April 14, 2023
These days there’s a lot of chatter going on about the dollar — namely the fate of its reserve status.
Many who write about that declining status, employ a little tactic known as “fear porn.” “Fear porn” is content that specifically plays to target people’s fears on a particular topic. Where the US dollar goes, it sounds something like this: The world turns its collective back on the dollar and the US is instantly reduced to banana republic status with 10,000% hyperinflation!!!!!
I’ve been writing about the dollar myself for over a year (hopefully in a more balanced tone):
- Reshuffling the Geopolitical Deck
- A More Serious Consequence Of Russia-Ukraine
- Doubling Down on Stupid: Economic Warnings Already Coming to Pass
- Powell Says the Unthinkable Out Loud
- Dodging the Dollar’s Reserve Status
The thing is, some parts of this topic are exaggerated to grab attention. Other parts, however, are accurate.
This week, I wanted to take a little deeper dive into the US dollar, its position on the world stage, the benefits that position has given the US, the future of the dollar and what it all means to you.
But to do that, we need to back up in time to get a running start…
How We Got Here
The story starts over a century ago.
World War I — the war to end all wars — not only destroyed a good chunk of the world, it destroyed much of the global economy as well. Participant nations all found themselves broke and heavily in debt. The winners looked to the losers for financial reparations. The US looked to the UK who looked to France… Ultimately everyone looked to Germany — who couldn’t pay anyone.
The resulting instability led to widespread economic isolationism and, some would say, the second World War.
Emerging from yet another massive global crisis, the victorious powers were determined to NOT replay the financial aftermath of the previous global war.
So after peace treaties were signed, representatives from 44 countries met at a resort in Bretton Woods, New Hampshire to negotiate a system of exchange that would actually promote global economic cooperation and growth instead of the isolationism that followed WWI.
Here’s the short version of the whole thing…
…its provisions called for the U.S. dollar to be pegged to the value of gold. Moreover, all other currencies in the system were then pegged to the U.S. dollar’s value. The exchange rate applied at the time set the price of gold at $35 an ounce.
Being the anchor to which all other currencies are pegged gives the anchoring country some serious perks. It created an artificial demand for US dollars, which meant the US could pretty much print and spend way more currency than it could otherwise. (I’ll come back to explain how this works in just a second.)
It’s interesting to note that, while the framework was passed in 1944, Bretton Woods wasn’t fully implemented until 1958. I say it’s interesting because the agreement that took all of 14 years to put in place, collapsed 13 years later in 1971.
And why did it collapse?
As the anchor under Bretton Woods, dollars held by foreign countries could be redeemed for gold at a price of $35 per ounce.
During those intervening 13 years, the supply of dollars in circulation increased so much relative to the gold reserves the country had, that President Nixon was forced to devalue the dollar (increasing the price of gold) which led to a “gold run” by dollar-holders around the world.
Ultimately Nixon “closed the gold window” completely and unlinked the dollar from gold.
Searching for a New Anchor
Like I mentioned earlier, it was the dollar/gold link that created an artificial demand for our currency (and debt).
Without that artificial demand, the dollar would be free to float (and sink) versus other global currencies. It also created a problem where the government’s rapidly growing addiction to printing money went.
All this quickly became a serious threat to our economy as well as our standing in the world.
But Washington wasn’t without a plan. In order to shore up the dollar, a small team led by Nixon’s Secretary of State, Henry Kissinger, struck a deal with the Saudi royal family.
According to the agreement, the United States would offer military protection for Saudi Arabia’s oil fields and provide the Saudis with weapons.
In exchange for all that, the Saudis simply had to agree to price all of their oil transactions in US dollars. (In other words, they’d refuse all other currencies as payment for their oil.)
The “petrodollar” was born. (This arrangement informally became known as “Bretton Woods 2”.) And by once again linking the US dollar to something of real value — something people needed to buy — an artificial demand was created for it.
For nearly 50 years — half a century — (compared to 13 years of BW1) that “backing” by Saudi oil has sustained the US dollar. And not just the dollar. It has also sustained the entire economic prosperity and standard of living that US citizens have become accustomed to.
Now, it looks like that support has begun to crack.
