It was not the Fed which surprised markets on August 1 – it was Fitch, a well-respected bond rating service which downgraded the quality of U.S. government securities from AAA to AA+. This follows a similar action taken by Standard and Poor’s over a decade ago after the Great Recession and an all too familiar debt ceiling impasse. Fitch cited as reasons for the credit downgrade, “a deterioration in the standards of governance” and “repeated debt limit political standoffs and last-minute resolutions” to recurring debt ceiling stalemates. The action by Fitch did give the bond and stock markets here and abroad a bit of a shudder. Immediately, Fitch’s downgrade is of no great concern. The risk weighting of U.S. sovereign debt remains at 0. The Basel regulatory framework also imposes a 0% capital requirement for bonds rated between AAA and AA. So for banks, which are huge buyers of U.S. debt, this downgrade makes little to no difference. But America is hamstrung by a dysfunctional budget process, an ever-escalating deficit, and an artificially constructed debt ceiling that is counterproductive for a country whose currency serves as the basis for most global transactions as the world’s reserve currency.
On top of a budgetary process which is quite imbalanced, the U.S. government over the years seems to have fallen in love with the use of sanctions to punish people, institutions, even nations to try to correct unwanted behavior. In 2000, the U.S. Treasury Department sanctioned 912 individuals and entities. In 2021, that number had grown to 9,421. After Russia invaded Ukraine, 2500 sanctions were leveled at Russia alone. Economic and trade sanctions are now considered an essential tool in the projection of American power. Admittedly, well placed and constructed sanctions can be and have been of some use in U.S. foreign policy. Most importantly, certain sanctions can make an aggressor think twice about a particular path they might pursue. Certainly Russia, as it is feeling increasing economic pressure because of being sanctioned in a multitude of ways, has had to change military plans and to provide embarrassing rationales to its populace as to the logic behind the invasion of Ukraine. Further, China has been taking notes on how not to get enmeshed in a quagmire of U.S. economic sanctions, if it ever were to get into a serious fight with America. It is supposed by numerous experts that China, after seeing what has happened to Russia, has hesitated with regard to its plans for Taiwan. So while the U.S. is economically choking Russia, degrading Putin’s capacity to make war, China may be thinking twice about an aggressive move on Taiwan now – and that would be good value for American money. But the U.S. should not become blasé about the use of sanctions. Overusing sanctions gives countries more reasons to not use the dollar – to strip it as the world’s reserve currency, which would be huge problem for the U.S.
Why would it become a huge problem for America if the dollar were no longer the world’s reserve currency? Because America would lose tremendous monetary and financial flexibility. The U.S. would be forced by markets to balance budgets, pay down accumulated debt and have a better national balance sheet – nothing that we HAVE to do today. It would be nice to do the above – but we are not forced to do it. Other countries, whose currencies are not reserve currencies, must behave better financially than the US or their currencies would plummet. In America’s case, seemingly no matter how financially irresponsible we are, everyone else needs the dollar, because that is how the world trades. Thus, there is always demand for the dollar and support for the dollar. There are moves afoot to conduct trade ex the dollar. The Chinese have tried using renminbi. The Indians and Russians are conducting some very limited trade using rupees and rubles – with little satisfaction. So far, these experiments have come to naught. But it should not be lost on anyone that people are trying to move away from the dollar. Nations do not want to be ensnared in the dollar’s worldwide trade web if they are in a fight with the U.S. They do not want to be successfully sanctioned and have their economies exposed. While that may be what some others around the world want, it is still the case today and will be the case for a long time that the US dollar reigns supreme. The dollar’s “privilege” as the world’s reserve currency will not be successfully challenged because the U.S. has the deepest, broadest and most liquid markets in the world which are freely convertible and governed by a market friendly and property-protecting legal system. America has the world’s reserve currency today – but it can be lost. The pound Sterling was the world’s reserve currency for much of the 18th and 19th centuries. The British lost their crown to us as the U.S. could lose it in the future. Not a problem today or for the foreseeable future – but it could become a big problem if the U.S. is not careful.