Almost with total certainty, the gloomy predictions about the end of the dollar’s reign will, once again, be disproved by reality. But until the U.S. finds a new monetary system that suits it, there is much suffering ahead. A via crucis. The current one is running out. For decades, Washington has enjoyed the privilege of turning its trade deficits and debt into fiscal stimuli. An unparalleled boost for its growth and to lead the world. But the trick seems about to exceed the limit of sustainability.
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For some time now, there have been signs of some nervousness about the high levels of U.S. debt and its rapid growth. The cost of high interest rates is the canary in the coal mine, the alarm signal. And it was right in the middle of the vacation recess that things began to get complicated. The first relevant episode was the joint intervention of the U.S. and Japan to stop the depreciation of the yen, the Japanese currency.
Operation presented by Donald Trump as a “gesture of friendship,” but which is a corralito with an explicit threat to Japan of reprisals if it does not behave well. It prevents the Japanese from selling their Treasury debt securities to obtain dollars with which to buy yen to support its exchange rate. Selling U.S. debt these days will be considered a declaration of war by Trump, who has literally said so.
The plan imposed by Washington on Prime Minister Sanae Takaichi forces Tokyo to temporarily park those debt securities in the American Treasury in exchange for receiving dollars loaned by the same Treasury. Conclusion: Japan cannot sell the debt, the mortgage, and must pay up to 4% for the dollars it has borrowed. A mechanism reminiscent of Richard Nixon’s decision in 1971, when he ended gold convertibility and forced his partners to keep the dollars they already had, albeit devalued.
Japan is a significant investor in Treasury debt, the largest foreign holder, hence the importance of preventing it from rushing to sell it. And if the yen collapses, the country and its investors will stop buying more American bonds. But the problem for Scott Bessent, the Treasury Secretary, is not only or mainly the States, always more sensitive to the political extortion so favored by his boss in the White House, but the private investors, especially the boldest, who go to the limit.
Hedge funds hold more U.S. debt than Japan, the United Kingdom, and China combined
Hedge funds, genetically radically risky, already hold more than $3.4 trillion of U.S. debt in their hands, double what they had just three years ago. More than the sum of Japan, the United Kingdom, and China, the top three foreign holders. And these investments are supported by a huge mass of debt, the famous leverage. They did not like the Japanese medicine at all. If the turbulence worsens and these funds unwind their positions, they could trigger a devastating cascade of sales for the financial system.
That is why Bessent announced new measures this week trying to calm things down and assuring the repurchase of long-term debt starting in September, to avoid sales and contain the rise in interest rates. Deterrence instead of the judo lock applied to Japan. But it has barely had any effect on the markets. Partly because it is a drop in the ocean.
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And Bessent has had to take another step again. He has assured that the deficit has already reached its highest point and that from now on it will begin to decrease. His problem is that no one believes him. With the war front open in Iran, a request to double the Defense Department’s spending for next year, and tax cuts for the richest underway, the red numbers in public accounts can only grow.
The U.S. has never implemented a spending reduction plan since it became the hegemonic power. The partial exception was between 1998 and 2001, under President Bill Clinton, when the U.S. achieved a public surplus thanks to the stock market boom, which later would take its toll with the 2008 financial crisis, and the reduction of the military budget. A context very far from the current one.
Now, the world suffers the consequences of the Iran war. Since the 1960s, after every relevant armed conflict from the economic cost point of view undertaken by the U.S., a financial crisis has followed. This was the case with Vietnam or Afghanistan and Iraq. The current one in Iran will test whether that maxim still holds. Its cost is skyrocketing, between $100 billion and $200 billion according to sources, adding fuel to the fire of the deficit and debt.
The predictions about the end of dollar dominance will not be confirmed, but its current model is running out
The latest turbulence could be an early indicator of the incubation of that new crisis. It is not, for now, the consensus among economists. Many analysts, from Nobel laureate Paul Krugman to the renowned analyst Mohamed A. El-Erian, attribute the problems to the competition for credit posed by huge private investments in artificial intelligence gigafactories, an attractive alternative to public debt, which must offer higher returns to be appealing. A danger also for the stock markets. With serious consequences on the cost of financing States, social spending, and prices for consumers, which add to inflation caused by the war, but far from predicting panic or flight of investors from debt. But they also assure it predicts a positive future of more productivity with AI. We will have to see.
Trump seems to have already lost control of the economy. He has not fulfilled his commitments. Growth is less than promised, 1.5%; the deficit increases, as does the debt; industrial employment declines; inflation rises; gasoline is more expensive, as is credit, and he has cut social spending. It does not seem that his administration will be the one to usher in the new monetary system that the U.S. needs.
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