The dollar has been under attack for quite some time, but has been propped up by a global economic crisis and a lack of credible alternatives. This does not mean, however, that the dollar is a permanent bedrock of stability. Instead, the underpinnings of dollar resilience are being been pulled away one by one.
What makes the U.S. dollar valuable while the Zimbabwe dollar is worthless? Both are merely printed pieces of paper. One enjoys real value as a medium of exchange while the other has no value today. It wasn't always the case. In fact as recently as 1998 a Zimbabwe $100 bill could be exchanged for about $20 American. Ten years later, the Zimbabwe government was producing $100 trillion bills not worth an American penny.
The U.S. dollar has retained value for multiple reasons.
1. The American economy is much larger, more diverse, and has greater stability. That was true in 2008 and remains true today. Having said that, the era of American economic dominance is rapidly deteriorating according to many observers. In fact, a World Bank report suggests that the Chinese economy could pass that of the United States as soon as this year when adjusting for currency differences.
This is a huge change since 2005 when the Chinese economy was only 43% of the size of America's using the same measure (see table below). China is estimated to surpass America this year. India's economy has virtually doubled its share when compared to the U.S. as well over the same time period.
Of course, despite losing relative size, America is also viewed as a source of stability, especially during a crisis. Unfortunately, that is eroding as well. One proof that this is eroding is that despite the seriousness of global issues, Russia's invasion of Crimea and other unrest, the dollar has not strengthened this year as expected. From The Wall Street Journal Blog:
Sterling has swept higher, close to $1.70, in fact. The euro is on the up. The yen has been too. The New Zealand dollar has cranked higher to the point where its central bank governor is talking about the possibility of intervention. The glue here is the queasy U.S. dollar. But why is the buck under pressure? This was supposed to be the dollar's big year … Lee Hardman, currency analyst at Bank of Tokyo Mitsubishi UFJ: "The ongoing decline in U.S. yields despite building evidence that a strong economic rebound is underway in the U.S. is serving to undermine confidence in the U.S. dollar.
By any measure, it should be obvious that our once overwhelmingly dominant economy is no longer so. As a result, while economic dominance and stability once argued for our dollar to be the primary (if not exclusive) "reserve currency" of the world, the argument has weakened substantially. Without the global unrest, would the dollar begin to collapse?
2. Another reason often given for dollar dominance is its role as petrodollar. This means that since the early 1970s, oil has been sold almost exclusively for dollars. If someone in India wanted to buy barrels of oil from Saudi Arabia, they would have to exchange rupees for dollars to make the purchase. Saudi Arabia (as well as all of OPEC) would then accumulate dollars and use the excess to buy American Treasury debt. Basically, because the entire world needed oil, the entire world needed dollars. And, whenever oil was sold, the proceeds, or at least a large portion of them would wind up owning American Treasury debt. This situation has allowed the U.S. government to borrow money at substantially lower rates than most of the rest of the world. It has allowed our government to continue a debt and deficit policy with few repercussions. Even when a financial crisis occurs, the world turns to cash and the currency they have turned to has been the American dollar. This allowed the U.S. government great flexibility in the crash of 2008. When people panicked, cash flooded into "safe American bonds." With this money, the government could do bailout programs and stimulus without fear of harming the currency. Some economists even suggested adding trillions more to American debt levels, arguing that the dollar would not be harmed. Greece did not have this luxury and the austerity has been painful.
Unfortunately, the petrodollar is eroding. Russia's $400 billion energy deal with China will not involve dollars. Interestingly, while the American media reported on the deal, most ignored the critical factor that they agreed to bypass the dollar. Al Jazeera gleefully reported it, however, as shown in the following excerpts:
RUSSIA, CHINA SIGN DEAL TO BYPASS U.S. DOLLAR
Analysis: The agreement is a symbolic blow to US global financial hegemony and a signal of Russia-China rapprochementMay 20, 2014 5:00PM ET by Michael Pizzi @michaelwpizzi
In a symbolic blow to U.S. global financial hegemony, Russia and China took a small step toward undercutting the domination of the U.S. dollar as the international reserve currency on Tuesday when Russia's second biggest financial institution, VTB, signed a deal with the Bank of China to bypass the dollar and pay each other in domestic currencies.
