The buck stops here

The dollar as reserve currency gives the US huge power and influence. It can force other economies to its will. Even when there is an international crisis, it does not have to worry about a run on its currency as it is the one everyone turns to in an emergency.

Because everyone needs and wants to hold dollars or dollar-denominated investments, the US can also run huge budget and trade deficits. People want to own American debt so much that the US government has been able to run consistently high levels of borrowing, effortlessly. 

But all that would be under threat if the dollar were to lose its status as the world’s reserve currency, a threat that hardly anyone took seriously until Trump won his second term. 

Since that happened, we have had a series of farcical economic policy announcements, 

many of which are based on a complete misunderstanding of basic economics. The financial markets are naturally unnerved by constant pronouncements on trade wars, the introduction, suspension and reintroduction of tariffs, even threats to invade friendly nations. All of these would damage the US economy. 

Threatening the independence of the Federal Reserve – America’s central bank – and the rule of law are also potential threats to the dollar’s dominance. As Paul Krugman, the Nobel prize-winning economist, put it, one reason for the dominance of the dollar is that “Unless you’re a dictator planning to commit major war crimes, you needn’t fear that the US government will impound your assets; in China, your assets may be at risk if you say something the strongman in charge doesn’t like”. Could Krugman say that now with quite so much confidence?

Unluckily for the US, there is somewhere with its own currency, the second largest economy in the world, and with an admiration and devotion to the rule of law and the current world economic system. The euro is the obvious rival to the dollar, but so far it has not been a serious threat to the dollar’s dominance for two main reasons.

The first is that its strength and reputation was undermined by the credit crunch and the financial crises in Greece, Ireland, Italy and Portugal, all members of the eurozone.  The other factor is that the euro is still very much a sum of its parts. Each country issues its own bonds and budget, taxes and borrows independently and so far, the members have failed to agree on a united system of borrowing as one. 

But the war in Ukraine and Trump’s abject betrayal of Kyiv mean that might be about to change. Such is the demand for more defence spending that the EU and its members will have to borrow vast amounts to pay for it. What better way to raise the money cheaply than to do it jointly? All of a sudden, the euro looks far more attractive. 

Sterling’s role as the reserve currency was already fatally undermined by the first world war but it continued to vie with the dollar for the role right up until the 1940s. Indeed, there were two reserve currencies for quite some time. 

The European Central Bank obviously does not think the euro can replace the dollar overnight but a dual system like in the 1920s and 30s is possible. Especially as Christine Lagarde, governor of the European Central Bank made clear in her 2024 annual review,  “Deeper European economic and financial integration… will be pivotal in increasing the resilience of the international role of the euro in a potentially more fragmented world.”

Luckily for the ECB, Trump’s appeasement of Russia is forcing the EU and the eurozone ever closer together, making its currency stronger, more trusted and more in demand. Increasing defence spending is being seen as a boon to the European economy and now it looks like America is heading for a recession. 

Ever closer union – of the single market, the eurozone, of EU-wide borrowing and economic policy – is now being seriously considered because of Trump’s actions. All such moves also strengthen the euro as a possible rival to the dollar.

Currently about 60% of all the foreign reserves held by the world’s central banks are dollars and only 20% are euros. But it would not take too much more of Trump’s antics to make many countries think about whether they want to hold so many dollars. 

What would happen if all those countries suddenly cut their holdings of dollars by, say, 5% and put the money into euros instead? Would the dollar’s status die?

A gradual decline of the dollar as the world’s reserve currency would be bad enough – the US government could no longer absolutely rely on the world lending it money at very cheap rates. To fund its huge spending deficit, interest rates would have to rise. Us administrations, especially Republican ones have become addicted to low taxes and high spending, selling the mad idea that trickledown economics will eventually pay for the tax cuts to millionaires. Well, we have been waiting 45 years for that to happen and in the meantime, Washington has borrowed more and more to fill the gap.

As the cost of doing that rose, reality would eventually have to dawn – the low-tax economy is built on sand. Taxes would have to rise sharply, or spending slashed massively. Not in a Tusk/DOGE manner, but real cuts to defence spending or agricultural subsidies or education and real tax rises for everyone, including the wealthiest.

Living beyond its means will eventually have to end in America but the doomsday scenario is even worse. A sudden collapse of the dollar’s position is unlikely, but it should be keeping us all awake at night. 

The US dollar would plummet in value overnight, the ability to avoid shutting down the government by endlessly increasing the amount of borrowing would end overnight too. Washington might have to default on its huge debts, interest rates would soar, and taxes too. Government spending would be slashed. Recession, if not depression would follow.

That would echo around the world, with the added problem that the countries that have lent the US trillions would find their investments almost worthless overnight. The West’s economic system could not easily survive such a disaster, we would have to bail out America; if we could find the will and the money to do that.

America can only survive as a dynamic low-tax economy because it borrows trillions from abroad to finance its state spending and its huge armed forces. Trump wants to slash taxes further and that will mean even more borrowing.

He can only get away with that so long as the dollar is THE reserve currency. Undermining that by making it less secure and less attractive is playing with fire.