominant currency in the global system and that gives its movements, the dollar itself, heft beyond that which will follow from the size of the US economy alone. And that dominance shows up in several important ways. So first, a large portion of global trade is invoiced in dollars, including in trade relationships, where both trade partners are third parties vis-a-vis the dollar. Key commodities, so think of oil and food in particular, are priced and settled in dollars. And many places and entities outside the US, especially in the emerging world but also elsewhere, have large stocks of debt denominated in dollars. This is both governments’ so called ‘original sin’, which has been implicated in previous financial crises but also corporates as well that borrow in dollars. And these various uses mean that an appreciation in the dollar is effectively a tightening in global financial conditions. And the reason for that is, well, first, a stronger dollar means that more of a domestic currency needs to be given up to pay for the import of goods and services that are priced in dollars. So again, think particularly about oil and food, they're becoming more expensive. And then second, and relatedly, more domestic currency also needs to be given up to service the debt payments of that debt, which is dollar denominated. So that's effectively like interest rates have increased on that dollar borrowing.

And then finally, many central banks have to set their own monetary policy with this dollar dominance in mind. And so, what they end up doing is setting policy tighter than they otherwise might do so on the basis of domestic conditions, to try and keep their currency stronger. And that in turn further tightens financial conditions. So, all in a stronger dollar tends to push down on global growth and in limit can cause crisis as firms and governments struggle to get hold of and so end up defaulting on this dollar debt.

Paul Diggle
Yeah, I think it really can't be understated Luke quite how dominant a currency the US dollar is. I mean, the dollars share in global trade, in finance, far exceeds the US’s share of global GDP or trade or banking activity. For example, the US is something like 15% plus of global GDP depending on exactly how you measure it. But the dollar is 60% of global currency reserves, it's 50% of cross-border bank loans, it's 45% of over-the-counter FX transactions. And while the US is on one side or the other about 10% of global trade, the dollar is used in something like 40% of global trade transaction. So a lot of countries are buying or selling imports/exports to one another in dollars, and the US is not a party to those transactions. So how did the dollar get to this position of such dominance? Well, it's partly an historical story that you could trace back to at least, the Bretton Woods Conference in the final years and of the Second World War, which placed the dollar at the centre of the post war monetary order. The dollar was convertible to gold and other currencies were in turn pegged to the dollar. So, the hierarchy was pretty clear. But of course, dollar dominance survived the collapse of Bretton Woods in the 70s. And partly that is a story of the size of the US economy, its global superpower status, but it's also I think, Luke a lot down to network effects and path dependency - the fact that dollar markets are deep and liquid, that the US has an open capital account. Contrast that to countries such as China, where there's less flow of dollars into international markets, and at least on some tellings, the US’s institutions, its institutional and political stability, its rule of law, are also important in the dollar being the global reserve asset. 

Luke Bartholomew
And perhaps institution that's most important, there is the Fed, the US Federal Reserve itself, which has proved itself willing to effectively be the lender of last resort, the backstop to this global dollar system. It’s a global dollar system, it's worth saying, that didn't entirely develop under its supervision. There's a sense in which some of this is an offshoot of private sector actors, in particular, the Eurodollar market and the way in which this became a key part of various banking relationships. But nonetheless, the Fed proved itself willing to be a backstop to this system, most notably in the swap lines that extended during the global financial crisis and again, following the COVID pandemic, as well. And there's a sense in which acting as this lender of last resort also is a form of path dependency, in a sense that by proving yourself willing to support this system, in moments of crisis, it reinforces private sector actors’ willingness to engage in the system, and in a sense they sort of end up doubling down on this system, because they know the Fed is there to support it.

