The Risk We Forgot to Price ft. Barry Eichengreen

[00:00:06] Barry

I think it’s about to… The trade war of the 1930s spilled over into all kinds of diplomatic and geopolitical problems. So, there’s the danger of that.

The US, then, experienced three major banking crises and everybody liquidated their dollar reserves, leaving not enough global liquidity to go around. So, one could imagine a similar chain of events unfolding now.

[00:00:37] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

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Here’s your host, veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:32] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is a series that I not only find incredibly interesting as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game changing issues and hopefully dig out nuances in their work through meaningful conversations.

Please enjoy today’s episode hosted by Alan Dunne.

[00:02:16] Alan

Thanks for that introduction, Niels. Today I’m delighted to be joined by Professor Barry Eichengreen. Barry is professor of Economics and Political Science at University California, Berkeley. He has written and researched extensively on international monetary affairs, international finance, and economic history. He’s the author of a number of highly acclaimed books including Exorbitant Privilege and Hall of Mirrors.

Barry, great to have you back on Top Traders Unplugged. How are you?

[00:02:46] Barry

Very well. Good to be back with you, Alan.

[00:02:49] Alan

Great. Well, you were a previous guest back in 2023 I believe. So, if anybody wants to hear about your background, the full story, they can go back and check out that episode. But it’s very timely to have you on because, obviously, a lot of the research and writing you’ve done has been on international finance, the reserve role of the US dollar, and more recently you’ve written a lot about debt as well. So, I think we’ve lots of stuff to talk about.

You wrote an article in the Financial Times, at the end of March, which looks quite prescient now, talking about some of the risks to the US dollar’s, I guess, international standing and reserve status. And in that piece you pointed to, I guess, some of the factors that tend to be less talked about, namely the importance of personalities and people over capital markets and institutions. So, have you become very concerned about the longer-term outlook for the dollar?

[00:03:51] Barry

I have grown very concerned. The book that you mentioned, Alan, Exorbitant Privilege, came out in 2011. And I suggested that the dollar’s dominance as the ‘go to currency’ for traders ,and financiers, and importers, and exporters, around the world, that dominance was likely to erode very gradually over time as the weight of the US economy on the global stage similarly declined very gradually over time. And I suggested the dollar would have to share the international stage with other currencies such as the euro and the Chinese renminbi.

What I thought would be a gradual glacial process of financial rebalancing has come forward in time. Obviously, Mr. Trump has brought it forward in time and we now face the possibility that there will be flight away from the dollar due to unpredictable US policies. And what could have been an orderly process of rebalancing could turn into a chaotic period of financial turmoil. So, I’m worried not only for the dollar, but for the global economy and the global financial system.

[00:05:18] Alan

And I mean, it’s interesting, I guess, people when they talk about the dollar, I mean, sentiment always seems to shift to the possibility of an abrupt end to the dollar status. But obviously, you’ve written about this before with Exorbitant Privilege, and you looked at the scenario of the last major transition, I guess, which was sterling in the World War period. And sterling, in reading your book, it started to lose its status maybe in the ‘20s, but sterling remained stable for quite a while after that.

So, I mean, the dollar could lose its reserve status without suffering a major decline. But it sounds like there are concerns on both sides now, isn’t that fair to say, in terms of reserve status and just general appetite for international appetite for the dollar?

[00:06:09] Barry

Well, the dollar and the US treasury market are important for the world because dollars are the grease and the wheels of globalization, if you will. The dollar is the dominant form of international liquidity that is used for commodity and merchandise, imports and exports, and cross border financial transactions alike.

But the US treasury market is important for the United States itself. There’s the question of what interest rates the government will have to pay to service its debt, and whether there will continue to be sufficient appetite for US treasury securities to keep those debt servicing costs under control. So, there is the issue of fiscal and debt sustainability in the United States. And what happens in the United States doesn’t stay in the United States – financial problems here tend to infect other countries and the globe as a whole.

[00:07:23] Alan

One of the interesting features of, I suppose, our experience with the dollar in the last few years has been that we’ve also had these episodes of periodic spikes in the dollar, and this idea that the world is kind of structurally short dollars, but at the same time you hear people being overweight dollar assets. And, I guess, if you look at the experience of the global financial crisis, and again, during COVID when you had funding stress and the scramble to raise dollars, the dollar spiked. So, is that going to be still a factor that we have this huge issuance of dollar liabilities?

Will that always kind of cause the dollar to maintain this kind of characteristic of in times of severe stress it would still benefit from that dynamic? Or how do you reconcile those two kind of country kind of perspectives?

