Replacing the US Dollar is not easy.
We do not understand what makes for US dollar hegemony, why it is difficult to break, how to break it and why AND also why the US also needs the world not dependent on the dollar. Lets dive in.
There is also talk about de-dollarisation, whether cryptocurrency could replace it and the potential for the Indian Rupee as a contender. And then these kinds of headlines come up.
This reflects a profound misunderstanding of what makes for US dollar hegemony, why it is difficult to break, how to break it, and why AND also why the US needs the world not dependent on the dollar.
The building of the dollar world.
US Dollar took over as the world currency thanks to Bretton Woods in 1944, at the end of World War II. With the world facing tremendous calamity, a sensible system was put in place, incorporating the learnings from the failures of the Treaty of Versailles.
With its inception, the European states set out on a post-war development spree that has since remained unmatched. Even the rise of China in peacetime does not match the speed and quality of development. But with development, there appeared cracks in the Bretton Woods system. Well, not precisely the Bretton Woods system - but the currency system. There appeared a fundamental incompatibility between the unique construction of the US Dollar and the structure of Bretton Woods.
The Construct of the US Dollar
The US Dollar created in the aftermath of the American struggle for independence was gold backed as was required to be able to trade in the global system. In the early stage, US Dollar was made out of a gold-silver mix (1:15), and each dollar was backed by 1.60gm of gold. The gold-silver ratio was reduced to 1:16, thereby devaluing the gold equivalence, which now came to 1.5gm gold for each dollar. The new coins were made of a gold-silver mix, so the exact devaluation is hard to measure. However, the weights of the coins continued to be reduced over the 19th century.
This bimetallism had to be gradually dropped since the silver coin weights were reduced, and later substantial silver deposits were discovered, leading to wild price fluctuations. Thus US Dollar became the exclusive gold standard. The formal gold standard act backed the Dollar with 1.67 gms of Gold - a minor devaluation by itself.
The Pound Sterling was the dominant currency exclusively backed by gold then. The Pound also fluctuated in its gold peg till the early 19th century, when the British put in place the gold standard. Their widespread empire and British respect for the value of the pound contract meant it quickly became a global currency. US dollar was emulating this precedent.Â
In this process, the pegs to the gold were altered by World War I, and subsequently, in 1931, Britain gave up the Gold Standard, leaving American Dollar as a strong contender for a world currency. All this was formalized in 1944 at Bretton Woods.
The Second part of the Bretton Woods Agreement
At Bretton Woods, despite warnings from Keynes, US representative Harry White, insisted on US dollar being the primary currency. It was also agreed that exchange rates between some dominant currencies would be pegged to the US Dollar and backed by gold. D
With such a policy in place, European countries started on the most ambitious reconstruction plan. This was supposed to be an opportunity for American companies, and it was.
The US realised that two factors drove the adoption of dollars by the international system. The US was the largest producer of oil, which was fast becoming the lifeblood of the modern economy, and the US was the biggest producer of goods and services the world wanted to buy. International trade soon became thoroughly dollarized.
However, the US raised a bulwark, using the post-war institutional framework - World Bank, IMF and United Nations, that placed the US in the substantial lead over others. This cemented the place of US dollars in the system.
We want THAT currency that can pay for things we want.
But European development also created many European companies who became competitive vis-a-vis their American counterparts and started a cross-flow of trade and commerce. The Europeans used the pegged currency to their advantage, creating pressure on US companies.
With the growing US population and economic growth, the demand from the US for European goods also increased. To pay for these, more US Dollars were created, and soon there were too many and not enough gold to back it.Â
This fact was noticed by the trading community, who started bidding up the Gold prices prompting then-Treasury Secretary John Connally to push for abandoning the gold standard.
“My philosophy is that all foreigners are out to screw us, and it’s our job to screw them first."
John Connally
The Fiat-Dollar era - Oil priced in US dollars
With the gold standard abandoned, the US could print as many dollars as possible. This raised alarms in Europe. In response, John Connally said: "The dollar is our currency, and it is your problem".
"The dollar is our currency, and it is your problem".
John Connally
Through various means the US leaned on the Europeans to open their currencies and reach a system that auto balances the competitive advantages.
As the production of quality goods spread across the western world, the US realised that the success of the US dollar as the dominant currency rested on Oil.
Until then, the US controlled most of the oil as producers since 1900s and control of Middle Eastern fields through US based companies. As middle-east started to nationalize its oil fields, the US made a deal with Middle Eastern countries to price Oil in US dollars. The status of the US dollar was secure. Thus a large share in sought-after products, services, and oil helped support the US dollar as a dominant system.
But other countries moved to take advantage of this.
The dollar-peg concept went from Europe to Japan. The latest in that phase came with the dollar peg by East Asian Tigers, mainly China. These countries voluntarily gave up their freedom to conduct their monetary policy - depending on the prudence of the US FED. This system then created today's unique problems.
Now with the US dollar being the defacto currency in the world, the US lost its ability to devalue.
