The Collapse of the Dollar Empire?

Is the dollar's status as the world's reserve currency coming to an end?

The high point of the Roman Empire is generally considered to have been during the reign of Emperor Trajan. Trajan ruled from 98 AD to 117 AD, and under his leadership, the empire reached its greatest territorial extent. Trajan's reign is often seen as the era when the Roman Empire was at its most prosperous, stable, and expansive. However, from the second century onwards, Romans began to fret about the future of the empire. Writers like Cassius Dio and Ammianus Marcellinus wrote extensively about Rome’s troubles, suggesting that its politics, loss of morals, and economic malaise would lead to the empire's demise. These naysayers turned out to be right when, in 476 AD, Rome was overrun by the Goths, and they deposed the last Emperor of Western Rome, Romulus Augustulus.

In a similar fashion to Marcellinus, there has been a marked increase in the number of market commentators prophesying the coming collapse of the dollar empire, which has ruled as the undisputed global reserve currency of choice for nearly 80 years. De-dollarization is a complex, long-term structural trend, and if the dollar empire has entered its death throes, it is likely to have major ramifications for investors and the global market.

To try and unpack such a tricky topic, I wanted to share the stage with Daniel Babington, a portfolio manager at TAM Asset Management. The decline of the dollar has been a topic Dan and I have been going back-and-forth on for some time, and I thought it would be fun for us to explore the arguments for and against the concept of de-dollarization. For full disclosure, Dan believes strongly in the idea of de-dollarization, while I remain skeptical. But as a wise old strategist once told me, “It takes two views to make a market.”

The U.S. Dollar in Its Death Throes

An empire is rarely undone by one deadly blow. Instead, it is a series of seemingly minor issues and developments that gradually undermine the structural integrity before it collapses in on itself. In a similar manner, the fall of the dollar kingdom is unlikely to occur due to one factor. It’ll likely be a series of issues that compound and gradually lead to its collapse.

Dan’s view is that some factors that increasingly played into the US’ favor have reached their crescendo, which may eventually turn the tide away from the greenback. One such boon was the petrodollar system, which arguably formed the foundation of the U.S. dollar’s dominance as the world’s primary reserve currency. Initially, the Bretton Woods Agreement saw the U.S. dollar become the world’s primary reserve currency, originally pegged to gold at $35/oz. However, confidence in the maintenance of this convertibility was shaken amid fiscal deficits and inflation as spending rapidly ramped up during the Vietnam War. This led to President Nixon abandoning the gold convertibility, and thus the formation of fiat, unbacked paper currencies in 1971. Fast-forward two years into the oil crisis of ’73, which formed the bedrock of a unifying agreement to have all oil exports priced exclusively in dollars. The advent of this gave oil-exporting countries pools of paper dollars. With no fundamental use within their own economy, and due to the expiration of the Bretton Woods agreement, no defined convertibility to gold, these dollars were used to purchase hard assets, mostly stocks, in America.

Now, what does this whistle-stop tour of early 70’s geopolitics have to do with 21st-century de-dollarization rhetoric? Well, after 50 years of drastically increasing global dollar supply and consequently international share of US assets, the petrodollar agreement has expired, which leaves emerging economies to push the global usage of their own currencies and reduce reliance on dollars—a potentially major shift in global financial dynamics.

These economies may be increasingly keen to become more insular and champion their own currencies on the global stage as deglobalization trends and increased defense spending form a reversal of the multilateral trade patterns which have defined the 21st century.

Adding to this, a potential growing disdain towards the U.S. may emerge at the possibility of Trump being re-elected and opting to start a renewed round of trade tensions. A reignition of trade tariffs as a protectionist move but also coined as a policy to reduce the U.S. deficit, would likely generate even more instability given the heightened tensions in Eastern Europe, the Middle East, and Asia.

In addition, the weaponization of the dollar startled a number of countries. Since annexing Crimea in 2014, Russia had taken a number of steps to try to put its economy on a war footing ahead of the invasion of Ukraine. But despite this, no Russian policymaker thought it was likely that their $3 billion in foreign exchange reserves could be in jeopardy. The shock at which U.S. authorities looked to cut Russia off the dollar system (and cause a subsequent sovereign default) has prompted a number of other countries to diversify their FX reserves.

Although there are tailwinds forming behind the de-dollarisation narrative, the issue remains that there are no suitable alternatives. One option is gold which has increasingly featured in the portfolios of central banks. A recent survey amongst the major central banks indicated that 60% of them thought gold would make up a larger share of their reserves in five years time versus current levels. So as the dollar empire collapses, gold may stand to benefit as a safe, reliable asset class.

The U.S. Dollar Reigns Supreme

The U.S. dollar empire has certainly taken some losses as of late. The rise of cryptocurrencies and the increased movement of foreign currency reserves into gold certainly challenge the narrative that the U.S. dollar reigns supreme. However, as I have talked about in a previous blog post, bringing down the dollar empire is no easy task, and if history is any guide, it requires the U.S. government to actively seek to abdicate this position of power, something I can’t see them doing anytime soon.

I’d also be mindful that gold has its flaws, particularly as a long-term option for central banks to park their foreign currency reserves. Firstly, the asset class suffers from negative carry. Not only does gold not generate a yield, but in order to effectively circumvent capital controls, central banks must hold it in a physical form, resulting in storage costs. There are also some liquidity concerns which can become a real issue during a crisis. Emerging markets often deploy currency reserves to stabilize their domestic currency. While small purchases are likely to be easy enough to cover, large-scale currency intervention required during a crisis requires assets to be held in a liquid, accessible form, something gold can simply not provide.

While the transition to gold is only one part of the de-dollarization narrative, I would highlight that there is still a long way to go before the empire collapses. Indeed, over the last 25 years, the dollar has fallen from around 75% to just 60% of foreign reserves. However, there has been no major beneficiary of this diversification in reserves, with central banks opting to hold more Australian dollar, New Zealand dollar, and Chinese Renminbi, but each of these countries amount to only 2-3%.

Despite significant saber-rattling from emerging economies about the death of the dollar, pulling down the walls defending the greenback empire is no easy task. The dominant position the U.S. dollar has in global trade and financial markets means that turning away from it can come at a cost, especially during a moment of crisis. There are also self-reinforcing network effects whereby individuals and corporations prefer to transact in reliable currencies such as the dollar, making it a difficult cycle to break.

There is also the possibility that the empire will strike back. As I have argued before, I am a big believer in U.S. exceptionalism. The country commands an almost unassailable position and the best days of the U.S. dollar may be ahead of it. The country’s unique bankruptcy structure allows it to recycle capital in an efficient manner that encourages continuous creative destruction. Its legal structure robustly protects patents and intellectual property, driving innovation and ensuring the U.S. leads the way in technological prowess. Most importantly, the country’s overall productivity, especially since COVID-19, has dwarfed every other advanced nation (see the chart below). Ultimately, a currency’s strength is drawn from its economic power, and the U.S. still has plenty left on that front.

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