The Future of the Dollar
I try to avoid writing about currencies. This isn’t because I find them uninteresting. Rather, it is because most currency discussions invariably involve taking a directional view. Anyone familiar with exchange rate models, or the track record of professional forecasters, would appreciate that this is a fool’s errand. However, we are at a moment in the history of the international financial system when a discussion about the future of the dollar cannot be dismissed.
Over the past few weeks, we have heard many comments from Trump administration officials suggesting that questions around the future role of the dollar are front of mind. These include comments from Treasury Secretary Bessent that “overuse of sanctions could affect the US dollar’s supremacy”, and also that “we are going to keep the US the dominant reserve currency in the world, and we will use stablecoins to do that.” On his part President Trump signed an order creating a strategic crypto currency reserve and appointed David Sacks as “crypto czar”. Importantly, Trump also nominated Stephen Miran as the new chair of the Council of Economic Advisors. Miran had published work highlighting the costs of the dollar’s current role to the US economy, and promoted the idea of a “Mar a Lago” accord to help engineer a depreciation of the dollar.
Why is all of this happening?
Over the past few years, there has been a proliferation of research into the creation of central bank digital currencies (CBDCs), inspired in part by the proliferation of crypto assets. The purpose of CBDCs would be to launch a form of money that can lower transactions costs. The Bank of International Settlements has also been coordinating research between central banks for two purposes: interconnecting domestic payment systems globally (Project Nexus) and exploring the facilitation of tokenised cross-border payments (Project Agora). There is broad recognition that the technology of the “plumbing” of the international financial system needs to be updated.
At the same time, the use of sanctions has indeed increased the international transaction costs of the use of the dollar. In particular, the use of secondary sanctions on financial institutions to force compliance with primary sanctions adds to costs. Thus, for many participants, the costs of using systems like SWIFT are far higher than the true economic value added of the system.
Some countries – particularly the “BRICS” - are questioning the role of the dollar, while President Trump has threatened them with 100% tariffs if “they want to play games with the dollar”. With technological change likely to the plumbing of the international financial system, questions regarding the dollar’s pre-eminence are unsurprising.
The dual role of the dollar
There are multiple necessary characteristics for an international reserve currency. But at the core, these can be reduced to two overarching traits: it must be a stable store of value and a widely accepted medium of exchange. For the former, the currency must experience relatively low inflation, and for the latter it must offer ample liquidity and be easily convertible to other currencies at minimal cost. The dollar has played both roles with historically unprecedented success since the end of the second world war.
How did the dollar become the centrepiece of the international financial system?
Throughout history various currencies assumed a prominent role in international finance. The role of the US dollar was cemented in the aftermath of the second world war, when all the economies of the free world were in tatters. With America the only economy standing, the Bretton Woods agreement was devised as a way to help post-war reconstruction by providing an anchor for currencies.
The Bretton Woods agreement stipulated that all currencies would be pegged to the US dollar. The IMF was created to provide support to countries to maintain their pegs, as long as the exchange rate level was justified by economic fundamentals. If not, the IMF would suggest reforms or a devaluation in exchange for financial support. For its part, America undertook to peg its own currency against gold.
Maintaining a system of pegged exchange rates requires that countries adjust their monetary and fiscal policies to remain consistent with the exchange rate level. At the time of the Bretton Woods Agreement, John Maynard Keynes proposed the creation of an international currency managed by the IMF (the Bancor) as the centrepiece of the global financial system. America rejected this idea, because it was not willing to have its policy choices constrained by the need to maintain an exchange rate vis-à-vis another currency. It chose gold simply because gold was in vogue at various points in history, and it is easy for people to understand a gold-based system.
Gold has always failed as a currency anchor. The value of gold is derived from the fact that it is a desirable (but not necessary) metal that is scarce. But when this “scarcity” is coupled with creating a demand for gold as a reserve, the growth in the supply of gold will be less that the growth of goods and services in the economy. Therefore, if an economy were to rely on maintaining the value of its currency in terms of gold, growth in the supply of goods and services will necessarily mean that their prices need to fall in relation to gold. This is deflation. Deflation can be as dangerous as high inflation. If people expect prices to fall, they will hold back consumption, triggering a vicious circle. It then becomes necessary for a central bank to issue currency in excess of its gold reserves. This is precisely what happened.
By 1971, the official price of a gold ounce was $35, while its market price was $43. It is no surprise that President Nixon needed to abandon the convertibility of the dollar into gold. It was never economically realistic for America to pursue the deflationary policies needed to maintain the value of the dollar against gold. It was also geopolitically unpalatable to maintain a system where the growth of the money supply of the free world was dependent on mining activity in the Soviet Union and Apartheid-era South Africa.
