By Julius Probst
If the events of recent months have shown anything, it is that the dollar still king. While many predicted the dollar’s demise already during the financial crisis of 2008, the claim of the dollar’s diminished status turned out to be not just premature, but even completely wrong. Despite the US’s share of global GDP declining significantly, from an all-time high of almost 40% after WWII to less than 20% in 2020, the role of the dollar has actually not diminished but rather increased in recent years. This was also the topic of former BOE’s governor Mark Carney’s Jackson speech at the Hole Economic Symposium (Carney, 2019).
To some it might seem remarkable that during a crisis like the Great Recession, which originated in the US and then spread from there to the rest of the world, the US dollar actually gained in importance. From an economic history point of view, though, this isn’t all that surprising. When it comes to being the currency of choice for international transactions and reserves, there are powerful network effects at work, which is also why I am relatively skeptical about Crypto Assets. Think in terms of social networks like Facebook, Twitter, and LinkedIn – of course, any individual always has the choice to not participate in existing networks and start his or her own competing one. Just as it is a coordination problem to make people switch from one platform to another, a similar network effect exists with currencies.
While it is not impossible for one currency to replace another one as the international money standard, the process is never instantaneous. Economic historian Barry Eichengreen has outlined how New York became the predominant financial center at the turn of the 20th century, and how the US dollar replaced the British pound after centuries of British financial dominance. While Eichengreen (2008) has suggested that we might slowly pivot towards a world not with one international currency but with several key currencies that might compete with each other, I do think that the current Covid shock is more likely to cement the dollar’s predominant situation than to erode it. Let me explain why.
Even during a crisis that originated in the US, we can actually observe a flight into the dollar and US Treasuries rather than an exodus from the dollar. The chart below displays the real effective exchange rate for the US currency for 3 different moments in time, the 2001 Dot Com bubble, the 2008 US financial crisis, and the current Corona shock.
The Dot Com bubble and the 2008 financial crisis were largely caused by irrational exuberance and financial fragility that endogenously built up within the US financial system as leverage and risk-taking increased. However, even as these bubbles burst in the US, investors did not flee from the dollar but actually went into the dollar for its safe haven status. In times of increased global uncertainty, the dollar tends to appreciate sharply in real terms, which also leads to a tightening of global monetary conditions.
During each of the three crises, the real effective exchange rate increased sharply by some 6 percent within just a matter of months.
The appreciation of the dollar during times of global economic stress does not reflect a strengthening of the US economy but rather a tightening of Fed monetary policy. Moreover, as the dollar is a safe haven, global financial turmoil literally causes a dollar crunch as investors are flocking to safe haven assets.
David Beckworth and Crowe (2017) have dubbed this the monetary superpower hypothesis. Given that a significant share of global trade is invoiced in dollars, and that Emerging Markets tend to borrow in dollars, the Fed acts as the global Central Bank and provider of liquidity for the entire world and all global financial markets. Furthermore, as a result of this currency mismatch between EM liabilities in dollars and EM assets valued in their own currency, a dollar appreciation can lead to significant adverse balance sheet effects across EMs, thereby causing a growth slowdown in the countries affected.
There is therefore reason to believe that the global business cycle is actually a dollar liquidity/debt cycle. Whenever the Fed tightens monetary policy, this causes adverse spillover effects across EMs, and the same goes for Fed easing cycles.
The chart below shows that there is a relatively high negative correlation between the Global Manufacturing PMI and the real dollar exchange rate from the early 2000s. In other words, a strong dollar seems to be bad news for global industrial production.
Furthermore, there is also a strong positive correlation between the US 10 year yield and the global PMI. Remember that interest rates are not a good indicator of the stance of monetary policy and that low rates do not imply easy money. Interest rates are usually high during booms and low during busts. Low rates reflect a combination of low GDP growth (expectations) and low inflation (expectations) – the Fisher effect. Therefore, as Milton Friedman has argued, low interest rates are usually a sign that money has been tight, whereas high rates are a sign that money has been easy.
The following graph therefore also supports the notion that dollar tightness and global industrial production are correlated. Lower Treasury yields, a sign of dollar tightness, and the global PMI have shown quite a significant correlation over the last decade.
Last but not least, the graph below displays our inhouse US financial condition index, courtesy of William Peters. Given the dollar’s central role in our global financial system as well as the sheer size of US capital markets, US financial conditions matter for global liquidity.
Again, the next chart shows a relatively high correlation between our financial conditions index and the global PMI. Dollar liquidity matters for global output.
The dollar’s global dominance therefore is also a cause of concern during times of severe financial stress. Similarly to 2008, there has been a scramble for short-term dollar funding across the world in recent weeks.
As only the Fed can be a provider of dollar funds, it opened its swap facilities with several other major Central Banks again (ECB, BOE, BOC, SNB, DNK). Fed swaps therefore have quickly reached some 385 billion in recent weeks as financial entities across advanced economies are craving short-term dollar funding.
