By Leonid Bershidsky
President Donald Trump keeps bragging about the stock index gains since his election. He did so again on Friday, claiming he'd helped create "six trillion dollars in value." Be that as it may, it's also likely that Trump is at least partially responsible for the dollar's weak performance in 2017, which, from an international perspective, wiped out much of that "value."
Last year, the US dollar lost 10 per cent against the euro and 5.5 per cent against the renminbi. It was the second worst performer among major currencies after the New Zealand dollar, and its drop was the steepest in more than a decade despite three interest rate hikes and the passage of Trump's tax reform, which could logically be expected to drive the dollar's value upward. This happened for a complex set of reasons which may include the dollar's popularity as a funding tool for foreign companies and governments, but Trumps's effect on his country's global standing must be a key driver of the dollar's decline.
In a 2017 paper, Barry Eichengreen of the University of California, Berkeley, and Arnaud Mehl and Livia Chitu of the European Central Bank developed a "Mercury and Mars" hypothesis about the value of reserve currencies. They wrote that there are two sides to a currency's appeal. The Mercury side is economic: It's all about safety, liquidity, network effects and economic connections. The Mars side is geopolitical: It reflects the issuing country's strategic, diplomatic and military power.
The researchers attempted to quantify this duality by looking at the composition of nations' currency reserves. They found that as long ago as between 1890 and 1913, countries were more likely to hold reserves in the currencies of their defense pact partners, even when purely economic choice would have dictated otherwise. The same is still true, with a nuclear-era twist. Nations such as Japan and South Korea, dependent on the US for security, hold a greater share of reserves in dollars than France, Russia or China, which possess their own nuclear deterrent. Eichengreen, Mehl and Chitu developed a model to predict the composition of countries' foreign reserves with and without the "Mars effect" and found that for America's security dependents, the actual share of dollar holdings (shown on the chart below) was always higher than the model's highest predictions:
Eichengreen and collaborators argued that the dollar's "security premium" accounts for a significant part of its attractiveness as a reserve currency. Losing it would mean a 30 per centage point reduction in the share of US currency in nations' reserves. Isolationist "America First" policies would certainly seem to undermine the "security premium." Einchengreen, Mehl and Chitu wrote:
The dollar's dominance as an international unit is buttressed by the country's role as a global power guaranteeing the security of allied nations. If that role were seen as less sure and that security guarantee as less ironclad, because the US was disengaging from global geopolitics in favor of more stand-alone, inward-looking policies, the security premium enjoyed by the US dollar could diminish. Our estimates suggest, in this scenario, that $750 billion worth of official US dollar-denominated assets – equivalent to 5 per cent of US marketable public debt – would be liquidated and invested into other currencies such as the yen, the euro or the renminbi.
All year, the Trump administration has blown hot and cold on its commitment to alliances, to the point that any assurances it makes today can't be taken at face value. Trump's quick temper and his willingness to play the "whose nuclear button is bigger" game haven't helped bolster the US reputation as a security guarantor. The constant leaks pointing to Trump's incompetence, such as the new Michael Wolff book, appropriately titled "Fire and Fury," also detract from the dollar's reputation as a safe asset.
No wonder its share of global foreign exchange reserves, as reported to the International Monetary Fund, stood by the end of the third quarter of 2017 at the lowest level since the middle of 2014. It declined throughout the first three quarters of last year.
That share still stands at 63.5 per cent, dwarfing other reserve currencies. Central banks hold $6.13 trillion. It would take many years or even more drastic shake-ups to destroy both the "Mercury" and the "Mars" advantages of the US juggernaut. But the slight shift in favor of other currencies reflects a perception that making bigger bets on the US might be unsafe. That's likely one of the motives behind other reserve currencies' exchange rate gains relative to the dollar.
Trump, of course, has spoken out in favor of a weak dollar because it helps trade competitiveness. But the US currency is not weakening because of any consistent policy. On the contrary, it's Trump's loose cannon behavior that's undermining it. An unhinged Mars is beating up Mercury in a fit of fire and fury.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.