Exporting Dollars… AND Inflation
In the 1960s the French Minister of Finance, Valéry Giscard d’Estaing, coined the phrase “exorbitant privilege” referring to the US dollar’s peg to gold. The idea was that making the US dollar the world’s reserve currency…
…resulted in an “asymmetric financial system” where foreigners “see themselves supporting American living standards and subsidizing American multinationals”.
In other words, America could simply print its own money to spend while the rest of the world had to actually create value to access it.
And printing one’s own currency, when you don’t have to have any value behind it, is a heady and dangerous privilege. Because ultimately the results of your country’s economic policies (in this case, inflation) get spread throughout the world.
Here’s what I mean.
The idea of exporting inflation isn’t widely considered because most countries can’t do it. Their currencies are local to their countries. Reserve currencies (like petrodollars) however, are required for certain purchases globally.
The US is the largest economy in the world by far and over 60% of our GDP comes from consumption — which basically makes the US the biggest consumer in the world. Everyone exports to us.
Now these countries who are net exporters (export more than they import) get dollars for what they sell.
The glut of dollars they receive relative to their own currencies makes their currencies appreciate in value relative to the dollar. That, in turn, makes all their exports more expensive. In theory, trade would shift from the now more expensive net exporters to the net importers’ market (whose goods are cheaper) and through the miracle of supply and demand global trade balances itself.
Unless there’s manipulation — and there’s always manipulation…
Net exporting countries (usually emerging markets) rely on exports for their prosperity. And they don’t want to see their sales decline. So they devalue their own currencies (print more) to match the dollar. This keeps their export prices artificially low internationally, but also fuels inflation in their country.
Most dollars the US spends on imports never come back to impact the US economy. Instead, they sit as dollar reserves in other central bank accounts for when the reserve currency is needed.
The ones that do come back to the US — and this is yet another HUGE perk — are generally in the form of US Treasury purchases which is fine with us because more debt means more money for politicians to spend… But that’s another discussion.
So to summarize… Reserve status allows the US to print and spend practically unlimited amounts of its currency without feeling the full inflationary effects of those actions, while at the same time creating demand for our Treasuries which funds our excessive overspending (debt) at home.
Now if you understand this general concept, here are a couple charts to show you what the US has been doing to the rest of the world. They’re charts of the US Trade Balance. Negative balances indicate the years we have been net importers — in other words the years we pumped out more dollars than goods.
US Trade Balance: 1950-1970
In the 20 years from 1950 to 1970 you can see a positive trade balance for a good portion of the period meaning the US was a net exporter of goods. And you can see how that balance swung between an extreme and zero pretty much illustrating how healthy global markets should work.
Now let’s look 20 years forward, after the US dollar got linked to oil and effectively taken off its leash…
US Trade Balance: 1970-1990
You can see the almost immediate decline into deficit (net importer) territory. This chart looks pretty dramatic until you look at one from 1950 until today…
US Trade Balance: 1950-2023
That’s what exporting inflation looks like.
The Last Dollar Straw
According to economist Luke Gromen:
By the mid-2000s, the USD was the only thing the world really needed the US for on a net basis anymore (besides certain defense and technology products).
In other words, the dollar has been the US’ only export.
Since the 1970s the world has tolerated this subservience to the dollar (despite the fact that the US had actually defaulted on its global financial gold obligations.)
But things have begun to change.
Instead of just drowning the world in worthless dollars, the current administration has taken to weaponizing our currency.
A year ago, when Russia invaded Ukraine, the first action that the US took wasn’t simply to sanction trade with Russia, but rather to freeze some $300 billion in Russian oligarchs’ dollar accounts.
Remember dollars are intrinsically worthless — backed by nothing but the “full faith and credit” of the US government (which ain’t saying much). But they are universally accepted for global trade.
Now we can debate what action should have been taken and certainly the Russian elite who were impacted are no angels BUT…
The implication from the Biden administration that, “you do something we don’t like and we’ll take our dollars back to punish you” sets a dangerous precedent given how dependent WE are on the rest of the world demanding our dollars.
It’s borderline hubris to think the world would grind to a halt without our dollars.
And the world has started to respond.
Recently China and Brazil have struck a bilateral trade deal…
India is the third largest importer of oil in the world and Russia has become their largest supplier. Now they’ve struck a deal that leaves the dollar out…
Saudi Arabia has also been looking to secure a larger share of China’s demand (who also does a ton of business with Russia) by steering away from the dollar.
