Almighty Dollar lets Americans eat their inflation and have cake, too.

The question is: How long will $ dominance last?

When we were junior military officers, my best friend at Osan airbase told me about this other young officer who got on his nerves. Why? The guy was always mixing metaphors, saying things like, “After that three-day drill, I felt so tired that I was out like a lamp!” Or, “Sergeant Dearborn’s only job is to make the phones work. It isn’t rocket surgery.” When Sean described these malapropisms, I burst out laughing, which annoyed him even more. “Did you ever consider the possibility that this guy is a genius? I think he’s saying these things on purpose.” All of a sudden, Sean got a devious smile on his face and discovered an appreciation for what was happening.

“He’s a son of a biscuit,” I observed.

The story of malaprops is presented here as a kind of metaphor for interest rate hikes by the U.S. central bank, and here’s why. Unlike every other country, the United States has the unique ability to fight recessions (and inflation) with a currency that is dominant over all others — and that role as the world’s Reserve Currency offers paradoxical power. When the U.S. lowers interest rates, the dollar becomes more attractive to investors, even foreign investors. Investors also “fly to safety” when the opposite happens and the central bank raises rates.

One of the consequences is that the United States is able to export inflation, as the Washington Post’s Megan McArdle explained in a recent column:

Higher interest rates made U.S. assets more attractive to global capital. To buy these assets, people and companies first had to buy dollars with whatever other currencies they had. This effect has been exacerbated by the “flight to quality” that always takes place in times of uncertainty.

Inflation in the United States — now 7.7 percent year over year — is relatively quiet compared with what has happened in many European countries that were exposed to the soaring cost of gas when Russia cut off supplies. Inflation is 11.1 percent in Britain, 14.3 percent in the Netherlands and 11.6 percent in Germany, which is known for its constitutional inflation hawkery.

The ability to export inflation so quickly must and should weigh on the Fed Board as its members try to finesse a soft landing. The primary indicators of GDP and Jobs remain hot, so the first instinct must be to continue raising the Fed Funds Rate until those cool. Yet other signs of disinflation are obvious and severe. Foreign inflation is the opposite side of lower prices for imports, but the ice cold U.S. housing market is also stark. Brakes on the economy, for better and worse, are never even. In other words, landings are only soft on average, and maybe only at the beginning. Landing a jumbo economy softly on one wheel while crashing the other suggests the scene at the end of the runway won’t be good.

My economic pessimism has actually abated because of the dollar’s unique role. We may be witnessing not just the US exporting inflation, but exporting its recession. Unfair, perhaps, and one wonders how long such imbalance currency power can last. That’s why my long-term pessimism remains steely. I constantly wonder how long the dollar will retain its dominant Reserve status. What we know is that the dollar won’t just fade. It has to be replaced by some alternative that investors trust more.

The alternative won’t be the Euro, and I scoff at the idea of Chinese Yuan displacing the dollar. No, I think the century opening before us will be shaped not by nation-state institutions of the past, but by digital-protocol institutions in utero. The smoking hole of FTX & SBF certainly doused enthusiasm for cybercurrency to displace the dollar. That offers some solace. I suppose the first time an attack on Constantinople’s walls was repelled offered some solace, too.

Photo by qi xna on Unsplash

Someday our dollar cake will be eaten and gone. Let me put some meat on the bones here. A recent report from the Bank of International Settlements (BIS, aka the bank of banks) warns that there are huge, shadowy sums unaccounted for in international currency exchange markets, which are very largely in dollars. The title is worth a thousand bucks: “Dollar debt in FX swaps and forwards: Huge, Missing and Growing.” The point is that the Treasury market (a.k.a., safety) looks less safe to me the more closely I look into it. Ultimately, the Congress approving trillions more debt to that market each year is fiscally irresponsible to the highest degree, but I’ll let the BIS have the last worries:

The missing dollar debt from FX swaps/forwards and currency swaps is huge, adding to the vulnerabilities created by on-balance sheet dollar debts of non-US borrowers. It has reached $26 trillion for non-banks outside the United States, double their on-balance sheet debt. Moreover, it has grown smartly since 2016, despite the often significant premium demanded on dollar swap funding (Borio et al (2016)). For banks headquartered outside the United States, dollar debt from these instruments is estimated at $39 trillion, more than double their on-balance sheet dollar debt and more than 10 times their capital.