The Battle for the Dollar: China’s Ambitions and the Federal Reserve’s New Era
The global financial order is currently facing a two-front pressure campaign. Externally, geopolitical rivals led by China are explicitly moving to challenge the dominance of the U.S. dollar. Internally, the United States is preparing for a shift in monetary policy under a potential new Federal Reserve regime appointed by Donald Trump. While the actors and methods differ, both fronts are driven by the mechanics of global debt, inflation, and the necessity of expanding the money supply.
The External Threat: BRICS and the "Exorbitant Privilege"
For the first time in decades, the conditions for a genuine challenge to the U.S. dollar’s status as the world reserve currency appear to be aligning. Geopolitical tensions, fracturing trade relationships, and the weaponization of sanctions have eroded trust in the existing financial order. The BRICS nations - Brazil, Russia, India, China, and South Africa - are actively seeking alternatives to the dollar, with China’s leader publicly urging that the Chinese yuan evolve into a widely used international currency and global reserve asset.
Current global economics rely on what economists call the United States' "exorbitant privilege". Because the dollar is the default currency for global trade - used for oil, commodities, and shipping - there is a permanent global demand for U.S. dollars and dollar-denominated assets like Treasuries. This allows the U.S. to consume more than it produces, run massive deficits, and pay for the difference by printing its own money, all while keeping interest rates lower than they otherwise would be.
China, however, operates on the opposite side of this system. Unlike the U.S., China runs persistent trade surpluses, producing more than it consumes. To maintain stability and employment, Beijing carefully controls the value and flow of the yuan. This creates a paradox for China’s ambitions: becoming the world reserve currency requires deep, open capital markets and the willingness to lose control over one's monetary system - tolerating asset bubbles, crashes, and foreign influence. It remains unclear if China is truly willing to sacrifice its tight economic control to burden itself with the volatility inherent in issuing the world's reserve currency.
The Domestic Pivot: Trump, Warsh, and the Fed
While China maneuvers abroad, the U.S. faces significant internal monetary shifts. President Trump has selected Kevin Warsh to replace Jerome Powell as Chairman of the Federal Reserve. This selection surprised many, as Warsh has historically been a critic of the very "easy money" policies Trump often favors.
Warsh, a Fed veteran who served during the 2008 financial crisis, has been vocally critical of Quantitative Easing (QE) and the suppression of interest rates over the last decade. He has argued that the Fed’s aggressive expansion of its balance sheet contributed directly to the widening wealth gap, asserting that asset prices rose far more than the Fed anticipated while wages and purchasing power for the average worker stagnated.
Despite Warsh’s hawkish history, his appointment may not signal an end to government borrowing. The U.S. government has an "unlimited appetite" for new money to fund its spending, and without this expansion, the economy risks entering a deflationary death spiral. Consequently, the financial system is expected to find ways to facilitate government borrowing regardless of who leads the Federal Reserve.
The New Mechanism: How Banks Could Replace the Fed
The intersection of Trump’s desire for low rates and Warsh’s desire for a smaller Fed balance sheet could result in a new financial mechanism: bank deregulation.
Currently, banks are restricted in how many U.S. Treasuries they can hold by the "supplementary leverage ratio" (SLR), because Treasuries can lose value. However, there is a push to deregulate this sector, potentially removing the SLR and allowing banks to buy an unlimited number of U.S. Treasuries. This setup would create a scenario where banks effectively perform QE on behalf of the Federal Reserve. Banks are incentivized to buy government debt because they profit from the "spread" - the difference between the yield they receive from the government and the minimal interest they pay to depositors. To mitigate the risk of these Treasuries losing value, the Fed can utilize tools like the "bank term funding program," acting as a backstop to bail out banks temporarily if asset prices drop.
Under this potential regime: -Trump gets the lower short-term interest rates he desires. -Warsh maintains a smaller official Federal Reserve balance sheet. -Banks gain an unlimited capacity to buy government debt, effectively funding the U.S. deficit.
The Inflationary Reality
Regardless of whether the liquidity comes from the Federal Reserve directly or through deregulated banks, the outcome for the currency remains similar. As the government borrows and spends more, the money supply increases. A rising money supply generally leads to higher prices, as more dollars chase the same amount of goods.
Rational investors, seeing this trend of endless borrowing and money creation, may demand higher interest rates on long-term bonds to compensate for the loss of purchasing power. This explains why, even as the Fed has moved to lower short-term rates, long-term Treasury yields have arguably risen. The convergence of these factors - China’s accumulation of gold and attempt to de-dollarize, and the U.S. government’s need to engineer new ways to fund its deficit - suggests a volatile future for the dollar. Investors have already seen precious metals rise as a hedge against this uncertainty, signaling a potential loss of confidence in the dollar system from both foreign nations and domestic markets. As the U.S. attempts to navigate this "late-stage" monetary environment, the only certainty appears to be the continued expansion of the money supply.