Without the devaluation, the US is not getting the turbo-boost to kick start the growth leading many to call the other countries' monetary policy "predatory". This problem is a corollary of the famous "Impossible Trinity" or "Mundell-Fleming Trilemma".
US realised that reserve currency is exorbitant privilege but there are exorbitant costs too. Therefore, US did what John Connally advised. It printed and printed and printed even more. But so did everyone else - by default. And they impaired their debt-to-GDP ratios, trade balance, wobbly banking system and most other macro indicators. Today we are at a situation where most countries are in WORSE position despite the US having printed more money that all the countries combined. In effect, we do not see US Dollar being devalued.
Necessary conditions for a reserve currency.
There are few things that make a the currency of challenger country a reserve currency.
A few basic things are necessary but not sufficient.
There should be a good demand for challenger country products from large number of countries.
There should also be equal amount of things challenger country can purchase from the world.
There should be interest seeking investments and urge to supply to the challenger country.
Finally there has to be substantial demand and supply of commodities directly and indirectly linked with the challenger country.
For instance, countries need Chinese products and services. But they also sell rights to their resources for China to invest in. There are a large number of countries that can swap Chinese currency leading China to believe that it can be the reserver currency.
But that is not enough - Critical conditions for reserve currency
There are certain factors that are critical without which currency cannot become reserve currency even though all necessary conditions are met.
The reserve currency needs robust institutional infrastructure - where other countries maintain their accounts and do not worry about mismanagement and geopolitical considerations. That means challenger country needs to have rule of law, speedy judicial systems, respect for contracts.
The reserve currency needs deep financial markets. When the money is being used for trading, the money will be parked somewhere and deep financial markets allow trading capital to move in and out of various agreements and deals seamlessly. We need to seek and find risk, have financial instruments to mitigate the risk. All this needs deep financial markets with robust price discovery and contract development.
A reserve currency needs strong regulations that makes it fair and transparent what the deal for investors and traders is. If there are clandestine machinations that subvert what is logical and fair position, you will not become a reserve currency. Remember that money is created by banks based on the loan demands they see in the economy. If the regulatory mechanisms are lax then you will have unruly money creation.
A reserve currency needs robust monetary systems. The management of currency often lands up as a responsibility of the central bank. A reliable and logical central bank that knows what it is doing is critical to the reserve currency status.
A reserve currency needs prudent fiscal management. As the central banks management can influence the currency so can fiscal management. A profligate country hiding fiscal skeleton cannot develop the discipline to manage the currency.
A reserve currency also needs strong cultural support structure. Since reserve currency involves interactions between people across the world, there needs to be acceptance of global cultures.
Finally reserve currency needs TRUST.
Yes US has declined on each of these requirements!
Over the last 30 years the US has made its own position as reserve currency vulnerable.
On each of the parameters I mentioned above, US has made blunders.
US regulatory simplicity is long gone. The regulatory structures like Glass-Steagall were brought down. Regulatory interventions became more idiosyncratic.
Whether it was the Greenspan treatment of 9/11 or Bernanke’s handling of Global Financial Crisis or Yellen’s lower for longer. There has been mismanagement all around in monetary policy department.
The less said about Fiscal the better.
What US has done by weaponising SWIFT and other financial networks has dented its credibility.
The US has also frozen bank accounts and assets of various countries just to arm twist them into complying with US demands.
We may say from US actions that US really does not want to be the reserve currency of the world. It would rather have its monetary policy independence back with ability to be competitively well positioned in the world.
But others have blundered even more!
Instead of taking advantage of the US weakness, other countries have done much worse in every single aspect. The two dominant challengers to the US dollar as reserve currency is the Euro and the Yuan. Both have a long way to go just to be considered as potential reserve currency. A wobbly dollar is a better alternative than Chinese Yuan.
What should be a decent international currency system?
The denudation of the US reserve currency system has prompted people to seek out alternatives.
To be blunt, neither Chinese Yuan nor Indian Rupee nor the Euro will be the next reserve currency. They only satisfy necessary but not sufficient conditions but do not qualify on critical conditions.
Some look at Gold and Bitcoin. I will write why both are bad ideas in some later post. Gold can be a good stop-gap arrangement if US indeed wants to abandon its own reserve currency status.
The ideal solution will be a two-level international currency system. A global currency, it could be what Keynes proposed at the Bretten Woods in 1944, the SDR, controlled by a global central bank - the IMF. And local currencies controlled by their respective countries’ central banks. But that is something for a later date.
Notes
Yanis Varoufakis - And the weak shall suffer what they must.
Eurodollar system is another aspect of global dollar ecosystem. You can delve more into it in the Eurodollar University at Macrovoices.
Over the past century, two impulses have dominated global thinking. Control and the financialization of executive thinking. Both are reductive forms of thinking as people and the institutions of society are exploited for their financial value. In other words, they are costs that need to be minimized. This push to centralize all aspects of life on our planet, regardless of reason, is a form of mental and moral weakness. What these global leaders do not understand because of their isolation from real life is that people and society never stand still, but are always adapting to life situations at the micro-level. Of course the children who are our leaders are incapable of understanding this.