In 2018, investment manager Brent Johnson introduced the Dollar Milkshake Theory to answer a big puzzle in modern economics: Why does the dollar grow stronger during crises, even when the US is printing money?

Johnson argues that a strong US dollar (the straw) sucks up liquidity from global markets (the milkshake) into dollar-denominated debt and assets.

Fair Observer Editor-in-Chief Atul Singh has explained the Dollar Milkshake Theory simply. According to this theory, the dollar owes its strength not to markets, superiority of technology or confidence in future growth, but to expansionary monetary policy distortions. As Singh says: 

A constant supply of artificially cheap credit and market interventions has created a global economic order in which capital is allocated not based on productivity, innovation, or comparative advantage, but instead on the relative ease of financial arbitrage. No currency or commodity allows for this arbitrage better than the dollar. Moreover, policymakers believe that the US dollar is the only truly safe currency in the world and that increased geopolitical turbulence is likely to lead to a greater demand for dollars.

According to the Dollar Milkshake Theory, the US dollar acts like a bully in the global economy. Those who buy into this theory base their argument on the following:

1. The US dollar is still the world’s reserve currency.
2. Most global trade happens in dollars.
3. Most foreign debt is denominated in dollars.
4. The entire global financial system runs on dollars.

The inevitable question arises: Why?

Convenience

Imagine you own a market. You sell oranges, bananas and black olives. You have buyers from different countries, and they would like to pay in their local currencies, and you price the goods in many different currencies. Bananas in dollars, in euros, and in yen. When foreign exchange rates change overnight, you would have to change the price tags in the morning, or risk getting taken advantage of. Your oranges could be copper, your bananas gold and your black olives, crude oil. Now, imagine selling copper, gold and crude oil in different currencies. Suffice to say, your life is much easier if you price everything in the same currency!

Necessity

Imagine living in the Principality of Seborga, a small village in Italy that claims independence. It uses a local currency called the Seborga Luigino (SPL). There are only a few thousand SPL coins in circulation. Your local gas station is running dry and you order a fuel truck to replenish the tank. For the refinery that lies outside the Principality of Seborga, your local SPL coins are worthless, since they are not convertible into any goods outside of the principality. So, you need to pay with a currency that is globally accepted, which, in this case, is the euro. That’s what happens to importers in many countries that do not have a globally accepted currency and they are forced to use the dollar!

More Necessity

Imagine you are a vanilla grower on the island of Madagascar. Your production is growing. You need a larger storage and packaging facility. The local banking infrastructure is underdeveloped, so you apply for a loan from the World Bank. The World Bank believes you will be able to pay back the loan in five years. But the bank has no Malagasy ariary (MGA), which is the local currency. Also, the bank does not want to be paid back in MGA, since nobody knows how much it will be worth in five years’ time. The World Bank lends in dollars; it wants to be paid back in dollars, and you don’t have a choice but to use dollars!

Fear

Imagine you are responsible for investing the $1.3 trillion foreign currency reserves of the Bank of Japan, which are the result of years of trade surpluses achieved through the hard work of Japanese workers making some of the world’s most reliable cars. Suppose you could choose any currency of your liking, which one would you pick? 

Foreign exchange investing carries risk. If your investments lose money, you will lose your job. So, you want to avoid losing money and definitely avoid blame if you end up losing money. Here, the old saying applies: “Nobody ever got fired for buying IBM.” This means that if you are the head of the IT department, and you bought IBM computers, you will not get fired even if those computers don’t work, because (a) they are very unlikely not to work, and (b) nobody can fault you for buying the “gold standard” in computing!

As a non-American central banker, you prefer US dollars, since you are unlikely to lose your job for buying them.

Practicality

Imagine you are the central banker of an oil-exporting country on the Arabian Peninsula. Your oil revenue makes up between 35% to 40% of the gross domestic product (GDP). This means an awful lot of dollars are coming into the country since you are selling oil for dollars. Your local currency is either pegged to the dollar, as in the case of Saudi Arabia, United Arab Emirates, Iraq and Qatar, or to a basket of international currencies, as in the case of Kuwait. 

