In the last 2 articles, I discussed the two biggest stressors of a traditional finance ecosystem, a fiat-based monetary system and the Central Banks. In the third part of this series, I discuss the role of reserve currency in the global trade and commerce A fully floating global reserve currency (US dollar) has created serious trade imbalances over time and made the entire global trading ecosystem fragile. Let’s see how…
Bretton Woods Agreement
The current monetary mess has its origins in the Bretton Woods agreement signed by most countries in 1944. By then, United States and the UK had built a global payments infrastructure that helped companies and countries export (import) goods and receive (pay) money for those goods. Exchanging goods for gold was a logistic nightmare for most countries because of the challenges involved in storing, protecting and moving gold. Leveraging the global payment infrastructure that uses fiat currencies & banks by depositing their gold in New York or London vaults (ie handing over gold custody to the US/UK governments) was much easier for most countries. Fiat based global settlement systems were cheap, convenient and more secure than gold based settlement systems.
It is in this context that Bretton Woods Agreement was signed by member nations. As per the agreement, United States would peg the dollar to a fixed gold price and in-turn, each country would peg its native currency to the US dollar. This would ensure global price stability & also assure the world that their gold is in safe custody (and can be redeemed in future). United States made a solemn commitment to countries that they can exchange their dollar reserves for gold anytime in the future. In effect, countries around the world entrusted the United States with the job of controlling dollar supply to ensure that th
United States over the next 25 years printed a lot of currency to fund its military expansion and spend on welfare activities. Simultaneously Europe and Japan were building world class products that were increasingly out-competing their peers from the United States. World needed lesser dollars to buy US goods and preferred to save their surplus in gold over US dollars. Net result was a much higher supply of US dollars held by foreigners compared to the gold held in the United States vaults.
Giving one currency the power to act as a medium of exchange leads to what is called as ‘Triffins Dilemma’. The country which controls the reserve currency wields its power by printing money to supply this ‘medium of exchange’. But every time it supplies additional currency by printing, existing stakeholders who lent their gold to the reserve pool are diluted further. Persistent printing by the country that controls reserve currency makes others stake holders lose trust in the reserve currency (remember the Wakanda example ).
Undocumented Sovereign Default
Confidence in the US dollar was shrinking as the United States began to fear a run on its gold reserves. Once countries started demanding their gold back in exchange of dollars, US was under a risk of monetary collapse. In his infamous 1971 speech, Richard Nixon temporarily suspended the dollar’s convertibility to gold. This created shockwaves in the global currency markets as this meant a new world order.
By 1973, the Bretton woods agreement collapsed and all countries were forced to move to a floating exchange rate regime. In essence, it was a major sovereign default by the United States, a terrible breach of trust. Unfortunately, military might writes history & this event was never recorded as a ‘sovereign default’ by any economist/historian.
Rise of the (unpegged) Dollar
Thus began the rise of the unpegged Dollar, the monopoly reserve currency of the world. It was now free from any monetary restrictions & the powers that be had unlimited control on the ‘never ending’ tap of US dollars.
To the crypto enthusiasts, imagine a hypothetical blockchain where there was only one node – the only validator on this network who validates all transactions is the Federal Reserve. Fed can print new transactions, erase transactions & manipulate transactions at will (as we have seen in the recent Russia-Ukraine War where the Fed froze Russian Central Bank reserves.. more on this later).
In essence, as Saifedean Ammous rightly claims in his book ‘Fiat Standard’, US dollar is the only Layer 1 blockchain running the current financial infrastructure and all other currencies are merely Layer 2’s. Layer 2’s have no significance in the larger scheme of things because Layer 1 is THE eventual settlement layer. Entire world is forced to play by the rules of this Layer 1 blockchain (US Dollar) where money holds its value only if you are obedient to the system.
Global Trade Imbalance
Current Account Deficit
In the year 2021, Current Account Deficit (CAD) was at $214 billion. Current account deficit is the difference in value of what you export v/s what you import – in effect, each year United States citizens are consuming 200 billion dollars worth of excess value from the world compared to what they are producing.
If we look at Budget Deficit, which is the total spending by the United States Federal Government v/s the total revenue, we see that year after year, USA has maintained budget deficits. Such massive current account deficits & budget deficits would have been impossible under Bretton woods agreement.
Every house-hold intuitively understands that it cannot spend more than what it earns. This situation is only sustainable by resorting to debt. Every parent knows that excess debt risks the future of their children. What is common knowledge in every household is unfortunately uncommon to the policy makers running the country.
