The rise (and potential fall) of the USD as global reserve currency. Episode 1

Sometimes it becomes a little tedious to write about the daily machinations of the currency world. One has to find new analogies or euphemisms to try and describe what is happening. I find it far more interesting to attempt to decipher what the future may look like. Last year, you may recall, we published a series on inflation, and today we publish the first episode in a series of why the USD enjoys tremendous advantage over others as the world’s reserve currency, and why potentially that hegemony may be challenged in the years ahead. As always, if we want to see  where we are going, it’s always illuminating to see where we have come from.  My colleagues do like to remind me that I have been around for a long time, with some of the cheekier millennials accusing me of being the maître d at the last supper. So I want to add a disclaimer here. NO, I was not around at the time of most of these events.

  • Currencies rise and currencies fall, for different reasons. Currencies are born and currencies die, also for different reasons. But since 1944 (actually 30 years before that) one currency in particular has enjoyed a status that has afforded it users a major advantage over others.
  •  After world war 1 and 2 the USA emerged as the major beneficiary and creditor to the rest of the world. As the world’s largest economy, and due to their late entry into both conflicts, and also due to the fact that the Country itself was never invaded (Pearl Harbour aside), it was the Country that everyone turned to for funding and weapons. When peace was eventually achieved, most of the Western World was effectively bankrupt, and had paid over most of their gold reserves to the USA.
  • In 1944 a conference was convened at a place called Bretton Woods, and effectively a new  global economic regime  was negotiated whereby other currencies would be linked or pegged  to the USD, and importantly the USD was pegged or linked to a fixed gold price (the USA owned most of the gold).
  • And everyone was happy – for a while. Before we get to the “for a while part”, lets discuss why this was such an advantage for the USA.
  • Firstly they effectively became the lender of last resort. In effect they became the world’s central bank.
  • Secondly, global trade was now taking place with the USD as the central payment mechanism. Goods and services were paid for with USD, because the recipients of USD were confident that they could redeem said USD’s for gold at any point.
  • A third consequence of this set up was – and this is important for what would happen in the future – the US treasury market became the dominant credit market in the world.
  • Because moving gold around was a cumbersome exercise, Recipients of USD (export nations) would buy interest baring US treasuries. Thus warehousing the USD reserves in an instrument that paid interest.  Again , everyone was happy – for a while.
  • Consequently , this allowed the USA to borrow bigger amounts, and at lower rates because gold was backing everything , and in theory the USA owned all the gold.
  • Every now and again a little glitch appeared in the matrix – but by and large this system was in play for a few decades.
  • Then things began to change, The USA entered into two conflicts.
  • The first in Korea and the second a few years later  in Vietnam.
  • Wars are expensive – especially long and protracted ones, and the Vietnam war lasted close to 15 years. This cost the US close to 170 billion USD (over 1 trillion USD in todays money), and even today Vietnam veterans and their families are paid benefits totaling some 22 billion USD per annum.
  • This spending impacted the US fiscus as more and more resources were allocated to the war, resulting in increased borrowing needs.
  • This initially was not a problem, because the US could tap lenders through the US treasury market. And lenders were happy because they could earn fees, and were confident that if things turned sour they could call on the federal reserve to repay them in Gold.
  • Over time though the skies began to darken ….The US was making very little military progress. In fact the war was expanding to Cambodia and Laos, and costs were rising exponentially as the US had to send more and more equipment and troops to the conflict zone.
  • In short the US was tapped out … had maxxed out on Visa and MasterCard. Credit demand rose , and lenders began to bluetick the USA.
  • We are going to leave it here for this episode.  What happened next, again changed the way the world worked. I did not know it yet but it’s  the reason I have enjoyed a career as a currency trader.