In theory, you could exchange your dollar proceeds from oil into local currency. But the amount of incoming dollars relative to the size of your local currency is so large that the peg would break, and your exchange rate would go through the roof. You are better off keeping the dollars, recycling them into US Treasury securities instead.

Despair

Ecuador adopted the US dollar in 2000 after a severe financial crisis destroyed the value of its currency, the sucre. Was it a success? Initially, yes. The move killed hyperinflation and stabilized the economy. However, Ecuador now had a currency it did not control, and the same holds true for interest rates. When oil prices — Ecuador’s main source of revenue — dropped, the government was unable to devalue its currency. 

A central bank acts as the ‘lender of last resort’. In a credit crisis, it can help to reliquify lending markets by purchasing assets (loans) and taking doubtful loans off commercial banks’ balance sheets. This prevents bank runs and enables credit creation to continue. However, Ecuador’s central bank cannot “print” dollars and create credit in a crisis. Unsurprisingly, Ecuador has defaulted on its external dollar liabilities twice already. Following these defaults in 2008 and 2020, Ecuador “survives” only thanks to dollar loans from the International Monetary Fund (IMF).

We now know why the world uses the dollar. Now, another question arises: Why does the dollar strengthen in a crisis?

1. The size effect

The US equity market has a market capitalization of nearly $70 trillion and commands a 48% share of the global equity market. Foreign investors own a relatively small share of the US domestic market. Because of the sheer size of the US equity market, foreigners have a relatively small impact on stock prices. 

In contrast, the German equity market has a market capitalization of $3 trillion, comprising only 2% world market share. Notably, American investors own around a third of German stocks and, consequently, have a major impact on stock prices.

In a crisis, investors cut risk by withdrawing from foreign “adventures,” recoiling from less familiar markets. US investors repatriating money from German equity markets have a far greater impact on stock prices than German investors selling shares of American companies. This phenomenon intensifies crashes for the German stock market, while the US market is largely insulated from capital outflows and, more often than not, rebounds quickly.

2. The lending effect

A lot of dollar lending outside of the US is done in so-called eurodollars. To keep things simple, those dollars are created outside the US banking system. They are literally lent into existence by non-US institutions. The eurodollar is a currency without a central bank, even though its value is pegged to the US dollar. The Federal Reserve, rightly, does not feel “responsible” for those eurodollars. They are created outside the Fed’s jurisdiction. Also, they lie outside US regulations and were created without its blessing. Those eurodollars have no lender of last resort.

A credit crisis often begins with an innocent event: some borrower cannot service its debt. The bank licks its wounds, writes down the loan and takes a loss. It instructs the credit committee to be “more careful” going forward. After this event, the bank may decide to lend less aggressively or not to extend credit lines to certain borrowers. These borrowers then go on to knock on other doors, often without success.

The lack of a lender of last resort creates a potential instability for the eurodollar market. It is best compared to a game of musical chairs. As long as the music plays, the kids happily dance around and enjoy the party. When the music stops, a mad scramble for available chairs ensues and often ends up causing panic. Even the absence of a single chair throws the entire party into disarray.

In a crisis, forced repayments of Eurodollars often cause dollar shortages. This occurs because the loan proceeds have been invested in longer-dated assets that cannot immediately be liquidated. Access to on-shore dollar creation is only possible through a US financial institution willing to extend additional dollar loans, which will come at a price. In case of a severe shortage, the Federal Reserve might offer so-called dollar swap lines to foreign central banks, which, in turn, can use those to lend dollars to financial institutions in their jurisdictions. The Federal Reserve takes neither currency nor counterparty risk — those remain with foreign central banks. Under the current US administration, the withholding of swap lines could be used as a weapon, even against countries formerly believed to be allies.

3. The flight to a safe haven

A similar phenomenon occurs on the investment side. When times are good, investors venture out on the risk ladder, often attracted by higher yields abroad. Currently, Brazilian government bonds yield above 13%, compared to just above 4% for the US. To invest in Brazilian bonds, you first have to purchase Brazilian reals using US dollars. This demand for reals appreciates the value of the Brazilian currency. 

When a crisis hits, investors panic and retreat to the safest assets possible. Despite rising US debt and excessive money printing, US Treasuries remain the ultimate safe haven for investors worldwide. No other alternatives exist at scale. Investors sell Brazilian reals and buy US dollars. Hence, the dollar appreciates.

