China is a big country, inhabited by many Chinese — Charles de Gaulle
Perpetual budget deficits. Ballooning trade imbalances. Political infighting, followed by repeated displays of economic brinkmanship. Once upon a time, the term ‘full faith and credit of the United States government‘ was sacrosanct throughout the world.
A few short years later, a number of governments are calling for the dollar to be replaced as the world’s principal reserve currency.
Could this actually happen, and if so, what would the effects be on the U.S. economy?
The Bretton Woods System Established the Dollar as the World’s Reserve Currency
During the early 1900s, global trade was fraught with currency manipulations by governments in blatant attempts to ‘game’ the system to their advantage. Ultimately, the combination of trade wars during the period along with rampant currency manipulation helped fuel the events which led to the Great Depression.
Recognizing the urgent need for trade stability, representatives from 44 nations met at the Bretton Woods Monetary Conference from July 1 through July 22, 1944, held in Bretton Woods, New Hampshire. During the historic meeting, the representatives created a system for exchanging world currencies, establishing the International Monetary Fund (IMF), along with the World Bank. Perhaps most significantly, in the wake of Great Britain’s political and economic decline and the emergence of the United States as the world’s preeminent superpower, the British Sterling Pound was supplanted by the U.S. dollar as the world’s most-utilized reserve currency. The dollar was tied to the gold standard, backed by reserves held primary in Fort Knox, Kentucky.
In 1973, with gold reserves far below the amount necessary to back all the dollars in circulation, President Nixon took the dollar off the gold standard. The U.S. dollar officially became a ‘fiat currency’, which Investopedia defines as follows:
Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith. Fiat is the Latin word for “it shall be”.
Faith in the Dollar as Reserve Currency is Waning
China, which holds $1.3 trillion of U.S. treasuries and other debt instruments, has been calling for the end of the dollar as the world’s reserve currency for years. An article in China’s official news agency Xinhua stated, “It is perhaps a good time for the befuddled world to start considering building a de-Americanized world.”
Furthermore, China and Japan have executed bilateral agreements to conduct trade with one another in their own currencies, as has Russia. Recognizing the emergence of the yuan, Australia recently announced it would move 5% of its currency reserves into Chinese bonds.
Why has the dollar started to lose favor? The vitriolic budget battles over the past few years, the soaring national debt and the S&P credit downgrade of 2011 have all played roles in a loss of confidence in the greenback. The United States is essentially in the same position Great Britain was not long before the pound was demoted — suffering from financial instability and declining world-wide respect, with an emerging economic power on the verge of surpassing them.
The U.S. was the emerging power back then, but today is looking over its shoulder at the hard-charging China. China’s economy is predicted to overtake the U.S. as the world’s largest sometime in 2015, and although the yuan is nowhere near openly traded enough to become the world’s reserve currency, steps are underway to make it so.
US Economy: What if Dollar is Replaced?
Like most hypothetical scenarios, there are multiple opinions as to what might happen if the dollar were to be replaced as the world’s reserve currency. One unknown is whether it would technically be fully replaced, or would just become one of a ‘basket’ of currencies from which reserve currency status would be comprised. Regardless, the following are some of the potential ramifications.
- A drop in demand for dollars would lower the value of the dollar in comparison to other currencies, making U.S. goods more competitive and therefore boosting exports.
- An increase in exports and corresponding decrease in imports would help improve the balance of payments, which is almost always negative.
- Higher exporting and a lower balance of payments would create jobs and therefore increase GDP.
- With most of the world’s trade still negotiated in dollars, the demand for the greenback is strong enough to ensure a ready market for treasury instruments. Given that the U.S. finances its deficit spending by selling treasuries, the benefits of other nations being required to trade in dollars (and thus buy and sell treasuries) are clear.
- As demand for the dollar lessened due to fewer being held for reserve purposes, offshore dollars currently being held in reserve would return into circulation within the U.S. economy, increasing inflationary pressures.
- Interest rates would rise, perhaps dramatically.
- Seigniorage (the difference between the value of the currency and the cost required to produce the physical bills and coins) revenues of approximately $10 billion per year due to (essentially) interest-free loans from overseas countries holding U.S. currency and coins would be lost.
- Like Great Britain and other countries before it, the demise of the dollar as reserve currency would likely bring with it a loss of U.S. political power and influence around the world.
U.S. Dollar: Are We On the Brink?
Although steps have been taken to diversify global currency requirements, and despite calls for change by China and other nations, the fact remains that the dollar is likely to retain its lofty status as the world’s reserve currency for the immediate future. The U.S. has the largest economy, the most liquid and accessible financial markets, a readily-traded currency and despite our financial problems, is still considered a “safe haven” in periods of turmoil.
However, there are cracks in the system, not the least of which created by self-inflicted political and economic wounds. The dollar as reserve currency has already lasted longer than the currencies of Portugal and the Netherlands when theirs were considered as such in the 1400s and 1600s, respectively.
We all know that all good things eventually do come to an end, and as T.S. Eliot once wrote, “What we call the beginning is often the end. And to make an end is to make a beginning. The end is where we start from.”
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Center for Economic and Policy Research. If the Dollar Stopped Being the Preeminent Reserve Currency It Would Mean More Jobs and Growth. (2013). Accessed on December 16, 2013.
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