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The Situation
Rumors are floating around that the dollar is in danger of losing its reserve currency status. This is certainly a real possibility and it wouldn’t be the first time a currency has fallen from grace.
The loss could be sudden and traumatic, or insidious and stealthy, but in either case it would certainly have repercussions on every holder of dollars. Among these are ordinary citizens, the international trade sector, and many of the world’s central banks whose reserves are composed about 60 percent of US dollars and Treasury bonds.
Reserve currency status has its advantages, but these same advantages are also its drawbacks. Essentially, reserve currency status permits (obligates) the reserve-currency country to “devalue” its currency by issuing large quantities of its currency and expanding its national debt in order to accommodate that role.
As you can imagine, it’s great fun running up debt. A lot of us do it regularly, and the US government has had a field day – or rather a field 78-years – since 1944. The problem is that issuing money and financing national debt creates an enormous amount of credit-type money over and above the country’s own needs for transactions and savings, which creation, by definition, devalues the currency even though this reality is not recognized immediately by the national marketplace through price inflation.
The Danger
Internally, creating dollars to satisfy the world’s need for reserves causes US prices to reflect not only the usual market supply and demand pressures, but they also absorb, surreptitiously, the additional global demand for the reserve currency. Supply and demand are no longer the only voices in the fine-tuned chorus that determines the general price level. Distortions and misjudgments must inevitably occur, even if prices seem to be relatively stable.
If the dollar were to lose its status as the world’s reserve currency, it would probably follow a similar path as that taken by the English pound almost 80 years ago: devaluation. Or more accurately, the sudden awakening of the public to insidious and chronic – albeit hidden – devaluation.
Devaluation is usually accompanied by general price inflation either before or after the awakening. The British pound, for example, lost its official reserve currency status to the US dollar in 1944. Between 1935 and 2005, prices in British pound territory exploded 5,000 percent (around 70 percent a year), compared to 200 percent in the previous 185 years (around 1 percent a year).
Reserve currency status also implies an “imbalanced” trade account. Technically, a trade account cannot be imbalanced in the accounting sense. A negative trade balance is always offset by the amount of dollar instruments and dollar-denominated investments held in trading partners’ hands. However, such an imbalance can be deleterious through its unintended consequences.
According to some, reserve currency status destroys the industrial capacity of the reserve-currency nation, as happened in England throughout the 20th century. See this piece in Wikipedia regarding what’s called the Triffin Dilemma.
But at some point, the Piper has to be paid. Or at the very least, dollar holders must feel confident that the US can pay whatever it owes if required to do so. Imagine that you’re a baker and you promise 200 of your neighbors that you can furnish them a cake on demand. Things go well for a while with a few dozen requests a day. Everybody loves you. But one year on the 4th of July you accept lots of orders. You need 150 cakes, but it turns out you can only produce 100. The word will get around quickly that you are not reliable.
Today, as everyone observes, our national debt is reaching unfamiliar heights. How much higher can it go before it exceeds that confidence limit? If a shift away from the dollar occurred, it would happen when other nations lose that confidence. So far, no country really has an incentive to see the dollar collapse, since so many of them hold an enormous amount in their own reserves. Japan has $1.3 trillion, China $1 trillion, the UK $608 billion, Luxembourg $311 billion, and on down the list of 35 major holders of US Treasury securities alone.
On the other hand, those that hold debt denominated in dollars might be happy to see it fail, since they could pay back their debts in cheaper currency. There are quite a few of these, e.g., Indonesia ($19.7 billion), India ($18.8 billion), China ($16.2 billion), Brazil ($15.4 billion), Mexico ($15.2 billion) – a total of 78 countries at the World Bank alone.
It’s hard to predict how all of this will unwind, but in my opinion, given the spending spree we are currently on, unwind it must. In fact, China, Russia, Iran, India, Australia, and other nations have already started using other currencies in their trade transactions, probably because they have observed the over-expansion of the dollar.
The question is probably not if the US dollar will lose its unique status at the top of the reserve currency list, but rather how it will lose it and when. To paraphrase Keynes’s (or was it Shilling’s?) famous dictum, a currency can remain a reserve longer than you can remain patient. Good luck trying to predict when things will shift.
What To Do About It
As China, Japan and Russia continue to decrease their holdings of US Treasury bonds, which they have started to do over the past decade, the US Federal Reserve has been mopping up the slack. But the Fed is going to start decreasing its purchases, or at least that is what the governors have announced. We’ll see what they actually end up doing under the current delicate global and national circumstances.
There is talk of increasing the role of SDRs to take over the reserve currency role. SDRs are Special Drawing Rights at the IMF, currently composed of a reserved quantity of the five most “popular” fiat currencies: US dollar, euro, yuan, yen, and UK sterling.
SDRs are believed by some to be more independent and therefore more stable reserves for monetary systems. However, the IMF has been known to issue them arbitrarily, and please note that they too are based on fiat monies, which means that collectively they are no more stable than the average stability of all of them.
In my opinion, if the dollar’s reserve currency status came into serious question, a sudden adjustment for dollar devaluation would occur during a time of price inflation such as the one occurring now. The potential for a recession might also appear as interest rates rise, and gold’s dollar exchange rate would certainly rise, as it always has when the dollar’s lost purchasing power is recognized.
Fairly recently, the BIS (the Bank for International Settlements, which is the central banks’ central bank) augmented the role of gold in banking reserve requirements worldwide. So even though gold’s role as a monetary anchor has fallen off the politicians’ radar, it remains an anchor and probably will for the unforeseeable future.
Logically, holding some percentage of one’s portfolio in the one real money that has never disappeared or been devalued cannot be a bad idea. To affirm this notion, one can compare the results of investments in various financial vehicles over the last 50 years since the dollar was definitively severed from gold. One recent study finds that US stocks come in first, and in second place is gold, winning over foreign stocks, REITs, US bonds, and foreign bonds.
When you consider that US stocks are looking like the biggest bubble in history at the moment, second place doesn’t look so bad. Plus gold is inversely correlated to most other currency-denominated investments and therefore should do well in a recessionary and/or dollar-deflationary environment.
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