The US Dollar: Reigning Supreme in the Global Economy

The US dollar is the closest approximation to a global currency, serving as the preferred choice for most international transactions and a reserve currency for numerous countries, regardless of their stance towards the US. The dollar's dominance took hold after World War II, coinciding with the emergence of the US as a global superpower. Investors place their trust in the dollar and US assets, such as US Treasuries, viewing them as safe havens for wealth in both stable and volatile times. This trust is reinforced by the strength and stability of the US economy and its legal framework.

Why Is the Dollar So Dominant?

1. Economic Size and Liquidity 

The vast size of the US economy is a key factor in the dollar's dominance. The US economy rivals the combined economies of China, Japan, and Germany. This economic might is underpinned by the largest and most liquid capital markets globally. US stock markets, hosting many of the world's wealthiest and most innovative companies, overshadow those of other nations. The US bond markets are even more substantial, with the US Treasury market alone valued at $27 trillion. When entities need to raise funds, they often turn to US markets, offering an abundance of dollar-denominated assets that are easily bought and sold.

2. Stability and Institutional Strength 

The phrase "In God We Trust" on US banknotes symbolizes the underlying strength of American institutions, which bolster the dollar's reliability. The US has a robust rule of law, preventing arbitrary political power use, and its elections are historically free and fair. The Federal Reserve, the US central bank, maintains a strong record of independence, unlike many other countries' central banks. The US has never defaulted on its debt or experienced hyperinflation, making the dollar a dependable store of value and a safe bet during market volatility. For instance, during the 2008 housing crisis, the dollar rose over 26% against a basket of six major currencies within 12 months.

3. Entrenchment in the Global Financial System 

The dollar's dominance benefits from its longstanding role as the world's reserve currency. Historical shifts in reserve currencies, such as the transition from British sterling to the US dollar, have been gradual and crisis-driven. Today, the dollar's replacement would require not only an economic upheaval but also a fundamental change in financial transaction mechanisms. The world's financial systems are more intertwined and dollar-centric than ever, making the dollar's displacement even more challenging.

Benefits of a Strong Dollar

For the US

The US government can borrow large sums at relatively low interest rates due to trust in the dollar. This trust allows US borrowers to secure lower interest rates on mortgages, auto loans, and corporate debt, reinforcing the economic and financial dominance that established the dollar's preeminence. Additionally, being the center of the global financial network often shields the US from economic turmoil elsewhere.

For Other Countries

Approximately 70% of foreign debt is issued in dollars, significantly more than euros or yuan. This ties many countries' economic fortunes to the US. When the US Federal Reserve raises interest rates, it can increase the dollar's value, impacting other nations. These countries might need to raise their own interest rates to prevent their currencies from devaluing against the dollar, which can stifle economic growth. Alternatively, letting their currencies depreciate can fuel inflation and make dollar-denominated debt more expensive, potentially leading to financial crises, especially in developing countries.

The US also leverages the dollar as a foreign policy tool. Controlling many of the world's largest financial institutions and networks allows the US to cut off individuals, companies, and governments from the global financial system. For example, following Russia's 2022 invasion of Ukraine, the US and the EU cut off Russian banks from SWIFT and immobilized some Russian assets, causing the ruble to plunge before it rebounded.

Threats to Dollar Dominance

Political Dysfunction: Repeated brinkmanship over the US borrowing cap has led to credit rating downgrades, undermining confidence in the dollar.

Overuse of Economic Sanctions: Excessive or unpredictable use of sanctions may prompt countries to seek alternatives to the dollar, as seen with the BRICS nations' efforts to reduce dollar dependence.

Emergence of Alternative Currencies: The euro and Chinese yuan are potential alternatives, but they face significant challenges. The euro is relatively young and has experienced economic crises, while the yuan is hindered by capital controls and a lack of transparency.

Digital Currencies: Cryptocurrencies like Bitcoin offer decentralized alternatives, but their volatility and regulatory challenges currently limit their viability as global reserve currencies.

Economic Instability and Recession: Economic instability or a severe recession in the US could erode confidence in the dollar, exacerbated by trade deficits and slow growth.

Global Efforts to Reduce Dollar Dependence: International initiatives, such as the BRICS countries trading in local currencies and the European Union's financial mechanisms, aim to reduce reliance on the dollar.

Conclusion

Despite these risks, the US dollar remains the world's dominant currency. Its future dominance will depend on how well the US manages its economy and political system. While there is increasing talk about a post-dollar world, no clear contender is ready to take over anytime soon. The dollar's supremacy, like historical currencies before it, will ultimately hinge on the US's ability to navigate these challenges and maintain global confidence in its financial system.