[00:08:16] Barry

There’s no guarantee that what was true in the past will be true in the future. That’s a general rule of life, but it applies here as well. What you’re describing is the dollar’s traditional safe haven status – that the US treasury market is the single largest and most liquid financial market in the world. And when there is a crisis, when a bad thing happens, investors rush into that liquid market.

They are reassured that if they hold US treasuries, they can buy and sell them at a relatively stable price, at will. So, even when the US caused Lehman Brothers to fail, we did the bad thing. In 2008, investors rushed into dollars in the US treasury market and the dollar exchange rate strengthened. That’s the safe haven character of the dollar.

What we’ve seen in the last couple of months, however, is that when the VIX, a measure of global volatility, spikes, when US interest rates go up, investors move out of dollars. I think we’re seeing the erosion of that safe haven status because the US treasury market may be relatively liquid and stable at the moment, but the Trump administration has… Members of the Trump administration have made some peculiar suggestions about how that market might be managed in the future that have caused investors to begin to doubt whether the US treasury market is a safe place to park their funds.

[00:10:08] Alan

As you’re speaking, obviously, I suppose it’s clear that the outlook for the dollar is kind of inextricably linked with the outlook for treasury markets. And many of the same factors, I guess, are driving the two markets.

I suppose a big focus now in markets, with the passage of the Big Beautiful Bill going through Congress, is debt and deficits. And a couple of years ago you went to Jackson Hole and presented a paper on debt and kind of the likelihood that high debt levels are here to stay. I think bond yields are roughly where they were then, but at that point they were kind of trending higher, and then after that they went up towards 5% in the 10-year. So, it certainly brought it onto the radar.

I mean, what was the discussion like in Jackson Hole at the time? How was your paper received? Was there general acceptance that what you presented, which was that higher debts are here to stay, was that the consensus, would you say?

[00:11:11] Barry

I think the policymakers in the room were somewhat more optimistic or committed to the idea that governments were going to bring these high debt levels back down in order to restore government’s capacity to borrow in the future to meet the next emergency, the next pandemic, or financial crisis, or whatever warranted a new round of borrowing. In that paper, my co-author and I looked at past episodes. There were not a large number, but there were some past episodes where governments did succeed in bringing back down high levels of debt.

We found two robust predictors or correlates of success. One was growing the economy, growing the denominator of the debt to GDP ratio. That’s the painless way of bringing down debt. And low levels of political polarization, which enable countries to stay the course, if you will, even when government changes, they can continue the process of fiscal consolidation because there’s a political consensus around what needs to be done.

So, against that backdrop, I’ve become more and more pessimistic about the United States. Number one, the Trump administration has cut the legs out from under American exceptionalism, out from under the exceptional performance of the US economy by advanced country standards, based on research and development, public private sector collaboration, the excellence of our universities, you name it. There’s more reason to worry about American exceptionalism now than in the past.

And the problem of political polarization in the United States, which has been rising over time, shows no signs, to put it mildly, of reversing course. So, that combination of factors makes me even more worried about fiscal prospects in the US. And the Big Beautiful Bill kind of highlights that problem.

[00:13:40] Alan

You presented your paper in 2023, and at the time you highlighted that high levels of debt were likely to stay, but at the same time you didn’t see a fiscal crisis in the near term. I mean, your point was that, based on the broad parameters, the longer-term trajectory wasn’t great but it wasn’t unsustainable in the short term. Is that shifting now, given what we’ve seen in terms of deficits in the last couple of years? And at what point would, you know, or what would it take for you to say, okay, we could have a crisis in the next one to two years?

[00:14:17] Barry

In 2023 I could not imagine that our budget deficits in the United States would keep widening as they have. So, back then the deficit was 5% or 6% of GDP. Now it’s 7% of GDP, presumably, and heading higher. There is no constituency for addressing this problem. And with an economy whose growth is likely to slow going forward, 7% of GDP deficits are simply unsustainable. So, I’m more worried about this now than I was back then.

[00:14:58] Alan

Okay, and obviously, people focus on this relationship, R minus G, which is the rate of interest on the debt versus the growth rate. I guess the optimists would point to, you know, AI, the possibility for productivity boom. We’ve seen better productivity in the last one to two years, but that kind of followed a couple of years of weak productivity. So, averaging out, it’s probably average enough.

I know what you’ve written about how some of the Trump policies in terms of the universities, et cetera, could undermine productivity. What about AI? Is that going to be a possible savior?

[00:15:39] Barry

It’s a possible savior, but I think all the evidence we have from past general-purpose technologies, in other words, important innovations that can be utilized across the economy, they have to be utilized across the economy in order to boost productivity economy wide. All the evidence we have from the steam engine, the internal combustion engine, computerization, suggests that this takes time.

