Download The Demise of the Dollar

The Demise of the Dollar
Over twenty years ago, while walking the streets of Saigon, Vietnam, I came across an elderly drinks
seller who surprised me by pulling a sizeable wad of US dollars out from underneath her blouse in order
to communicate her willingness to exchange my dollars for Vietnamese dong. At that time, just two
years after the fall of the Berlin Wall, the US dollar was accepted and desired everywhere, even (or
perhaps especially) in countries such as Vietnam which remained communist.
Since the end of WWII, the US dollar has been the central pillar of the global monetary system.
Commodities such as oil, agricultural products and minerals are priced in dollars which causes countries
to hold dollars (often in the form of US Treasury Bonds) in their foreign currency reserves in order to
finance trade.
The benefits of having the US dollar serve as the world’s currency are apparent. For non-US countries,
trade is much easier if everything is priced in dollars and if everyone agrees to use dollars. Americans,
meanwhile, are able to acquire Saudi oil, Chinese electronics and African minerals using their own
money. While many of these dollars will in turn be used by foreigners to buy corn and airplanes from the
US, some of them will end up being used to facilitate trade deals that do not involve the US at all.
Happily for Americans, some foreign imports purchased using dollars will never need to be paid for with
American exports. Unlike any other nation, the US is able to run persistent trade deficits (where imports
exceed exports) without ever facing a currency crisis.
However, there is a responsibility associated with this privilege. In order for the dollar to remain a global
reserve currency the American government needs to keep the value of the dollar stable in terms of both
purchasing power and other currencies. No one can be expected to accept and hold dollars that are
losing value and thereby becoming less likely to be accepted and held by others.
After WWII the value of the dollar was fixed in terms of gold (at 1/35th of an ounce). However, by the
late 1960s, as American trade and budget deficits grew and as rising inflation eroded the purchasing
power of the dollar, nations such as France began to demand gold in exchange for their dollar reserves.
Facing a run on US gold reserves, Richard Nixon chose to ‘close the gold window’ and stopped offering
gold to foreign governments in exchange for dollars in August 1971.
As a result of this default, confidence in the dollar plummeted throughout the 1970s until by 1980 the
price of the dollar in terms of gold had fallen from 1/35th of an ounce to 1/850th of an ounce (ie gold
prices rose from $35 to $850 per ounce).
Faced with this collapse and accelerating inflation, in 1979 US President Jimmy Carter appointed Paul
Volcker to head the US Federal Reserve System. In order to tame inflation and restore confidence in the
dollar Volcker raised interest rates to over 20%. Speculators as well as homeowners and businesses
went bankrupt as asset prices fell, spending slowed and unemployment rose above 10%. However, while
the economic pain was terrible, inflation was beaten and confidence in the dollar was restored. The
world’s monetary system had been preserved.
For the next 20 years the dollar served the American and global economy well. However, as the
administration of George W. Bush began pursuing costly wars in Afghanistan and Iraq even as it
implemented massive tax cuts, American trade and budget deficits once again ballooned. Further, low
interest rates put in place by Alan Greenspan in the wake of the bursting of the technology stock bubble
in 2000 encouraged Americans to borrow ever greater amounts to both speculate in the housing market
and purchase foreign imports. Lastly, financial deregulation undertaken in the 1980s led banks to
transform themselves from careful stewards of their depositors’ savings into highly leveraged (which is
to say heavily indebted) speculators in the financial markets.
As a result of all this borrowing and spending, inflation began to rise and starting in about 2003 global
investors began to feel betrayed by America’s unwillingness to live within its means and preserve the
dollar’s value. As a consequence of this loss of faith, the euro, managed by the inflation-phobic
European Central Bank, gained favour and gold prices rose from under $300 an ounce in 2002 to over
$1000 an ounce in 2008.
In an attempt to re-balance the economy and restore confidence in the dollar, Alan Greenspan began
raising interest rates in 2004 but the resulting financial crisis of 2008 has meant that the overriding
priority of the US Federal Reserve System since then has been to keep interest rates low and encourage
inflation in order to ease the real burden of the debts held by the banking system.
This is an incredibly irresponsible policy choice on the part of the Fed, which should be more concerned
with maintaining confidence in the dollar as the world’s reserve currency. However, no one in
Washington is prepared to take responsibility for the wave of bankruptcies and defaults that would
ensue in the financial sector were interest rates to rise high enough to restore investor confidence in the
American dollar and American dollar assets.
Instead, the US government is attempting to restore confidence by creating an illusion of economic
health through market manipulation. As not many investors are interested in purchasing 10 year US
Treasury bonds paying less than 3% interest in an environment of rising inflation, the Fed has decided to
buy them itself using freshly printed money (aka “Quantitative Easing”) even as additional money
printing is used to push stock prices to record highs. Meanwhile, as evidenced by a number of ongoing
criminal investigations, the foreign currency and precious metals markets have been shamelessly
interfered with in order to convey an impression of continued dollar strength.
However, by suppressing the price signals (falling bond prices/rising bond interest rates, a falling
exchange rate and rising gold prices) that have in the past served to discipline governments pursuing
wealth-destroying economic policies, the US government and banking system have made a full-blown
currency crisis a real possibility, which, as the US dollar is so important to global trade and finance,
would be a disaster not just for the US but for the entire world.
A number of countries see the writing on the wall and are taking steps to protect themselves in the
event of a dollar collapse. After decades of selling, since 2010 central banks have been net buyers of
gold and some have even begun to, very quietly, use their US dollar reserves to purchase real assets
such as mines and farmland. This subtle approach appears wise as more direct attempts to reduce
exposure to the dollar, such as Iraq’s attempt in the early 2000s to establish a euro-denominated oil
market and Libya’s attempt a few years ago to introduce a gold-backed dinar to be used for trade
amongst African nations did not turn out so well for those governments and their leaders.
Those experiences aside, the bottom line is that the continued health of the global economy depends on
policymakers in Washington realizing that they cannot have it both ways. Either they can continue to
issue the world’s reserve currency or they can paper over the problems of an insolvent banking system
with higher inflation. For all our sakes, I hope that they will have the courage to choose the first option
so that twenty years from now drinks sellers in Saigon will still be happy to accept dollars.