The so-called Agreement on Cooperation — signed in the presence of Chinese President Xi Jinping and Russian President Vladimir Putin, who is on a visit to Shanghai — was followed by the long-awaited announcement on Wednesday of a massive natural gas deal 10 years in the making.
"Our countries have done a huge job to reach a new historic landmark," Putin said on Tuesday, making note of the $100 billion in annual trade that has been achieved between the two countries.
Demand for the dollar, which has long served as a safe and reliable reserve currency in international transactions, has allowed the U.S. to borrow almost unlimited cash and spend well beyond its means, which some economists say has afforded the United States an outsize influence on world affairs.
But the BRICS countries — Brazil, Russia, India, China and South Africa, a bloc of the world's five major emerging economies — have long sought to diminish their dependence on the dollar as a means of reshaping the world financial and geopolitical order. In the absence of a viable alternative, however, replacing it has proved difficult.
For its part, "China sees the dominance of the dollar in international trade transactions as a remnant of American global dominance, which they hope to overthrow in the years ahead," said Michael Klare, a professor of peace and world security studies at Hampshire College. "This is a small step in that direction, to reduce the primacy of the dollar in international trade."
Some have been tempted to view Tuesday's deal in the context of Putin's showdown with the West over the crisis in Ukraine. After the U.S. and Europe imposed sanctions on Moscow for its annexation of Ukraine's Crimean peninsula, Putin may have finally made good on promised retaliation against what he views as Western hegemony in Russia's near abroad.
"Breaking the dominance of the U.S. dollar in international trade between the BRICS is something that the group has been talking about for some time," said Chris Weafer, a founding partner of Macro-Advisory, a consultancy in Moscow. "The Ukraine crisis and the threats voiced by the U.S. administration may well provide the catalyst for that to start happening."
And, other global trade is happening without dollars as well. One example may be a sudden halt to dollar-based transactions between Afghanistan and China. While it may be that the Chinese are concerned about money-laundering it is also possible that this is an attempt to minimize dollar use. This idea is supported by statements that the Chinese would continue transactions with Afghanistan using other currencies as reported by CNBC. Other examples include Brazil/China trade deals bypassing the dollar. Russia is offering to sell gas to Europe for Euros as well. Now, China and Qatar are looking to invest MORE in Russia even as we impose sanctions. Australia and China are bypassing the dollar as well. Russia and China seem dedicated to proving to the world that America isn't necessary.
Saudi Arabia has removed the United States as its preferred customer and replaced us with China, something that has been building for years. They now look to China for military hardware as well. Will it be long before they accept Chinese Yuan as payment? The Saudis certainly seem open to the idea.
No matter how you look at it, the stronghold of the petrodollar continues to decline. That's a clear goal of Russia, China, and the other emerging economies. According to Russian press:
"The dollar is evil. It is a dirty green paper stained with blood of hundreds of thousands of civilian citizens of Japan, Serbia, Afghanistan, Iraq, Syria, Libya, Korea and Vietnam," one of the authors of the motion, Mikhail Degtyaryov of the conservative nationalist party LDPR said in an interview with Izvestia daily.
3. The depth of the U.S. Treasury market has allowed the dollar to remain important. Essentially, America is the only nation with a large enough debt to absorb all of the global liquidity. So, even when the U.S. debt was downgraded, people kept on buying Treasury bonds. There is simply no other place to put all the money.
The problem with this argument, however, is that it presupposes long-term stability. Unfortunately, this is eroding as well. The Chinese have called for a de-Americanized world precisely because they view our political wrangling as a sign of instability. And, the idea that there are insufficient debt markets to absorb liquidity is false. There is plenty of debt in the world, including in China. The question is whether or not it can be organized properly. The Euro has made some strides in this direction. And, other holdings have grown much faster than the dollar. The largest increase has been in "unallocated reserves" according to the IMF. Even the Yuan is bidding for reserve status.
