The United States’ unraveling defense commitments to Europe raise fundamental questions about geopolitical alignments, while U.S. President Donald Trump’s aggressive tariffs threaten a major reorientation of world trade. But there’s another set of risks lurking for global financial markets, which depend on reliable and ample dollar liquidity ultimately backstopped by the U.S. Federal Reserve.
As the only institution that can create dollars, the Fed has established swap lines to foreign central banks that have been critical in meeting sudden demand for dollars and calming global financial markets in times of panic. With an administration in Washington that likes to use support for foreign countries as leverage, can the vast market of dollar-denominated bonds, deposits, and currency swaps still count on the Fed when the next financial crisis hits?
The United States’ unraveling defense commitments to Europe raise fundamental questions about geopolitical alignments, while U.S. President Donald Trump’s aggressive tariffs threaten a major reorientation of world trade. But there’s another set of risks lurking for global financial markets, which depend on reliable and ample dollar liquidity ultimately backstopped by the U.S. Federal Reserve.
As the only institution that can create dollars, the Fed has established swap lines to foreign central banks that have been critical in meeting sudden demand for dollars and calming global financial markets in times of panic. With an administration in Washington that likes to use support for foreign countries as leverage, can the vast market of dollar-denominated bonds, deposits, and currency swaps still count on the Fed when the next financial crisis hits?
Today, the Fed’s support for foreign central banks is largely uncontroversial. And the Fed is formally independent from the White House. But institutional arrangements can be changed and traditional policies upended, especially by a president who likes to accumulate as much leverage as he can.
Consider the start of the COVID-19 pandemic. As countries shut down and economic activity seized up in early 2020, panicked investors all around the world raced for the safety of dollars and dollar-denominated assets. This skyrocketing demand for liquidity triggered a surge in short-term interest rates and a sharp strengthening in the dollar’s exchange rate.
To stave off the risks of cascading defaults in foreign markets that would surely reverberate in the U.S. economy, the Fed established swap lines with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, and the Swiss National Bank. These facilities gave banks in these countries access to dollars through their own central banks. Temporary arrangements were also extended to the central banks of Norway, Sweden, Denmark, Australia, New Zealand, Mexico, Brazil, South Korea, and Singapore.
Consider, as well, the 2008 global financial crisis, when Armageddon seemed just one more insolvent bank away. Frozen U.S. and European credit markets threatened to set off a cascading series of defaults and even deeper global recession, or worse. The decision to extend swap lines to emerging markets like Mexico, Brazil, Singapore, and South Korea was an important departure at the time and a recognition that financial instability there could seriously damage the United States.
Now compare the list of countries the Fed has supported in recent financial emergencies with those the Trump administration has threatened, bullied, or slammed with tariffs over the past six weeks. They include Canada and Mexico on grounds of illegal immigration and drug enforcement, the European Union over trade imbalances, Canada and Denmark over territorial expansion, and Brazil over the status of the dollar as reserve currency. At the time of writing, the United Kingdom, Japan, and Switzerland have largely been spared, but that could change at any minute.
The Fed’s independence from the White House has been enshrined in law, as have the tools it chooses to deploy in support of its mandates to ensure price stability and full employment. This includes decisions to extend these swap lines, and the list of countries that qualified has been mostly uncontroversial. Indeed, the largest offshore dollar markets have mainly developed in the United States’ closest allies—or, more precisely, the countries Washington historically considered its allies.
The offshore dollar market actually dates back to the 1950s, when communist countries earning dollars on exports sought banks that could not be subjected to U.S. sanctions. British banks also lured dollar deposits across the Atlantic with higher rates than the Fed allowed. In recent decades, the U.S. government has welcomed the deep pool of global capital eager to buy mounting U.S. debt even as Washington officials remained nervous about the risks from so many dollars circulating beyond their regulatory control.
These days, demand for dollars outside the United States adds up to many trillions of dollars in loans, bonds, currency swaps, and other financial instruments. Foreign banks alone roll over obligations on a $16 trillion stock of bonds and deposits. Around $3 trillion are at U.S. branches and subsidiaries abroad that automatically have access to the Fed’s discount window, but the rest have to rely on their own central banks when liquidity disappears. Those central banks, in turn, rely on the Fed to backstop dollar liquidity in times of crisis.
In 2020, emergency swap lines added another $450 billion to a Fed balance sheet that grew to $7 trillion during the first three months of the COVID-19 crisis. These holdings carry minimal risk and earn the United States money: The Fed gets an equivalent amount in foreign currency as security plus interest accrued during the swap period.
But the Trump administration takes a narrower view of the United States’ global responsibilities, even as it takes a more flexible approach to the Fed’s independence. Recall that during the election campaign, Trump insisted that he could do a better job as Fed chair than the current incumbent, Jerome Powell. It doesn’t take much imagination to envision Trump threatening to withhold swap lines from allies perceived as uncooperative or ungrateful. Even if Trump doesn’t have the legal authority to fire Powell or force him to do his bidding, the attempt to block the Fed’s emergency rescue will shatter whatever market confidence might remain.
Imagine a financial crisis that hits as Washington is renegotiating the U.S.-Mexico-Canada Agreement, wrangling with the EU over German car exports, and pressuring Japan to buy more U.S.-grown rice. Bank failures that cascade through major markets might be stopped with the Fed’s trusty swap lines, but would the White House force the Fed to delay a decision for diplomatic leverage? Will Canada accept U.S. statehood to avoid financial collapse? Will Denmark hand over Greenland to save Europe’s banks? Will Japan have to buy more U.S. farm exports to save avoid a deeper recession?
The problem is that even without explicit threats, investors may run for safety before any backstops are deployed. Eventually, rising uncertainty over U.S. policy and the workings of U.S. institutions will extend even to the Fed—and raise the question of how it might respond to a financial crisis on Trump’s watch. Markets are already rattled by Trump’s remark this week that he doesn’t care as much about falling stock markets as many had expected. And the consequences may be far more immediate than any speculative worries about the dollar’s status as a reserve currency.
Just as doubts about the U.S. commitment to NATO undermine European security, doubts about the Fed’s reliability in a crisis threaten global financial stability. If Washington’s definition of enlightened self-interest has become as narrow as the last six weeks suggest, the United States’ reliability may be tested in markets long before it gets tested on a battlefield.
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