Companies have to figure out how to make productive use of this new technology. They need to reorganize their affairs. And it can take years, it can take decades. It literally took decades in the case of the steam engine, electricity, the internal combustion engine, before productivity, economy wide, responded.

Often, productivity, economy wide, declined before it accelerated because the process of reorganization, in order to capitalize on these new technologies, is disruptive. So, before electricity, you had the steam engine, and factories had machines, each of which ran on a centralized steam engine connected to that engine with a system of gears and pulleys that ran overhead. All of that had to be disassembled and the factory floor had to be reorganized to capitalize on the availability of self-standing electric engines. So, productivity went down for two decades before it began to go back up. It’s quite possible, likely, in my view, that we’ll see something similar, maybe a bit compressed in time, but still similar in the case of AI.

[00:17:38] Alan

Okay. And I guess we’re talking about the reaction you got at Jackson Hole and the perspective of policymakers, once debt levels and deficits get too large, you get this phenomenon of fiscal dominance and the need for monetary policy to be directed towards, I guess, you know, trying to keep bond yields in check and financing the government. I mean, that’s something that’s been talked about for a while. I suppose we saw it a little bit during COVID. We saw it in the gilt market, effectively I think, at that point in time. And you could argue that the Fed was effectively doing that during COVID as well. But I mean, is that something that could really become a feature of the landscape, do you think, in the coming years?

[00:18:25] Barry

Well, the answer depends, I think, on the country that one is talking about. So, in the United States… Here I’m going to speak like an economist, on the one hand, the Fed is independent and the Supreme Court has just issued a judgment, if you will, that the independence of the Fed is stronger than that of other supposed independent agencies in the US.

I think the Fed is deeply committed to its inflation target and would be reluctant to abandon that in order to bail the government out of its debt servicing problems. On the other hand, however, Mr. Trump is a low interest rate man. He’s interested in low interest rates for a variety of reasons, but he will surely be interested in them in the future as a way of keeping debt service and costs down and freeing up government resources for other purposes, whatever. And he will arm-twist the Fed to keep interest rates lower than otherwise.

So, how that plays out over time, none of us can predict. But I think there is a scenario where the Fed feels intense pressure to keep interest rates lower than otherwise because of debt servicing problems. And one can imagine other countries where the central bank is less independent, where that pressure is even more effective.

[00:20:08] Alan

I mean, I have seen it being suggested that we’re already seeing that in Japan. Obviously, the bank of Japan is maintaining low rates. Inflation has continued to be at or above target. Now, I guess you can make the point that there’s a question of how sustainable those inflation rates are. But is that the type of example that comes to mind when you’re talking about some central banks who might be less independent.

[00:20:37] Barry

Not yet. So, I think the BOJ is still looking at the Japanese economy through the rear-view mirror. That’s often what central banks do. It is not convinced that the long period of deflation is over, so it’s reluctant to raise interest rates faster. Now that it sees a spike in JGB yields, it may begin to worry about something else, namely debt servicing costs. But it will begin to look through the windshield rather than the rear-view mirror. But for the time being, I think it’s been responding to a history of deflation and not worried about fiscal dominance at least yet.

[00:21:23] Alan

And as you say in your paper, you pointed out the various ways that can get reduced over time and you mentioned higher growth being one, and then actually, I guess fiscal rectitude being another one. And then obviously people point to higher inflation has been a third way to reduce the real value of debt.

And that, I guess, has, so far, had been successful, and had been a positive side effect of the inflation we saw in the US. And I think I’ve asked this to some other academic guests before. I mean, does that ever really become a part of the conversations in central banks in the developed world – we should allow inflation to run a little bit higher to help our debt levels? Or is that really more of, as you say, a phenomenon that comes into play when the central bank becomes compromised and less independent? Or do you think you get that kind of, I suppose, coordination between the monetary and fiscal authorities in the developed markets?

[00:22:23] Barry

Well, we have seen it in the past. An example would be the United States during and immediately after World War II, for the agreement between the Treasury and the Fed in 1951, ’52, that the Fed should be left to its own devices and no longer aid the Treasury in keeping interest rates down and servicing the debt. Before the accord, the Fed had basically given up its independence in the interest of fighting the war. Quite understandable under the circumstances.

So, it kept interest rates down and that helped the Treasury issue more bonds and service them more easily. I do think we are in a different world now, at least in the United States. And the question is how long that different world, when the Fed is independent and committed to its 2% inflation target, survives.

[00:23:30] Alan

I think the other kind of policy choice in the menu of policy options for highly indebted nations is the idea of financial repression. And this is where you either force certain institutions or entities to buy bonds or encourage them in some way.