Paul Diggle
A financial system woven in dollars and the Federal Reserve willing to be the backstop the lender of last resort,that system has given the dollar a dominant status in the global economy. And that brings certain benefits to the US. Economists talk of so-called ‘exorbitant privilege’. It’s a term coined by French president Valery Giscard D’Estaing in the 1960s to describe the way in which a dominant dollar effectively prevents the US having balance of payments crises. Unlike other countries, its buying and selling all of its trade in its own currency. It means it can't have the same crises that other currencies, particularly emerging market economies often experience. And more broadly, issuing the global safe asset means that everyone runs towards you in a crisis, even if you are the source of the crisis. So that means that the US benefits from lower interest rates. It has the benefit of inflows into Treasury markets during times of acute stress and crisis even if worries about US debt sustainability or budget spats are the source of those crises. It's a powerful, self-correcting mechanism which we call exorbitant privilege. And moreover, having the dominant currency, being the global reserve asset, is a source of huge political power, both soft power, but also hard economic power. For example, the US can enforce economic sanctions by making it illegal to transact with a sanctioned country or individual using the dollar payment system. Because basically all trade and financial transactions at some point touch the dollar payment system, it's a powerful, although certainly not foolproof, way to enforce the US sanctions. It does it of course in the likes of Iran, North Korea, Russia, Venezuela at the moment, and this ability to use the dollar dominance in sanctions took on a new form following the Russian invasion of Ukraine. With central bank sanctions, the US froze the Russian Central Bank’s dollar assets. The point is that the US can actually weaponize make an economic weapon of dollar dominance. And then the swap lines you were talking about Luke used during the financial crisis in late 2007/8, and again during COVID, in which the Fed becomes a lender of last resort, a supplier of dollar liquidity to other central banks, allowing them in turn to shore up their own financial systems, their own financial sector, which has substantial dollar exposures. Well, that is also a source of political power. The Fed’s willingness to do that has in part cemented the dollar’s role in the global economy. But it only has dollar swap lines with certain central banks. It has standing swap lines with the European Central Bank, the Bank of England, Bank of Japan, the Bank of Canada, the Swiss National Bank, and a large group of central banks have had temporary swap lines during times of crisis. But many other countries’ economy central banks are also outside the system of dollar swap lines. It’s not that the US is explicitly using this for wider geopolitical ends. It's just that the very existence of dollar swap lines is an exercise in profound economic power. 

Luke Bartholomew
And the way that the US Treasury Department, at least for the last 30 years or so, has navigated this world of dollar dominance and continued to buttress its status has been to avoid actively intervening in FX markets and trying to steer the level of the dollar. Perhaps the clearest articulation of this is the so- called Bob Rubin maxim dating back to the mid-1990s (he was the Treasury Secretary under the Clinton presidency), which was effectively saying that, whenever he was asked about the dollar, that a strong dollar is in the US national interest, which was a very boilerplate kind of thing to say that he would repeat in all contexts. And the idea of really was basically to avoid anything that would hint at intervention. And that may be solved some problems politically with financial markets. But it also brought other political problems, perhaps in the medium to long run in the sense that a stronger dollar does have implications for US trade. I mean, it makes the goods that the US exports more expensive, and so a stronger dollar would tend to lead to a larger US trade deficit. And in particular, it would be the manufacturing sector that is probably squeezed the most by a stronger dollar. And so there's a sense in which, you know, the US Treasury Department going around talking about the virtues of a strong dollar sounds a bit tone deaf to those particular industries and interests.

Paul Diggle
Yeah, and US manufacturing employment has been on a downward path as a share of overall US employment for a long time for many different reasons. But one rather important individual Luke, former President Donald Trump sees that decline as in part a dollar story, the dollar may have been too strong, so as to have harmed US manufacturing export competitiveness. And now admittedly, Trump has at times been all over the place on dollar views, looking back over his history of statements, vis-a- vis the dollar, so at times he has stuck to that more traditional strong dollar official view, perhaps for patriotic reasons, even for macho reasons, but most recently, he has, or people around him have been talking about dropping the strong dollar policy. 

Luke Bartholomew
Yeah, that's right. So not only Trump himself who as you say can be a little bit all over the place when it comes to this kind of thing. But the kind of advisors that he is assembling around him who are likely to form the spine of his next cabinet and economic policymakers do seem to have settled on the idea that they would prefer a weak dollar policy. In particular, Robert Lighthizer, who was the trade adviser in the first Trump administration is highly tipped to become Treasury Secretary in a second administration were Trump to win election again, or at least to hold some sort of high-ranking economic position, has been quoted, as you know, putting together this committee which is explicitly talking about ways to devalue the dollar and boost trade. Now, the problem with that is that the other policies that Trump and indeed the Lighthizers as of this world would like to pursue, would tend to push the dollar higher rather than lower. So, on fiscal policy, I think a second Trump term would be broadly committed to, again, the kind of tax cuts that we saw in the first term, and possibly spending increases as well. So easier fiscal policy, and that would tend to, all else equal, push up on inflation, so require the Fed to keep monetary policy tighter than it otherwise would have been, which is another way of saying it would push up interest rates with regard to the rest of the world. And as you said, Paul, interest rate differentials are a key driver of currencies and dollar strength in particular, recently, and this would only seem to exacerbate those problems. And then, moreover, exactly the tariffs that the likes of Lighthizer and others talk about as a way of dealing with the US trade deficit would also tend to cause dollar appreciation as markets typically move to change currency rates to in some sense, offset some of the price increases that come from tariffs. So that policy combination of protectionism and easier fiscal policy, which would probably make the dollar stronger, rather than weaker. So it seems that their answer to this question, such as they have one, is to threaten significant policy intervention and the kind of intervention they have in mind, the sort of paradigmatic example of what it might look like, is the so called Plaza Accord in 1985, which followed during the Reagan administration, and you could argue a pretty similar set of economic circumstances - in the sense that there was this combination of easier fiscal policy, but tighter monetary policy as the Fed was still trying to get a grip on inflation and that made the dollar extremely strong, and that was leading to a large trade deficit. And at that point, Japan was very much in the spotlight amongst US policymakers, as a trade partner that they had a large deficit with, and so the Plaza Accord involved bringing together the US, Japan, UK, France, and West Germany as was, to agree to a significant depreciation in the dollar. Those were all going to intervene in the currency markets to push the dollar weaker and their own respective currencies stronger. 