Why does the dollar remain the anchor of global finance?
The collapse of Bretton Woods ended the de jure role of the US dollar. While every country has been able to choose its own exchange arrangement since 1970s, the dollar has nonetheless remained the de facto anchor. It is the currency of choice for payments, pricing of international trade, foreign exchange reserves and the most common anchor for the disparate group of countries choosing to peg their exchange rates. The continued success of the dollar today is clearly the product of market forces, not of purposeful design. The dollar remained the best store of value and medium of exchange for several reasons:
First, the dollar offered a high degree of convertibility. America did not maintain capital controls, except for a brief period in the 1960s, via taxation of foreign security purchases, to maintain the peg to gold under the Bretton Woods system. Most other countries maintained extensive controls during the post-war period. For example, the UK did not liberalise capital movements until 1979. The Netherlands did so in 1986, Germany and France in 1988 and 1989 respectively. Even today, the countries that seem to complain the most about “dollar dominance”, such as China, India and Brazil, do not allow full convertibility of their own currencies.
Second, by virtue of the sheer size of the US economy, the dollar offered more liquidity in short term instruments to hold the cash than any other currency. Although the Eurozone is a very large economy, the fragmented sovereign bond market of eurozone members does not offer similar liquidity at the same credit quality.
Third, America offered a trustworthy legal system and a predictable economic policy framework. Although many European countries offer the same, the ECB is much younger than the Fed. There are also kinks in Europe’s track record. For example, in 2012 the Greek parliament passed a law that retroactively changed the terms of its outstanding bonds. In 2013, Cyprus imposed capital controls while still being a member of the Eurozone.
What are the benefits and costs of issuing a reserve currency?
Valéry Giscard d’Estaing famously talked of the dollar’s “exorbitant privilege.” This was during the era of Bretton Woods, but arguably the privileges remain to this day. Because of the need of the rest of the world for reserves, America can finance fiscal and current account deficits at lower interest rates than would otherwise be the case. Additionally, as the use of sanctions has demonstrated, the dollar is very powerful tool.
It can be argued that because the demand for dollar exceeds what is strictly justified by trade flows and relative investment opportunities, the dollar has the tendency to become overvalued, particularly at times of global economic uncertainty. It is this overvaluation that is the focus of some members of the Trump administration. They argue that overvaluation is what led to deindustrialisation over time, by making exports expensive and imports cheap. Past administrations have looked at this issue positively: by keeping imports cheap, the dollar has effectively provided a subsidy to American consumers.
If there is an overvaluation, what is its magnitude? The IMF estimates that the role of the dollar would explain a current account deficit of about 2% of GDP. Deficits above that level would need to be explained by other factors. There is a kernel of truth in what the Trump administration is suggesting, but the scale of the problem is not as large.
The impact of technological change
A common joke that circulated as Bitcoin gained prominence: it is a solution in search of a problem. This is partially true. The world does not need a new store of value. It certainly does not need a purported store of value that incorporates the same Achilles Heel as gold: scarcity. As a medium of exchange, however, Bitcoin offered a “first draft” of a technology that is potentially seismic for the plumbing of the international financial system.
Blockchain technology and subsequent developments offered a novel mechanism for transactions to take place without the need for a centralised clearing system. Payments can be made peer-to-peer. This sets the stage for a more efficient and robust international payments system.
All major central banks have been undertaking their own research into ways to offer their respective currencies in digital form. China has been leading the world in the roll-out of its digital currency and enabling its use for international payments with some trading partners such as Russia. Central banks across the world have been cooperating under the auspices of BIS to devise ways to enable global transactions by connecting the domestic payments systems. The technology to connect the world with frictionless, low-cost payments is already here. Why aren’t we all using digital currencies already?
The Pandora’s Box of policy questions
Digital currency enthusiasts tend to focus on the benefits of the technology. But the policy questions that the technology raises are far-reaching and far from resolved.
Digital currencies are by their nature programmable. This can theoretically strip all semblance of privacy. More worryingly, programmability can offer the government hitherto unimaginable powers. It is not hard to think of a scenario where a government programs digital payments to make it impossible for welfare recipients to use their currencies to place gambling bets. Most voters will enthusiastically support this. But then what if the government makes it impossible for recipients of health care benefits to purchase tobacco? How about then placing restrictions on how much any individual can spend on alcohol as percentage of their income? Rather than regulate the amount of sugar in a drink, why not limit spending on all sugary products?