In your paper you were, I think, a little bit kind of skeptical about the ability of authorities to maybe engage in financial repression to the extent that they might have maybe back in the 1970s. And I guess the idea would be to force banks or life insurance companies to hold more treasuries, or maybe even public pension funds, or entities like that. So why do you think it’s harder now to do that financial repression?

[00:24:16] Barry

Because of financial globalization, because of financial liberalization. I think the toothpaste is out of the tube, and moving back to the kind of tightly regulated financial markets we had in the 1950s, 1960s is simply not possible at this point in time. I have an interesting, pleasant, ongoing debate with my Harvard colleague Carmen Reinhart, who believes that financial repression is coming. I am more skeptical.

This may reflect a difference in temperament between the two of us or it may reflect the fact that Carmen has much more experience and knowledge in emerging markets where restrictions on financial transactions have been and remain more prevalent. So, he’s familiar with the world of financial repression and more convinced than I am that it is coming.

Maybe this is an indication that it’s coming in certain parts of the world, but not others, like the United States, where banks and others prefer a world of free capital markets, light touch regulation, and they also have a lot of leverage over the political system to make their preferences known.

The other thing, Alan, I want to say that I missed out on earlier on is I think inflation can be useful for bringing down debt to GDP ratios once, but can’t be resorted to repeatedly because markets, and therefore interest rates, will react more quickly after the surprise inflation. How frequently can you surprise the markets? Inflation surprised all of us in ‘21, ‘22 and that brought the debt to GDP ratio down one time. But I don’t think this will work on an ongoing basis.

[00:26:24] Alan

The other kind of lever. Well, there’s a couple of other levers, I guess the Treasury has. One is this policy around the capital treatment of bonds for banks that was brought in during the COVID crisis and it’s due to come back, I believe. I mean, would that be significant enough to… Would that encourage banks to hold a lot more treasuries? Would that be kind of a meaningful shift in demand for treasuries, would you say?

[00:26:53] Barry

Well, with $30 trillion of treasuries out there, I don’t think that is likely to make a significant dent in the problem. Again, if banks and insurance companies and other institutional investors were all mandated to hold a lot more treasuries, that would make a difference, but that would be your financial repression scenario, which I do not find plausible.

[00:27:23] Alan

And given the, I guess, current tensions between Trump and some US universities, I mean, forcing endowments to hold more treasuries, things like that, could that be part of the landscape?

[00:27:36] Barry

That one hadn’t occurred to me. But I think if that’s the bargain that Trump is offering Harvard University, if you hold more treasuries, we will otherwise be hands-off. Harvard would be wise to take that deal.

[00:27:56] Alan

You mentioned Carmen Reinhardt and her role in emerging markets and other perspectives there. And I guess one of the features that we’re seeing in markets now is investors increasingly looking at the US through an emerging market lens and an emerging debt lens. And I guess, obviously, you’ve done a lot of research on economic history, and not just in emerging markets, but developed markets.

If you go back in time, you have this idea of a sudden stop in capital flows. As you say, I mean, maybe it’s more of an emerging market phenomenon, but what are the typical triggers for a very abrupt reversal in capital flows that could potentially undermine the dollar?

[00:28:40] Barry

Well, the trigger is often a combination of financial weakness and political weakness. Problems in financial markets which, going forward, could emanate from the treasury market, as we’ve discussed, or who knows, from instability spilling over from the crypto sphere into conventional financial markets. We don’t know where the next financial problem will pop up, but we know there will always be one. And then the inability of a government, whether because of weak political support or simple policy incoherence, to respond in a stabilizing fashion.

So, you know, when we talk about banana republics, we talk about unsustainable finances, but we also talk about unsustainable politics, absence of rule of law, division of powers, et cetera, et cetera. The United States is clearly showing some of those problems. And whether this Treasury and this government, this White House, would respond in a concerted, coherent manner to the next financial problem I think is something to ponder.

[00:30:08] Alan

And I mean, speaking of possible financial crises, obviously, when we had the first run-up in yields, that was kind of followed by the challenges for SVB Bank, with banks having a lot of long duration assets under balance sheet and then taking a hit on that. Now, the Fed did bring in some liquidity measures to deal with that at the time.

Is that still out there as a possible risk if we saw 10-year yields surging hard again? Or does that kind of liquidity provision take care of that problem? Or do you… I guess I’m trying to think, can you see kind of some second order obvious effects of if we were to see kind of a sudden move higher in US yields?

[00:30:57] Barry

So, I certainly would not rule out the idea that important institutional investors, banks, or others, would be wrong footed by a spike in yields. I’m not a close student of individual bank balance sheets, so I can’t give you a where and when, but there are centuries of history that suggest that banks take excessive risks in good times, and when good times turn bad, they get caught out.