However, as I argued in our latest piece, Emerging Market currency crises are probably coming, and these countries might be in even greater need of dollar funds. Treasuries held at the Fed have declined significantly as EMs are currently selling off their safe assets. Holding a Treasury is not the same as having access do cash during a severe market selloff. For cash-constrained agents, liquidity is the only thing that matters. As Perry Mehrlig has put it: Liquidity kills you quick.
In order to prevent this drawdown, the Fed has now opened its swap lines also for several other countries, including some Emerging Markets. It will help, but might only be a drop in the bucket as some 80 countries have already gone to the IMF and asked for emergency financing help.
Putting all these facts together, one can be sure that the dollar as the international financing currency of choice is not going anywhere any time soon, even if it turns out that the US gets hit hardest by the crisis. Our current international trade and finance arrangements are built around the dollar, and there is simply no substitute that is even close.
Wonkish: Estimating an Impulse Response functions in a VAR model
Anybody who is not that into economic models should probably avoid the next couple of paragraphs and just skip ahead to the next section. For the econometrics nerds out there, I have used the VAR tool in Macrobond to quickly estimate a so-called Vector Autoregression model between the policy rates of some of the major Central Banks. As the chart below shows, changes in the Fed policy rate seem to affect all of the other central banks’ policy rates with a lag.
The chart above on its own obviously does not reveal causality yet. It simply suggests that central bank policies across advanced economies display co-movement. This is not too surprising in a world that has become increasingly integrated via finance and trade in recent decades, which also implies that the business cycle has become more synchronized across countries (De Grauwe and Ji, 2016).
We can test the relationship between central bank policy rates by using a VAR model, which estimates a system of simultaneous equations with several endogenous variables, in our case the policy rates above.
Macrobond Moment: Macrobond quickly allows you to estimate a VAR model with just a couple of clicks, including the Impulse Response function (IRF) when one endogenous variable shocks another. If you don’t have Macrobond, you can now try it for free.
The IRF shows that a unit shock to US interest rates raises ECB rates by almost a percentage point over the subsequent 18 months while no such effect can be detected when shocking the ECB rate and estimating the response of the Fed rate.
Again, this supports the fact that the Fed is a leader in setting global interest rates, and that changes in US monetary policy have effects on policy rates in other countries. While this is not very surprising given the US dollar’s dominance, other central banks having to follow US monetary policy in the long-run supports the fact that the global business cycle might to some extent be a Fed-induced monetary policy cycle.
A short note of caution, though. The VAR model I have estimated seems to be somewhat sensitive to the ordering of the variables in the system, a feature that is not that uncommon, and therefore the results should be taken with a grain of salt.
Can the Euro become a close substitute for safe dollar assets?
The dollar’s current dominance obviously raises the interesting question of whether there can be a substitute in the near future – the Euro maybe. The short answer, in my view, is no, at least not with the current institutional arrangement of the Eurozone.
Simply adding up the public debt for some select advanced economies gives us an approximation of the global bond market for government securities.
As one can see, the US is the first and foremost provider of safe debt securities, followed by Japan. However, keep in mind that about half of Japanese debt is now already owned by the Bank of Japan, meaning that available net debt is actually much lower. Similarly, ECB and Eurosystem holdings as a share of total debt outstanding are currently much higher than the Fed equivalent (even though the Fed is doing its best to change that with “QE infinity”). Combined with the fact that German debt is relatively low and was on a downward trend before the Corona crisis, Eurozone assets weren’t exactly heading towards becoming a substitute for the dollar.
In terms of monetary policy, the ECB’s task would become easier and the conduct of monetary policy would be somewhat simpler if Eurobonds issued together by all Eurozone governments existed. Issuing “Covid bonds” during this unique health and economic crisis was, in my view, an opportunity to prevent further fractionalization of the Eurozone and show solidarity with Southern Europe. The fact that the Euro has not become a close competitor with the dollar is therefore also as much a political question as an economic one. As the always-smart Brad Setzer has argued in a Twitter exchange:
In my opinion, the Euro can only start to seriously compete with the dollar if member countries start to issue a common safe asset and if that asset is in relatively abundant supply. Given historically low interest rates across advanced economies right now, the demand for such a bond would be very high and yields would be low. Especially during this unprecedented shock, it would provide Southern European countries another source of funding, which they desperately need right now. Another decade of stagnation in the Southern Europe simply cannot be in Northern Europe’s best interest. Moreover, in times of secular stagnation, being a second issuer of a global safe asset besides US Treasuries would provide a positive externality to the rest of the world.
Disclaimer: We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of the author. While we think our writers are very smart, Macrobond Financial does not expressly endorse the views presented here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have Macrobond, you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have Macrobond, now you have a great reason to get it.