The Dollar’s Fall From Grace: ‘The Dollar is the World’s Currency, but the Federal Reserve is America’s Central Bank!’
When considering the dollar’s status as the world’s reserve currency, I cannot help but recall the words of Jim Grant (of Grant’s Interest Rate Observer):
The dollar is the world’s currency but the Federal Reserve is America’s central bank! Period!
The dollar reserve standard connects corners of the world in ways which seem to be unperceived by the authorities at the Fed. Currently, the growing disconnect articulated by the quote above seems to be invoking the dollar’s fall from grace.
Now, I know what you’re thinking; ‘Gosh, not another senseless article about how the dollar is losing its reserve currency status!’. I get your frustration, and I encourage you to read on in the knowledge that I’m aware of it! What follows will be something a little different to the usual simplistic; ‘emerging market politicians have spoken against the dollar, therefore the dollar is losing its reserve currency status’ or ‘emerging market central banks have bought gold therefore the dollar is losing its reserve currency status’. Although these kinds of statements do contain some truth, I would contend that they miss the point. Articles and essays based solely on these kinds of observations are ultimately crude extrapolations of the past and/or appeals to the supposed ‘authority’ of political musings! (Since when have politicians told the truth!?)
So, instead of sending you to sleep with the usual hodge-podge, I hope to outline a view on the dollar’s fall from grace that does grab your attention. Hopefully, what follows will convey the secular forces at play in addition to the twists and turns that may occur along the way. In short, I’ll get to grips with the global interconnectedness inherent in the dollar reserve standard, the growing disconnect between the interests of users and the issuer of the dollar and finally a few investment implications for the coming months and years.
[Our regular readers may wish to skip the next section.]
The Structure of Irredeemable Fiat Currency Systems:
In order to properly grasp the secular trends in the currency markets, it will be well for us to consider the rudimentary structure of irredeemable fiat currency systems.
Basically, we can say that modern monetary systems consist of central bank notes (& reserve balances) and ‘IOU claims’ upon such central bank notes. People tend to call both central bank notes (i.e. the notes that people go around carrying in their pockets) and ‘IOU claims’ upon central bank notes (i.e. the balances that people look at on their internet banking screens) ‘money’. With people defining ‘money’ as lots of different things, it is no wonder that monetary matters are debated so hotly. So, just to get things clear here, I invite you to forget about the issue of ‘what is money?’ (which is highly complicated and to be dealt with elsewhere) and to think in terms of the central bank notes, and ‘IOU claims’ upon central bank notes (I’ll get onto reserve balances in due course).
So, first things first, what are these ‘central bank notes’? Well, as was said above, they’re the bits of paper that you and I carry around in our pockets all day long. But what the hell kind of explanation is that – I hear you ask? Indeed, pretty much none at all – and unfortunately most people don’t even get as far as to ask that question. Central bank notes are the carcasses of redeemable currencies of the past. Roughly speaking, the deal used to be that any person who owned a Federal Reserve note (or whichever note your country uses), could go and redeem it for a certain quantity of gold. With this arrangement, central bankers found that great quantities of the gold reserves (backing the notes) remained dormant in their vaults. So, one by one, the central banks of the world succumbed to the temptation of issuing way more notes than could be honored with the quantity of gold backing them. One by one, then, central banks eventually ‘went off the gold standard’; meaning, they reneged on their promises to exchange gold for notes upon demand. This is the rudimentary structure of the central bank notes of the world, they are the carcasses of the former redeemable currencies of the world. Unlike previously, they aren’t specific ‘promises’ as such. Rather, they are Frankenstein currencies – irredeemable claims upon the portfolios of assets held by central banks (and decided upon by central bankers).
What about the ‘IOU claims’? Again, most of us deal with these things all day long — they’re the deposit balances that we hold at commercial banks (and similar depository institutions). We all know the deal, you deposit your central bank notes, and you’re supposed to be able to withdraw them at any time that you please (within certain constraints). In short, the issuers of these things (commercial banks & other depository institutions) have pseudo-short positions on central bank notes. Once they get the deposited cash, the fractional-reserve banking process ultimately implies that they own stuff, and owe central bank notes. In order to honor their redemption promises to depositors, they have to sell stuff to ‘buy central bank notes’.
[What about reserve balances? They are very similar to central bank notes in the sense that they are liabilities of central banks (by contrast, ‘IOU claims upon central bank notes’ are liabilities of the issuing commercial bank or depository institution). They are the ‘reserve form’ of central bank notes — if you will. They are the electronic deposits that commercial banks hold with their respective central banks to ‘back up’ the ‘IOU claims’ that those commercial banks issue. Should a commercial bank need to convert its reserve balances into central bank notes, it can simply request delivery from its central bank. Importantly, central banks don’t have to alter the structures their balance sheets in order to meet these kinds of conversions (but they would if they were to ‘back’ all commercial bank deposits as many people believe).]