[00:31:30] Alan

Just on that. I mean, another part of the whole Trump platform is deregulation. Is there, you know, I think within the banking system, obviously, with respect to capital treatment of bonds, that’s one aspect. But are there other aspects of it that could be more positive for the market from a deregulation perspective, notwithstanding the risks you’re talking about?

[00:31:56] Barry

More positive from the point of view the markets, I’m not sure. One of the problems that tighter regulation has caused is that the dealers, mainly a handful of big banks that are at the center of the treasury market, you know, they hold inventories of treasuries and they book the trades for buyers and sellers. Tighter regulation limits how many additional treasuries they can take on when their counterparties want to sell.

So, loosening those regulations could eliminate or moderate this particular pressure point in the treasury market, which became evident in March of 2020, and again in March of 2023, the dealers hit their limits, if you will, in how many treasuries they could buy. So, yields spiked. Lighter regulation would eliminate that problem, but I think it would create the potential for many others.

[00:33:04] Alan

Okay, maybe just shifting gears a little bit. I mean, a lot of people have been scratching their heads trying to understand what the objective really is with the tariffs. It’s been so on/off, et cetera. But I guess there has been, I suppose, a mercantilist kind of policy underpinning the Trump platform to date. I mean, from your perspective what do you think the administration is trying to achieve? Is it kind of re-industrialization of the US? Is it primarily to boost manufacturing, or do you see it primarily tariffs as a tool to address the deficit, or a bit of everything?

[00:33:46] Barry

I think we have to be careful (we, collectively) imputing a strategy to the administration. You know, we’re trained to look for a strategy, and it could be that there, in fact, is none. If I force myself to impute a motive and a strategy, however, I would say, yes, there is a belief in crude mercantilism, that running a trade surplus makes the country stronger, and somehow running a trade deficit makes it weaker.

There is a belief that manufacturing jobs are still the best jobs. They are still good jobs for an economy like the that of the United States. So that creating more manufacturing will be good for living standards in the US. If you look at auto plants in the American South, a lot of workers are making what, $14, $16, $20 an hour. Those are not the best jobs in a modern 21st century economy.

Finally, I think there is, in some circles, a coherent national security argument for tariffs. That strategic dual use technologies – we can’t rely on China to supply them, we need produce them at home. But implementation of that policy has been scattershot.

You know, for that you want to do what the Biden administration had done previously (selective tariffs and selective subsidies for building the plants and the productive capacity in those specific sectors), not “reciprocal tariffs” affecting all imports from all economies.

[00:35:44] Alan

I mean, if what we’re saying here is the case, and that is the strategy and kind of policy that kind of levels out reflecting that, so, tariffs would then be here to stay, and there is this focus on trying to grow manufacturing (rightly or wrongly). I mean, what would you say are the kind of economic impacts? And would you expect to see more companies relocating more manufacturing to actually relocate to the US? And would you see that actually reducing the current kind of deficit, even if that’s by weaker economic activity?

[00:36:23] Barry

Well, I do think that some companies are finding it more expensive to produce abroad and export to the United States, given a 10% tariff or whatever the ‘new normal’ turns out to be. Will it build more productive capacity domestically? I don’t think that will raise US living standards, to the contrary, because we will be paying higher prices for goods that will be more costly to produce at home.

Will it, at the end of the day, strengthen the trade balance? That’s a separate question. So, the trade balance, or (to go academic on you for a moment) the current account of the balance of payments, is the difference between our investment and our savings in the United States. Will a 10% tariff fundamentally change the level of investment? Will it encourage households to save more? I don’t really see it. So, we may be importing a bit less under this tariff ridden new normal, but we may be exporting a bit less as well.

[00:37:40] Alan

Yeah, I mean, taking the other side of it, obviously you talked about the current account deficit, and I guess some other economists point to the capital account surplus has really been the thing that’s driving it. And I guess the two things are coincidence. It’s hard to say which is the driver But I suppose at the same time, if you get less capital inflows from abroad, then I guess that would push up bond yields and that would force some of the adjustment. Is that how it would play out?

[00:38:08] Barry

Yeah. So, it would force adjustment, but I think the main thing it would do would be to collapse investment. We would be balancing trade by reducing the gap between our investment at home and our savings at home. And an economy that invests less, other things equal, would not be a faster growing economy. To the contrary.

[00:38:33] Alan

Yeah, and I mean, what we’ve already seen in, say, in Germany, with their shift in policy towards higher investment in infrastructure and defense, which will presumably lead to a smaller German surplus and less kind of capital to be then exported overseas. So, I mean, do you think we’re already seeing some of the adjustment already in terms of these international imbalances?

