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Dollar crisis on the horizon
A PIVOTAL element of the global economy is whether the international monetary system engineers credit creation or operates by credit transfer. In the first case, credit is available and countries can finance deficits on their current account. Imbalances are not addressed. Creditors maintain their propensity to save and debtors continue to spend. This leads to higher global growth. In the second case, creditors limit the amount of credit available. This forces debtors to apply tight fiscal and monetary policies. Global imbalances are addressed, but debtors' efforts to suppress demand stifle global growth.
Between 1870-1914, Britain managed to control credit creation through the limits set by the gold standard, which made all sterling bank notes convertible into gold. The system did not get its strength from gold, but from the role of Britain's economy. In every decade since 1870, Britain ran a current account surplus. The trade balance showed a small deficit in the 1890s and 1900s, with balance in the 1880s and small surpluses in the 1870s and between 1910-14. Britain loaned to the world and in return the world bought British goods and services.
Things changed at the 1944 Bretton Woods conference when Britain, exhausted by its efforts in World War II, pleaded for credit creation. The US rejected this, fearing the rest of the world would use US credit to buy goods and services without any prospect of the loans being paid back. The US won, as creditors normally do. Limited credit transfers kept financing low, forcing the rest of the world to address imbalances - Britain depreciated sterling by 30 per cent in 1949 - which put a lid on global growth.
END OF THE GOLD STANDARD
In the early 1960s, the outstanding amount of dollars rose so much that the unilateral commitment to redeem dollars into gold lost credibility. Between 1971-73 the US renounced the gold standard and switched to credit creation by printing dollars without restrictions. The money printed by the Federal Reserve System underpinned expansion in emerging markets.
It also undermined the domestic economy by laying the foundation for a spectacular consumption boom.
After staying steady for decades at around 62 per cent, private consumption's share of US GDP has risen to 69 per cent in 2018. Unlike Britain, which was both banker and supplier of goods and services, the US has become just the banker and sacrificed its role as a major manufacturer. The result is an inherently unstable system with glaring global imbalances where the US runs permanent current account deficits and creditors run permanent surpluses.
The first line of defence when the gold standard crisis began in 1971 was to offer a higher yield on 10-year Treasury bonds. Yield rose to almost 8 per cent in August 1971 from around 4 per cent in 1962. That worked for a short time. But by the end of 1972 the yield had not fallen; in fact, it was on an upward trajectory. What creditors wanted was a depreciation of the dollar, and they got it. In early 1973, President Richard Nixon's administration negotiated a coordinated depreciation of the dollar against other major currencies.
This illustrates what happens when a reserve currency is overstretched. First, creditors ask for a rise in yields. When that proves insufficient, they move to the second stage and ask the administration to make it cheaper to buy the reserve country's goods and services. There is a considerable risk that this will happen to the dollar.
Yields on 10-year Treasury bonds have started to rise significantly. Creditors may hold dollars for a while, but are likely eventually to move to the second stage, engineering a fall in the real effective exchange rate. They may demand both a permanently higher yield and a depreciation in exchange for not unloading dollars. If the US continues to pump dollars into the global economy, the yield will go up and the dollar down. In the light of Mr Donald Trump's views on international negotiations, it is hard to imagine a repetition of the Nixon administration's skilful handling of such a crisis.
In the short term, this does not mean much for the future of the dollar as a reserve currency. There is a lack of a genuine alternative. In the medium and long term, the analysis is less comfortable for the US.
Countries hold currency so that they can purchase goods and services and invest in foreign corporations, real estate or financial assets. Logic dictates they choose the currency of the largest and strongest economy that offers the most valuable goods, services and assets.
The conclusion is straightforward: the propensity to hold another nation's currency in reserve is almost directly proportional to that nation's share of global GDP. In relation to banking, a global reserve currency's collateral is its share of global GDP. The smaller the outstanding amount of dollars compared to its share of global GDP, the more secure it is to keep dollars in reserve.
The outstanding amount of dollars that are claims on future US production is rising. The US' capability to deliver the products that the rest of the world is interested in buying is falling. When these two trends intersect, there will be a dollar crisis.
RISE OF A NEW CURRENCY
This process is already under way. Gazprom Neft, Russia's third largest oil producer, has for three years settled its crude sales to China in renminbi. In March 2018 news broke that Beijing is planning a pilot project for the second half of the year to pay for imported crude oil with renminbi instead of dollars. The two countries allegedly selected for the pilot are Russia and Angola, with rumours that Saudi Arabia and the United Arab Emirates may become involved. If this venture is successful, it will act as a spur to similar schemes for other imports and primary products.
China needs primary products, while exporters of such products need capital goods for domestic investment. China offers those goods - the US also does, but to a lesser extent.
So why should these trades continue to be made in dollars? Furthermore, a system where money can be printed without restrictions, as has been the case in the US since it renounced the gold standard in the 1970s, has not instilled confidence in politicians and central bankers. Some commentators have proposed reintroducing a link to a fixed asset; this time not gold, but minerals or other primary products.
The emergence of a multicurrency or multi-asset international payments system will take time. It doesn't portend a collapse of the global payments system, but does point to a redistribution of global wealth. The seigniorage harvested by the US as the world's banker will gradually fall, narrowing the room for manoeuvre in US economic policy, which for the last 70 years has had the greatest influence on markets globally. As the power of the dollar wanes, the US will be pressured to adjust to a world economy vastly changed since 1945. OMFIF
- The writer is senior research fellow at ISEAS-Yusof Ishak Institute in Singapore, and a former State Secretary at the Danish foreign ministry. This was first published as a two-part commentary in the Official Monetary and Financial Institutions Forum website