What’s the ‘Dollar Reserve Standard’ then?
So, with the above in mind; we come on to the topic of the dollar reserve standard. All it means is that a great proportion of the world’s central bank notes are ‘backed’ by dollars and/or dollar-denominated securities (typically US government debt). That is to say; a large proportion of the world’s central banks own significant holdings of dollars & US treasury securities. In this way, to one degree or another, many of the world’s central bank notes are in fact irredeemable claims upon dollars. [Which, in turn, are irredeemable claims upon the assets held at the Federal Reserve banks.]
So what? One may ask. Well, this monetary structure means that whatever funny business goes on with Federal Reserve notes is implicitly imparted upon global currencies (again, to one degree or another).
Trends in ‘IOU money’ production:
Now, if you’re a producer of ‘IOU money’ (for example, if you’re a commercial bank), you basically want the burden of your redemption liabilities (i.e. the burden of the ‘IOU money’ that you issued) to be as low as possible. In other words, you want the market value of your loans, bonds etc. to be high and rising in money terms.
Economies tend to embark on long-term cycles where the production of ‘IOU money’ (i.e. the extension of credit / the creation of fiduciary media), tends to wax and wane. That is, where people tend to increase the degree to which they use leverage over years and decades, regret it, and then decrease the degree to which they use leverage. Both legs of the cycle invoke enormous momentum in the ‘IOU money’ production business. On the legs up, banks are laughing, and their most profitable positions are the ones entered in at the earliest stage. The rush to be first, then, invokes progressively larger issuances of ‘IOU money’ (i.e. progressively greater extensions of credit), which invites further issues. The legs up tend to be accompanied by increases in the money prices of bank loans, bonds etc. At some point, the house of cards must tend to collapse, as was seen in 2008/2009. At some point, a maximum capacity for leverage is reached, and ‘IOU money’ issuers find that they have to sell things to buy central bank notes. As they all rush for the exit at once; that is, they all seek to supply things and demand central bank notes, the money prices of things fall dramatically and the solvency of the banking system is thrown into question.
As we have written about extensively here on greshams-law.com, the West (particularly America) reached a maximum capacity for leverage in 2008/2009. Ever since, there has been a tendency towards what is commonly referred to as ‘private sector de-leveraging’. While the developing economies also reached intermediate peaks in the production of their respective ‘IOU monies’, they had hardly engaged in the degree of credit expansion witnessed in the West.
Modern Monetary Debasement:
In modern-day democracies, outright credit-collapse (or – if you will – widespread extinguishment of ‘IOU money’) is entirely unpalatable. Such collapses, which occur when the underlying central bank notes are kept in tact, mean that ‘IOU money’ issuers simply cannot pay their bills. The prices of things fall in a dramatic 1930s-style fashion. People lose their jobs and find that they can’t get their money back from the bank…
Thus, the people call upon government to rescue them from the problems created by governments. In modern-day irredeemable fiat currency systems, this amounts to central bankers ‘coming to the rescue’ by debauching central bank notes. Resultantly, the ‘IOU money’ formerly produced become easier to honor. The ‘I owe you something’ becomes ‘I owe you something that ain’t as good as before’, and so the issuers find them easier to honor. [Incidentally, the democratic masses praise this debauchery as 'good' and 'just'!]
The means by which central bankers debauch their notes is by balance sheet expansions in favor of junk (which is inherently dilutive and changes the consistency of central bank notes). In this way, central bank notes morph into irredeemable claims upon tiny proportions of quantitatively and qualitatively different portfolios of assets.
‘The Dollar is the World’s Currency but America’s Central Bank!’
So finally we get on to the crux of the matter. The US recently experienced a ‘bubble in credit’ that was of epic proportions. Seemingly, all areas of the US economy have been infected, and the initial collapse was so drastic that there was scarcely a place to hide. In short, the degree to which the US is over-leverged (or if you will, the degree to which there is an overhang of ‘IOU money’) is historically monstrous. Given that the US is a democracy, and suffers from the Western trend towards statism, they are intent on debasing Federal Reserve notes in order to preserve the status quo in the ‘IOU money’ business. However, and this is important, the degree to which the US ‘have to’ debase Federal Reserve notes is entirely and unequivocally inappropriate for developing economies (and other parts of the world). And yet, because a great proportion of the world’s central bank notes are essentially irredeemable claims upon dollars and dollar-denominated government securities, the world receives the debasement that is only ‘appropriate’ for the monetary status of America. So, as it turns out, the problems inherent in the dollar reserve standard are nicely summarized by Jim Grant’s exclamation:
The dollar is the world’s currency but the Federal Reserve is America’s central bank! Period!
