The U.S. dollar’s role as the global reserve currency has been questioned repeatedly during the 7o years since it was established at the Bretton Woods conference in 1944. Current opposition to the U.S. monetary order and calls for its replacement are nothing new and echo past critics who have complained that the U.S. abuses the system to favor its own interests. Yet, the dollar system today in many ways is stronger than ever, and there are currently no viable alternatives.
At the Bretton Woods conference strong opposition to a U.S. centric monetary order was voiced by Maynard Keynes who argued instead for a decentralized system which would prevent countries from running persistent current account imbalances. Keynes’s fears proved well-founded, and by the late 1960’s persistent U.S. current account deficits led France to denounce what it called America’s “exorbitant privilege” (i.e., the ability to pay for imports with printed fiat money). First France and then several more countries demanded to move their gold reserves back home, which left U.S. dollar reserves depleted and undermined the implicit U.S. dollar-gold connection that had been a key feature of the Bretton Woods agreement. In August 1971, Richard Nixon announced the end to the convertibility of dollars into gold, which gave birth to the current U.S. fiat currency monetary system.
The current dollar reserve system has been unique in both its nature and scope. It is the first major currency reserve system in 700 years of Western financial history which is not linked to a metal and relies exclusively on the creditworthiness of the issuer. Second, the U.S. dollar can be considered the first truly global currency, as no previous reserve currency has had its geographical reach.
Nixon’s decision was momentous. It had been assumed that a stable monetary order would require a link to gold. England had been able to maintain a stable gold price for nearly 200 years. The U.S. has secured a stable gold price around $20/ounce since 1792, with the only exception being FDR’s devaluation in 1934, to $35/ounce. FDR’s decision had been seen to be an adjustment within the system, while Nixon’s was perceived as its full repudiation. The chart below shows the evolution of the USD/gold price from 1931 (before FDR’s decision) until 1980.
Not surprisingly, Nixon’s decision was not well received by global capital. It led to the first genuine dollar crisis (chart below) and to a long period of dollar weakness, high inflation and economic “malaise,” as described by Jimmy Carter. During the 1970s talk of the rise of the Deutsche mark and the Japanese yen as viable reserve currencies was prevalent and both currencies appreciated by more than 40% against the USD.
Two separate events were instrumental in recovering the dollar’s credibility. First, behind the scenes, in 1974 a secret deal was reached between Treasury Secretary William Simon and Saudi Arabia’s King Faisal for the Saudis to agree to invoice all oil exports in USD in exchange for U.S. weaponry and protection. This deal, in essence, defined the terms of the new fiat monetary system, providing a mechanism for recycling persistent U.S. current account deficits back into U.S. financial assets. The new “petrodollar system” allowed for the “neutralization” of the high commodity prices of the 1970s by channeling windfall OPEC oil profits into Wall Street banks, which, in turn, flooded the world with dollar loans.
The second event that established the dollar’s supremacy was the appointment of Paul Volcker to head the U.S. Treasury in 1979 . He proceeded to raise the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. Volcker’s super-hawkish policy coincided with the election of Ronal Reagan in November 1980, and the combination of tight monetary policy with the promise of economic rejuvenation through “supply-side” economics led to a massive dollar rally, lasting t0 1985.
The twenty years between 1980 and 2000 can be considered the golden age of the dollar. The “Petrodollar System” for recycling U.S. current account deficits back into the U.S. financial system worked smoothly over this period of relative economic and price stability. One of the assumptions of the system was that the U.S. would manage its economy to maintain general price stability and the purchasing power of commodities. We can see in the following chart that this was largely achieved during this time, as oil prices were kept stable in both nominal and real terms (and at acceptably high prices for OPEC).
This period of faith in dollar supremacy led global central banks to sell long-held gold reserves in exchange for treasury notes and other U.S. assets. The following chart from Ray Dalio shows clearly why the 1980-2000 can be considered the dollar’s heyday. We can see that Central Banks aggressively sold dollars for gold and Deutsche marks during the 1970s, only to about-face when Volcker hiked rates. Central Banks then proceeded to dump gold reserves for the next twenty years. By 2000, the dollar’s share of central bank reserves was at its all-time high while gold reserves were at all-time lows.
This golden period for the USD unleashed two powerful trends: first, deflation (closely linked to hyper-globalization and the rise of China); second, hyper-financialization and chronic financial bubbles (directly linked to asymmetric policies pursued by an emboldened Fed convinced that modern macro economists had discovered the key to the “Great Moderation.” Naturally, these two trends are interdependent. Hyper-globalization could never have occurred without a financial system able to absorb enormous inflows of foreign dollar reserves and also systematically increase credit to the U.S. consumer. At the same time, hyper-financialization relied on deflation persistently repressing interest rates which enabled the Fed “put” to be activated anytime the system was perturbed.
Since its peak around 2000, the dollar fiat system has been under stress. The unwinding of the great TMT bubble in 2000 , the Great Financial crisis in 2008 and then a long period of extraordinary “experimental” Fed policy from 2008 until today are manifestations of an unanchored monetary policy. Going back to the previous chart showing historical WTI prices, we can see that the the assumption of price stability which was part of the “Petrodollar anchor” has come completely unglued since 2000, with enormous volatility on both the up and downside.
The only thing left from the Petrodollar regime are enormous current account deficits , now no longer driven by energy imports but rather by Asian consumer manufactured goods (the U.S. is now a net exporter of energy and commodities). Keynes’s imbalances and France’s “exorbitant privilege” are greater than ever, remaining the essence of the U.S. centric monetary system.
But, as the eminent economist Joseph Stiglitz has noted ,”The system in which the dollar is the reserve currency is a system that has long recognized to be unsustainable in the long run.” This is because, over time, structural current account deficits erode a country’s manufacturing base and competitiveness. This is even more true when, as has been the case for decades, prominent competitors pursue mercantilistic policies to promote their industrial exports (e.g., China, East Asia, Germany). The two charts below illustrate the essence of these circumstances: first, the persistent U.S. current account deficits over the past 40 years; second, the U.S. role in absorbing the impact of trade surpluses generated by mercantilist competitors).
As shown below, not only has the U.S. lost competitiveness, it has also sold off a significant part of its industrial base and corporations to foreign creditors, moving from a positive international investment position to a highly negative one since 1980. This deterioration in net creditor status has accelerated in the past decade, and foreign creditors have increasingly shunned treasury bills in favor of direct investments, stocks and real estate.
If the current system is untenable, what can replace it? Talk of a new monetary order built around China is idle, as the RMB does not meet the basic requirements of a reserve currency (rule of law, property rights, deep and liquid capital markets, free movement of capital). Moreover, a formidable mercantilist China could never assume the responsibility of providing liquidity to the global market. Most likely, eventually Keynes’s old proposal from Bretton Woods will be resurrected.
Meanwhile, the USD remains king. Ironically, the system’s probable slow death will create intense havoc and uncertainty, conditions that favor USD strength not weakness. We have seen this clearly in recent years as the dollar has been strengthening, driven by massive capital flows out of international and emerging markets.
Simply amazing. Thank you so much for your knowledge!