David Gracey

David Gracey

David Gracey

Head of Foreign Exchange and Fixed Income Trading

Episode 2: The rise (and potential fall) of the USD as global reserve currency.

Today we continue our stroll down history lane as we attempt to analyse how lessons from our past may influence what happens in the future. We pick the story up in 1971. The USA was embroiled in the Vietnam conflict, the cold war was heating up, and at this stage the so called “gold standard” was still in effect. This was the Bretton Woods agreement, where the USD was valued at a fixed gold price and all other currencies were pegged (or fixed) to the USD.

  • By 1971, and for a number of reasons,  this system was coming under pressure.
  • Firstly, in the US, inflation was on the rise as the US government increased its money supply. The cost of the Vietnam conflict was rising exponentially and the US economy was under pressure. Unemployment was rising and the social fabric in America was unravelling, firstly as a consequence of US troop losses, and also as a consequence of increasing civil rights unrest.
  • Trading counterparties began to feel discomfort with the rising levels of US debt and started to redeem their USD reserves for gold held by the USA.
  • When it became evident that the US would be unable to honour its obligation to deliver the required gold, (money supply had increased so much in the US that there was no longer enough gold held by the US treasury to honour its obligations) some European nations exited the Bretton Woods agreement (taking themselves off the gold standard) resulting in a substantial decline in the value of the USD thus adding to the USA inflation burden.
  • Something needed to be done, and quickly.
  • In August 1971 President Nixon “suspended” or took the US off the gold standard. Initially this was purported to be a temporary suspension, however by this time the US had lost the battle and the USD lost almost a third of its international purchasing power over the next decade.
  • By 1973 a new currency regime was in place internationally – free floating exchange rates were the order of the day.
  • By today’s standards and quantum’s it’s difficult to deal with the numbers involved – they seem rather trivial by comparison, but in real terms they were substantial as the world adjusted to the “new normal”. For example, on the day that Nixon announced the suspension of the gold standard the DOW Jones rose by a rather paltry 33 points – however that was the single biggest gain in history (at that point). In percentage terms it was a massive 4% one day move.
  • Anecdotally, It may seem counter intuitive that equity prices rise substantially during economic crisis, but you may recall in our series on inflation, that equity prices tend to rise in times of high inflation.
  • There were other consequences to Nixons actions. As the USD dropped in value, so other nations intervened in an attempt to stem the rise of their own currencies. When currencies strengthen (or weaken) substantially, it alters that nations ability to price goods and services on the international stage.
  • For example, Japan, by this time a major exporter of manufactured goods saw the value of those goods diminish as the Japanese Yen strengthened. In an attempt to keep the Yen at 360 to the USD the Central bank of Japan bought 1.3 billion USD in a 2 day period, causing a massive  30% increase in the value of its USD reserves. And these USD were no longer backed up by gold.
  • Paper money was now the order of the day, and these USD needed to be processed, and ironically found their way back into the US treasury market, the very reason that the crisis had materialised.
  • The 60’s and 70’s was a period of economic and social  turmoil. To quote Nixon when he took the US of the Gold standard….
    • In the past 7 years, there has been an average of one international monetary crisis every year. Now who gains from these crises? Not the workingman; not the investor; not the real producers of wealth. The gainers are the international money speculators. Because they thrive on crises, they help to create them.
  • Whether you agree with Nixon or not, the age of the economic crisis was upon us.
  • There were more shocks around the corner, but this new system of floating exchange rates (fiat currencies) that were not backed by anything but trust, was here to stay. Currencies were volatile as economies around the world adjusted to the new regime.
  • The upshot of all of this, and what was to come, was that the USD remained the dominant means of trade globally, even as its value declined substantially over the years.
  • Inflation was a problem, but there was one commodity that was about to create even more problems for the global economy. More about that in the next episode.