Everyone needs dollars to pay their debts, fund their trades and buy safe assets. In a crisis, though, dollars are flowing back to America. The most basic economic law of supply and demand tells us what happens next — the dollar appreciates as demand spikes while supply outside the US shrinks.

What does the Dollar Milkshake Theory predict

In a crisis, a stronger dollar makes everything worse for the rest of the world. Foreign companies with dollar debt suddenly owe more in their local currency. This creates more stress, more defaults and a greater flight of capital back to the US.

The US literally “drinks the milkshake” of global liquidity. This phenomenon happened both in 2008 and 2020: Despite financial crises and extremely loose monetary policy, the dollar strengthened as global capital fled to the only market big enough to absorb it. America’s financial dominance means even a crisis originating in the US strengthens America’s position.

Valéry Giscard d’Estaing, the late French finance minister and president, captured this phenomenon with the term privilège exorbitant — better known as ”exorbitant privilege” in English — for the dollar. Simply put, this means that the issuer of the international reserve currency can issue debt at cheaper rates than other countries and run perpetual trade deficits with impunity. 

Having a trade deficit means more stuff is coming into the country than leaving. It also means more money leaving the country than coming in. Every other country experiencing large, persistent trade deficits would inevitably see its currency depreciate. Recipients of the currency of a country running a trade deficit would want to exchange it for local money. An increased supply of this currency would exert downward pressure on its exchange rate value. Once this currency has a lower exchange rate value, exports would become cheaper and imports more expensive. This would encourage exports and discourage imports until, ideally, the trade balance would reach equilibrium.

This does not happen in the case of the dollar because of its status as the international reserve currency. Everyone wants the dollar, allowing the US to run persistent trade deficits. But such a status comes with strings attached.

Exorbitant privilege comes with a dangerous curse

As the international reserve currency, the dollar is hoarded globally. This stops the dollar from depreciating and pumps up its value artificially. Over the last few decades, this persistent overvaluation caused a hollowing out of the US manufacturing base. The number of employees in the manufacturing sector declined from 20 million in 1980 to a mere 13 million today.

A strong dollar not only discourages exports but also encourages imports. It serves as a transfer of wealth from foreign workers to US consumers. The latter can afford a higher standard of living by spending less on imported goods thanks to the strong dollar. In contrast, foreign workers need to produce additional goods for export to satisfy their trade surplus. In exchange for goods consumed by Americans, exporting economies receive foreign-denominated IOUs — dollars. In aggregate, exporter nations will never be able to collect on these IOUs because this would require the US to run a trade surplus.

Being the issuer of the world’s reserve currency is indeed an exorbitant privilege in the short term. In the long term, though, this privilege turns into a dangerous curse, hollowing out the industrial base and causing overindebtedness. This is not a desirable position for the economy of the world’s reserve currency because industrial decline and overindebtedness inevitably lead to a financial crisis. 

This phenomenon has occurred in recent history. Before the US, the UK enjoyed exorbitant privilege from 1815 to 1945. In 1815, when the Duke of Wellington beat Napoleon Bonaparte in the Battle of Waterloo, British national debt accounted for more than half of the world’s traded securities. In February 1943, the pound sterling enjoyed 74.9% of central bank foreign exchange reserves. The story of British industrial decline is all too familiar to be repeated here.

Before the British pound, the French livre briefly had currency reserve status. The Dutch guilder replaced the Spanish real, which substituted the Portuguese real. The Venetian ducat took the crown from the Florentine florin. Note that most reserve currencies lasted around 100 years.

In the case of the dollar, it seems inevitable that the milkshake becomes so big that it breaks the straw. America’s monetary superpower has become so asymmetrically dominant that it destroys the host country, and with it the current monetary system. A dollar has no intrinsic value. It is neither backed by gold nor land. Ultimately, the dollar is a fiat currency. People around the world accept it out of convenience, practicality, necessity and other reasons enumerated above.

Most importantly, people accept the dollar because of trust in the US government. If that trust erodes significantly, people will stop using the dollar as a store of value, even if they continue to use it as a means of exchange.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.