The Breakdown - What Happens if the Dollar Loses Reserve Currency Status?

Episode Date: August 8, 2021

On this week’s “Long Reads Sunday,” NLW reads David Z. Morris’ “The End of Exorbitant Privilege: Inflation, the Global Dollar and What Comes Next,” which covers inflation’s potential impact on the status of the USD. Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW The Breakdown is written, produced by and features NLW, with editing by Rob Mitchell and additional production support by Eleanor Pahl. Adam B. Levine is our executive producer and our theme music is “Countdown” by Neon Beach. The music you heard today behind our sponsor is “Tidal Wave” by BRASKO. Image credit: blinow61/iStock/Getty Images, modified by CoinDesk.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by Nidig and produced and distributed by CoinDesk. What's going on, guys? It is Sunday, August 8th, and that means it's time for Long Read Sunday. And this week, since we've had so many big, heady things, I thought I'd do something light and little for Long Read Sunday. so, of course, I picked an essay about the end of the dollar's global reserve status and what comes next. It is specifically called the end of exorbitant privilege, inflation, the global dollar, and what comes next. It's by David Z. Morris, the man, the myth, the legend himself,

CoinDesk's chief insight writer, and it's actually the first of two points. So if you like it, I'll read the other one in the weeks to come. I think it does a great job of setting up a huge amount of what's going on in the larger macro context, so I hope you enjoy it. The year has been rife with anxiety about inflation. Economist Lawrence Summers sent up an early warning flare in March, speculating that debt-financed government-coronavirus pandemic relief payments could overheat the economy. Summers got some vindication from consumer price index numbers this summer,

including 5.4% annualized CPI growth in June. Inflation terrifies people for a lot of reasons, including its erosion of the purchasing power of wages and the value of dollar-denominated debt. But in May, a leading foreign exchange trader named Stanley Druckenmiller warned of an even bigger long-term risk of inflation, that it might threaten the U.S. dollar's status as the world's dominant reserve currency. The U.S. dollar is overwhelmingly the preferred currency for international trade. For instance, the huge global oil trade is the dollar denominated and settled. The dollar is also the most widely held foreign currency in central banks. This produces major economic

benefits for Americans, what has come to be known as the exorbitant privilege of the dollar, and its decline could harm the U.S. economy. We're still miles away from the kind of hyperinflation that can truly wreck a currency or an economy. Argentina is currently dealing with 50% inflation for comparison. There's also a lot of evidence that current U.S. inflation is highly concentrated in a few sectors, and bond investors have remained stubbornly skeptical of inflation doomsaying. But whether inflation pushes things along or not, it's clear the dollar's reserve status is already under pressure.

In May, the dollar's share of global reserves dropped to a 25-year low. Since 1999, the dollar's share has dropped from about 71% to just below 60%. And the competition is only heating up. The Eurozone has begun issuing debt that could make it a more viable reserve. China has spent more than a decade trying to make its currency more appealing internationally, including, some observers argue, through its creation of a central bank digital currency. And the adoption of Bitcoin as legal tender by El Salvador hints at the possibility that a digital currency or other exotic instrument could become part of the equation.

So what's causing the decline and why could inflation accelerate it? If the dollar's retreat continues, how serious would the impact on the USB? and how viable are the leading candidates for taking up the dollar's mantle? What is a reserve currency? In the 21st century, reserve status is not an official designation, but rather a competitive position based on which currency is most trustworthy and most useful for global trade. That means the dominant reserve currency can change. Before World War I, it was the British pound. As recounted by University of California at Berkeley economist Barry Eichen Green,

the dollar continued to gain dominance as the U.S. sold arms to combatants around World War II, increasing its gold reserves. That transition also reflects the general rule that dominant global trading nations tend to have dominant global currencies. Businesses or governments needed to hold American currency to buy American products, and the United States remain the dominant global manufacturer for many decades after the end of World War II. Some countries also hold various currencies for use in stabilizing the global price of their own currency. If the pound drops against the yen, for instance, the Bank of England might sell yen from its reserves to try and bring prices back down. This is the basic mechanism that our

algorithmic stable coins try to mimic. Exchange rate policy has broadly shifted over the past century, though, and fewer countries now have formal currency pegs that demand large reserves. Utility for trade and currency pegging aren't enough to make a reserve currency, though. The dollar also came to make up more and more of foreign central bank holdings because it was trusted, in part because it was backed by gold under the Breton Woods Agreement. After the end of the gold standard in 1971, the dollar retained its dominance not just because of U.S. economic strength, but because of trust in the stability of the U.S. government and its economic policies. The lack of any viable alternatives to the dollar, though, has also been crucial to its continued dominance. That may still

