'King dollar' dethroned? USD dominance in an age of geo-economic fragmentation

From the return of war in Europe to the resurgence of armed conflict in the Middle East – and from the rise of the right within certain advanced economies, and a spike in economic nationalism and protectionist measures across the globe – it is apt to say that we live in a fragmented geo-economic landscape.

However, there is one arena on the global stage which seems to be somewhat immune to the flares of fragmentation: the international financial system. As one seasoned practitioner astutely observed, so far, the US dollar remains the world’s “dominant currency".

The persistence of US dollar (USD) dominance draws wonder as well as ire: how is it that amidst debt and political dysfunction – prompting credit downgrades – the United States retains its ‘exorbitant privilege’ as the world’s reserve currency?

Even as the US withdraws into ‘fortress America’, retrenching from its role as global policeman as well as global trading partner, the greenback still remains the preferred medium of exchange for trade invoicing within many regions, and represents 88% of foreign exchange transactions worldwide.

Moreover, while the US represents nearly a quarter of global GDP, about half of all cross-border bank lending and international debt securities are issued in USD. And, even amid the perplexing endurance of ‘crypto mania’—which, some say, would render the advent of a currency-free world – the USD remains a principal backing for stablecoins.

Some central bankers and financial policy-makers have recently expressed their indignation on the strength of the US dollar: that the currency, although reflective of a robust economic performance, is actually running hot off the back of over-stimulative fiscal policy, and this relative strength of USD vis-a-vis other advanced economy currencies is frustratingly contributing to imported inflation (quite sharply felt in Japan).

Meanwhile, in geopolitical corridors, certain global leaders have bemoaned the ‘extraterritoriality’ of the US dollar and have also called for the advent of a Brazil, Russia, India and China [BRIC] currency to challenge US dollar dominance.

Many astute observers point to a potential misuse of sanctions which might undermine the position of the US dollar as a reserve currency, and thus might prompt certain emerging market / developing economy central banks to rotate back into gold as a reserve currency. So far, however, such calls are somewhat overblown, as central bank gold holdings presently remain modest by historical standards.

So what might thwart the position of “king dollar” over the medium to longer term? To chart out the future, we must explore the past, and specifically, the historical forces which have shaped the trajectory of USD dominance.

The outsized role of the USD as a store of value (or reserve currency); as a unit of account (or funding currency); and as a medium of exchange (in trade and forex transactions) on the global stage has been enshrined by three key interrelated movements: Bretton Woods; the Marshall Plan and the Washington Consensus.

First of all, in 1944, the greenback became a prominent pillar of monetary order amid reconstruction efforts in the wake of the Second World War. Effectively, during Bretton Woods, the USD unseeded the GBP as the world’s reserve currency (although this would take time to play out) and became fixed as the anchor for other global currencies, and backed up by the world’s largest gold reserves.

Secondly, amidst fears of a growing threat from communism within postwar Europe, the US enacted the Marshall Plan, according to which it contributed to the reconstruction of postwar Europe through economic relief packages, infrastructure development and the rebuilding of cities.

Effectively, the US also created for itself a market for its exports, thereby enhancing the role of the USD as a unit of account, and as a medium of exchange. These commercial and market-based mechanisms were also synergistic with US support for democratic governments within Europe.

Thirdly, the US (as well as other multilateral development banks and institutions) has pushed the Washington Consensus, a set of guiding principles more or less commensurate with neoliberalism and free market economics which underpinned several decades of hyperglobalization, beginning in 1990.

By supporting trade liberalization, privatization, and monetary and fiscal policies designed to manage inflation and reduce deficits, the US was further able to promote the role of the dollar within the international trading and financial system, and the function of the USD as a medium of exchange.

In considering each of these historical developments – and their relative stickiness to continue to amplify the dollar across the various functions of money within the international financial system – the Bretton Woods-induced enshrinement of the greenback as the world’s reserve currency is likely to be the most durable force over a long period of time. As we can see below, of all disclosed official reserves on a global basis, the USD reigns supreme, hovering at about 58%.

Many of these USD reserves are held as treasury securities, and foreign investors hold about 30% of the $8 trillion dollar US treasury market. Although much ‘sturm und drang’ has been made about certain countries reducing their holdings of US treasuries as of late (namely, China; but also, Japan, in 2023) the argument can be made that the divestment of such assets serves a primary, market-oriented purpose of shoring up the value of the yuan and the yen respectively, rather than an emotionally-driven dumping or ‘weaponization’ of treasury holdings.

