The U.S. dollar is still considered to be the world’s reserve currency. A lot of global trade is done with the use of dollars.
The U.S. dollar has had this status for many decades. It could be dated to the end of World War 2. Actually, the Bretton Woods agreement was first established in 1944.
The U.S. dollar operated on something resembling an international gold standard from that point until 1971. It was a regular fiat currency for Americans, who weren’t even allowed to legally own gold, with certain exceptions. But foreign governments could redeem gold for the dollars they held, or at least that’s what they were told.
France, under Charles de Gaulle, actually did start redeeming gold for dollar holdings. This is one of the reasons why the U.S., under Nixon, abandoned the last remains of the gold standard on August 15, 1971.
It wasn’t France’s fault though. If it hadn’t been France, it would have been another country. The main reason that the U.S. abandoned the international gold standard is because the gold reserves were not increasing in correspondence to the money being printed. When money is being created out of thin air, you will eventually run out of gold as foreign governments redeem those depreciating dollars for gold.
The situation was unsustainable. Either the money creation had to stop or promises had to be broken. It’s not a surprise which route was taken by the U.S. government in hand with the Federal Reserve. It was easier to revoke a previous promise than it would have been to stop inflating the currency.
It’s no surprise that a period of even higher inflation occurred after this move. The 1970s was the worst period in terms of price inflation in the 20thcentury in the United States.
Paul Volcker eventually came in as Fed chair and did what was necessary to reduce price inflation and eventually bring interest rates back down. Volcker’s Fed simply stopped creating money out of thin air for a period of time, and it allowed interest rates to go up to what could be called market-clearing levels. This saved the dollar from hyperinflation. It saved the dollar as the world’s reserve currency.
Since the early 1980s, the U.S. dollar’s spot as the reserve currency of the world has been secure. While the euro came about in the late 1990s and China has seen tremendous growth over the last 4 decades (life changing for most Chinese), the U.S. dollar is still considered king.
This is for a combination of reasons. People often cite one reason on why the U.S. dollar is the world’s reserve currency, but I do believe it is the combination of multiple factors. The U.S. is a military superpower (when it isn’t fighting regional wars and occupying other countries). The U.S. is a large country. The U.S. is by far the wealthiest country. And for all its faults, the U.S. dollar is a relatively stable currency. These factors all contribute to the U.S. dollar’s status.
Some of this is self-reinforcing. For example, the U.S. dollar may be more stable because it is the world’s reserve currency.
The U.S. government also managed to compel or bribe major oil exporters in the Middle East, particularly Saudi Arabia, to do business in dollars. This is why it is referred to as the petro dollar. It is amazing that this has continued for this long.
Exporting Inflation?
I am not a fan of the term “exporting inflation”. I think it is misused, but there is also something to it. What I will say is that the U.S. dollar’s use as a reserve currency means that Americans experience lower price inflation than what otherwise would have been the case.
When the Fed creates new money, it is mostly through digits. But there is some corresponding increase in the actual currency being printed. We know that a lot of currency is sent overseas. It is done largely by U.S. residents who originated in other countries. They are sending money “home” to their families living in other countries. U.S. dollars are widely used in other countries around the world. They can be especially useful in third-world countries in which the government/ central bank inflates like crazy.
When U.S. dollars go to foreign countries to be used as a form of money, this reduces the supply in the United States. This has a deflationary effect, or perhaps more accurately, cancels out some of the inflation.
Most of the money created out of thin air by the Fed is done in the form of digits. As this additional new money resides in the banking system, you can’t really export this to other countries.
Sure, you could take your dollars and buy some goods from someone in China. But then what does the Chinese person do with these dollars? That person can convert it right back into his own currency or use it to buy American goods. Either way, it isn’t really exported out of the U.S. the same way that physical currency is.
The main way that digital currency is, in a sense, exported is through the buying of U.S. Treasury bills, particularly by foreign central banks.
Treasury Securities Held by Foreign Countries
There is a chart updated once a month showing the Treasury securities held by major foreign holders.
China and Japan are by far the top holders of U.S. government debt. They are both over $1 trillion. The next closest is the United Kingdom with just over $400 billion.
The two countries (China and Japan) have been close, although China has typically held a bit more through most of the 21stcentury.
Japan is now in the lead with over $200 billion more than China, as of July 2020. China has reduced its holdings a little from the previous year, but the main thing is that Japan has increased its holdings rather significantly.
So if you hear that China is getting out of U.S. Treasury securities, it isn’t really true so far. The holdings have only gone down a little. Russia is a country that has mostly abandoned U.S. Treasuries.
If the Chinese central bank wants to reduce its exposure, it doesn’t need to sell any U.S. government debt. It just has to allow it to mature without replacing it.
Despite the tough talk coming out of Washington DC with regard to China, it hasn’t seemed to make much difference. I don’t think the Chinese are going to go on a massive selling spree of U.S. Treasuries. If anything, there may be a gradual reduction over time, but I don’t even see that coming soon.
Amplified Effects
While Americans have seemingly benefitted from having the U.S. dollar serve as the world’s reserve currency, it is not without consequences, at least in the future.
In some ways, I compare it to someone dependent on welfare. Americans have been getting a free ride in some ways. The U.S. government can spend recklessly, while foreigners buy up some of the debt that is incurred in order to support the spending. American consumers benefit with cheaper prices than what otherwise would have been.
The downside is that it has helped sustain the reckless spending from Washington DC. If foreigners weren’t buying up U.S. government debt, then the Fed would have to buy up the debt, which would be more inflationary. It would put stronger limits on what the federal government could do.
I also believe that this is the equivalent of using leverage. As real estate investors know, using leverage can be really beneficial. You can use smaller amounts of money, but make amplified profits.
But also, as every real estate investor should know, leverage can be quite dangerous. If things go bad, the leverage can amplify the down side. Instead of having amplified profits, you get amplified losses, which often means bankruptcy.
I see this as an analogy to the U.S. dollar being the world’s reserve currency. What happens if and when this status is quickly lost?
I don’t think another currency is going to replace the dollar as the world’s reserve currency. I just don’t think the world needs one. In our modern technological world, you can trade between currencies almost instantaneously.
If China is buying oil from Russia, why do they need to use the dollar? They can use their own currencies.
If we see another reserve currency, it will more likely be gold.
But back to the question of what happens if the dollar’s status goes away. Or what happens even if price inflation becomes a major concern? What if foreign central banks start reducing their holdings of U.S. government debt while at the same time foreigners start sending some of their physical currency back to the U.S.?
The effects will be amplified going the other way. We could see price inflation worse than it otherwise would have been.
I believe that monetary inflation and all of its consequences is the major threat facing our economy. Rising prices could be one of the consequences, but there are many others to be sure. Resources are being misallocated. Saving and investment are discouraged. Our living standards are lower than what they should be.
I don’t see any panic coming out of the central banks in China or Japan. But things can change quickly. And if fear of price inflation all of a sudden becomes relevant, we could see amplified effects. We won’t see the reversal of the dollar’s status from the last 75 years all in one day, but there is potential to see major impacts when price inflation becomes a major issue.