Weaponising US dollar and monetary policy risks setting the global economy on fire

When global finance is used to punish political adversaries and economic competitors rather than promote growth, it undermines a global public good
For the US too, a powerful currency is also a double-edged sword

Andrew Sheng

Published: 3:30am, 22 Apr 2023

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With the world likely to head towards a recession, what is the future of the US dollar and monetary policy?

Two weeks ago, I explored how difficult it was to know where to put your money in a world turned upside down because of financial and geopolitical risks. There are no simple answers because how you allocate your money depends on your risk appetite and your exact circumstances, which is why broad strategies don’t work in times of massive change.

Caught in a world between higher inflation, geopolitical risks and possible recession, central bankers in the advanced markets are rethinking what to do in a period when monetary policy has to respond to splits in global supply chains disrupted by tight labour markets and Russia’s invasion of Ukraine.

The global financial system is being split from a dollar-dominated system into one likely to be in blocs with different payment systems. The US dollar system will be dominant for a while yet, but the more the currency is used in terms of sanctions, the more users will want to move away from it.

Global finance is seriously conflicted as to its real objectives – promote growth, control inflation or go fight the next war.

Basically, the four top central banks – the US Federal Reserve, European Central Bank (ECB), Bank of Japan (BOJ) and People’s Bank of China – together run monetary policy for the world as they operate the key reserve currencies.

Federal Reserve Board chair Jerome Powell leaves after a news conference at the Federal Reserve in Washington on March 22. The four central banks that operate the key reserve currencies effectively set the monetary policy for the world, but the Fed is head and shoulders above the rest because of the dominant position of the US dollar. Photo: AFP

However, the Fed is clearly heads and shoulders above the rest because of the dominant position of the US dollar, which accounts for about 60 per cent of global foreign exchange reserves. The ECB has been expansionary, but the leading quantitative easing champion is the BOJ, whose balance sheet is now 125 per cent of Japanese GDP.

When the Fed, ECB and BOJ started on quantitative easing after the 2008 global financial crisis, their balance sheets increased six times from US$4.6 trillion at the end of 2007 to US$27.9 trillion at the end of 2020.

During this period, their total financial assets dropped as a percentage of total Group of 20 (G20) financial assets from 75.5 per cent to 63.7 per cent. In the meantime, slower growth in those three economies meant their share of G20 GDP dropped from 66.1 per cent to 56.1 per cent.

When global inflation started to pick up in 2022, the Fed and the ECB started raising interest rates, with the BOJ lagging behind. This caused the US dollar to strengthen as there was not just a flight to quality arising from rising geopolitical tensions, investors were seeking higher returns as the rest of the central banks were slow to react on interest rates. This allowed most currencies to depreciate against the US dollar.

When the dollar is strong, world trade tends to contract and growth tends to slow. US buying power increases, but the world has to contend with tighter liquidity. However, after the United States became a net debtor to the world in 1990, any increase in US interest rates meant a higher US debt burden and therefore was contractionary on the economy.

If you strip off the veil of money, you would discover that money and finance are like a shell game that hides what is happening in the real economy – the things that matter, such as jobs, food, health and so on. Essentially, life is about reciprocity – if you owe someone, you have to pay back sooner or later in material goods, services or just making that person happy.

So when financial pundits say that the US dollar is so dominant that there is no alternative, they forget that the dollar is a two-edged sword for the US.

It is very powerful and can be weaponised, giving the US government the ability to sanction any dollar holders. However, the neocons in Washington tend to forget they are recommending the US fight World War III on a credit card.

The US national debt is already at the same level in relation to GDP that it was at its peak at the end of World War II. At the same time, other people around the world likely understand that holding more US dollars could mean they are funding the next US aircraft that might bomb them to smithereens.

In the short run, the US dollar’s dominance means that it is difficult to move away from it.

A hoarding showing the debt limit is seen in Washington on April 17. The US government is expected to run out of money in the summer if Congress does not authorise additional borrowing. Photo: AFP

The conclusion is that if the US, European and Japanese central banks keep easing monetary policy to continue supporting their financial system and rescue their economy from recession, the implication is to weaken their currencies. If so, we could get a situation where everyone else starts to devalue their currencies, sparking a global race to devaluation will end up with stagnation and higher inflation.

Traditional central banking claims that inflation is essentially a monetary phenomenon. If you print more money than the growth of real goods, then inflation is inevitable. Furthermore, if you increase defence spending, which does not add to global productivity, we end up weaponising global money towards global conflict.

In a nuclear war, all currencies and financial systems will be nuked. That is the ultimate de-dollarisation.

Weaponising the world’s money is killing global public goods. If you want a brawl, please don’t break the bar.

Andrew Sheng writes on global issues from an Asian perspective