Friday Finance: USD will die hard

Or will it?

Source

[Edit: I wrote this article before the Ukraine war and have added an update at the end. Let’s see how wrong I was.]

We’ll all be rooned!

There’s a lot of panic about the American dollar going the way the Zimbabwean dollar, what with all the brrr* and inflation and what-not.

It’s important to keep this in persective.

In the foreseeable future, uncomfortably high inflation is likely but hyperinflation is not.

Given the Japanese experience, the chances of deflation are >0.

Reserve currency

The US can get away with its policy shenanigans more than other countries as its dollar is the world’s reserve currency. It has been so since 1944, when 44 countries agreed to adopt it as such.

From Investopedia (read the whole article if this is new to you):

A reserve currency is a large quantity of currency maintained by central banks and other major financial institutions to prepare for investments, transactions, and international debt obligations, or to influence their domestic exchange rate. A large percentage of commodities, such as gold and oil, are priced in the reserve currency, causing other countries to hold this currency to pay for these goods.

In other words, a lot of trade around the world is done in USD. It isn’t only used in America.

In comparison, the Australian dollar (AUD) and the Moroccan dirham (MAD) are only used in Australia and Morocco respectively, for the most part. You might be able to use Aussies in a few Pacific microstates but Brazil is not using AUD to buy oil from Saudi Arabia, nor is Canada holding reserves of MAD to manage the exchange rate or settle its debts.

While most countries use their own currencies for most domestic transactions, international settlements are often made in USD. Most countries hold reserves of US treasury bonds, which are basically IOUs from the American government, as they have long been considered about the safest asset you can get. US treasuries usually dwarf holdings of gold.

Because other countries are using the USD for these purposes, the currency maintains a high value despite policies that might undermine a weaker currency.

Been here before

Present circumstances rhyme with the past.

In the 1970s, the US needed more money to simultaneously fund social programs and the Vietnam War. It did this by printing more dollars. Back then, the greenback was pegged to gold. Too many countries were redeeming their dollars for gold, so Nixon decoupled the two. Since then, currencies around the the world have moved to a free-floating system where they are priced according to supply and demand like everything else, and they move around quite a bit.

The US experienced high inflation at this time but not hyperinflation. The greenback remained the world’s reserve currency for the same reasons as today.

Reason 1 – habituation

One reason for the USD retaining its world reserve status is inertia. Everyone has been using it for so long that it has become a habit. Around the world, countries value their own currencies primarily against the greenback. It is still used in international settlements. It’s the easiest currency to change, anywhere. Travellers following the principles of pirate finance continue to carry a few hundred dollars of USD wherever they go, just in case.

Countries already have reserves of USD and suddenly changing to something else wouldn’t be easy.

Reason 2 – lack of alternatives

If the world suddenly lost faith in the US dollar, what reserve currency would it use instead?

Euro

The next most used widely currency is the euro. Yes, the euro – the same currency that looked in danger of being undermined by Mediterranean profligacy and disappearing altogether a decade ago. It’s stabilised now but the same imbalances and lack of political unity that led to that trouble still exit in Europe. Similar issues may reemerge in the future.

In comparison, despite all America’s ructions through the Sixties, Seventies and recent times, the USD has not been remotely threatened yet.

Renminbi (RMB)

For its currency to become the international reserve, the CCP would have to do several things that it does not want to do.

It would have to allow the currency to be freely traded and release the peg to the US dollar, likely causing the value of the RMB to rise and thereby hurt Chinese exports. Having a strong currency has its drawbacks, especially a current account deficit. This would reverse the economic model that led to China’s development so far.

It would have to win the world’s trust regarding future polices, transparency and stability. At the moment, international trust in the CCP is lacking due to its instinctive treachery.

At the moment, Chinese policy swings wildly and often upon a whim. Whole industries are rendered illegal at the stroke of a pen. In addition, there are tight controls on capital flows and investment. The window for Hong Kong to become the global financial centre appears to have closed.

Put it this way: wealthy Chinese would rather hold USD than their own currency and go to great lengths to sneak their money out of the country. That is not a ‘world reserve currency’ tell.

The RMB is certainly being used more widely around the world and is displacing the USD here and there. However, the chances that this insular country can open up enough to host the world reserve currency over the next few decades are low.

The Chinese would love to have that power but are not prepared to accept the costs. They may not yet realise this themselves.

Cryptocurrencies

In case you’re new here, my priors are that I’m a pro-coin no-coiner. I reckon cryptocurrencies have great potential but I don’t have any and don’t want any in the near future.

It would be brilliant if bitcoin or similar became the world’s reserve currency. Imagine all that power being stripped away from governments and decentralised.

One with native, anarchist tendencies must keep a foot on the ground, however.

First, cryptos are not being used to actually buy and sell things, much less do they form a major part of international settlements. They are mostly a speculative asset. This will have to change before crypto has a shot at the big time.

Second, they are insanely volatile. It’s next to impossible to trade with a currency that swings around wildly, which is why the few that do immediately convert to fiat currency after receiving payment.

Third, bitcoin is too inefficient for mass transactions. Other cryptos are better at this but are hardly being used.

I’m barracking for crypto but can’t see it happening any time soon. Maybe one day. Who knows.

The USD will remain the world’s reserve currency for decades to come because it is enjoying a Bradbury win. Troubled and debased though it is, there’s no viable alternative. A lot of its disadvantages apply equally to other national currencies, which means that none of them are necessarily better.

In fact, an alternative is so distant that there’s still little agreement of what it is likely to be. Perhaps it doesn’t exist yet. Monetised booster shot derivatives, perhaps? NFTs? Flint?

One day, the USD must lose its reserve currency status. Nothing lasts forever.

That date seems to be far off. Even if the US continues its current decline, its currency and other institutions will likely plod along unchallenged for many years. There’s a lot of ruin in a nation and America still has a long way to go.

As a consequence, the US can get away with some pretty extravagant policies without the dollar collapsing. They did it in the Seventies and they’ll do it again.

Inflation? Yes. Collapse? No.

Not yet.

---

Post-Ukraine War update

Life comes at you fast.

In response to Western sanctions, especially the seizure of Russia’s assets and partial blocking of the SWIFT banking communication system, several countries are making tentative steps towards sidestepping the US dollar system.

These moves are a testing of the waters rather than a full-blown breakout. For example, some nations are buying oil in rubles or other currencies, but the ultimate price of oil still comes down to its USD price. Recent innovations are only a step removed from the status quo.

That said, tentative steps can lead to bolder steps. I still predict the USD will remain dominant throughout the 2020s but the 2030s may be a different matter.

The main stumbling block remains that there is no particular currency that is ready to replace the dollar. Stated issues with the RMB remain. As for rubles, who’s going to hold their reserves in Russian bonds? Not going to happen.

There are some theories about what may happen next. One is that a new currency system may emerge based on resources (perhaps including gold) rather than the dollar. Another is that inflation and other problems will lead Western nations to announce a new digital currency for international settlements. Perhaps a bit of all of these will happen, with the West using one system, the East using another and those stuck in the middle using both.

Still, this would be unusual. The world normally has one reserve currency that all other currencies are based on. I’m not sure how such a multipolar world would work but I’m no longer so sure of myself and I watch developments with interest.

I cannot think of any novel ways of preparing for the uncertainly ahead aside from continuing to diversify assets – a recommendation I will devilishly argue against in next week’s Friday Finance as we consider the tailwinds behind the US economy over the next decade compared to everybody else.

---

*I’ve mentioned before that the Ethiopian currency is called the birr, right? They don’t accept it at their own airport duty-free shops, nor can you exchange birr for other currencies on your way out.