Dethroning the Dollar, Part 2

Read Part One Here.

Last week, I explained why the U.S. dollar is the most powerful currency on the planet.

To summarize: Because everyone uses it in global trade, everybody wants dollars. That demand for dollars is what makes it so valuable.

To dethrone the dollar, people would have to stop pricing transactions in it. Currencies people choose to use instead of the dollar would gain in value, and the dollar would decline.

The question, then, is what it would take for that to happen. To answer that, let's review why the dollar is the de facto global currency in the first place:

  • At the end of World War II, the U.S. economy was the world's biggest, and has remained so ever since. Given the sheer volume of goods and services produced in the U.S., people trusted that the dollar would always be able to buy something of value.
  • The U.S. has had the world's largest gold reserves since World War II. Even if the dollar wasn't formally backed by gold, people assumed it could be if necessary.
  • The U.S. political system was stable, and U.S. economic and monetary management was highly professional. That gave people confidence in the dollar.
  • Crude oil has been the world's most important commodity for more than a century. After World War II, the U.S. made an unwritten deal with the oil producing states of the Persian Gulf: If you trade oil exclusively in dollars, we will protect you militarily.

That allows us to see what it would take to remove the dollar from its perch… as well as how likely this is.

First, the U.S. economy would have to decline in relative size by enough that people began to assume that they would be buying goods and services from somewhere else in the near future.

In that respect, China is indeed hot on America's heels. By some measures China has already overtaken the U.S. to be the world's largest economy. But as we'll see, that is not the only or even most important consideration.

Second, although gold is still a financial reserve, the bedrock of the global financial system is now U.S. Treasury bonds. Treasurys are collateral for trillions of dollars’ worth of global financial transactions. The demand for that collateral helps to boost the value of the dollar.

In this sense, dethroning the dollar means dethroning Treasurys as the anchor of global finance. Until recently that hasn't seemed likely. And the U.S. still has the world's largest gold reserves, by a considerable margin.

Third, until recently the U.S. political system has been stable and a responsible custodian of the world's global currency. The Federal Reserve is the de facto global central bank. The only comparable player is the eurozone, but it is an association of independent countries, and not in a position to play this role.

This is the dollar’s gravest threat. The U.S. political system has become dysfunctional. Critical economic issues remain unaddressed. The Republican Party's habit of using threats of default on federal debt to extract concessions from Democratic administrations is causing extreme alarm amongst global financial players.

If this were to happen, even momentarily, it would call into question the value of the trillions of dollars of Treasurys being used as collateral around the world. That would cause a catastrophic global financial collapse that would make the Great Depression look like a picnic.

The Fed’s aggressive quantitative easing policies over the last decade have also caused concerns. The Fed created an oversupply of dollars, causing inflation in both asset and commodity markets. Its recent moves to rein in inflation have helped offset those concerns, however.

Then there is the U.S. use of financial sanctions against Russia. Even observers opposed to Russian belligerence worry that disallowing the use of U.S. dollars in trade with Moscow is an alarming precedent.

Finally, energy continues to be priced in U.S. dollars. China has made a one-off deal with Saudi Arabia to pay for oil in yuan, but there are no moves to make a wholesale break from the greenback.

Of course, oil will become less critical to the global economy as renewable energy takes off. That will tend to undermine oil’s role in supporting dollar dominance, but it will take time.

Putting this all together, the most likely scenario for the dollar’s demise as the global currency involves a gradual decline in U.S. political and economic power, accompanied by increasing instability in U.S. governance and monetary management. Eventually, the conditions that make the dollar so desirable to hold today will evaporate.

Critically, how rapidly this happens depends on the emergence of an alternative source of economic, political and monetary power. The dollar's resilience in the face of increasing U.S. political instability reflects the absence of such an alternative.

The only potential is China. But despite the size of its economy, it’s still significantly behind the U.S. in terms of the breadth and quality of its output. Politically, under Xi Jinping China is clearly unsuited to global leadership. Its government is undemocratic, authoritarian and economically interventionist. Its central bank openly manipulates the currency. Most countries fear China more than love it. China would undoubtedly use control of a global reserve currency even more aggressively and arbitrarily than the U.S.

My conclusion, therefore, is that the dollar is likely to be the world's global currency for many years to come. How long that lasts depends largely on the folks in Washington DC.

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Ted Baumann is International Living’s Chief Global Diversification Expert. He's traveled to nearly 90 countries and is a dual citizen of the United States and South Africa. Ted has been published in international research journals, as well as in media outlets such as Barrons, Forbes, and Cheddar. Learn more about Ted Baumann here.

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