Now, the problem I think, with the likes of Lighthizer and others imagining that that's going to be 
a good example of what they could do this time around is well, first, foreign exchange markets are vastly bigger these days, so governments may not have the firepower to make the kind of interventions that were made back in the 1980s. So even if they wanted to, they might not be able to move FX markets in those directions. And second, note that the trade partners who were involved in the Plaza Accord were all very much US allies, especially in the Cold War context, whereas I think the trade partner who the US would really like to have a weaker currency against is China. And it's not obvious that there is much of an interest in China to agree to a significant appreciation of the RMB against the dollar. So, there's unlikely to be anything like the kind of international coordination that was involved in the Plaza Accord. So, I kind of think that these sorts of interventions, it's not to say they don't have any short-term effect, but it's very unlikely that they would do much to change the long-run fundamentals of of where the dollar would go under Trump. 


Paul Diggle
Indeed, and in a world in which the US - China trade tariffs are rising, which is the world under Biden at the moment, but perhaps even more so under any potential second Trump term, the pressure, as you say Luke would be to push the RMB lower. That was what happened in the first Trump - China trade war as the adjustment mechanism. I suppose, in the absence then of international agreement of a Plaza Accord 2.0. what's left for the Trump administration if they want to affect the direction of the dollar, is the Fed, right? 

Luke Bartholomew
Yeah, exactly. I mean, you can think of this as effectively being the so-called ‘trilemma’ in action. This is a foundational result in international macro theory. And it's the idea that you can't have all three of a fixed exchange rate, open capital markets and monetary policy set in accordance entirely with domestic economic conditions. You have to pick two of those three and western countries over the last 40 years have typically chosen free capital mobility and sovereign monetary policy combined with floating exchange rates. But maybe what they could try to do was to bully the Fed or get the Fed to change policy in some way that it wasn't being set in accordance to domestic monetary conditions – but was set in accordance to where the administration wanted the dollar to go. Now, the problem is that that runs straight up against the Fed’s mandate, which is for domestic economic conditions, price stability, and full employment. And so, it is likely if they wanted to go down this monetary policy route, it would require quite significant changes at the Fed and there have already been some press rumours that Trump is actively considering ways to have more control over the Fed. I mean, to be fair, he did appoint at least those who made it to the Board relatively institutional candidates at the Fed last time round. Indeed, Powell himself was a Trump appointment. But I think in due course, Trump came to regret that decision, as he proved rather less biddable than Trump was hoping in terms of how policy was set. He gets the opportunity, Trump this is, in 2026, to appoint the Fed chair again. And it's quite possible that he could appoint someone much more biddable then or indeed, you could use moral suasion or just make Powell’s position so unviable that he resigns power this is and Trump is able to appoint someone else. So all of which is to say that this desire to have a weak dollar when combined with the other aspects of the administration's putative economic policy, does run up against the Fed and does therefore raised the very real risk that the Fed finds itself dragged into a political fights, that it is highly politicised, and Trump ends up appointing people who are not necessarily considered by the market to be able to run monetary policy, or indeed sort of the broader backstop to this global dollar system that we talked of as being so important in the way that inspires the kind of credibility that keeps inflation expectations well anchored and financial stability risks in check. So, I think of this as being a very real risk for markets to monitor, were Trump to be elected again.

Paul Diggle
Great, so interesting times ahead, no doubt. But that's about all we have time for this week. Thank you very much for listening to Macro Bytes. Please allow me to remind you to like or subscribe on your podcast platform of choice, but until next time, Goodbye and good luck out there.



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