The King Dollar Dilemma: Rising Powers and the Future of Global Currency

Vladimir Putin got a lot wrong with his invasion of Ukraine, and one of his major mistakes was not realizing the U.S. would freeze his dollars in banks as part of a multi-pronged effort to impose sanctions. This aggressive move has been unquestioned in the West, even though sanctions have never made any rogue nation cry “uncle,” from Cuba to Iran to Syria to Venezuela.

The U.S. controls all dollars in circulation, regardless of where they are domiciled. While keeping Russia away from its more than $700 billion no doubt hurts Putin’s war effort, it also tells China, Saudi Arabia, and other well-to-do countries that often run afoul of U.S. foreign policy that keeping too many dollars around is risky. No one can “own” a dollar; they merely “lease” it at the sole discretion of the U.S. president. This is an alert to all governments who might not fully buy into the democracy versus autocracy mantle that foreign policy establishments from both parties have embraced.

This partially explains the lack of buy-in from much of the world for Russian sanctions. Generally, Europe, the UK, Australia, Japan and Korea agree with the U.S. that the Russian invasion of Ukraine needs to be rolled back, but 80% of the world’s population, led by China and India, have decided that this is a bi-lateral dispute between Eurasian neighbors, and business with Russia will continue. Similarly, U.S. efforts to rally a coalition against China have been stiff-armed by most of the developing world, Brazil, Mexico, the Middle East, Africa and of course, India. As Larry Summers said, “China comes to build a bridge, the U.S. comes to give a lecture.”

This, of course, is an over-simplification. But in general, China is interested in doing business without trying to impose any values-based strings. This allows it to influence the political and not just the economic world. The Chinese brokered a deal between two mortal enemies, Saudi Arabia and Iran, which overcame 800 years of religious differences (Sunni and Shia) and many proxy wars over the last century. They have begun official diplomatic relations. China has started to trade with Russia, Saudi Arabia and others in the Chinese yuan. Democratically elected Brazilian President Lulu suggested recently that Brazil, Russia, India and China (the BRIC nations) should lead the charge to find ways to trade outside the dollar. U.S. foreign policy, which historically sought to isolate China and Russia, has driven them to the tightest friendship in their history. Henry Kissinger was the architect of the policy that Russia and China should dislike each other more than they dislike the United States. But realism in foreign policy is out of favor inside the beltway, in both Democrat and Republican circles. Thus, Russia and China are determined to work together to undermine U.S. political and economic hegemony.

“Why does it matter?” Americans might ask.

Democracy versus autocracy is good — we are standing up for the Jeffersonian ideals that America was built on, right? Well, not so fast. The budget negotiations between Republicans and Democrats freeze framed a chilling reality. The fastest growing part of the federal budget is interest on its debt, not welfare benefits or cruise missiles for Ukraine. Both parties spent money for 20 years like it was a Monopoly game. No deficit was too big or even in the conversation because interest rates plummeted. More new debt at lower rates could replace older, higher-rate debt being retired.

Unfortunately, this virtuous cycle has ended. If the Federal Reserve keeps rates anywhere near current levels, the federal government’s interest costs are set to skyrocket. This, combined with entitlement spending being off limits and a need for robust defense spending to protect against threats posed by China and Russia, leaves less than 20% of federal spending to absorb all the coming frugality. This reality made the deficit-ceiling crisis much more difficult to solve than the stock market discounted. A way to “pretend and extend” was found to postpone the day of reckoning one more time. But the federal government won’t be able to postpone forever. One day, Washington, D.C. will face the riots that took place in the streets of Paris when entitlements inevitably enter the conversation.

While most politicians are not economists, international trade and monetary theory tells you that if a country runs consistent trade and budget deficits, it needs to run a capital surplus. This means foreigners have to buy our bonds, and it is just a question of how much interest the U.S. needs to offer. Anything that subtracts from the U.S. dollar demand, by definition, will cause higher bond interest rates to clear the market.

In the short term, a U.S. debt default would have caused the U.S. dollar and bonds to rally in a flight to quality, as the market usually has a knee-jerk reaction in times of a crisis due to the economic slowdown that would likely occur. That said, longer term, there will be a higher risk premium for U.S. bonds and, therefore, higher interest rates, all things being equal.

A country that needs to deficit spend must think hard before alienating its financial backers from the Middle East and China. The U.S. has benefited greatly from the “king” dollar, and it should be careful not to throw away this competitive advantage. With less foreign capital in the future, the coming austerity when Washington finally embraces the entitlement debacle will make the current debt-ceiling compromise seem nostalgically pleasant.

Rhys Williams is chief strategist at Spouting Rock Asset Management.

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