[00:38:59] Barry

I don’t think we’ve seen very much yet. But as you say, if Germany is investing more at home, it will be exporting less capital, and its particular trade imbalance will be somewhat smaller but I don’t think there has been much visible adjustment yet. In terms of the German and the European fiscal stimulus, more defense spending, more infrastructure spending, it’s still very early days. And one important question, unanswered, is to what extent that will support faster growth in Europe? I actually have my doubts.

I think the multiplier, the fiscal multiplier around defense spending is relatively small. And spillovers from defense spending to the economy as a whole are relatively small. And some of the German economic institutes, that have raised the forecast for German economic growth over the next decade by a percentage point a year or by a percentage point and a half a year, are being overly optimistic.

[00:40:14] Alan

And why is that multiplier so weak? I mean, will it go to domestic production largely or not? Do you understand?

[00:40:23] Barry

Yeah, well, because we have a lot of experience that suggests that defense production is not the most productive part of the economy or the part of the economy where output per worker rose most rapidly. The US, during World War II, is an example of an economy where we ramped up defense spending a lot, but the productivity of that spending was relatively low.

The economist Alexander Field has written a great book on that experience. And more generally, another economist, Valerie Ramey, at UC San Diego and now the Hoover Institution, has spent her career studying the impact of fiscal policy impulses on the economy and concludes that the spillover effects are small.

[00:41:20] Alan

I mentioned one of the books you wrote, which was called Hall of Mirrors, which kind of drew parallels between the Great Financial Crisis and the Great Depression, obviously, back in the 1930s, part of the feature was the tariff war that we saw back then. How bad would things have to get now for a parallel to be relevant between now and the 1930s in terms of trade tensions?

[00:41:46] Barry

In terms of the impact of tariffs, I think there is more at risk for the United States and the global economy today than there was in the 1930s because the US trades more today than it did back then, because global supply chains, global, value chains, are a thing today when they weren’t back then. So, the supply side disruptions from tariffs could be more severe. And we’re about to see them show up on US shores.

Container traffic from Asia to the US has gone down, but the impact of that hasn’t hit the store shelves quite yet. I think it’s about to. The trade war of the 1930s spilled over into all kinds of diplomatic and geopolitical problems. So, there’s the danger of that. Yet, again, Trump has just now put his, what was it, 50% tariff on imports from the EU on hold for a month and a half, or however long it takes us to get to early July. But tensions, diplomatic tensions between the US and Europe are already high because of the spat around NATO and all that.

So yes, I am worried about all that. And to circle back to where we started, the other thing that happened in the 1930s was a global liquidity crisis as international investors fled the dollar. The dollar and sterling were the two global reserve currencies in the 1930s. The US then experienced three major banking crises, and everybody liquidated their dollar reserves, leaving not enough global liquidity to go around. So, one could imagine a similar chain of events unfolding now.

[00:43:50] Alan

Interesting, I mean, from your perspective, looking at the Fed at the moment, they’re obviously saying it’s too early to call the impact of the tariffs. You’ve got an inflationary impact, you’ve got an adverse impact on growth. Is there any sense on which of those two will dominate in the near term or over the next few months?

[00:44:11] Barry

Well, this is clearly a nightmare scenario for a central bank. On the one hand, they want to raise interest rates because of inflation that is coming, on the other hand, they want to lower rates because of the distinct possibility of recession coming. So, what to do? My guess is that they will raise before they lower, that the inflation will show up in consumer prices soon, and recession will take time to develop. Recessionary trends are not evident in the data yet, and I think it may take some quarters until the end of the year.

But this scenario of raising rates, to reiterate the Fed’s commitment to its price stability target, will not calm the President and will make it harder for the Fed to say we did the right thing once the recession materializes. So, it is, as I said, kind of a nightmare scenario for the Fed. There’s no easy way out. There’s no simple solution. But I think both for political and economic reasons, it will raise before it cuts.

[00:45:27] Alan

Interesting, I mean, the market has taken out its… Well, a lot of the easing it has factored in. But even at the last press conference, I think the general sense was either pause or cut, but nobody was actually asking about the possibility of rate hikes. I think that would certainly be quite a shock to the market. As you say, that scenario is unlikely to go down well at the White House.

I guess we’re already now into talking about who might be a replacement for Powell. Any thoughts on that? I mean, you mentioned how Trump could see a scenario where Trump is arm twisting the Fed. Who would be the kind of potential successors for a Powell that would be most amenable to that?