Here, we might think of an oft-used acronym in economics: that is ‘there is no alternative’ – or ‘TINA” – to the US dollar as a reserve currency. As we can see in the graphic above, even the Euro has not gained steam on USD, with its share of global reserves standing at 21%. Nothing compares with the liquidity, depth and convertibility of the US treasury market. For example, even in the wake of the COVID-19 pandemic relief efforts, when the European Union issued jointly-backed debt, the €400 billion ($430 billion) of notes pale in comparison to $20 trillion worth of outstanding US treasuries.

In considering the role of the USD as a medium of exchange, one could argue that a bit of the wind has gone out of the sails of the Washington Consensus. As the US has retrenched from elements of the globalized order it largely facilitated – for example, trade as a percentage of GDP for the US been on the downward trend since 2011 – and as both Republicans and Democrats alike continue to issue protectionist measures, so, too, we might conclude that the greenback might lose its lustre as a dominant form of trade invoicing.

Set against the backdrop of a trend of greater trade regionalization, the USD may continue to underpin trade within the Americas, and to a lesser extent, within Asia – but the Euro is certainly dominant within advanced economy groupings.

Added to that, within ‘ROW’ or the rest of the world, other currencies such as the Chinese renminbi might play a more pronounced role in trade settlements. It is important to note that these shifts would not present an outright challenge to the US dollar: but rather, indicate the growing role of other currencies such as the yuan in a basket of global currencies.

Of the three historical developments, the one most in jeopardy going forward is the Marshall Plan – the dissolution of which might have deleterious impacts on the US’s ‘exorbitant privilege’ as the world’s reserve currency.

If we take the spirit of the Marshall Plan writ large – that of the US’s commitment to benevolently ensure the peace and security of other countries via investment, trade flows and the establishment of export markets – and extend this to other regions of the world, such as Asia-Pacific, we might say that the US ability to deliver on such promises has been eroded over the march of time.

This is partly due to US disengaging from the world; and also resulting from the changing nature of risk, according to which, in a globalized world, it is very difficult to eliminate or contain risks – one can only manage risks.

Thus, amid rising trade barriers – as well as the return of conflict in Europe and the Middle East – it can be argued that the US cannot necessarily guarantee the economic peace and security in the world to which it was once so committed.

And research shows that this might have consequences for the USD as a reserve currency. Eichengreen et al point to the ‘Mars’ factor: that military alliances can be determinative of reserve currency choice and that alliances have the potential to ‘boost the share of a currency in the partner’s foreign reserve holdings by 30 percentage points.’

Accordingly, in a hypothetical scenario of a sustained US withdrawal from the world, this could push up long-term interest rates by 80 basis points. This, of course, would push up borrowing costs for US households, and for the government—and this would unfold at a time in which debt held by the US public is set to breach record highs.

This leads us to a final point: the ultimate challenge to the USD as a reserve currency might come from within. As prominent policy-makers have pointed out, debt and dysfunction remain two key risks on the dashboard of the US economy.

Republicans and Democrats are in tacit agreement that the fiscal deficit doesn’t matter, and that the US can continue to afford to be an adolescent country, as long as the world demands its debt. However, regardless of who takes the White House in 2025, the US is on a discernible path of retrenching from the globalized and Marshall Plan-laced world it created.

Even Harry Dexter White, one of the architects of Bretton Woods, highlighted the greatest peril for the greenback as a reserve: US isolationism. By one estimate, three-quarters of the foreign holdings of safe US assets are held in reserve by ‘countries with some military tie to the US’.

Something that Dexter White might not have forecasted – the irresponsible mounting of the fiscal deficit – constitutes a catalysing force with risks significantly skewed to the downside for US interests in the medium to longer term.

True, these forces might take over a decade to play out; which provides all the more reason for policy-makers to temporarily suspend the short-termism so endemic to our current political realm, and to make difficult decisions to restore a degree of fiscal rectitude in the management of government accounts.

Although the US may no longer be able to deliver on the terms of the Marshall Plan – and may indeed be increasingly myopic and inward-looking – it can turn the interior gaze to the glaring domestic issue, which will likely have ramifications for the rest of the world.