The U.S. dollar has enjoyed an enviable position for years as the reserve currency of the world. This has allowed the Treasury Department presses to run around the clock printing new dollars that will be used to facilitate global trade, finance the Federal Reserve’s Quantitative Easing, and fund our deficit spending. But the dollar’s status as the reserve global reserve currency is slowly unraveling. The consequences of losing that most favored currency status could be devastatingly inflationary.
In 1944, an international conference was held at Bretton Woods, New Hampshire that included a gathering of over 700 delegates from all 44 Allied nations of the 2nd World War. The purpose was to design a global currency system that would facilitate trade and render financial order to the post-war world. Several significant developments resulted from this summit, formally called the United Nations Monetary and Financial Conference.
The General Agreement on Tariffs and Trade (GATT), was established, as well as the establishment of the World Bank and the International Monetary Fund. Resolutions accepted at the conference led to the transition of world reserve currency status from the war-ravaged British sterling, to the U.S. Dollar.
The function of the reserve currency is to serve as a standard of value by which all global financial transactions are measured and facilitated. And after Bretton Woods, the dollar was it. All other currencies were fiat currencies that had no intrinsic value, but rather derived their value compared to, and relative to, the dollar, which in turn was tied to the value of gold at $35 per ounce.
This meant that all global transactions were consummated by exchanging national currencies to dollars for uniformity and accuracy. The dollar has continued in this role, even after the dollar was removed from the gold standard in 1971.
What led to the demise of the gold standard has relevance to today’s challenge to the dollar. During the late sixties, government spending grew significantly with the costs of the escalation of the Vietnam conflict and funding of LBJ’s Great Society programs. These were funded mostly by deficit spending, essentially charging the costs with a promise to pay for them in the future. This was extremely risky while the dollar was tied to the value of gold, for overspending and printing of dollars meant an excess of dollars in global circulation which could then be exchanged back to gold, depleting U.S. gold reserves.
This limited the extent to which Washington could deficit-spend, and caused inflationary pressures on the economy. With Washington lacking the fiscal policy discipline to control the spending, President Richard Nixon issued Executive Order 11615, which “closed the gold window,” making the dollar just another fiat currency with a free-floating value for global exchange.
In many ways, we’re facing a similar situation now. The United States has had five consecutive years of more than $1 trillion in deficit spending. The first two of those years we were within a few hundred billion of spending twice what we were collecting in treasury receipts. The lack of discipline and fiscal responsibility in Washington led to a downgrade of the nation’s sea of debt two years ago by Standard & Poor’s. The ratings organization stated at the time, “Elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a ‘AAA’ rating.”
S&P added that the nation’s credit rating could be lowered even further if serious attempts to reduce the debt and deficit were not successful. They further asserted that $4 trillion in spending reduction would be a “good start” towards rebuilding our credit rating.
Global confidence in the dollar is weakening. The massive spending which led to the downgrade of our debt has only been exacerbated by the Federal Reserve’s easy money policy of low interest rates and Quantitative Easing, funded by free-running printing presses and newly minted dollars. As a result, the dollar’s standing as the global reserve currency is steadily eroding.
China has been aggressively touting their yuan, or renminbi, as a replacement to the dollar as the world’s reserve currency. Many nations have already agreed to bilateral trade with China, bypassing conversion to dollars. Just in the past two years, China has inked deals with Germany, Russia, Brazil, Australia, Japan, France, Chile, South Korea, United Arab Emirates, India, and South Africa.
“Generally speaking, it is not believed by the vast majority that the American dollar will be overthrown,” Dick Bove, vice president of equity research at Rafferty Capital Markets, said recently. “But it will be, and this defrocking may occur in as short a period as five to 10 years… If the dollar loses status as the world’s most reliable currency, the United States will lose the right to print money to pay its debt. It will be forced to pay this debt. The ratings agencies are already arguing that the government’s debt may be too highly rated. The United States Congress, in both its houses, as well as the president, are demonstrating a total lack of fiscal credibility.”
Money News reported in February, “The greenback is declining as a percentage of the world’s currency supply. Compared with its peers, it has dropped to a 15-year low, as nations show a willingness to use other currencies to conduct business, according to the International Monetary Fund.”
In March, the Wall Street Journal ran a piece titled, “Why The Dollar’s Reign Is Near an End.” They pointed to some of the obvious implications of the dollar’s demise as the reserve currency. “In this new monetary world, the U.S. government will not be able to finance its budget deficits so cheaply, since there will no longer be as big an appetite for U.S. Treasury securities on the part of foreign central banks. Nor will the U.S. be able to run such large trade and current-account deficits, since financing them will become more expensive.” In fact, the March Congressional Budget Office projections indicate that we will be paying over $5 trillion for the next ten years just to pay the interest on the national debt. This figure will be adjusted much higher as the dollar declines in use as the reserve currency, leading to an erosion of its purchasing power.
Sam Zell, chairman of Equity Group Investments, said in an interview with CNBC: “My single biggest financial concern is the loss of the dollar as the reserve currency. I can’t imagine anything more disastrous to our country. I’m hoping against hope that isn’t going happen, but you’re already seeing things in the markets that are suggesting that confidence in the dollar is waning. I think you could see a 25% reduction in the standard of living in this country if the U.S. dollar was no longer the world’s reserve currency. That’s how valuable it is.”
The managing director of Pimco, Bill Gross, who manages more bond assets than anyone else in the world, wrote recently, “The future price tag of printing six trillion dollars worth of checks comes in the form of inflation and devaluation of currencies.”
The Wall Street Journal’s George Melloan concurred, “Indeed, it is unlikely that Americans themselves will escape the inflationary consequences of current Fed policy. The Fed is financing a vast and rising federal deficit, following a practice that has been a surefire prescription for domestic inflation from time immemorial.”
Investor Jim Rogers recently advised, “The dollar is not just in decline; it’s a mess. If something isn’t done soon, I believe the dollar could lose its status as the world’s reserve currency and medium of exchange, something that would lead to a huge decline in the standard of living for U.S. citizens like nothing we’ve seen in nearly a century.”
Dollar weakness has accelerated since the downgrade of U.S. debt. To prevent this continued decline Washington must get a handle on spending, and make serious cuts, not just cuts in the rate of growth as the recent sequester was. The Federal Reserve must discontinue the Quantitative Easing that has buoyed domestic equity markets, but has infused too many dollars into global markets, and created a fiscally incestuous relationship with the Fed buying our own debt. If these actions are not taken soon, all Americans can expect to see double-digit hyperinflation comparable to the 1980s. The continued erosion of the dollar as the reserve currency will affect all of us.
AP award winning columnist Richard Larsen is President of Larsen Financial, a brokerage and financial planning firm in Pocatello, Idaho and is a graduate of Idaho State University with a BA in Political Science and History and former member of the Idaho State Journal Editorial Board. He can be reached at [email protected].