Even more startling was news this past week…
French President Emanuel Macron met with Chinese President Xi Jinping to discuss this “strategic autonomy.”
After spending around six hours with Chinese President Xi Jinping as part of a three-day state visit to China, Macron made extremely clear that France wants nothing to do with WWIII, emphasizing that Europe must employ “strategic autonomy,” presumably led by France, to become a “third superpower,” according to Politico.
In all seriousness, that’s a lot of big talk. I highly doubt that France could persuade the EU to “strategically detach” from the US and become the leader of a third superpower. But the point is he’s out there saying it with a straight face.
There has been talk like this before. And frankly little has come of it.
But today that may be changing.
So What Is the Dollar’s Potential Fate Today?
There have been grumblings in the past about exiting the dollar as the world’s reserve currency — usually from emerging market economies (like the BRICs a few years back) whose prosperity was largely dependent on their exports and who benefited the least from the US’ chief export (inflation).
Today those grumblings are back in full force. So what’s the reality of this apparent backlash against the dollar? Could the US suddenly lose its reserve currency status?
In a word, not likely. The dollar couldn’t just be dropped from the global market.
For one thing, the dollar is held by way too many countries as part of their foreign exchange reserves. Ironically, our years of profligacy might be one factor that keeps us in business.
Another factor is that there are a number of countries, including Saudi Arabia, that peg their currencies to the dollar. An abrupt depegging would be a dramatic shock to their currencies and economies.
Finally there is the notion that…
…the US dollar is not only backed by the largest economy in the world, it is backed by the American system that is known for being free and open.
US political stability (yeah even today!) and the rule of law are two intangibles that make the dollar a desirable reserve choice. That’s why the Congolese franc isn’t the world’s reserve currency!
On the other hand, if you look at the situation from a foreign country’s perspective, there are some reasons to consider alternative payment options.
The decades of forced inflation are bad enough but now they’re seeing how the US has weaponized the US dollar against Russia. Granted those actions were in response to an act of war. But if the US would be willing to cancel your country’s dollar reserves because they deemed you a problem (or just didn’t like you), what would be the point in holding them?
Truth is, there is nothing etched in stone that demands the US dollar be the reserve currency. The Saudis have already indicated they would be interested in exploring other options. Would there be any takers? Economist Luke Gromen poses a question worth considering…
What nation would not lend to Saudi or supply Saudi’s social needs in exchange for the right to price Saudi oil in its own currency? Do you think any nation would decline that offer?
And what currency could possibly replace the dollar on the global stage?
Given the dollar’s intrinsic value of zero (only what you can trade it for) and given that its consistent devaluation makes the things you can trade it for cost more and more, a more logical choice would be some real asset (commodity) based currency. The currency of a country that produces real value.
And there are more than a few of those out there.
The Fallout of a De-Dollarized World
The truth is, a “de-dollarization” of global trade is not inconceivable. While the dollar won’t disappear overnight, it is possible its attractiveness could wane over the coming years.
So what would any kind of aftermath look like from a US perspective?
The biggest impact would come from the dropoff in demand for dollars. With no more artificial demand for our dollars, two things will happen.
First, demand for US Treasury debt (how we finance our overspending at home) would take a hit as well.
We’ve already seen a preview of what that looks like.
During the 2020 stimulus push there was no one to fund the insane spending the G undertook. That left one party to pick up the slack… the Fed. They wound up expanding their balance sheet by some $9 trillion.
In December of 2002, they held just under $720 billion in assets… Today — after the wind down has begun — they still hold over $8.6 trillion. (There is such a thing as abusing the “exorbitant privilege.”)
The only recourse the government would have would be to curb its spending. And we all know that’s a hard pill for the G to swallow.
A reduction in spending by the government would come with its own consequences namely a significant slow down in the economy.
Of course if they didn’t — and without the ability to EXPORT the inflation we create — the only option we will have here is to suffer it internally.
Kind of like we’re doing now…
Bottom line, until we see some meaningful settlements of traditional dollar-based trades in non-dollar currencies, I wouldn’t worry too much. But given the state of the world today, and the potential impact a shift in dollar trade could have on our economy, it’s definitely something worth paying attention to…
Make the trend your friend,
Editor, Streetlight Confidential