Our currency (US dollar), the problem of the world
The Bank of England bails out British pension funds. The Bank of Japan uses excessive monetary policy to protect its currency and cap interest rates. China encourages its banks to buy stocks. The dollar, the global currency, is collapsing, interest rates are skyrocketing and the financial world is fracturing.
Unlike any other currency, the US dollar is the engine of the global economy and financial markets. Due to the dollar’s status as the world’s reserve currency, the monetary policy actions of the Fed play a vital role in directing the US economy and all global economies and financial markets.
To predict the next crisis, it is imperative to understand the role of the dollar in global finance and the economy and the resulting role the Fed plays in influencing international monetary policy. To do this, we start with an overview of Triffin warned us, an article we published in 2018.
These “steep notes” for the article lay the groundwork for Part 2. After this article, we’ll discuss the risks investors face as the Fed attempts to rein in inflation.
The Bretton Woods Agreement
In 1944, the United States and many countries reached an important financial agreement in Bretton Woods, New Hampshire. The deal has brought huge economic dividends to the United States. However, it has a flawed incongruity with an expensive price pointing the tip of its nose today.
Under the terms of the 1944 Bretton Woods agreement, the US dollar supplanted the British pound to become the world’s reserve currency. The agreement guaranteed that a large majority of world trade would be conducted in US dollars, whether or not the United States participated in that trade. Additionally, he set up a system by which other nations would peg their currency to the dollar. This arrangement is akin to the concept of global currency made popular by John Maynard Keynes. Keynes’ brainchild was the Bancor, a supranational currency.
Under the terms of the agreement, there was a supposed cure for one of the abuses that countries with reserve currency status typically commit, running continuous trade and fiscal deficits. The pact discouraged such behavior by allowing participating nations to exchange US dollars for gold.Therefore, other countries that were accumulating too many dollars, a side effect of US trade deficits, could exchange their excess dollars for gold held by the United States. Accordingly, a rise in the price of gold, indicative of a devaluation of the US dollar, would be a telltale sign that America was abusing its privilege.
London Pool of Gold
The deal began to unravel soon after. In 1961, the major nations of the world established the London Gold Pool. The goal was to fix the price of gold at $35 an ounce. The action was an attempt to maintain the Bretton Woods status quo. By manipulating the price of gold, an important indicator of the size of US trade deficits was shattered. Therefore, there was less incentive to trade dollars for gold.
Seven years later, France comes out of the ranks. France withdrew from the gold pool and demanded large amounts of gold in exchange for dollars. As a result, in 1971 President Richard Nixon, fearing that the United States would lose its gold, suspended the convertibility of dollars into gold.
From then on, the US dollar was a floating currency. There was no longer the discipline imposed on him by the convertibility of gold. Nixon’s actions essentially nullified the Bretton Woods agreement.
The following decade saw double-digit inflation, persistent trade deficits and weak economic growth. These were signs that America was abusing its privilege as a reserve currency. The first graph below shows that, like clockwork, the United States began running annual trade deficits in 1971. The second graph shows how inflation rose sharply after 1971.
In the late 1970s, Fed Chairman Paul Volcker raised interest rates from 5.875% to nearly 20.00% to bring inflation down decisively. Although economically painful, Volcker’s actions not only ended ten years of persistently high inflation and restored economic stability, but, more importantly, kept America’s trading partners happy. The dollar, now at a floating rate, has regained the integrity required to be the world’s reserve currency. And this despite the absence of the checks and balances imposed by the Bretton Woods agreement and the gold standard.
Our August 15 article explains how Nixon’s “suspension” of the gold window triggered the Federal Reserve.
Enter Dr. Triffin
In 1960, 11 years before Nixon’s suspension of gold convertibility and the effective demise of the Bretton Woods agreements, Robert Tiffin foresaw this inevitable problem in his book Gold and the dollar crisis: the future of convertibility. According to its logic, the privilege of becoming the world’s reserve currency would be ultimately bear a heavy sentence for the United States
At the time, few paid attention to Triffin’s thesis. However, he was invited to a Congressional hearing of the Joint Economic Committee in December of that year.
What he described in his book and testimony to Congress became known as Triffin’s paradox. Events unfolded mostly as he had planned.
Essentially, he argued that reserve status forces a good percentage of world trade to be in US dollars. For global trade and economies to thrive in such a system, the United States must supply the world with US dollars.
To supply the world with dollars, the United States must constantly run a trade deficit. Running persistent deficits, the United States would become a debtor nation.
Foreign creditors favor US deficits
Foreign nations accumulate and spend dollars through trade. They keep extra dollars on hand to manage their economy and limit financial shocks. These dollars, known as excess reserves, are invested primarily in US dollar-denominated investments, ranging from bank deposits to US Treasury securities and a wide range of other financial securities. As the global economy grew and trade multiplied, additional dollars were needed. As a result, foreign dollar reserves increased and were lent to the US economy.
Making the world even more dependent on the dollar, many foreign countries and companies are issuing debt securities denominated in US dollars to better facilitate trade and take advantage of the liquid financial markets of the United States.
The arrangement benefits all parties involved. The United States buys imports with dollars lent to them by the same nations that sold the goods. Additionally, the need for foreign countries to hold dollars and invest them in the United States drives down US interest rates, which further encourages domestic consumption and provides relative support for the dollar.
For their part, foreign nations benefit from the shift of manufacturing from the United States to their country. When this happened, increased demand for their products supported job and income growth, increasing the prosperity of their respective citizens.
A win-win or a Ponzi scheme?
While it may seem like the post-Bretton Woods convention is a win-win deal, there is a huge cost for everyone involved.
The United States is too indebted. As such, it has become increasingly dependent on low interest rates to stimulate debt-driven consumption and to pay interest and principal on existing debt.
Interest rates below the appropriate level lead to non-performing debt, as can be seen with the stock of debt growing at a much faster rate than GDP. The growing discrepancy between debt and the ability to pay it, GDP, is simply unsustainable.
Triffin’s paradox states that with the benefits of reserve currency also comes an inevitable tipping point or failure.
As we see with the current example of rising interest rates and inflation, this point of failure is approaching the United States and the rest of the world.
The second part of this article will focus on dollar and Fed monetary policy and what it may entail as the Fed continues to push interest rates higher.
The author or his company may have positions in the titles mentioned at the time of publication. Any opinions expressed herein are solely those of the author and in no way represent the views or opinions of any other person or entity.