The possibility of a programmable currency has placed questions of privacy and anonymity at the centre of the debate on digital currencies in America and Europe. China’s digital surveillance capabilities have only heightened these concerns, and it is for this reason that Republican representatives introduced bills to ban the use of China’s digital currency in the US. The ECB’s experiments with the digital Euro have focussed on its pseudonymous and encryption features. The question of privacy has particular sensitivity in Germany. Scarred by Nazi-era atrocities, cash still represents over 50% of transactions in Germany, compared to 16% in the US and 12% in the UK.
As experience with card transactions demonstrates, however, consumers are not necessarily averse to sharing a lot of data. They willingly share it with their banks and share even more personal information on social media. But they do so in a legal framework where they know that these companies will only share sensitive information with the government if there is a legal warrant, not for surveillance purposes. They also know that if these companies abuse the data, they can turn to the government for redress. In other words: there are some checks and balances.
If a government issues a digital currency, what can offer a check on the abuse of data by the government? And how can individuals verify that they can still – if they so choose – enjoy the same level of anonymity afforded by the spending the cash in their wallet?
Digital currencies can also raise risks to macroeconomic stability. If individuals can hold digital assets themselves without the need for an intermediary, what happens to the financial system if – in times of economic uncertainty – people shift all their cash out of the banking system immediately? We have recently seen a preview of this scenario with Silicon Valley Bank. On 9 March 2023, customers withdrew 25% of the bank’s deposits. This cash went to other banks. But what if it went to no other bank, what happens to the economy as a whole?
Another policy problem is how to tackle questions around KYC, especially with digital payments that offer privacy and encryption. In 2018, some studies found that digital asset payments for illicit activity accounted for around one quarter of all users. This share has dropped dramatically, especially since the approval of cryptocurrency ETFs that became very active participants in the market. The volume of illicit payments in cryptocurrencies has been increasing, but it is declining as a share of the total simply because more people are speculating that “number go up”.
The ECB recently tested a connection between the real time payments system within the Eurozone with Buna, a payment system developed by the Arab Monetary Fund. This enables direct person to person payments between Europe and any Arab country. The only reason the system is not available to the public is because no one has figured out how to do the KYC to get people onboarded on the system. Can governments undertake a KYC exercise to allow their own citizens to hold and use digital cash? This is more like planting the seed of a dystopian future than a harbinger of promising innovation.
The value-added of financial institutions
The birth of Bitcoin and similar digital assets happened at a moment of deep anxiety over the health of the global financial system, and mistrust of banks. But do customers really want to dispense with banking as we know it? I’m not convinced that this in fact what customers want, even if they profess to hate banks.
Zero cost peer-to-peer payments are highly desirable, especially when they are cross-border. Smart contracts and other features are touted as enhancing trust. None of this replaces the value of an intermediary. If I was shopping online, refreshed a webpage and accidentally made a card payment twice, I know I can call my bank to get a transaction reversed. The merchant at the other end has more incentive to cooperate with a payment provider than with a customer who they may never deal with again. The average person is far more likely to get comfort from customer service at a bank, than the fine print of a “smart contract” that they do not fully understand, or that cannot possibly cover all possible reasons for things going wrong.
Customers can also be deeply attached to the overall package of services from their banks. For example, some studies have shown that consumers value airmiles that come with their card purchases (typically having a cash value between 0.5-1%) more than the cash-back schemes that often offer more than 1%. As anyone who has struggled to find an empty seat in an airport lounge can attest, people simply love the free lounge access offered by their credit cards.
Financial institutions also offer important services in terms of interest on deposits and credit. While there have been many innovations in this area, customer behaviour shows that relationships are very important. In the US, 70% of credit to businesses with less than 100 employees comes from local or regional banks, rather than large national banks. By having bankers that know the customers, these banks can offer more flexible terms at better rates than national banks.
While businesses like Klarna have shown it is possible to use data technology to issue mass credit competitively, we have yet to see the viability and macro-economic implications of such businesses on display through a full credit cycle. And we’re far from seeing the development of technology that would offer the flexibility that a relationship with a bank can offer.
What does all of this mean for the future of the dollar as a means of payment?
As I try to illustrate in this note, it is worth separating the question of the role of the dollar as a reserve currency from the role of the dollar as the lubricant of the international payments system. Recent pronouncements from the Trump administration regarding the role of the dollar touch on both issues.
Technology has certainly evolved in a way that diminishes the need to rely on payments systems that were built over decades with dollar clearing as its foundational stone. Because this technology offers cheaper and faster transactions, America cannot sit idly and risk falling behind while new systems are being developed that could – at some point in the future – offer viable alternatives. The same is true of Europe, given the Euro’s role as the second biggest global reserve currency.