[00:46:10] Barry

Well, there have been a couple of Kevins who have been mentioned, but the point I would make is that the chair doesn’t make policy, that there are 12 members of the FOMC. They are experienced policymakers and financial hands, and I think only one of them comes up for renewal or replacement in the next 12 months.

So, if past practice continues, Trump can’t pack the Federal Reserve Board, much less the Federal Open Market Committee on which sit six regional reserve bank presidents that are appointed, not by the US President but by their own separate boards of directors. It is costly and embarrassing for the Fed Chair to dissent from the rest of the committee.

So, this has happened. For example, in the late 1970s, the then Fed chair, G. William Miller was quickly replaced by Paul Volcker. So, I think the discipline of the committee, as a whole, is important. Which of the two Kevins gets appointed as the next Fed chair – Less important.

[00:47:29] Alan

I think even Volcker got outvoted at times as well as Fed Chair. But I guess people more naturally think of the Arthur Burns experience, through much of the ‘70s with Nixon. And I guess even without having been dramatically pursuing the wrong policies, but just the Fed Chair is still influential. I guess it could still tilt the conversation to a more dovish stance. That would be reasonably easy to envisage, wouldn’t you say?

[00:48:03] Barry

Yeah, Nixon’s plumbers planted stories in the press about Burns wanting a pay increase when the US was under wage and price controls, and nobody else was getting a wage increase, and did a variety of other things to pressure Burns to keep interest rates down when Nixon was running for reelection in 1972. And Burns did so. So, that was an example of successful presidential pressure.

But the more important point is that Burns didn’t believe that the Fed determined the rate of inflation. He believed that wage pressure from unions and markups from big corporations were the fundamental drivers of inflation. And doctrine and belief is now very different. Everybody in the Fed realizes that they are the fundamental shapers of inflation and that they have to do what it takes to keep inflation under control.

[00:49:06] Alan

Just coming back to the maybe to the US Dollar outlook which we touched on at the start, I mean, we’ve talked a little bit, I guess, about the US perspective and the risks from a credibility perspective and debt levels, et cetera. I mean, parallel to that, the question is, is there an alternative?

And for a long while it had been TINA – there is no credible alternative, but I guess it is shifting slowly. And I know when we spoke before you talked about how even, notwithstanding, the kind of the slow growth of the euro and renminbi and reserve holders, even smaller currencies in the developed markets were growing in terms of their allocation.

But maybe focusing on the renminbi and the euro, do you see reasons to think that this is their moment now to step up and to assume a larger position in international portfolios?

[00:50:01] Barry

I think there’s scope for them to assume a slightly larger position, but the fundamental constraints on their replacing the dollar on the global stage remain. So, in the case of the euro, I think the most important one is shortage of safe euro assets – AAA rated government bonds available to the rest of the world for use as reserves in payments and so forth. Back when we spoke, only three euro area governments had AAA ratings from all three rating agencies. That remains true today. And many of their bonds have to be held by Europe’s own banks, so they’re not available to the rest of the world.

One could imagine Europe, the European Union creating more safe assets by buying bonds from the member states and crossing them into a safe slice and a secondary less safe slice. Markus Brunnermeier, at Princeton, and others have suggestions to this effect.

Nothing has been done in three, four, five years since these proposals have been floating around because it’s kind of viewed as a further expansion of the role of the European Commission and the European Union. And the membership states still are reluctant about that prospect.

In the case of China, there still are capital controls. China is starting out way behind the United States. It still accounts for only 3.5% of payments through SWIFT and through the global payment system, only 2% of global foreign exchange transactions, only 2% plus of global foreign exchange reserves. So, I think the role of the renminbi is growing fairly rapidly, but it is so far behind the US. They’ve been doing currency internationalization for 15 years. We’ve been doing it in the US for 115 years.

So, the euro and the renminbi can gain ground on the dollar, on the margin. And they will gain ground on the dollar faster now that these new doubts about the stability and prospects of the greenback have been heightened. But the danger, it seems to me, is if there develops really serious concerns about the dollar, and there is liquidation of dollar reserves and flight away from the dollar, TINA is the problem. And we end up with inadequate global liquidity to support 21st century globalization as we know it.

[00:52:56] Alan

I think there was a story out earlier today about the PBOC mandating local banks to invoice more in dollars or to increase that level. I think the threshold had been 25% and they’re pushing it up to 40% for international transactions.

So there does seem to be an incremental shift there. For a long time there was a sense that the Chinese were reluctant to fully internationalize. I mean, from a policy, or from their own appetite perspective, do you think that is becoming greater and the challenges, just, as you say, it’s starting off a low base, or how would you see that kind of appetite to take on a bigger role?

