The Falling Dollar; Cyclical or Secular?

The U.S. dollar has been trending down for the past year relative to the currencies of the major trading partners of the United States. This raises the possibility that the cycle of dollar strength which started in 2012 may have ended. Moreover, the remarkable fiscal extravagance of the American government and gaping current account deficits have led some to predict a more severe permanent deterioration in the status of the USD.

Renowned macro-trader Stanley Druckenmiller said last week that persistent U.S. fiscal and monetary profligacy and rising debt level will have serious consequences: “The Fed will have to monetize it. I believe it will have horrible implications for the dollar…. it’s more likely than not within 15 years that we lose reserve currency status.”

These concerns with the fate of the dollar come at a time when a possible alternative reserve currency is  becoming realistic for the first time since the 1970s when the Deutsche mark briefly rose in prominence until Fed Chairman Paul Volcker’s monetary rectitude restored the USD’s credibility.

Taking a long term view, Ray Dalio of the Bridgewater hedge fund argues that it is only a question of time before China  assumes that mantle: “China already has the world’s second largest capital markets, and I think they will eventually vie for having the world’s financial center. Throughout history, the largest trading countries evolved into having the global financial center and the global reserve currency. When you see the transition from one empire to another, from the Dutch to the British to the American, to me it just looks like that all over again.”

Dalio’s view of financial history is that it consists of various cycles that repeat themselves over and over again on relatively predictable timeframes. Countries achieve great power status by attaining  measurable metrics and this hegemonic influence manifests itself through control over trade and finance, including reserve currency status. Eventually, great powers overextend themselves militarily, slide into financial, political and social decadence and enter into decline.

Dalio’s two charts below show this process at work. The first chart shows 500 years of the ebb and flow of global hegemonic power. The periods of dominance seem to last in the order of 150 years, which would imply that the United States is in the late stages. The second chart shows the evolution of the  different attributes required to achieve hegemonic influence, including reserve currency status which is seen as a lagging indicator.

Academic specialists such as Berkeley’s Barry Eichengreen provide a similar framework for understanding the process of achieving reserve currency status. The conclusion is that reserve currency status is a consequence of economic dominance which  can be measured by three statistics: economic output; share of trade; and net creditor standing.

Since Roman times, every dominant economic power has had these characteristics and seen its money prevail. We can separate the reserve currencies in the chart below in terms of the central axis of the international trade flows they facilitated: Mediterranean (denari, solidus, dinar, ducato and florin); Spain/Mexico (Spanish dollar based on Mexican and Peruvian silver); Northern Europe (guilder, franc, pound); and United States (dollar). The Spanish dollar can be considered the first truly global currency, as it was  widely used in China and the British colonies from the 16^th to the 19^th century.

 

The chart below shows the evolution of economic dominance over the past 150 years based on economic output, share of global trade and creditor status.  Around 1870 can be considered the peak of Britain’s economic dominance. By the eve of W.W. I, the UK’s edge had been greatly narrowed by both Germany and the U.S.. Coming out of the war, the U.S. was the clear dominant economy and it reached its peak soon after W.W. II. The post-war recovery of Europe and Asia has slowly undermined American dominance, and the recent rise of China has made it questionable.

The brief 70-year history of USD dominance can be separated into four periods, as  illustrated in the following chart. The U.S. came out of WW II as the undisputed global hegemon and the USD consistently replaced gold and pound sterling as the reserve currency of choice (period 1). After President Nixon broke the USD link with gold in 1971, gold and the deutsche mark  partially  replaced the USD (period 2).  A hawkish Fed under Paul Volcker and the deflationary forces unleashed by neoliberal economic policies and accelerated trade globalization resulted in the heyday of the USD (period 3). Finally, increasing financial instability caused by high debt and chronic fiscal and current account deficits have gradually undermined U.S. monetary policy effectiveness and increased demand for alternative currencies and gold. (period 4)

The next three charts show graphically the decline in the dominance of the U.S. economy. The first chart shows that share of global GDP peaked soon after W.W. II and has been on a rapid pace of decline since the USD was unfettered from gold in 1971. The second chart shows that American participation  in global trade peaked in 2000 and has fallen sharply since then because of the rise of China. The third chart shows the evolution of the U.S. from the primary creditor nation to the world’s largest debtor, a result of chronic current account deficits.

Clearly the evidence shows a steady fall in the justification for U.S. reserve currency status. However, there are two reasons to believe that the USD is not under imminent threat of losing its dominance. First, historical evidence tells us that reserve currencies lose their relevance slowly.  The Spanish dollar remained widely used long after Spain entered economic irrelevance. As the next chart shows, the same can be said about the British pound which remained an important reserve currency in the 1950s and beyond. This points to a slow decline of the USD, unless the U.S. accelerates its fiscal and monetary profligacy. Of course, the USD is a fiat currency not backed by anything more than the credibility of the government, so the risk of a steeper decline than with previous reserve currencies is not negligible.

The second reason that the USD reserve status is safe for now is that modern fiat currency reserve systems are much more a “debilitating burden” then the “extravagant privilege” once denounced by French  finance minister Valery Giscard D’Estaing. The American experience has shown how under a fiat currency regime  the U.S. has had to assume the responsibility for absorbing global trade imbalances through persistent current account deficits which can be financed indefinitely as along as foreigners are willing to accumulate American assets, both physical and financial. The consequence for the U.S. has been hyper-financialization,  deindustrialization  and an increasingly vulnerable American economy, kept afloat only by monetary bailouts and rising stock prices.

It is a safe bet that, at least for now, the Chinese are not interested in shouldering this debilitating burden of having to absorb global imbalances.  Quite the opposite, more than ever China is committed to its mercantilist “China 2025”  industrial planning model, as it is determined to wean itself from  dependency on the West for key technologies. This model is built on financial repression and is incompatible with currency reserve status which would require current account deficits to provide renminbi liquidity to the global economy.