16 April 2020

Veron: Risks for the US Dollar as the World's Reserve Currency

I argue that the main present risk comes from overreach by the United States in their application of financial sanctions, a risk that is highly correlated to the outcome of this year's presidential election.

The dollar is dominant because it is so much safer and more convenient to use than any other alternative. If, however, using the dollar comes with an elevated perception of risk, its use will ultimately become less common. This is what may happen if the Trump administration’s incontinent use of financial sanctions is maintained over the next few years.

The United States has wielded financial sanctions for a long time, and their use has been renewed and expanded following the attacks on September 11, 2001. Even during the 2000s and until the end of the Obama administration, however, there was a keen awareness within the U.S. executive branch of a fundamental trade-off. Sanctions were viewed as a powerful tool that could bring effective benefits to U.S. foreign policy; but if they were used too aggressively, their effectiveness would be blunted by the incentive created for non-U.S. actors to move away from using the dollar for their international transactions. Thus, the best possible use of sanctions was targeted and parsimonious.

That caution has, like so many other things, been thrown out of the window by the Trump administration since 2018. The administration has either imposed sanctions or threatened them on the business interests of Oleg Deripaska in Russia, the companies involved in building the Nord Stream 2 gas pipeline between Russia and Germany, Turkey, Iraq, and more. Its scattershot moves have seeded a perception that U.S. sanctions may possibly hit anyone anywhere in the world, based on essentially unpredictable whims.

Given considerable inertia in such matters, this perception has not yet led to very widespread changes of behavior. If Donald Trump is reelected, however, the unpredictability of sanctions could well become an entrenched belief that is part of a “new normal” set of assumptions. If, by contrast, Trump loses this year’s presidential contest, it is likely that the new administration will review the use of sanctions, and that of trade tariffs too, with the aim to reassure traditional allies that the U.S. government is keen to mend fences.

The dominance of the dollar is fundamentally linked to its assessment by a critical mass of market participants as the least-risky currency to use as reference. If, in the calculus of most players, using the dollar becomes structurally more risky than, say, the euro, then a massive shift in financial behavior could happen within a few years. True, one could hope that a second Trump term might be more moderate in international policy than the first one, as happened with George W. Bush. Nothing in the Trump administration’s track record so far, however, provides comfort that such hope is more than wishful thinking.

Nicholas Veron

© Nicolas Véron