A view on the the role of the USD in the world market

The United States, despite its trials and tribulations in recent years, remains the world’s largest economy. Its currency, the almighty Dollar (no need to add in the US because by default ‘Dollar’ refers to the USD), is the undisputed de facto international currency. As of 2012, the USD represents 61.2% of the world’s foreign exchange reserves (see, for example, this document: http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf). What this means is that countries use the USD as a common currency for exporting and importing. For any country that is not the USA, they would have to first purchase USD from the US government with their own currency, most likely at an exchange rate favorable to the US, then use those Dollars to buy what they need from other countries. They would then pass the cost to their consumers. Thus importing for any country that is not America is expensive; both for the government and for the consumer. This also means that America can enjoy cheap imports because they have their own money already.

There are historical reasons for the dominance of the Dollar. America has profited significantly from both world wars, when Europe (and rest of the world) was blown to bits… twice, while little infrastructure in the US was touched. This naturally gave opportunities for massive amounts of American goods and capital to flood into the world market. Further, people trusted the USD because of the Gold Standard. That is, prior to 1971, you could take a Dollar and trade it for a fixed amount of gold from the Federal Reserves. Thus the faith in the Dollar was equivalent to the faith in the value of gold; which is basically ironclad. Nixon axed this in 1971.

However, trust in the USD persisted for many decades, because the United States was by far the world’s largest economy and there was no other currency even remotely close to the reliability of the Dollar. Even though the USD was no longer tied to a specific commodity like gold, it was widely believed that the US government would keep its currency stable, since doing otherwise would wreck havoc on its own economy (specifically, causing inflation or currency shortage). This basic belief system persisted until 2008, when in the wake of the financial crisis the US government decided to be reckless with its monetary policy. More specifically, the Federal Reserves printed off massive amounts of paper money, essentially diverting their national debt to the rest of the world. Further, it was quickly realized that the Dollar was critically linked to the domestic politics of the United States. A unilateral decision by the United States Government to borrow more money, shut down government, default on a debt, or print more money affected the entire world.

Thus, governments around the world are either starting to actively ween themselves off the Dollar, or at least considering the option. A more stable international currency is sought after, one that is not at the mercy of a single national government.

This shift could be devastating to the American economy, whose financial sector has essentially built a house of cards on the foundation of the dominance of the Dollar. Right now, the US enjoys a two-fold benefit for having their currency as the international standard. First, each country in the world has to buy up a large amount of USD in their reserves, in order to be able to make purchases and do business with other countries. However, having all of this cash just sitting around isn’t productive; so what is needed is low-risk, low interest debt instruments that can be converted into cash quickly. The natural answer is US national debt. This allows other countries to collect a (small amount of) interest on their USD reserves, while having the flexibility needed to make purchases and do business. The US benefits from this greatly because not only are they making a profit by selling their own currency, they also get to borrow money very cheaply (low interest rates) by selling bonds.

However, the basic requirement for low interest rates is ‘low risk’. The only way someone is going to lend you money without expecting a lot of interest is if they’re very very sure that they will get their money back. In the past, this belief was solid: there was no way anyone can imagine that the US will default on a loan. However, the recent US government shutdown and the almost-happened default on foreign debt had the debt ceiling not be raised, had greatly shaken this belief. When countries no longer feel that the US will pay them back, they will ask for higher interests; and since the US owes so much, it can scarcely afford to pay even the interest, much less the principal.

Further, it is this basic interest rate that drives all other interest rates. If US government bonds have to pay a higher interest rate, it would push everything else up, including home mortgages. Even what seems like a modest increase from a 6% interest rate on a 300,000 dollar, 30 year mortgage to say 8%, would cause the monthly payment from $1,784.48 to $2,174.14, or a 21% increase (calculations based on the Royal Bank’s mortgage calculator: https://www.rbcroyalbank.com/cgi-bin/mortgage/mpc/start.cgi). Businesses also borrow money to do their work, and a similar effect will propagate throughout the economy. Simply speaking, everything will cost 20% more. That will have a dramatic impact on the domestic economy in the USA.

Unfortunately for the USA, the move to freedom from the Dollar is already starting, Recently, the People’s Bank of China (China’s equivalent to the Bank of Canada or the Federal Reserves) has stated that it is no longer in China’s interests increase reserves of the USD. What this may signal is that China is going to slow or stop its acquisition of the USD and thus significantly reduce international demand for the USD thus putting a downward pressure on its price, and further will signal that China is no longer willing to purchase more US debt. With many US domestic policies riding on the US government being able to reliably borrow money cheaply, this could point to a pending collapse of the US financial system and the greater economy as a whole much larger in scale than the 2008 incident.

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