But as the questions above highlight, America and Europe cannot move rapidly in this area. This is not because of complacency. It is because it is not as easy to answer the questions raised by the technology in a democratic society as it is in authoritarian states like China or Russia. There is a bitter irony that an innovation developed by idealists as an alternative to state-regulated systems has evolved into something that can potentially give governments hitherto unfathomable levels of information and control.
What could the Treasury Secretary really mean when he suggests that “we are going to keep the US the dominant reserve currency in the world, and we will use stablecoins to do that”? Or when President Trump suggests that he will make the US the “crypto capital of the world”?
Stable coins are privately issued digital assets whose value to the dollar is fixed. They serve the purpose of digital payments without the price volatility of crypto currencies like Bitcoin. The regulatory framework around stable coins is weak. The largest stable coin, Tether, is regularly criticized for the lack of sufficient transparency around the reserves it holds.
Stable coins can indeed offer the building blocks for international payments. And having multiple stable coins compete for market share may be better for innovation than a centralised government-issued currency. But to gain enough trust to play a meaningful role in international payments, a stable coin needs to be perceived to be as good as a dollar deposited with a large, regulated bank. The regulation around stable coins needs to change.
This is already happening with proposals such as STABLE Act and the GENIUS Act. Secretary Bessent is simply expressing the Administration’s interest in how these regulations are formulated. As it stands, the proposals will strictly limit what stable coins could hold as reserves. Tether, for example, holds a portion of its reserves in gold, which the proposed regulations will force it to sell.
It is possible that by heavily regulating stable coins, the US can then develop systems for international payments that can replace systems like SWIFT over time. In this sense, stable coins will play a role like that of the global clearing banks that currently comprise the SWIFT association. This would enable the dollar to remain a centrepiece of global payments, without the need for the Fed itself to issue a digital currency that is raising concerns.
None of this means that banks are likely to be replaced by stable coins. The value of this technology is simply to reduce the costs of transactions and reduce the risks of centralisation. Consumers will continue to need all the other services offered by financial institutions. In this sense, the technology seems to be more useful at the wholesale than at the retail level.
What about the dollar as a reserve currency?
The demand for dollars for transaction purposes is separate from demand as a store of value. Once a transaction is settled, the final recipient of a payment needs to decide how to hold the cash. The characteristics of the dollar outlined above do not change much by the technical form of the payment. The dollar’s desirability as a reserve currency, however, is impacted by the perceived stability and predictability of economic policies, as well as the rule of law to protect investors.
If there is validity to the argument that the dollar tends to become overvalued because it is highly desirable, how can America mitigate this risk? In the 1980’s the Reagan Administration invited policy makers from its G7 allies to a meeting, where they hammered out the Plaza Accord that entailed foreign exchange intervention and coordinated policies to depreciate the dollar against its main trading partners.
Such an accord cannot work today. The largest holders of foreign reserves are not America’s allies, but its competitors and adversaries. China holds more dollars than Japan. India holds more dollars than the ECB. Can President Trump convince Saudi Arabia to abandon its dollar peg and sell its holdings of dollars?
This reality has given rise to the disconcerting suggestions supported by Stephen Miran around a possible “Mar-a-Lago” accord. In a nutshell, it is proposed that the US should corral its allies and suggest that continued US security guarantees will be contingent on their support in helping depreciate the dollar. They would need to do so by buying longer term bonds, instead of short-term Treasury bills. This will have the effect of increasing the demand for these bonds, lowering long term interest rates. Another suggestion would be introducing a transaction tax, or a tax on the interest paid to foreign Treasury bond holders. This would be tantamount to reducing the effective interest rate received by foreigners, reducing the demand for dollars.
The Trump administration has recently demonstrated it is willing to conflate economic and security questions in relation to tariffs and trade policy. It is possible that the pattern will extend financial policies. The idea of reducing demand for US treasuries, however, is a very risky strategy at the time when the fiscal deficit is large, and tax cuts are being contemplated. There is an inherent inconsistency in these ideas being proposed at the same time. This raises economic risks.
The real risks to the dollar are not external. They do not emanate from the risk of an alternative currency becoming more attractive. The BRICs are proposing to issue a new currency that has no track record and is backed by countries that do not even offer full convertibility of their own currencies. This is a distraction, not a serious threat. The real risks to the dollar are internal and emanate from departing from the economic coherence that made the dollar the world’s currency of choice.
