In defense of the dollar – POLITICO

Jay Newman was a senior portfolio manager at Elliott Management and is the author of the bestselling thriller “Undermoney.” Meyrick Chapman’s career spans 40 years in international finance and currently lectures University of Buckingham. He founded Hedge Analytics Ltd in 2020.

There’s no question about it — the United States dollar is under attack.

Finance is prone to fads, and its latest mania is de-dollarization: the notion that the dollar will soon meet its demise as the world’s preeminent reserve currency.

Everyone seems to hate the greenback. China recently crowed about its “triumphant” purchase of an LNG cargo, which was paid for in yuan and traded through China’s Shanghai Petroleum & Natural Gas Exchange. And Brazilian President Luiz Inácio Lula da Silva has called for development of a new currency for BRIC countries — Brazil, Russia, India, China and South Africa — to dethrone the dollar.

Such events attract media attention, of course, but they may just turn out to be sideshows. Of greater import are China’s arbitrary punishment of Deloitte for alleged audit failures, the summary arrest of the Mintz Group’s corporate due diligence team in Beijing and the political corruption that has long plagued Brazil.

In essence, the devil may be hated, but for all the chatter about its death, neither the numbers nor the stories support the hype. And while it’s true that the U.S. government does itself no favors by applying economic sanctions indiscriminately, spending profligately and printing money, in the immediate future, there’s no replacing the dollar and the institutions that go along with it.

To be clear, there is a credible threat to dollar supremacy, but that threat comes more from fragmentation than the emergence of a true competitor. For America’s rivals, though, fragmentation is good enough, as it damages the dollar system — but less obvious is that it will also be very costly, reduce information and flexibility, encourage fragility and abet repression.

In addition, while technology may help to displace the dollar over time, decentralized finance has lost much of its luster after the last 12 scandal-ridden months in the crypto world — though “smart contracts” and blockchain-based public ledgers could offer transparent and enforceable transactions in the longer term, without the dollar serving as an intermediary. 

However, the biggest failing of this decentralized nirvana is that there’s no one to complain to if —and when — things go wrong. To whom do you appeal for restitution when a contract fails? Until that important question is settled, trusted legal systems, which in practice means the U.S. and the United Kingdom, will remain the easy fallback.

Much of this de-dollarization narrative — like so many stories that take on a life of their own — seems to arise from social media, as if organically bubbling up from the grassroots. More likely, though, there’s a widespread astroturf campaign afoot to amplify a scant body of isolated “facts” in hopes that something sticks — which would suit America’s economic and geopolitical rivals.

Examined closely, however, the origin story — that the dollar is dominant because trade is denominated in dollars and that the role of the dollar in trade is eroding — is fatally flawed. And it’s not just wrong on the volume of trade, it has things backward in terms of why the dollar is so useful.

First off, trade flows show no sign of erosion. Stories about elaborate new commodities and securities exchanges in Shanghai might seem impressive but most will only have marginal long-run impact. Consider this: Global trade in 2022 totaled $32 trillion, and the dollar is one side of over 72 percent of those transactions — a percentage that’s remained steady for 30 years.

But the more salient point is that international trade isn’t the right measure of the dollar’s significance — the gold standard here is its role in financial transactions. And in 2022, the U.S. capital markets turned over $32 trillion per month, on average — equivalent to annual global trade turnover.

That figure doesn’t include funding markets such as repurchase agreements and loans or derivatives in foreign exchange, interest rate and options trading either. At the end of 2022, the Bank for International Settlements reported that the value of derivative contracts totaled over $638 trillion, while turnover of foreign exchange derivatives amounted to $7 trillion per day — with the dollar on one side of 88 percent of all trades — and over-the-counter interest rate derivatives averaged another $5 trillion per day.

That fact is that trade and financial transactions are denominated in dollars because the dollar is trusted.

And that trust has been earned because contracts governed by U.S. (and U.K.) law — i.e. common law systems — embody legal and social norms that have been developed and tested over centuries. Rivals can offer nothing even remotely comparable.

In fact, there’s reason to argue that common law — enforceable in U.S. and U.K. courts — not only underpins the value of the dollar but is, in and of itself, the equivalent of a reserve currency. Rather than failing and fading as geopolitics becomes more fraught and contentious, both the dollar and the legal system that defines it will grow in influence and utility.

Simply put, the “dollar” isn’t just a pile of banknotes: It’s shorthand for an intricate web of institutions structured to ensure property rights — laws, rules, clearing systems, messaging systems and relationships among thousands of central and commercial banks, financial institutions and businesses. And perhaps most importantly, common law is built on court systems that function with integrity, transparency and flexibility.

Flexibility is an unusual feature of common law, enabling it to absorb and adapt to changing social norms. In common law systems, there’s a constant interplay between the legal system, legislatures and society in ways that are impossible to achieve in a civil law system — and, of course impossible in authoritarian countries.

And the power of common law is often most evident in the fundamental principle that governs legal actions — full disclosure.

This means the complete, often intrusive, disgorgement of all information relevant to any case at hand is mandatory, which makes the legal process less amenable to powerful interests and less susceptible to fraud. Common law has thus proven itself to be uniquely adaptable to new businesses and new ways of conducting business, making it the global legal standard for mobile transactions, maritime, commodity trading, swaps and derivatives, international insurance contracts and, increasingly, digital assets.

Given such utility, it should come as no surprise that a clever sovereign might take a run at supplanting the dollar by mimicking a common law framework — and Abu Dhabi is attempting just that, purporting to introduce a common law system for environmental matters, virtual assets, commodities and stock listings. Saudi Arabia and Vietnam have toyed with the idea of introducing a common law-like system as well, and arguments have been put forward for Ukraine — or at least some part of it — to introduce common law for the country’s reconstruction.

And eventually, some, or all, of this may well work — although investors might want to wait a generation or three before entrusting significant sums to the new kids. And the same wait-and-see approach would also be warranted before risking too much on new commodities exchanges domiciled where the rule of law is . . . well, malleable.

Memories are short, so it’s worth recalling that less than three years ago, after the enactment of China’s National Security Law, international law firms and global fund management companies began to flee Hong Kong — and Hong Kong law started to be excluded from most contracts.

And if one requires further proof that a Chinese legal system isn’t up for transparency, then look no further than a recent study of 100 loan contracts between China and participants in its Belt & Road Initiative — all containing a toxic brew that limits borrowers’ rights, complicates crisis management, debt renegotiation and offers no clarity on enforceability. Leading us back to the dollar.

As an institution, the dollar isn’t perfect, administered, as it is, by feckless politicians and a Federal Reserve Bank that too often seems to function as an arm of the executive branch. But, for all its foibles, nothing on the horizon comes close to replicating what It offers.

Dollar-substitutes will, of course, persist at the margins but, for the most part, they are riskier, entail higher transaction costs and are attractive to people and countries with something to hide.

Yet, this doesn’t mean that continued dominance of the dollar is inevitable.

The U.S. economy remains a marvel of innovation and productivity, but the biggest risk here isn’t geopolitical competitiveness — it’s the U.S. government itself. Failure to rein in spending, cut red tape, stem inflation, and use economic sanctions profligately will all weigh on the dollar’s preeminence.

For the time being, though, it’s fair to say that while some brave or foolhardy souls will experiment with alternatives, most are likely to continue using the dollar.