President Trump's recent tariff policies have led to a decline in global risk markets, including US stocks, rising bond yields, and a drop in the US dollar. The simultaneous occurrence of these three events is a dangerous signal for economists. Is Trump causing permanent damage to the US economy?
This week, The Economist released a new interview where economist editor Henry Curr shared his concerns about the erosion of the US dollar's foundation as a global reserve currency, potentially leading to systemic risks. Here are the key points:
Why Is the Financial Market's Response to Trump's Tariffs Worrying?
Henry points out that the recent market volatility is not just a stock market sell-off. The deeper warning is that investors seem to be generally withdrawing from US assets, and if this trend continues to worsen, it could pose a serious threat to the US dollar's status as a world reserve currency.
It's important to know that the stability of the current global financial system and the functioning of the global economy largely depend on the dollar's special status.
Since President Trump announced "reciprocal tariffs" in early April, global stock markets have experienced significant declines, which is well-known. However, more worrying is the simultaneous sell-off of US Treasury bonds and the US dollar.
Typically, when US Treasury bond yields rise, the US dollar exchange rate would also rise as holding dollars to buy bonds offers higher returns. But now, bond yields are soaring while the dollar is falling instead. This abnormal phenomenon indicates a widespread sell-off of US assets and loss of confidence, a sign of "fleeing".
This dynamic is more common in emerging markets or in market collapses like the one triggered by former UK Prime Minister Liz Truss's disastrous "mini-budget". This strongly suggests that investors may have started demanding a "risk premium" for US assets. Foreign investors, mainly from the private sector, hold $8.5 trillion in US Treasury bonds. If these investors begin selling, it will further drive up US borrowing costs.
Fiscal Deficit Pouring Fuel on the Fire
Besides trade war tensions, another factor exacerbating market concerns is the US Congress's plan to further loosen fiscal policy. Congress not only intends to continue Trump's first-term tax cuts but may even expand them.
According to the Committee for a Responsible Federal Budget, the approved budget framework is extremely aggressive in fiscal relaxation, potentially exceeding the total of Trump's tax cuts, COVID-19 stimulus measures, and Biden's stimulus plan. Currently, the US fiscal deficit has reached 7% of GDP, an unusual figure during strong economic times, typically only seen during economic crises.
Such a large-scale fiscal expansion is enough to raise high alerts among bond market and US dollar investors.
Puzzlingly, despite frequent market warnings, the Trump administration seems unconcerned, with some high-ranking officials even doubting the dollar's reserve currency status. The White House Council of Economic Advisers chair has publicly stated that a strong dollar is like a tax on manufacturing workers because it makes US exports more expensive.
Senator J.D. Vance has expressed similar views. In the "Make America Great Again" (MAGA) circle, there is indeed a voice believing that reserve currency status brings enormous costs to the US. Senior government officials publicly questioning the long-standing official US stance of "welcoming a strong dollar and viewing the US as a safe haven for international investors" undoubtedly undermines market confidence.
Nightmare Scenario: Uncontrolled Chain Reaction
If the current initial signs continue to worsen, the most direct consequence will be a continued rise in US Treasury bond yields.
Given the US's massive national debt (about 100% of GDP), each percentage point increase in yields will ultimately force the government to pay additional interest costs by increasing tax revenue or cutting spending equivalent to 1% of GDP. This will create a vicious cycle, forcing Congress to take emergency measures to stabilize the market, potentially on a scale and with urgency comparable to the global financial crisis.
However, the question is whether the current highly polarized US political system can quickly reach a consensus and implement necessary but painful fiscal austerity (such as cutting social welfare). If the president vetoes related bills, can Congress override the veto with a two-thirds majority?
The US has used its reserve currency status to accumulate high debt and maintain surprising deficits even during strong economic times. This means that if a crisis erupts, the required policy corrections will be enormous, presenting a severe test to the political system.
At the same time, the role of the Federal Reserve (Fed) has become complicated. Although the Fed will almost certainly want to intervene to stabilize the bond market, the current environment is different from the global financial crisis. At that time, inflation was not the main threat, but now, partly due to tariff impacts, US inflation is heating up, and consumer inflation expectations are rising sharply.
Moreover, the Fed is facing pressure from the Trump administration to lower interest rates, and the appointment of the Fed chairman will expire next year. More worryingly, a court case that could weaken the protection of Fed board members from dismissal is currently being heard. These factors could undermine the Fed's ability to independently respond to crises, forcing it to stabilize the market while avoiding the impression of "paying for congressional fiscal deficits".
After the US Dollar, Who Will Rise and Fall?
If the US dollar truly loses its reserve currency status, who could replace it?
Henry believes that for decades, people have loved discussing whether the renminbi will replace the US dollar. However, considering China's current economic situation, capital controls, lack of independent rule of law, and the impact of trade wars, the renminbi is unlikely to gain the full trust of global investors in the short term and lacks the legal and market infrastructure required to be a reserve currency.
The reality is that many alternatives to the US dollar exist, but none completely match the US in terms of safety, liquidity, and economic scale. The euro is backed by a massive economy but lacks a unified and deep capital market and a jointly issued asset like US Treasury bonds. Nordic currencies are stable, but their economic scale is too small. Japan has heavy domestic debt. Switzerland is also limited in scale. Additionally, traditional safe-haven assets like gold and even cryptocurrencies might play a certain role.
However, a world without a clear dominant reserve currency will be a more unstable world.
Part of the reserve currency's safety comes from the herd effect of "everyone believing it is safe". Once this consensus collapses, the market will become more fragmented, more prone to runs from one currency to another and destructive capital flows. This would be a massive loss for the global financial system built on the belief that the US dollar and US Treasury bonds are "rock solid". We might face a transitional financial crisis, ultimately entering a world with more diverse asset parking options, but lower overall safety and stability.
Although the crisis has not fully erupted, the US government still has the opportunity to stabilize the situation by adjusting policies (such as rolling back tariffs and making fiscal corrections). The US dollar's status remains strong in the short term. However, recent turbulence and official statements have undoubtedly planted seeds of doubt. Even if the situation is stabilized in the short term, investors may have realized that similar turbulence could occur at any time. A slight risk premium on the US dollar and US Treasury bonds might become the norm, and once trust is cracked, it will be difficult to fully repair.