The Implication of ‘Sinking Reserves’ with 2008/2009 on the brain…
As the central bank notes of the world are irredeemable claims upon ‘sinking reserves’ (dollars), the ‘IOU money’ production business in unlevered countries is getting a boost. They love it, right? Remember, they own stuff (loans, bonds etc.), and owe people central bank notes whenever they want them. So, if the central banks notes that they owe are sinking (not necessarily because of domestic central bank policies, but because of Federal Reserve policies), they want to issue as many as possible and own much stuff against those issued ‘IOU monies’. That is, those developing economies get all of the signals to increase the degrees to which they use leverage (while the West continues to suffer from the hangover of their former levering expeditions).
Some might say, so what? What are they complaining about? Well, over the past few years it has become blindingly clear that what goes up must come down. Moreover, unlike before 2008, we all know what it is like to go down! Now that the cat’s out of the bag and everyone knows that excessive debt is bad, that it creates booms and busts, yada yada yada, central bankers of the East are probably increasingly worried about the degrees of credit growth that they are witnessing in their respective economies. Moreover, as their economies become increasingly dependent on their respective stocks of ‘IOU money’, it is quite conceivable that a mistaken tightening or even slowing monetary debauchery in the US could trigger onerous and unpalatable credit-collapses across the globe.
The Truth About the Currency Users’ Intentions:
It’s not like the developing economies of the world are uber-’hard money’ fanatics who are upset at the degree of monetary debauchery in the US. It’s just that the timing of US monetary debasement is becoming increasingly inappropriate for the rest of the world. After all, those dollar reserves ended up on the balance sheets of the world’s central banks because they were relatively stable things. Remember, emerging market countries are reknown for ‘revaluing’ (i.e. debasing) against the dollar.
Now, because of the monstrous legacy of debt in the US and the masses’ distaste for a swift and clean adjustment, the reserves that used to be relatively stable have begun to fluctuate erratically. Thus, excessive ‘IOU money’ production (and the subsequent task of ‘revaluing’) is becoming an unnecessarily frequent for countries with currencies that are by and large ‘backed by’ the dollar. Consequently we must conclude that the case for a decline in the dollar’s reserve currency status is not really an ode to the capitalistic intelligence of the rest of the world, but really a function of the following:
- The West’s dismal decline into socialistic thought (i.e. these days monetary debasement is the only politically palatable prospect in an over-levered economy).
- And – quite simply - timing.
How we get there:
We would contend that it won’t be a straight road to lower holdings of dollars and dollar-denominated securities by global central banks. Here at greshams-law.com, we believe that the precondition — if you will — is a long and arduous journey with respect to the dollar. Our premise is that politicians and central bankers are scarcely alert and forward-looking individuals. To be sure, there may be varying degrees of responsibility among politicians, but let’s not get carried away – they’re still politicians. With the very few exceptions, they’re devoted to the status quo if it’s relatively ok and will induce re-election. We hardly think that they would have the foresight to properly preempt this secular trend (and they haven’t really had this foresight to date).
Rather, we contend that it is the economic trends described above; of vast increases in credit growth followed by twisting and unpalatable declines in money prices and heavy bank withdrawals, that will eventually force them to say ‘enough is enough’.
All of the above has some peculiar investment implications. It means that the long-term, secular decline in the value of the dollar is wholly intertwined with the concept that the dollar will be unpalatably strong for brief periods of time along the way. Essentially, the problem is that excessively loose monetary policy in the US will produces bubbles elsewhere in the world, and that an occasionally (and irritatingly) strong dollar will invoke subsequent credit-collapses.
Although we believe that the dollar is losing its reserve currency status that this is intertwined with monetary debauchery in the US (and thus a concomitant fall in the value of the dollar over the long term), we also think that an occasionally strong dollar is a vital and inescapable piece of the puzzle.
Here at greshams-law.com, we don’t believe that the dollar’s fall from grace is an ode to the rest of the world and a huge insult to the US. Remember, regardless of the deteriorating intellectual, social and political trends in the US, it still has one of the largest free-market communities and a strong history of respecting private property rights (especially when compared to the rest of the world). It’s a matter of timing. We’re sure that many global central banks would be equally profligate if they had similar legacies of debt. But they don’t, and – whether we like it or not – the US is not what it used to be and has no interest in being the hard-money centre of the world. Resultantly, the dollar is becoming decreasingly suitable as a reserve currency of the world. The unintended consequences of US monetary policies will probably exacerbate booms and busts across the world. Our presumption is this will bring about circumstances that are too onerous for developing economies to bear.
Even though the secular trend in the dollar may be down, intermittent dollar strength will be an integral feature of the journey. For instance, we’re quite positive on the dollar right now. If you’re interested in following our views on the practicalities of month-by-month trading, our newsletter might be interest you.
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012