S9 Ep52: The Dollar Anchor Is Slipping

Episode Summary

Executive Summary: The episode examines why the US dollar remains the global safe-haven and anchor currency, arguing that its status stems from the US economy’s “effective size” and openness rather than institutions alone. It then models how tariffs and capital controls weaken that role, while greater European integration could make the euro the next anchor currency. China is seen as an unlikely rival unless it liberalizes heavily.

Main Topics: Why the dollar is the global safe-haven currency (Priority: 5/5): Tarek Hassan explains that the dollar, alongside a few others, rises in crises because investors see it as a store of value; the dollar is the strongest example of this pattern. The US economy’s ‘effective size’ and safe-haven status (Priority: 5/5): The paper argues the dollar’s dominance comes from the US being the largest, highly open economy whose shocks strongly move global prices and trade. Tariffs, capital controls, and the erosion of dollar dominance (Priority: 5/5): US tariffs and restrictions on cross-border investment reduce America’s effective size, weaken the dollar’s crisis behavior, and make it less attractive as an anchor currency. Europe’s path to a stronger euro anchor role (Priority: 5/5): The euro could become the anchor currency if Europe deepens economic integration, enlarges the EU’s functional market, maintains trade openness, and preserves capital openness. Why China is not currently a serious anchor-currency contender (Priority: 4/5): China’s closed capital account and financial repression make the renminbi unattractive as a safe-haven or anchor currency despite China’s large economy. Policy and political stakes for Europe and the US (Priority: 4/5): A euro anchor would lower European borrowing costs and raise investment, while inward-looking policies in Europe would undermine these gains; the US risks losing ‘exorbitant privilege’ if current policies persist.

Key Arguments: The dollar is a safe-haven currency because it appreciates when global stress rises, preserving value for investors. The US dollar’s special status is not accidental; it follows from the US being large and deeply integrated into world trade. What matters is not just size, but ‘effective size’—how much US demand and shocks affect world traded-goods prices. Tariffs shrink effective size by isolating the US from global goods markets, reducing the dollar’s tendency to strengthen in bad times. Capital controls make a currency less safe by preventing international risk-sharing and limiting how domestic shocks transmit abroad. European integration, especially with currently partially integrated economies, could raise the euro’s effective size enough to surpass the dollar. China would need major liberalization of its capital account to compete as an anchor currency, which looks difficult and uncertain.

Data Points: Share of currency trades involving the dollar: 89% - The dollar sits on one side of nearly all global currency transactions. Countries stabilizing against the dollar: Two-thirds - Many central banks manage exchange rates relative to the US dollar to make their currencies safer to foreign investors. Current average tariff on US imports and exports: About 12% - Includes tariffs imposed by the US and retaliatory tariffs from trading partners. Tariff level that would make the euro safer than the dollar: 26% - Under current European structure, this is the tipping point where foreign countries would prefer stabilizing against the euro. Tariff level under deeper European integration that would flip the anchor role: 6% - If Europe were more fully economically integrated, much smaller US tariffs would be enough to make the euro the anchor currency. Estimated rise in US interest rates from current tariffs: 0.4 to 0.5 percentage points - The model estimates current tariff levels already lift US borrowing costs. Eurozone’s effective size today: 15% of world GDP - Measured as the current core euro area’s share of global output. Effective size after full EU integration: 17% of world GDP - If existing EU economies were as integrated as Germany and Hungary are in the euro area. Effective size with UK and EFTA added: 22% of world GDP - Includes the UK, Norway, Switzerland, and similar economies more fully integrated with Europe. China household foreign investment limit: $50,000 per year - Used to illustrate China’s tight capital controls and restrictions on outward investment. Public debt impact of lower European rates: Hundreds of billions of euros per year - Estimated budget savings if euro-area rates fell by 1–2 percentage points. Common monetary policy contribution to euro integration gains: About one-fifth - Most gains from euro integration come from real economic integration, not just shared monetary policy.

Pivotal Quotes: "The US dollar is the champion or the superstar of the safe haven currencies that kind of appreciates the most when things go wrong." — Tarek Hassan: Explaining what a safe-haven currency is and why the dollar stands out. "It’s not enough to be big, but you have to be big in a way that makes you important for the world economy when something bad happens." — Tarek Hassan: Defining ‘effective size’ as the key mechanism behind anchor-currency status. "Just integrating Europe fully would make the Euro the anchor currency." — Tim Phillips: Summarizing the paper’s central policy implication for Europe.

Implications: If the US keeps raising tariffs and restricting capital flows, dollar dominance could weaken faster than many expect. Europe could gain from deeper integration and euro bonds, while China remains far from credible anchor status without major liberalization.