Dr Anand VP Gurumoorthy
THE US dollar has been in a pre-eminent position for the past many decades, since the end of World War II. Having been the reserve currency for world trade, is it possible that the US dollar may lose its pre-eminence in the coming years? Many experts such as Peter Schiff and Jim Rogers believe so. This article explores the reason why such a situation might arise starting from the point where the dollar began its journey in 1944.
In July 1944, the soon-to-be victors of the Second World War met at Bretton-Woods, New Hampshire at the United Nations Monetary and Financial Conference to lay down the blueprint for the post-war economy. They discussed many things including the establishment of the World Bank and the IMF. They also agreed that the US dollar would be accorded the reserve currency status, i.e., countries world-wide would use the US dollar as the transactional currency and the currency in which to hold their reserves. The Bretton-Woods agreement led to what is called the gold-exchange standard – the dollar was fixed in terms of gold and all other currencies were fixed to the dollar. The Bretton-Woods system achieved a measure of stability for sometime but soon started unraveling.
1971 was a devastating blow for the gold-exchange standard. The US President Richard Nixon closed the gold window, i.e., delinked the dollar from the gold reserves. Why was this done? The 1960s was a period of great spending by the US government on the Vietnam War and the space race and other things. It had significant budget deficits that were financed by money supply from the Federal Reserve. As Peter Schiff reports in his book, Crash Proof 2.0:
“With the Federal Reserve thus expanding the money supply and creating inflation domestically in the later 1960s, countries abroad were forced to expand their money supplies at the same pace in order to maintain the agreed-upon ratios of their currencies to the dollar. The result of these expansions of foreign local currencies was inflation overseas that was, in effect, being exported by the United States.
“As these patterns continued through the late 1960s, European and Asian countries, by then restored to economic robustness and aware that expansions of their domestic money supplies were creating inflation, began returning excess dollars to the United States, demanding redemption in gold at the agreed-upon rate of exchange.”
This caused the US gold reserves to dwindle and the US government was forced to close the gold window. Peter Schiff’s words cannot be mistaken: “The significance of that repudiation cannot be minimized. It was the national equivalent of declaring bankruptcy.”
After 1971 the dollar was backed by the “full faith and credit of the US government,” whatever that means. In one stroke, the leading currency of the world had become “fiat money”, that is, money whose validity is backed solely by the say-so of the government. Some even call it “funny money” since it is backed by effectively nothing.
In the 1980s, the economy of the US took a grave turn. It started borrowing from other countries in trillions by issuing government bonds to them (This was the Republican alternative to raising taxes to meet government expenditures). At the same time, it was also transitioning to a service economy from a manufacturing economy. This means that export-driven countries like China would sell cheap products to the US, be paid in dollars, and use the same dollars to buy US bonds. Countries like China, Britain and Japan have trillions of dollars worth of US bonds waiting to be cashed in. How is the US going to pay it all back? If the US was a manufacturing economy instead of a paper-shuffling economy (a.k.a. a service economy) it could pay it all back in goods. If it simply starts printing more dollar bills to pay back the debt, no country would accept that. They would want redemption in stuff, not paper.
The US is in a fix. It has been indulging in over consumption resulting from heavy borrowings. The US people have very low savings. The reason the US has survived thus far is the amount of customer confidence placed on the dollar. Even now the confidence has not waned, considering how Europeans are hoarding money in the form of dollars. But that would be a disastrous game to play if the US dollar loses the confidence reposed on it.
The great US President Abraham Lincoln has said: “You cannot fool all of the people all of the time.” The 2008 crisis has shown that the US has enjoyed two decades of phony growth. The economy fuelled by Ronald Reagan’s “voodoo economics” and Alan Greenspan’s abstruse but ultimately self-defeating policies cannot sustain.
As several experts such as Jim Rogers and Peter Schiff and Ron Paul have suggested, a correct measure would be to accept the economy’s phoniness and take steps to rectify. As these experts suggest, the US needs to tighten their belt and under-consume. The US needs to take steps to regain the manufacturing economy status and produce tangible goods. But Barack Obama, under the influence of the Keynesians, has gone the other way and indulged in more borrowing and more spending. Indeed, they are encouraging the Europeans to do the same. Where will this end? How will it end?
It is the Asian countries that are propping up the US dollar by still exporting to the US. But as they realise the ugly truth about the American dream, that it has vanished in a puff of smoke, will they stop exports to the US? Where will the dollar go then? How will the debt be repaid? Will the dollar lose its reserve currency status and thus its pre-eminence?
The US has bailed out a lot of countries in the past. Two events that come to mind are the Mexican Peso Crisis of 1994 and the Asian Economic Crisis of 1997. Who will bail out the US if there is a crisis in the US?
An indication of the position of the US dollar comes from the BRIC/ BRICS Summits held in the past few years. The First BRIC Summit was held in June 2009 at Yekaterinburg, Russia. In the aftermath of the Summit, the BRIC nations announced the need for a new global reserve currency, which would have to be ‘diversified, stable and predictable’. In the recently concluded BRICS Summit held in March 2012 at New Delhi, there has been an agreement on trading in local currencies instead of the US dollar. Wikipedia states, “A report released by the United Nations Conference on Trade and Development in 2010, called for abandoning the US dollar as the single major reserve currency. The report states that the new reserve system should not be based on a single currency or even multiple national currencies but instead permit the emission of international liquidity to create a more stable global financial system.”
Latest update: On September 13, 2012, Ben Bernanke of the US Fed announced QE3 (Quantitative Easing 3) and stated that the US Fed will purchase $40 billion worth of bonds monthly for an indefinite period of time. What this means is that the US is going to print money in a planned basis indefinitely! This can only mean an inflationary rise and further debasing of the currency. It is predicted (for instance see the various videos uploaded on YouTube) that this will only hasten the collapse of the dollar rather than bring about economic recovery and reduction in unemployment which are the prime motives for the move.
(The author is a PhD from IIT-Bombay and is currently working as an Associate Professor at VIT University, Vellore Campus. He can be reached at [email protected])