There is a growing rift between America and Europe over the Joint Comprehensive Plan of Action (JCPOA), also known as the Iran nuclear deal. President Donald Trump pulled out of the agreement, while Europe—due to business and security interests—wants to keep the deal in place. But European efforts to save the deal are growing more difficult as America imposes heavy sanctions on the Islamic Republic—and even on its own allies if they continue to do business with Iran.

In early August, America’s first round of sanctions on Iran kicked in, targeting its auto industry, its trade in gold, and its access to dollars, among other things. High inflation and unemployment mean that the Iranian economy is already in shambles. And that’s before the most hard-hitting sanctions—on Iran’s energy exports—go into effect later this year.

Now, some hawkish senators are urging the Trump administration to cut off Iranian banks—to the extent that they aren’t already—from the rest of the world by barring Iran from the Society for Worldwide Interbank Financial Telecommunication (SWIFT) payments system.

Europe seeks economic autonomy from America

The SWIFT network, based in Belgium and co-owned by the world’s largest banks, facilitates cross-border payments between financial institutions. While transactions don’t get transferred through SWIFT, the network keeps track of accounts and acts as a secure and standardized form of communication between banks. This makes SWIFT all-important to the global financial system.

Talk of using SWIFT as a tool of American foreign policy has some Europeans looking at alternatives.

Last week, Germany’s foreign minister called for the creation of a separate global payments system to avoid U.S. sanctions. German Chancellor Angela Merkel walked the idea back but signaled that Europe should begin to think through its options in this area.

Sure enough, Germany, France, and the UK have begun discussions that will examine the matter further. “I want Europe to be a sovereign continent not a vassal, and that means having totally independent financing instruments that do not today exist,” said France’s finance minister.

American policymakers should take note. Yes, the power of U.S. sanctions is completely unrivaled, but it also isn’t limitless—and as Europe’s quest to circumvent SWIFT shows, it might not last forever.

Explaining America’s economic might

Many policymakers fail to understand the source of our economic power, and its limits. That failure risks squandering our preeminence. America’s use of sanctions has grown substantially over the last two decades. Already this year, a record number of foreign countries, entities, and officials have been sanctioned by the United States.

Surely one reason for America’s sanctions power is our status as the world’s largest economy. Although international trade makes up a relatively small portion of our gross domestic product compared to other developed countries, foreign companies depend heavily on the U.S. market. If they get cut off from America, they face almost certain death. Other businesses are forced to comply with American sanctions and laws because they have a large number of U.S. shareholders, or because their suppliers or customers are tied to the American market.

But by far the biggest source of America’s economic power is the dollar’s status as the world’s reserve currency. This allows U.S. sanctions to reach businesses and countries that don’t even buy or sell with Americans. Foreign central banks must hold dollars to back up the value of their own currencies. In fact, about two thirds of foreign central bank reserves are in dollars, with the rest being mostly euros, Japanese yen, and British pound-sterling. The vast majority of global trade is conducted in dollars, too—half of all imports into Europe are invoiced in dollars. Meanwhile, the majority of cross-border debt—debt issued in a currency other than the home currency of the issuer—is denominated in dollars.

The dollar is the world’s reserve currency for several important reasons. First, it’s a stable and trusted measure of value. The purchasing power of the Brazilian or Iranian real, Indian rupee, or Mexican peso can significantly fluctuate in a matter of days. The dollar can lose purchasing power over time, but its value does not change wildly. Second, the dollar can be used to buy American assets, whether they be Treasury securities (U.S. government debt), stocks, or property. Foreigners can depend on the purchasing power of the dollar because America values the rule of law and private property rights, and because American courts are not arbitrary—they adjudicate relatively quickly.

The dollar is further boosted by what economists call network externalities. Similar to a big tech company, the more people use a platform, the more valuable it becomes to other users, and the more difficult it is for users to abandon it.

Because dollar settlement runs through banks that hold dollar deposits at the Federal Reserve, the dollar’s dominance means that most of the world’s international transactions flow through New York. This is true even for companies and countries that don’t do a lot of business in America. That allows the U.S. to go after firms that aren’t even tied to its own market, and isolate whole economies from the global financial system. Yes, dollar payments can flow through cities like Hong Kong or Tokyo, but the capacity to do so is limited and the dollars transacted in such a process are only worth something if they can eventually enter the American financial system.

This power over the global banking system gives America an outsized influence over SWIFT. But as Europe’s interest in circumventing the system shows, the risk is that foreign companies and economies integrate outside and around the U.S. market and financial system. The dollar’s status as the world’s reserve currency is more precarious than it appears.

