The Fed put a safety net under the global dollar. Could undermine it?

About the author: Vincient Arnold is a research associate at the Yale Program on Financial Stability and writes Discursive Etc., a blog on geopolitics and the financial system.

Foreign officials have recently become concerned that the Federal Reserve might refuse to extend its central bank swap lines during a crisis. While the Fed hasn’t changed its longstanding policy, Europeans (and their banks) are taking the possibility seriously given the Trump administration’s willingness to take unprecedented actions in service of its economic goals. But denigrating the reliability of the global dollar safety net would be a self-harming policy.

Swap lines are arrangements the Fed strikes with other central banks to provide dollars in moments when liquidity is scarce. Versions of these financial-stability tools have existed for decades, but they came into widespread use during the 2008-09 financial crisis. The Fed’s provision of global dollar liquidity is a public good, but it also benefits the U.S. Dollar markets abroad provide credit to U.S. households and businesses. A collapse in those markets would result in contagion to the U.S.

Although the Fed and other central banks describe them as neutral financial tools, I and other scholars have characterized them as implicitly geopolitical instruments, since they can align with national security and economic interests. The Trump administration may be tempted to see them solely in that light.

However, a pullback from offshore U.S. dollar markets would be at cross-purposes with many of the Trump administration’s core trade and economic goals. The Fed’s swaps serve as release valves for pressure abroad to hoard dollar assets—a pressure that works against the administration’s stated macroeconomic aims. The U.S. trade deficit, the current account, is financed by foreign capital inflows, the capital account. Reducing the trade deficit is clearly a Trump administration priority. To do that, it is implementing current-account-side interventions, such as tariffs.

Many analysts believe capital account intervention is also on the menu. Influential administration advisors, such as Stephen Miran, chair of the Council of Economic Advisers, have discussed that possibility, though Miran has since said the idea isn’t administration policy. Former U.S. Trade Representative Robert Lighthizer has also considered similar ideas. The logic of these proposals is that reducing the financing of the American deficit is one way to reduce the deficit itself.

Although there is reason to question such causal reasoning, strong academic evidence supports concerns that foreign accumulation of dollar claims contributed to the U.S. trade deficit. Swap lines may reduce the need for foreign governments and central banks to hold dollar reserves, because swap lines provide an alternative means of dollar insurance.

Asian economies discovered this relationship during their 1997 financial crisis, as economics commentator Martin Wolf said recently. They discovered they couldn’t print dollars during a run. “Their conclusion was, we must accumulate dollars without limit, more or less, and run current account surpluses to accumulate these dollars. Those two things came together and that led to an enormous expansion of the U.S. external deficit," he said.

That excess reserve accumulation contributes to harmful global imbalances is well-trodden ground, as Matthew C. Klein, an economics journalist, and Michael Pettis, a finance professor at Peking University, have argued. Of course, not all reserve accumulation is solely motivated by financial stability and dollar shortages; other contributors include currency control and trade practices. But Wolf correctly identifies the self-insurance role of reserve accumulation—it’s war chest-building.

Recent work by Haillie Lee and Phillip Lipscy at Princeton and Stanford, respectively, finds strong empirical evidence that reserve accumulation in East Asia (a land of huge surpluses and reserves) starting in the late 1990s was driven more by self-insurance motives than mercantilist trade policies. Anecdotally, this is consistent with private conversations with central bank staff in one the nations hardest hit by the Asian financial crisis. They aren’t ecstatic about the dollar’s centrality, but they have to deal with it. They don’t think the International Monetary Fund would help in a crisis (or would be overly punitive if it did). And they don’t think they would get a swap line from the Fed. So, they have concluded that the solution is to stockpile dollar assets either individually or collectively with other Southeast Asian nations.

Without access to the IMF or swaps, you should expect reserve stockpiling to increase. That implies at-risk nations are intentionally running trade surpluses to fund those reserve balances, thereby contributing to the U.S. capital account surplus (and trade deficit, all else equal). The upshot is, as Wolf has recently put it, that the resolution of global trade conflicts is conditional on the structure of the international monetary system.

Solutions to this problem could include a more muscular role for the IMF in the global financial safety net, something the Trump administration likely opposes; stronger and/or more swap lines (also not a Trump preference); or replacing the dollar as the global reserve currency (definitely not a Trump preference). Call it the Trump trilemma.

An extension of additional Fed swap lines would help relieve some of the foreign appetite for dollars. But they aren’t a panacea. As monetary policy experts Michael Bordo and Bob McCauley have pointed out, foreign official holdings of dollar assets have only accounted for a small share of the funding of the current-account deficit since the 2008 crisis. Central bank swap lines relieve dollar asset appetite only for official holders—central banks, sovereign-wealth funds, and other reserve managers. While the data is notoriously tricky to track, it is clear that foreign private holdings of Treasuries have accounted for much of the increase in aggregate foreign holdings in the past decade. (The evidence is less extreme for agency debt, but there is a similar trend). Swap lines don’t help there.

Further, the premise that foreign official investors have infinite demand for dollar assets is looking increasingly shaky, with recent reporting suggesting that one of the world’s largest official reserve managers—China’s State Administration of Foreign Exchange—is planning to shift away from dollar assets. That would be consistent with the long-run trend of the declining dollar share of global reserves.

Nonetheless, foreign official reserve managers are still large marginal buyers of dollar assets. They accounted for roughly one-fifth of all long-term U.S. securities ownership as of last year. To the extent that the Fed’s swap lines can reduce pressure on reserve managers to accumulate dollar assets, making them readily available would be consistent with the Trump administration’s goals. Taking steps to reduce foreign official holdings of Treasuries and agencies while also withholding swap lines would undermine the role of the U.S. as the world’s safe asset producer.

If Washington really wanted to withdraw itself as the issuer of the global reserve currency, forcing the Fed to withdraw its swap lines would be a step in that direction.

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