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America’s future rides on the dollar

“Live for excess. It’s the American way,” says a character from a Hollywood movie. “Greed will save the malfunctioning corporation called the USA,” says the other.

The hunger for more, it appears, is deeply embedded in the American psyche. How else would one explain the ever-growing trade deficit, sky-high obesity rate, or the unending number of undistinguishable versions of iPhones?

America’s propensity for indulgence also extends to its foreign policy. Currently, the U.S. has more than 750 military bases in over 80 countries – the highest in the world. For context, Russia has about three dozen and China has five. Apart from maintaining its own armada of military bases, Uncle Sam also pays for many of its allies’ defenses (NATO) and engages in nation-building projects whose costs run in the trillions. The war in Afghanistan and Vietnam, for instance, cost taxpayers approximately $2 trillion and $1 trillion, respectively. Most recently, Ukraine, while not a part of NATO, has received more than $75B in aid from the U.S. Similarly, Taiwan will be receiving billions in loans as America looks to counter China’s threat in the Pacific.

The driving force that helped America climb the world order has undoubtedly been the dollar. Since Bretton Woods, the greenback has become the de facto store of value for foreign governments. The yield on the two-year Treasury note, for instance, is widely hailed as the risk-free rate, as it is backed by the venerable Federal Reserve. Central bankers around the world look to the U.S. when making monetary policy and exchange rate decisions. This collective trust in the dollar bestowed upon Uncle Sam an unparalleled privilege – a credit card with a very low-interest rate and virtually no spending limit.

With a stable borrowing base and minimal cost of capital, America’s ambition was no longer limited by its own finances but by how much debt it could issue. Like a shopaholic, the credit card became an answer to many of America’s problems, and different administrations have used it with seemingly little regard for the country’s fiscal future. For instance, the wars in Afghanistan and Iraq in 2001 and 2003 were entirely financed with debt. Unlike Vietnam and Korea, where then presidents raised taxes and cut non-war spending, post-9/11 wars have been funded through borrowing without a tax increase. According to Brown University, interest payments on war-related debts alone would total over $6.5 trillion by 2050, that is with the assumption that America ceases all war spending today.

Apart from funding military efforts, the U.S. has also grown increasingly reliant on credit to get itself out of tough economic situations. For instance, during the 5 years following the 2008 financial crisis, America issued a total of $6.4 trillion in treasuries to fund stimulus packages and tax cuts. While this may have been warranted, it sets in motion a trend for policymakers to resort to using borrowed money. In 2020, when the coronavirus pandemic gripped international trade, President Trump issued aid packages totaling more than $3 trillion, the biggest package ever. That year, the Treasury issued more than $4 trillion in debt – the highest amount since 2000. The following year, President Biden signed a $1.9 trillion stimulus package, pushing America’s debt to its ceiling of $31.4 trillion.

For a country that runs such large amounts of deficits year over year, one would expect that the U.S. would increasingly face downward pressure on its currency and higher bond yields. Washington would then be forced to cut government spending and switch imports to domestic production. This is not the case, however, due to the fact that 70% of the world’s trade is conducted using dollars. Stable demand, combined with America’s large economy and deep capital markets, gives the dollar protection from normal market pressures that other currencies face. It is for this reason that the U.S. must defend the dollar’s status as a reserve currency if it wishes to continue exerting its influence around the world.

Protecting the mighty dollar is becoming more difficult, however, as more and more countries realize that their USD investments may be out of reach at a time when they need them most. Russia learned this after close to half of its $640B foreign reserve was frozen by the U.S. Afghanistan, Iran, and Venezuela similarly felt the effects of America using its currency as an economic weapon. Consequently, countries are moving away from parking their reserves in the greenback. According to the IMF, the dollar’s share of central banks’ reserves has declined over the past two decades from over 70% in 1999 to 59% in 2022.

Opinions about the future of the dollar appear mixed. Those who are bullish point to the fact that there is not yet an alternative currency that comes close to replacing the greenback. In addition, the fact that China cycles its trade surplus into dollars also ensures that there is stable demand for the currency. In contrast, those who are bearish point to talks of subjects like petroyuan, China’s increasing influence in the Persian Gulf and Russia, and America’s deteriorating fiscal situation.

While the dollar may not be supplanted any time soon, American policymakers need to pay closer attention to their currency. With soaring debt, sustained inflation, and an unfolding banking crisis, Washington cannot afford for the world to lose trust in its currency. Despite repeated warnings from the Treasury that the Congressional Budget Office that the government may run out of funds by next month, politicians have yet to resolve their impasse on raising the debt ceiling and fixing America’s balance sheet. Talks of sovereign default have spiked Treasury yields and volatility in the bond market. Eighty years ago, America convinced the world to adopt the dollar. Now its future depends on it.