The Threat to the Dollar as the World’s Primary Reserve Currency, by Patrick Barron

If you only read one article about economics this month, make this that article. Not only is the analysis correct, but so to is the prescription at the end. From Patrick Barron, at Mises Canada, mises.ca:

The Threat to the Dollar as the World’s Premier Reserve Currency

…but does it really matter?

By Patrick Barron

My answer is that, “Yes”, it really matters. And that is why we need to take action today to protect all of our interests. The source of the threat may surprise you.

We refer to the dollar as a “reserve currency” when referring to its use by other countries when settling their international trade accounts. For example, if Canada buys goods from China, China may prefer to be paid in US dollars rather than Canadian dollars. The US dollar is the more “marketable” money internationally, meaning that most countries will accept it in payment, so China can use its dollars to buy goods from other countries, not solely the US. Such might not be the case with the Canadian dollar, and China would have to hold its Canadian dollars until it found something to buy from Canada. Multiply this scenario by all the countries of the world who print their own money and one can see that without a currency accepted widely in the world, international trade would slow down and become more expensive. Its effect would be similar to that of erecting trade barriers, such as the infamous Smoot-Hawley Tariff of 1930 that contributed to the Great Depression. There are many who draw a link between the collapse of international trade and war. The great French economist Frederic Bastiat said that “when goods do not cross borders, soldiers will.” No nation can achieve a decent standard of living with a completely autarkic economy, meaning completely self-sufficient in all things. If it cannot trade for the goods that it needs, it feels forced to invade its neighbors to steal them. Thus, a near universally accepted currency is as vital to world peace as it is to world prosperity.

However, the foundation from which the term “reserve currency” originated no longer exists. Originally the term “reserve” referred to the promise that the currency was backed by and could be redeemed for a commodity, usually gold, at a promised exchange ratio. The first truly global reserve currency was the British Pound Sterling. Because the Pound was “good as gold”, many countries found it more convenient to hold Pounds rather than gold itself during the age of the gold standard. The world’s great trading nations settled their trade in gold, but they might accept Pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment. Toward the end of World War II the US dollar was given this status by treaty following the Bretton Woods Agreement. The US accumulated the lion’s share of the world’s gold as the “arsenal of democracy” for the allies even before we entered the war. (The US still owns more gold than any other country by a wide margin, with 8,133.5 tonnes to number two Germany with 3,384.2 tonnes.) The International Monetary Fund (IMF) was formed with the express purpose of monitoring the Federal Reserve’s commitment to Bretton Woods by ensuring that the Fed did not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce. Thusly, countries had confidence that their dollars held for trading purposes were as “good as gold”, as had been the British Pound at one time.

However, the Fed did not maintain its commitment to the Bretton Woods Agreement and the IMF did not attempt to force it to hold enough gold to honor all its outstanding currency in gold at $35 per ounce. During the 1960’s the US funded the War in Vietnam and President Lyndon Johnson’s War on Poverty with printed money. The volume of outstanding dollars exceeded the US’s store of gold at $35 per ounce. The Fed was called to account in the late 1960s first by the Bank of France and then by others. Central banks around the world, who had been content to hold dollars instead of gold, grew concerned that the US had sufficient gold reserves to honor its redemption promise. During the 1960’s the run on the Fed, led by France, caused the US’s gold stock to shrink dramatically from over 20,000 tons in 1958 to just over 8,000 tons in 1970. At the accelerating rate that these redemptions were occurring, the US had no choice but to revalue the dollar at some higher exchange rate or abrogate its responsibilities to honor dollars for gold entirely. To its everlasting shame, the US chose the latter and “went off the gold standard” in September 1971. (I have calculated that in 1971 the US would have needed to devalue the dollar from $35 per ounce to $400 per ounce in order to have sufficient gold stock to redeem all its currency for gold.) Nevertheless, the dollar was still held by the great trading nations, because it still performed the useful function of settling international trading accounts. There was no other currency that could match the dollar, despite the fact that it was “delinked” from gold.

There are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value over time. These two factors create a demand for holding a currency in reserve. Although the dollar was being inflated by the Fed, thusly losing its value vis a vis other commodities over time, there was no real competition. The German Deutschemark held its value better, but the German economy and its trade was a fraction that of the US, meaning that holders of marks would find less to buy in Germany than holders of dollars would find in the US. So demand for the mark was lower than demand for the dollar. Of course, psychological factors entered the demand for dollars, too, since the US was the military protector of all the Western nations against the communist countries.

Today we are seeing the beginnings of a change. The Fed has been inflating the dollar massively, reducing its purchasing power and creating an opportunity for the world’s great trading nations to use other, better monies. This is important, because a loss of demand for holding the US dollar as a reserve currency would mean that trillions of dollars held overseas could flow back into the US, causing either inflation, recession, or both. For example, the US dollar global share of central bank holdings currently is sixty-two percent, mostly in the form of US Treasury debt. (Central banks hold interest bearing Treasury debt rather than the dollars themselves.) Foreign holdings of US debt currently total $6.154 trillion. Compare this to the US monetary base of $3.839 trillion.

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To continue reading: The Threat to the Dollar