Don’t take the almighty dollar for granted

Having the world’s reserve currency has been called an exorbitant privilege. Unlike most other countries, America can run budget and trade deficits as far as the eye can see and not have its currency drop, which would dent the purchasing power of ordinary Americans.

On the other hand, when the U.S. runs a huge trade deficit, foreigners receive dollars in return for the goods they sell to America. Rather than getting rid of these dollars, they happily sit on them or use them to buy American assets, like U.S. government debt.

In such a system, the dollar doesn’t drop, and the cost of debt in America can actually get cheaper, as foreigners use their dollars to buy more of it.

That means America’s government can run up a gigantic debt and foreign countries still want to hold our debt and dollars. Politicians don’t have to make hard choices about defense spending or entitlements: they can have it all. That’s why debt doubled during the eight years of George W. Bush to about $10 trillion, and then doubled again under Barack Obama.   

Things weren’t always this way.

Before Richard Nixon took us off the Bretton Woods gold standard in 1971, even while the dollar was a reserve currency but backed by gold, dollars sent overseas via a trade and fiscal deficit came back to America and led to an outflow of gold reserves. Rates would then spike and crowd out private investment. As such, there used to be a natural business lobby pushing politicians not to run big deficits.

As Dwight Eisenhower wrote to a friend, “I have always maintained one thing—that the annual Federal deficit must be eliminated before tax reduction can begin. …So I spend my life trying to cut expenditures, balance the budget, and then get to the popular business of lowering taxes.”

That’s partly why the dollar’s reserve status in today’s era of post-Bretton Woods fiat money is a privilege. But it’s also a curse.

Just because politicians have so far gotten away with endless debt and deficits without a spike in rates doesn’t mean that there won’t one day be a reckoning. Our debt stands at $21 trillion and our deficit has neared $1 trillion, all without being in a recession. Meanwhile, the Baby Boomers are about to retire. And already, the persistent trade deficits and the great expansion of American household debt, spurred on by higher government debt, have disproportionately hurt blue-collar families.

Much of the world doesn’t like the dollar’s reserve status. Countries like China, Russia, and even India are looking for ways to trade in their own currencies. Russia has been dumping dollar assets and buying gold. China is pushing for oil to be traded in the yuan, its own currency.

But China has a closed capital account—meaning, like the Hotel California, you can buy Chinese assets but you might not be able to get your money out—and a shaky legal system that doesn’t protect the property that yuans are used to buy. So the yuan has a long way to go before it is a competitor to the dollar.

The euro isn’t a permanent replacement either, mostly due to Europe’s constant political risk and fragmented fiscal policy.

That means, for now, America’s economy and the dollar are the cleanest dirty shirt out there. But abusing a privilege can become an irreversible habit.

America’s vast economic power is a privilege to be maintained, not squandered

Doing what it takes to maintain this privilege—trading with the rest of the world on a level playing field, ending fiscal profligacy in Washington, providing a real return to middle-class Americans who store away dollars—has the added benefit of reducing the burden the dollar’s reserve status places on working-class Americans. But this requires us to elect good politicians, willing to make hard choices.

America also needs to uphold the rules-based economic order we created after World War II. Many of the hawkish senators who would like to crack down on Iran via SWIFT talk the talk on this issue, but overusing economic warfare will push countries to exit the system that America has worked so hard to build.

The solution here is to use sanctions judiciously and only as part of a careful, viable, and essential strategy to secure U.S. interests—they should not be the default response to any and all problems.

Sanctions are rarely effective—they always punish but they almost never achieve their strategic aims. In fact, an expansive study by Robert A. Pape found that sanctions work only 5 percent of the time. So if sanctions are imposed, they should be tailored in a precise way in order to have the greatest return on investment and create the least amount of collateral damage.

As for our long-run economic power, America needs to right its fiscal ship before being forced to during a crisis. That means Washington must skewer the sacred cows that prevent necessary reform. One of those sacred cows is our defense budget. America is not prioritizing threats to the homeland, and we have troops engaged in combat in countless countries in Africa and the Middle East. Our military—despite a defense budget higher in real terms than during Reagan’s defense boom—is overstretched as a result. Instead, threats should be prioritized and our power should be conserved. America should be reloading, not rapidly firing at every problem around the globe.

America is the greatest country the world has ever known. We have immense economic—and, as a result, military—power. The key priority of policymakers should be keeping it this way and maintaining America’s edge.

Willis L. Krumholz is a fellow at Defense Priorities. He holds a JD and MBA degree from the University of St. Thomas, and works in the financial services industry.