be its best defense today. Why might the dollar lose its reserve status? There are at least four headwinds that could plausibly threaten or at least weaken the dollar's position as a global reserve currency. They are fiscal weakness, the national debt, monetary weakness, inflation, political instability or problems with the structure of the market for treasury bonds. Most international reserves are held in the form of bonds, which are a form of loan. That means reserve status depends on a country's ability to pay off those loans. In the case of the U.S. and the dollar, repayment is a long-term concern, according to Stanford University economists and bond market expert Darrell Duffy, but not for the next few years or even

the next few decades. Inflation is at least potentially a more immediate threat. One major article of faith that helped the dollar gain reserve status was that the U.S. would not start indiscriminately printing money, because dollar inflation would erode the value of dollar denominated international holdings. The French francs lost its reserve status in the 1960s when the cost of the Algerian revolution drove the French government to print money. While the bond market has so far ignored the threat of inflation, it could easily turn on a truly irresponsible administration. That said, Eichen Green argues that there are many factors that are more important

than low inflation for a dominant reserve currency. Economic stature is key, which explains the long-term decline in dollar reserves. The rise of Japan, Mexico, Korea, China, Brazil, and many other countries as productive hubs means more of their currencies are circulating around the world as trade instruments than in the mid-20th century. The U.S. now produces only a little over 10% of all global exports, making the dollar less and less useful for trade. But it remains a uniquely powerful economy, which seems to explain why U.S. bond markets haven't buckled under inflation fears. The continued appetite for treasuries reflect the belief that a surge of debt spending right now will shore up the U.S. economy in the long term, and that it's a worthwhile trade-off for some

inflation risk. Equally crucial is the openness and reliability of financial systems themselves. This includes a stable system of financial rules and institutions that can quickly convert bonds or other instruments into cash. There was a scare on this front last March when the start of the pandemic triggered panic selling of U.S. bonds that overwhelmed Treasury markets. The good news, according to Duffy, is that this was a problem of market structure related partly to bank reserve requirements, rather than a lack of demand for U.S. Treasuries. But he says fixing problems in the Treasury market is necessary for the dollar's continuing health. Buyers want treasuries because they can be liquidated quickly, he says.

The concern that the market's not going to work could change the price at which the Treasury can sell bonds in the first place. Finally, political stability, trust, and transparency are also important for currency dominance. This is a continued barrier to adoption of the Chinese yuan. But it's also a rising risk for the U.S., given what some see as trade hostility, rising unrest, and anti-democratic efforts by some U.S. political factions. The good news is that right now, most of the threats to the dollar are either gradual or fairly far out on the horizon. In the short run, there's no serious risk of dollar displacement, says Yaya Funisi, a former CIA analyst and adjunct senior

fellow for currency issues at the center for a new American security. Still, if and when enough of these underpinnings fail, the world could turn away from the dollar incredibly quickly. There's an assumption that a reserve currency benefits from incumbency, or what the tech world might call network effects. But history teaches us that those effects are hardly determinative. The U.S. dollar itself first overtook the British pound in international finance in 1925, just 10 short years after the founding of the Federal Reserve in 1914. One of the most important developments in this space is that community banks, regional banks, and credit unions can now start offering Bitcoin to their customers. That's right. Checking, saving, and now Bitcoin. It's all happening seamlessly thanks to a

platform by NIDIG that offers institutional-grade custody and compliance. They're also the sponsor of the breakdown. And if you want to find out more, go to nidig.com slash NLW. That's nydig.com forward slash NLW. Why would losing reserve status hurt the U.S. running a global reserve currency isn't all wine and roses. U.S. Treasury economist Kenneth Austin has argued that reserve status harms the U.S. economy and manufacturing in particular, because it makes U.S. exports more expensive. But the current consensus is more focused on some major advantages the U.S. and its residents gain from the dollars reserve status. Some of them are matters of convenience, such as the ability of U.S. travelers to pay with dollars around the world, or the ease with which U.S.

businesses can manage invoicing and exchange rate risk. But other advantages are more profound. The most striking is what's known as seniorage, that foreign governments are willing to trade $100 worth of real goods and services for a $100 bill that only cost the U.S. mint a few cents to produce. The same more or less goes for treasury bonds. This produces some pretty astounding effects. About 500 billion in U.S. currency circulates worldwide, along with about 7 trillion worth of U.S. government bonds. Those ledger entries were granted in exchange for things like manufactured goods from China

that have immediate material impacts on American quality of life. Ike and Green describes this as an asymmetric financial system with the international community supporting American living standards and subsidizing American multinationals. In theory, this is justifiable because dollars in bonds can in turn be used to buy goods back from America. Both bills and bonds are essentially debts. But reserve currency status limits this backflow because the dollars are held as a long-term store of value. Bonds, as long as they stay trustworthy, can stay parked in foreign banks for decades. The $500 million or more in U.S. cash circulating internationally, meanwhile, is at least as likely to be used for transactions between