U.S dominance is clearly declining with nations opting to hold reserves outside of the major currencies. This does not bode well for the American dollar and with recent issues the trend seems likely to accelerate. Russia, China, and India in particular have rapidly increased their gold holdings. And, as trade patterns change, it seems likely that nations will want to hold the debt of their trading partners rather than U.S. dollars exclusively. This means much greater diversification and a diminishing of dollar holdings. So, the depth of the Treasury market may not remain such a powerful factor. In fact, as U.S. debt continues to balloon, that depth could appear to be a bottomless pit. The non-partisan Congressional Budget Office has said that our long-term debt picture is clearly unsustainable (emphasis added):
Between 2009 and 2012, the federal government recorded the largest budget deficits relative to the size of the economy since 1946, causing federal debt to soar. Federal debt held by the public is now about 73 percent of the economy's annual output, or gross domestic product (GDP). That percentage is higher than at any point in U.S. history except a brief period around World War II, and it is twice the percentage at the end of 2007 … CBO projects that federal debt held by the public would reach 100 percent of GDP in 2038, 25 years from now, even without accounting for the harmful effects that growing debt would have on the economy. Moreover, debt would be on an upward path relative to the size of the economy, a trend that could not be sustained indefinitely …
At some point, investors would begin to doubt the government's willingness or ability to pay U.S. debt obligations, making it more difficult or more expensive for the government to borrow money. Moreover, even before that point was reached, the high and rising amount of debt that CBO projects under the extended baseline would have significant negative consequences for both the economy and the federal budget:
- Increased borrowing by the federal government would eventually reduce private investment in productive capital, because the portion of total savings used to buy government securities would not be available to finance private investment. The result would be a smaller stock of capital and lower output and income in the long run than would otherwise be the case. Despite those reductions, however, the continued growth of productivity would make real (inflation-adjusted) output and income per person higher in the future than they are now.
- Federal spending on interest payments would rise, thus requiring larger changes in tax and spending policies to achieve any chosen targets for budget deficits and debt.
- The government would have less flexibility to use tax and spending policies to respond to unexpected challenges, such as economic downturns or wars.
- The risk of a fiscal crisis—in which investors demanded very high interest rates to finance the government's borrowing needs—would increase.
Bottom line? Our massive debt, once considered a "positive," at least in providing a deep and liquid market, will at some point (maybe sooner than we think) become a money-pit negative. To assume there are no alternatives to the dollar is naive.
4. The fact that the United States military defends the world has been cited as sufficient reason for foreigners to keep buying our debt. Trevor Loudon of New Zealand recently made that case. He said that the rest of the world doesn't like how we export inflation through the dollar but has put up with it because of a need for American military protection. Unfortunately, that is eroding as well. Confidence in America's military might is diminishing after the "red line in Syria" and promises to protect Ukrainian territorial sovereignty. In addition, even our own Department of Defense has admitted we are reducing capabilities to protect multiple theaters in a war. At the same time, China's military is rising. The Chinese have even asked Australia if they could replace the United States as "big brother" protector.
5. China would lose too much if the dollar collapsed. This argument breaks into two parts. First, there is an assumption that China's holding of $1.7 trillion in dollars prevents them from moving against the currency. This is clearly false. While the holdings are substantial, the Chinese are more than willing to write them off if they view it in their interest to do so. And, there is a growing voice inside China telling them that it is in their interest. We need to remember that the Chinese do not focus on the short-term. They keep the big picture squarely in focus with a long-term outlook. Second, we arrogantly assume that because we buy Chinese goods, they are dependent on us. This forgets the reality that we buy their goods and they buy our bonds, real estate, and productive assets. In other words, they are merely financing our purchases. There are other potential customers they can finance. In fact, China is the largest trading partner with a huge number of countries. And, China is working diligently to increase domestic consumption to offset any loss of American buying.
When you add it all up, there have been significant reasons for the dollar to be strong globally. Sadly, those reasons are beginning to fail. Who will buy our debt if China doesn't? What happens if Russia starts unloading our debt? In 2008, Russia started massive sales of our debt to harm our global market position and asked China to join them. The Chinese weren't ready and declined. Are they ready now?
Russia has started selling their holdings of American bonds again against a backdrop of sanctions and tension with the U.S.
