The mighty Greenback

October 16, 2015

There is widely shared feeling that the United States is no longer the superpower and global hegemon that it once was. At the same time, there is a feeling – commonly voiced in the financial media, although rarely in the mainstream US media – that the American dollar is also no longer what it once was, namely the dominant currency in the world’s financial system. Indeed, there is an entire school of thought that believes that ‘the dollar is doomed’ and that financial planning should be based on that assumption. In practical terms, this generally leads to the conclusion that to protect the value of one’s financial wealth one must buy gold – but for analytical purposes it is important to separate the diagnosis, namely that the dollar is toast, from the prescription, that to avoid going down with the dollar, one should buy and hold gold.


Given these two parallel ideas, one relating to the geo-political standing of the US and the other to the financial standing of its currency, there is an overwhelming temptation to combine the two – whether in a positive sense of adopting them both, or negatively by rejecting them both. Indeed, it seems logical to identify a cause-and-effect relationship between the two.


Most people would posit this as “because American power is crumbling…therefore the position of the dollar as the primary global currency has (or will) become untenable”. However, it is at least possible that the cause and effect run in the other direction: given the systematic and prolonged debasing of the US currency (usually attributed to the Federal Reserve), the USA has gradually lost its ability to create wealth and, as an inevitable consequence, it has become unable to maintain its economic and military power”. Comparisons with the supposed causes of the decline and fall of the Roman Empire are often appended to this kind of analysis, to ‘prove’ that monetary and/ or fiscal ruination are essential precursors of national decline, destroying the country or empire from within long before it suffers disaster on the battlefield.


This is all very interesting and, some would say, entertaining. But even the proponents of these theories agree that they are long-term processes requiring generations, if not centuries, to fully develop. Economic and, especially, financial trends usually develop over much shorter time-frames, so that the attempt to co-ordinate, synchronise or determine casual relationships between them and geo-political trends is difficult, and such attempts often seem forced.


The precedent of the pound


Rather than ruminating about the ruin of Rome, a more recent and relevant example of the demise of a global empire and the parallel loss of status of its currency is that of Great Britain. In this case, as late as 1914 the pound sterling was the world’s dominant currency (and London the world’s financial capital), but by 1944 that role had indubitably passed to the dollar (and, to a large extent, to New York).


Yet it is generally agreed that the apogee of Britain’s global power was reached between 1850-1870 – long before sterling lost its primacy. Furthermore, even after 1944, sterling remained a major currency with an important global role, enjoying a strong revival as late as the 1980s. In other words, the twin processes of decline are prolonged, asynchronous and not even linear – there are ups and downs along the way. Perhaps even more important aspect is that in the case of sterling, there was a rival and potential successor snapping at its heels and, arguably, hastening its decline. Even before 1914, it was clear that the US would eventually become the dominant economic power and its currency would be paramount. The two world wars considerably catalysed the process, but they did not cause it.


In sharp contradistinction, neither the USA nor its currency have obvious successors waiting in the wings. Until recently, it was commonplace to designate China in these roles but, with the emergence of severe economic and financial strains in its economy, not to mention its demographic problems, China’s succession is no longer so obvious. It certainly is not going to happen quickly – so that an interim period is possible in which there is no dominant currency.


Why the dollar will rise


However – and this is the key point for people and firms that do not think and operate in terms of decades – the erosion of the dollar’s primacy is not at all the same as an erosion in the dollar’s value. It may lose its primacy and yet have no successor, at least immediately, whereas in the global currency market, the dollar’s value can only rise or fall relative to other currencies and therefore it can – as we have seen in recent years – be ‘the best’ simply by being the least bad of a bad bunch.


How – and why – would the dollar rise in value if it was losing its status as the dominant global currency? This could — and will — occur when the world moves from accumulating ever more debt to being obliged to repaying (or repudiating) its existing debts. Since the amount of debt denominated in dollars is much greater than that denominated in other currencies, the demand for dollars – driven by the need to repay debts – will drive up the price. That scenario, of global debt-deflation, is what the central bankers are striving to prevent, but their continued success in doing so is far from assured.

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