United States is exploiting its ‘reserve currency’ status by printing worthless dollars and exporting them to other countries in exchange for real goods & services. The dollars exported help US citizens buy mobile phones, cars, food, metals, oil etc. These dollars will only be valuable if United States backs these dollars with real value produced by the time, energy, resources, human capital produced by the United States.
In the absence of such value, countries that have exported these real goods end up having money that isn’t really a store of value. By taking a shortcut of ‘minting’ money, United States government is resorting to ‘theft’ and ‘dishonesty’. On the other side, we have China holding bags of US dollars which it can’t dispose easily.. Lets look at the story of China…
The Excess Reserve Currency Problem
China has this unique problem of becoming the world’s factory. It has funded its growth by exporting goods in exchange for US treasuries (Treasuries are long term US securities that promise their holder an interest and a principal on maturity). US has borrowed excessively and China was happy to oblige it by exporting real goods in exchange of the US dollars.
As on date, China has more than $3 trillion reserves. Out of this, it is estimated that one-third ($1 trillion) is held in US paper securities. China knows that US does not have the ability to repay this debt without minting more currency out of thin air – sad part is that China cannot do anything about it – if it tries to dump these securities onto the world, dollar will collapse instantly and China will lose bulk of its reserves. It’s a mutual harakiri event that China cannot risk. (at this stage, atleast)
China in a way is compounding this problem by artificially holding its currency to a low value vis-a-vis US dollar. This helps Chinese manufacturers retain their supremacy over global exports.
Meanwhile, China is smartly increasing its gold reserves, buying mines and natural resources globally, upgrading its infrastructure (all hard assets funded by what China considers as a worthless US dollar). China is doing everything it can to offload US currency reserves without causing a collapse of the dollar.
Restrictive Capital Controls
As we have seen above, USA runs large deficits and supplies a lot of credit to the world at a really low interest rate. Even though US treasuries offer very low returns, investors hold these securities because they are considered ‘risk-free’. As we have seen in the article on Central Banks, the Fed controls the short term interest rate called the ‘Fed Funds Rate’. A higher fed funds rate makes holding US securities lot more attractive for investors.
Developing countries across the world need huge investments in infrastructure, healthcare, communications etc. In a bid to attract overseas investments, these countries offer higher returns to investors, much better than that offered by US treasuries. Although investors get a higher return, they are exposed to the depreciating foreign currency – if the currency depreciates, the converted US dollars will be worth a lot less when investors exit their investment.
When the US raises the Fed Funds Rate because of domestic economic considerations, it not only affects the fate of US citizens but also the developing countries. Suddenly the risk-reward payoff for US securities becomes better than that of developing economy investments. If there is a free-conversion of capital, investors will redeem their investments, convert the local currency into dollars and exit the country.
This causes a huge stress to monetary systems of these countries and leads to huge volatility in equity and foreign exchange markets. To defend themselves against such flight of capital, developing economies introduced ‘capital controls’ – these are rules that prevent investors from freely entering and exiting foreign markets.
Weaponizing the Reserve Currency
Whatever problems existed in the world, countries had faith in the US political & economic system. Events that unfolded after Russian invasion of Ukraine have washed away the last vestiges of that faith.
Joe Biden administration blundered by seizing the US currency reserves held by the Russian Central Bank. Russian Central bank acquired these foreign reserves by legitimately selling oil, metals and other commodities to the world. By seizing foreign currency reserves, United States weaponized the reserve currency.
The underlying message is very clear – By seizing legitimate reserves, United States can attack the sovereignty of any country at will. This will force every country holding US dollar reserves to swap those reserves to hard assets that cannot be seized by foreign powers.
To conclude, concept of ‘reserve currency’ was a sound one so long as everyone played by the rules laid down in the Bretton woods agreement – all countries will peg their currency value to US dollar & US would ensure that it regulates dollar supply to peg its value to gold.
Unfortunately, as the old adage goes, absolute power corrupts absolutely. USA could not control its spending & hence could not retain its peg to Gold. What ensued was a set of freely floating currencies controlled by their respective governments & a de-pegged US dollar as the global reserve currency (controlled by the United States).
This system has created serious challenges to traditional finance infrastructure in 50 years of its existence. Key ones are:
- Large global imbalances where some countries are only consuming while others are producing.
- Every country manipulating its own currency that hurts fair global trade
- Artificial capital controls that create undue investment uncertainty and risks
- Weaponizing reserve currency that is seen as the ultimate risk to a nation’s sovereignty
These massive structural problems will eventually blow up if not corrected. By adopting a universal standard where the ‘reserve currency’ is not controlled by a single country & the rules of engagement are same for everyone, the world can have a smoother, equitable and sustainable trade and development (read Bitcoin).