The world has been finding out the truth about the dollar system as increasingly rancorous opposition to Trump has been washing very dirty political laundry in public.
United States Treasury Secretary, Scott Beasant, portrayed the recent intervention US-Japanese in world currency markets, the largest markets in the world, to shore up the declining Japanese yen as act of solidarity for an ally. In an interview with Nikkei, he claimed that the Treasury purchased yen to prevent a broader Asian currency crisis, saying that “many Asian currencies follow the Japanese yen”. President Trump portrayed it as a ‘signal of friendship’ and ‘beneficial for the world economy. He further observation, with the usual Trumpian sting it the tail, that ‘"We're very strong -- very very strong financially. They are, you know, they have a weakening yen, and they wanted a little bit of help. And we're always there for Japan. Japan's been very good to us, with the exception, of course, of Pearl Harbor,".
However, much more is going on in this currency market intervention than US benevolence. Surprising though that might be, even more so is s that this is being openly admitted and discussed in the mainstream financial press. Truths about the dollar system rarely are.
For decades, discussion of the dollar system, dominated as it is by a small group of mostly United States based scholars, has been all about the strength and endurance of the dollar system, usually attributed to the United States’s economic and military strength and, ultimately, to its ‘wide and deep financial markets’, as the phrase goes. Since President Trump won election for a second time nearly two years ago and since he took office, jarring notes have been appearing in this otherwise consensual discourse. Thanks, in particular, to Trump’s brazen and unrestrained, and one might add, erratic pursuit of his MAGA agenda, Trump’s detractors, both outside and in his own party, have begun discussing the problems of the dollar system increasingly openly and volubly, chiefly to blame them on Trump. The world has been finding out the truth about the dollar system as increasingly rancorous opposition to Trump has been washing very dirty political laundry in public.
There are, of course, the inevitable complaints about the recent weaponization of the dollar system which, rather than being effective, is exposing the system’s own weaknesses. As a commentator noted, “As the US ratchets up pressure, other countries will look to escape dollar power, likely provoking the US to double down in response”. The result is not effective weaponization, but revelation that the dollar system is more water pistol than AK-47. Meanwhile, the Financial Times’s prestigious Lex column pointed out that the ECB now holds more gold than dollars in its reserves. If the US’s most loyal allies are choosing another reserve asset, that’s saying something. And yet another columnist noted the simple truth that the dollar system is reliant on massive capital inflows and that these are now endangered in many ways: by US stock markets’ dominance by a handful of companies investing in AI (and that dominance is already faltering); by the difficulty investors in dollar-denominated assets, whose circle has narrowed in recent years to other western countries, Japan and the countries of the Persian Gulf, may find sparing money for investment into the dollar system when they need it for so much else, including their own expanding economic and military needs; and by the declining tolerance of other countries for the currency weakness which is often the flip side of dollar strength. This declining tolerance must, in turn, put pressure on the dollar.
This last possibility became real with the recent weakness of the yen, prompted by many factors including rises in US interest rates in the wake of the post-pandemic inflationary tide, the requirements of the carry trade – borrowing cheaply in yen to engage in leveraged speculation on US markets, which requires yen to remain cheap even after Japan transitioned to positive interest rates – and by rising inflation making critical Japanese imports more expensive, a problem sharply exacerbated by the US-Israeli war on Iran.
Japan is particularly badly placed to tolerate yen weakness. With inflation already biting Japanese families and businesses used to stable or even declining prices for decades, a weak yen can only worsen things further. If the situation is to be addressed, there are two options. Both have monumentally adverse implications for the dollar.
One is intervention in currency markets. The Bank of Japan could use its dollar reserves usually held in US treasuries – and remember, today, Japan is the world’s largest single foreign holder of US treasuries – to buy yen and thus support the currency. However, this is precisely what the US would wish to avoid. Such an action would only throw more dollar assets onto a market that seems to have had its fill of them and, on top of that, is facing a torrent of new assets being offered it. They include higher borrowing that higher US deficits that Trump is piling up with his penchant for tax cuts and his half a trillion dollar increase in the military budget, which will result in higher issuance of US treasuries which the market must find the will to buy. They will also include the additional issuance that will be necessitated by higher interest costs as the US has been forced to increase interest rates to combat inflation, so far unsuccessfully. Finally, the torrent of assets on its way to find buyers on markets also includes new equity and debt issuance spurred by the bubble of US AI investment. All this would put too much strain on markets for US dollar-denominated assets, the foundation of the dollar system.
The second way the Japanese could deal with the problem of a lower yen is by raising Japanese interest rates. It is true that Prime Minister Sanae Takaichi does not favour this option and nor does the considerable political and business lobby behind her reflationary agenda. However, difficult though this choice may be, they may yet have to make it. What is more important from our point of view is that it is worse for the dollar system than for Japan on at least two counts. First, higher Japanese interest rates would set back the carry trade through which low-cost borrowing in Japan has facilitated the leveraged trading that has been so important in keeping up prices of dollar denominated assets on which the influx of money into the dollar system ultimately depends. Secondly, higher interest rates in Japan will also set back demand for US dollar-denominated assets more directly, as money pours into higher yeilding Japanese bonds.
This is why the US government intervened in currency markets to ‘save the yen’. It is noteworthy that the US did not buy yen and sell dollars but bought yen and sold euros, that too within informing the European Central Bank first. Another demonstration that the US’s allies are now required to be vassals.
In addition to these long-standing problems maturing, the credibility of the Federal Reserve has been thrown into question by many recent developments. There is, first, the Federal Reserve’s support for asset markets through Quantitative Easing after 2008 as well as, more recently, former Federal Reserve Chair Jay Powell’s tardy response to inflation. And in office, Trump has unusually and dangerously interfering in the policies of the ‘independent’ Federal Reserve, demanding lower interest rates. His Treasury Secretary, Scott Bessent has openly accepted, indeed boasted about, the political nature of Federal Reserve decisions. And now new questions about the strategy and competence of the new Federal Reserve Chair, Kevin Warsh, just appointed by the Trump administration, are already being aired.
It is therefore not a surprise that even a scholar as Barry Eichengreen, who has long talked up the dollar believes that the most important lesson of the yen intervention is that it is pushing the dollar system to the brink: ‘The bottom line is that Washington, fearing the consequences for US financial markets, is reluctant to see foreign central banks use their dollar reserves. This is telling us that the dollar is not the attractive reserve currency it once was. When this message sinks in, other countries will redouble their search for more attractive, readily usable alternatives. Reserve diversification is apt to gather steam.’
Well, there you have it, from the horses’ mouth. And the worst of it is that the intervention has not been particularly successful: the yen lost half its gains a couple of days later. It’s going to be a rocky rise for the dollar and the dollar system from here on.