third countries as it is to come back home and make a claim on goods. So that's about $7.5 trillion worth of goods and services that the U.S. has obtained at a fire sale discount. The torrent would not just slow but potentially reverse as the dollar's reserve status declines. This would most likely be a gradual process with incremental effects, as we've seen with the dollar's declining share already. But a run on the bank is also a possibility. If the dollar experiences a sharp shock, let's say something on the scale of a second U.S. civil war, foreign nations would move quickly to trade dollar bonds for superior assets from U.S. entities. There's nothing to stop this without implementing currency controls, which would ultimately end reserve status in itself. Such a rambunctious unwinding

of the dollar would be hugely damaging, but that kind of collapse would most likely only follow events so catastrophic that reserve status will be the last thing on our minds. For France in the 1960s, the death knell was out of control spending driven by the desperate attempt to hang on to the last shred of its empire. For England in the 1940s, it was a full-scale Nazi offensive. But unless things were already really disordered in the U.S. itself, a slow decline in the dollar's relative importance wouldn't actually trigger disorder or impoverishment. Senior age is nice, but the 7.5 trillion that the U.S. has gained from it over several decades is only about one-third of its annual GDP. According to Eichen Green's senior age is only the

23rd most important factor in America's global economic status. The U.S. also enjoys very cheap borrowing thanks to the dollar's reserve status, lowering its interest payments on all those bonds by hundreds of billions of dollars per year. The U.S. government can even borrow at two to three percentage points below what it earns on its own foreign investments. But less appetite for dollars would make borrowing more expensive. That could be the biggest threat losing reserve status poses to U.S. domestic economic security, since it would sharply reduce government revenue available for domestic spending. Finally, the dollar also grants the U.S. some less tangible benefits in geopolitical power.

The status quo for U.S. national economic security is that we have tremendous leverage, says fantasy. We can enforce policy interests with sanctions, all that stuff. While it's hard to put a dollar value on the power of international sanctions, you can imagine it's a tool that U.S. political leaders don't want to lose. What comes next? Global currencies are effectively in competition for use and trades in reserves, with convertibility and stability of the key metrics. After World War II, the dollar's reserve status was preserved in large part by the lack of competition.

The economies of France, England, and Germany were quite literally reduced to rubble, and a series of devaluations linked to rebuilding efforts in imperial decline severely eroded faith in the pound and franc. The landscape now is much different. The euro, the yen, and the yuan all have some features that would make them viable global reserves. And China in particular has been aggressively pursuing greater international yuan flows for at least a decade. The development of the digital yuan has been widely interpreted in the West as a part of that strategy, for instance. But despite some declines, the dollar has held onto its reserve and trade dominance. At least for now, experts believe each of the potential dollar competitors has some fatal shortcoming that makes it less preferable.

Japan, for instance, holds most of its debt domestically, making it unavailable for reserve holdings. China has domestic policy priorities that conflict with its reserve ambitions. In an upcoming companion piece, we'll be going into the strengths and weaknesses of competing fiat currencies in more detail. We'll also be exploring the viability of a new kind of reserve option, cryptocurrency. The idea of cryptocurrency as a global reserve hit the big time when El Salvador declared its intent to hold Bitcoin, though not explicitly as a reserve. Crypto has some appealing reserve properties, including its openness and liquidity.

Even more appealing may be that a true crypto-like Bitcoin would take monetary management decisions and the power to abuse them away from any single country. The idea of crypto reserves is novel and strange, and it would involve a lot of challenges, uncertainty and structural changes, all of which we'll dive into in that forthcoming companion piece. But crypto also has more legitimacy in mainstream economics than you might guess. Former Bank of England head Mark Carney has proposed a synthetic reserve currency

using some crypto-like technology, and Forex Titan Stanley Druckenmiller has said he thinks some sort of crypto will be the next major reserve currency. Time will tell, but at this point, I wouldn't. count it out. Back to NLW here, and I'm not going to say too much because I think it's pretty clear that we need to read the second piece now that we've read the first, but I think what's really important about this is setting the framework for these larger questions of where crypto fits in the monetary system. It's not just crypto versus the U.S. dollar, it's also

where the U.S. dollar sits relative to the rest of the world. This is a geopolitical power game, not just an internal domestic question, and that's why it gets so heightened so fast. Now, if you're really interested in this, go back and listen to especially my first episode with Luke Gromond and my first episode with Lynn Alden. Just search their names and you should be able to find them. And if you have any trouble, hit me up at NLW on Twitter. We talk a lot about exactly these issues and they're really, really good primers for more. So I hope you enjoyed this piece. Thanks to David for writing a great start of what seems like a good series. And until tomorrow, guys, be safe and take care of each other. Peace.