Who has been buying them? Belgium is the unusual answer. Belgium has added upwards of $200 billion worth of Treasury bonds to their holdings since the lows of last year. Of course, most believe that Belgium is simply a holding location for other buyers, potentially even entities funded by the Federal Reserve. Without doubt, Belgium's buying is a curiosity. They have nearly a year's worth of economic output now held in American Treasury bonds. Can we count on Belgium going forward?
In reality, it is likely the Federal Reserve has been holding up the dollar at this point, passing China as a holder of U.S. Treasury bonds. That has created enormous stress and dislocation with the Fed's balance sheet at all-time record levels. Keep in mind that the Federal Reserve has a balance sheet that is about five-times larger than it was a decade ago and more than four-times larger than at the start of the last financial crisis. It would be impossible for the Fed to increase it by a similar magnitude in the next crisis.
Another financial crisis is inevitable. What happens if the Fed is not able to step in and address it? From NewsMax TV:
A financial catastrophe worse than that of 2008 will hit us within five years, says James Rickards, best-selling author and senior managing director at Tangent Capital Partners. "The meltdown in 2008 was not a meltdown. It was sort of a half-meltdown," he told Dennis Kneale of Newsmax TV in an exclusive interview. While Lehman Brothers was the only major financial institution to completely collapse, others were close to it, said Rickards, author of "The Death of Money: The Coming Collapse of the International Monetary System."
But the Federal Reserve stepped in to prevent financial firms from going under. As a result, "the Fed truncated" the avalanche, he explained …"So everything about '08 that was too big to fail is bigger today. Those dominoes are still waiting." Meanwhile, the Fed has printed $4 trillion during the last six years. "So, they've got no more drive power," Rickards contended. Liquidity crises arise every five years, he said. "So what's going to happen when the next liquidity crisis comes?" It won't be pretty. "The next time it happens, it's going to be bigger than the Fed, that's why they're not going to be able to stop it," he predicted. The fact that the financial system is bigger than in 2008 will make this crisis worse, Rickards added.
By the way, all of this was warned about in our 2009 report to the Pentagon. We have watched it unfold just as predicted :
"The risk of a Phase Three has quickly emerged, suggesting a potential direct economic attack on the U.S. Treasury and U.S. dollar. Such an event has already been discussed by finance ministers in major emerging market nations such as China and Russia as well as Iran and the Arab states. A focused effort to collapse the dollar by dumping Treasury bonds has grave implications including the possibility of a downgrading of U.S. debtforcing rapidly rising interest rates and a collapse of the American economy. In short, a bear raid against the U.S. financial system remains possible and may even be likely."
While Phase One and Phase Two were troubling, the U.S. economy eventually was able to respond and the markets stabilized. Unfortunately, the response has saddled the U.S. Treasury with substantial debt. At the same time, the Federal Reserve has massively increased the money supply in response. In total, an estimated $12.8 trillion of economic stimulus has been put into the pipeline by the U.S. government and monetary authorities . . .For context, $12.8 trillion is roughly in line with total U.S. GDP and sharply greater than the value of all U.S. stocks at current prices. It is also roughly equivalent to the amount of price decline for all American assets, peak to trough, as a result of the financial crisis. It also is estimated to produce massive annual Federal budget deficits…
The concern is that the response to the recent collapse by itself will strain available economic resources for some time with large budget deficits and high inflation risks. The situation would be made significantly worse in the event of further economic attack. It is in this vein that a potential Phase Three must be considered.
Based on the assumed nature of Phase One and Phase Two, a Phase Three attack would likely involve dumping of U.S. Treasuries and a trashing of the dollar, removing it from reserve currency status. This is clearly foreseeable as a risk and even could float under the cover of a natural outcome in much the same way that Phases One and Two potentially have been hidden.
The implications are extremely serious. If the dollar were not the reserve currency, there would be a mass dumping of Treasury instruments by foreign holders. Treasury interest rates would skyrocket, further worsening the annual deficits due to sharply higher interest payments on expanding debts. The Treasury would have to raise taxes dramatically, further dampening growth or the Federal Reserve would be forced to monetize the debt, worsening inflation concerns."
BOTTOM LINE: Our enemies are more than aware of our difficult economic situation. We are extremely vulnerable. Our nation must address this systemic threat. As informed individuals, we must as well. We can no longer count on the assurance that the American dollar is the only money in the world.