[00:53:33] Barry

Then PBOC government Governor Zhao made a famous speech, in 2009, about the problems of a dollar-based system and that led to the current the renminbi internationalization push. They pushed hard and they moved in the direction of liberalizing access to their financial markets until they had a stock market crash in 2015. Since then they’ve been moving carefully, slowly, deliberately, and I think they will continue to do that.

They’re following the Fed’s early 20th century playbook in promoting use of the renminbi for trade settlements first, and assuming that that will spill over into use of the currency in financial transactions over time. So a majority of China’s own imports and exports are now invoiced and settled in the country’s own currency. Financial transactions are still much less so. But that’s the way dollar internationalization worked in the first half of the 20th century as well. So, I think it’s a sound strategy. It won’t transform renminbi into a leading international currency overnight, however.

[00:54:58] Alan

And we’re seeing and hearing more and more calls for digital currencies, even from official circles. So, Christine Lagarde, at the last press conference for the ECB, has been kind of calling on the Commission to make further progress on savings and investment union, but also, I think, plans for a digital euro. I mean, how does that alter the landscape, if any?

If you have a digital renminbi, a digital euro, talk of kind of banks in the US issuing a joint stablecoin, I mean, where does that fit into the whole debate about reserve currencies?

[00:55:38] Barry

Well, I think for the euro area or the United States, it doesn’t make a great big difference. Our financial markets and financial transactions are already heavily digital and Fedwire is now 24/7. In other words, we have existing digital payments, technologies, and a central bank digital currency might lower costs and increase speed on the margin. But I don’t think that would be transformative.

What would be transformative, in terms of payments, would be if China and some of its partners, allied countries, if you will, create a common platform that would render their central bank digital currencies directly interchangeable for one another so they wouldn’t have to go through SWIFT, and the dollar, and the US correspondent banking system when making payments. So, the fact of the matter is, this technology already exists. It’s called Project mBridge.

It’s been underway for three or four years originally with coordination from the bank for International Settlements. The BIS is now withdrawn because the US observed that this kind of platform could also be used as a backdoor for payments for countries like Russia.

But the code for Project mBridge was written in the Digital Institute of the PBOC. The PBOC, and the Saudi UAE, Thai central banks, and the Hong Kong Monetary Authority are the five partners in this experiment. They’re doing actual transactions using it already. So, the question is how many countries might participate? Would they be happy with a system dominated by the PBOC? Could the level of transactions be significantly scaled up from its current relatively low level? But that’s the context in which I think CBDCs could make a first order difference for the structure of the global system.

[00:58:05] Alan

And we’re talking about a payment clearance system as opposed to currencies wouldn’t be tied in any sense, but just they would all use the common platform.

[00:58:15] Barry

Right, they could all run on a single private permission blockchain. That’s basically what Project mBridge is.

[00:58:23] Alan

Yeah, just one final question on this whole topic, which is, you know, we had, during the financial crisis, the extension of these dollar swap lines, which, you know, were seen to really embed the dollar even more as the anchor to the system, you know, and to facilitate that transmission of liquidity in times of stress. And I think they were further extended in COVID.

There was always a question whether they would remain. You know, they kind of came in under the radar, in some sense, without kind of requiring any political approval. Would they be at risk, do you think, in any scenario? And does their existence still kind of give the dollar that stronghold in the international system?

[00:59:08] Barry

I think their existence is critically important. Dollar swap lines enable foreign central banks to get their hands on dollars when they need them. And that, in turn, allows foreign central banks to be more accommodating of their local banks and firms when the latter borrow dollars, and need dollars, and use dollars in their own transactions. So, the swap lines are important for cementing the dollar’s global role.

I think the Fed fully understands that and appreciates the value of these swap lines. But that’s a little bit like saying the US Defense Department appreciates the value of NATO. One can imagine a US president who says, if we’re going to give you these swap lines, you have to give us something in return, and I’m going to suspend the swap lines or force the Fed, somehow, to suspend the swap lines until you give us that other thing in advance.

So, CEA Chair Stephen Miran has this famous white paper, from November, saying the US can’t keep on providing global public goods freely to the rest of the world. We can’t afford it, he asserts, and I suspect he would view swap lines as a global public good that the US is freely giving away where it should be charging a user fee.

[01:00:43] Alan

Interesting. Well, I think this could be a topic we’re hinting at that could come on the radar at some point, but there’s been so much to touch on. Thanks very much for taking the time.

So, as you can hear, we’re at a critical junction, certainly in terms of the outlook for US treasuries and the dollar. So, stay tuned and follow Barry’s work for more. But for now, from all of us here on Top Traders Unplugged, thanks for tuning in and we’ll be back again soon.

[01:01:14] Ending

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