Decline Of The US Dollar – The Consequences

There are signs that the US dollar, instead of consolidating the sharp rise that peaked last March, might be reversing its previously rising trend.

Certainly, a weakening dollar fits with the Federal Reserve Board deferring attempts to raise interest rates from the zero bound, and reflects the growing chatter that negative rates cannot be ruled out. It should also interest us that there is evidence the Americans are beginning to take the threats to the dollars' hegemonic status seriously, and this is no longer just seen as a speculative possibility.

Secretary Kerry made this point for us in connection with another context, responding to a suggestion that he should renegotiate the Iran deal: "That is a recipe very quickly, my friends, businesspeople here, for the American dollar to cease to be the reserve currency of the world – which is already bubbling out there." So lucid was he on this subject that we can confidently assume that the dollar's status being undermined is being taken seriously at the highest levels of government.

And it should be. China is determined to free her trade from the dollar, and we can only guess at the scale of her ambitions. More might be revealed later this month when she publishes her thirteenth five-year plan. What we do know is that she has already overtaken America as the world's manufacturer, and despite the ups and downs of credit cycles, will dominate international trade even more in years to come.

To appreciate the importance of this change for the international currency scene, we should look back to when the dollar originally acquired the role as everyone's foreign currency of choice. It was not, as most people think, the Bretton Woods Agreement that gave it this status, it validated it. You need to go back to the 1882 and 1900 Acts under which the US Treasury issued gold certificates requiring it as issuer to give "to the bearer on demand dollars in gold coin".

At that time, Britain and her dominions dominated world trade, but Britain's was essentially a free-trade zone based on sterling closed-loop. America began to dominate the rest of the world's foreign trade, so it was only a matter of time before countries issuing their own fiat currencies accepted dollar reserves in the belief they were the equivalent of owning gold.

Arguably, it was from then that the US dollar gradually adopted the role of the world's reserve currency. The muddle between on the one hand a fiat currency having a gold exchange facility, and on the other hand gold itself, was necessary for this fiction to be accepted; but accepted it was and continued to be through two world wars, until the fiction was formalised at Bretton Woods.

In support of the dollar's adoption as the international monetary standard, there were therefore two factors: America's economy was emerging as the world's largest force in global trade, in much the same way as China has overtaken the US today, and also the dollar was regarded as good as gold, which was everyone's sound money.

The latter lost its relevance when President Nixon in 1971 finally dropped the fiction that the dollar is as good as gold. As a result the US Authorities have had to embark on a continuing campaign to persuade markets that the dollar replaced gold's millennial status. But that is all it is: a campaign and not reality. The rise of Asia with its people and their leaders (in private at least) still adhering to gold, challenges the dollar fallacy and is now the greatest threat to the dollar's future. The Chinese and Russian leaders recognise this point, and that America's gold policy is actually the dollar's Achilles heel.

India, the third Asian powerhouse, is today attempting to surreptitiously acquire its citizens' gold through gold monetisation and bond schemes. Just this week it was announced that there would be a limited issue of five and ten gram gold coins, reminding us of the US's 1882 and 1900 Acts referred to earlier; but to look at this as just a government grab of the people's gold is to miss the big picture. We know India is following China in her economic development and will wish to insulate the rupee from the consequences of the dollar's inevitable loss of reserve status as Asia's domination of world trade increases. For this India will need all the gold she can get.

We cannot blame China and India, or Russia for that matter, if they wish to protect themselves from western systemic risk by shifting their trade settlements away from the dollar. It is becoming clear to Asian leaders at least that the dollar's reserve status is an anachronism of the past and cannot last, a simple deduction that raises important questions not addressed for over a century. It can only be a matter of time before the whole currency system has to face a radical reset to reflect today's realities, for which the financial world is unprepared.

The textbooks will have to be rewritten
Today's economists and central bankers have only known a world that revolves round the dollar. If the dollar loses its reserve status, they will have to rewrite their textbooks. It will remove the fundamental prop supporting the pseudo-science of macroeconomics.

Before the dollar became adopted under the guise of a gold substitute, it was universally accepted by economists that sound money was a basic requirement for markets to work properly. Indeed, this is why fiat dollars had to masquerade as gold substitutes. Sound money was the link between production on one side and savings and consumption on the other. Say's law, or the law of the markets, which defines these relationships, was unquestioningly accepted.

The only way sound economic theory could be ditched and replaced by government-friendly economic beliefs was to make unsound money appear to be sound. At the fourth attempt in 133 years, a US central bank, the Federal Reserve Board, was successfully established in 1913/14, which gained its credibility by acquiring depositors' gold from the reserves of all the member banks. The American public was unaware that the gold they and their fathers deposited at their banks had become the property of the Fed, which eventually handed it on to the Treasury in 1934, under the Gold Reserve Act.

With sound money now tied up and the dollar circulating as if it was a paper version of gold, the money-quantity could be continually expanded without the general public and foreign creditors being any wiser. As the world's reserve currency, the Fed issued it for export to other central banks through currency swaps, and commercial banks issued dollars in the form of credit to US corporations pursuing overseas business. Furthermore, dollars were used to finance American wars in foreign lands without having to raise taxes at home. The benefits of having a universally accepted fiat currency were fully exploited by the US Government.

Crackpot economic theories could be entertained. Soon, under the influence of Lord Keynes, Say's law was dismissed by the new economics, which decreed that markets were imperfect, needing guidance and central planning to function in the common interest. Production and consumption were regarded as quasi-independent quantities, which could be managed selectively by the state. As long as the dollar remained sound in the eyes of the public, these experiments and macroeconomic assumptions could continue to be developed and deployed. The result was that a dynamic free-market system, allocating capital to meet evolving market-determined requirements, was increasingly stifled by state intervention, managed by macroeconomists who believed they knew better.

It all points to the dollar's demise
The end-point in this lunacy is upon us anyway, as we are now overburdened by the accumulation of unproductive debt and there is even speculation of negative interest rates as a monetary "final solution". It coincides with an attack on the dollar's hegemony led by China, but likely to be accompanied by all her major trading partners. Almost no oil is sold anymore to America from the Middle East, so the petrodollar is redundant. The potential for offshore dollars to return home has increased tremendously in recent years. Only short-term carry-trade imbalances have kept it up. The floodgates holding back returning dollars are waiting to be opened, which should lead to a substantial fall in the dollar's objective exchange-rate.

It's not clear what will replace the dollar in its current role. If it was up to ordinary people, they would almost certainly gravitate towards gold and silver as the yardsticks against which government currencies can be measured. Precious metals are the money of choice for truly free markets, but inevitably it's a decision that will be made by governments. Because it is the upcoming economic power, the successor to the dollar will be influenced by China and her Asian partners. At least they have a common penchant for gold, trusting it more than each other's currencies, so this appears to be the direction in which China is travelling.

China's yuan is the leading Asian currency for global trade, and she is setting the agenda. India's moves to build her gold reserves (by extracting it from her own citizens) are consistent with China's obvious desire to reintroduce gold into the Asian monetary system, and Russia is also building her gold reserves. So it would be logical for the new BRICS bank to set up a gold-backed rival to the SDR.

The future can only be guessed. However, as soon as China comes up with some clarity as to how she plans to move on from a dollar-dominated world, and assuming the plan is viable, the dollar could fall out of favour very quickly. The timing may be linked to China's thirteenth five-year plan, due to be published in the coming days, and which should be analysed carefully for clues as to what is intended.

Alasdair Macleod | Head of Research