For you and I, people who live in this century, United States has been the commander of the world’s economy for as long as we can remember. A tiny movement from the FED (Federal Reserve) would make the world hold its breath, and miscalculation decisions would bring catastrophic economic downfall to the rest of the world. U.S.’s power and influence came from its global reserve currency status. However, today, the great commander is injured and was on the brink of collapse. Will the U.S. preserve its global currency reserve status, overthrown by China, came back to the gold standard, or replaced by a new asset class?
The History of Global Reverse Currency
To understand the pattern, progress, and connection, we have to zoom out a little bit. For us, United States is the commander of the world. However, it was not always like this. For our great grandfather, United Kingdom is the king. And our great-great-great-grandfather, Netherlands is the master of the world.
Ray Dalio, the founder of Bridgewater, compiled and tracked the wealth and power of 11 leading empires over the last 500 years. The four most important empires: Dutch, British, American, and Chinese represented in thicker lines. Former ones held the last three reserve currencies status: Dutch Guilder was replaced by British Pound Sterling and subsequently was replaced by United States Dollar. Meanwhile, China is important because, today, is the second powerful empire/country and had been consistently powerful until 1850.
The Rise and Downfall of United States
Long before World War, most of the developed countries pegged their currencies to gold for maintaining stability in their currencies. At that time, British was the center of world commerce. Although the majority of transactions were still in British pounds, America was started to overtaken Britain’s economy as the world’s largest economy.
When World War 1 broke out in 1914, many countries abandoned the gold standard to finance their military expenses with paper money, which consequently devalued their currencies. As the leader of the world war, British abandoned the gold standard in 1919 and borrowed a lot of money to finance the war. The United States was Allie’s main supplier for weapons and other goods. During both wars, United States accumulated so much gold that, at the end of the war, the United States owned a majority of the world’s gold (see chart 5).
Even though Allied countries won the war, most of them are economically defeated and had high debt. For example, British which was the world’s reserve currency had high debt denominated in foreign currency (230% of GDP). Therefore, in 1944, an arrangement known as Bretton Woods Agreement established that central banks would maintain fixed rates between currencies to the United States Dollar, and could be exchanged for a fixed amount of gold. According to International Monetary Fund (IMF), today, 60% of all foreign bank reverse are denominated in US dollar and 40% of the world’s debt are in USD.
After World War 2, U.S. exports have been surplus at a steady 20%-25% (see chart 2) but started to downfall around the year 2000. Chinese exports rose from 5% to 15% (making it the largest exporter in the world) and US export fell to about 14% (making it become less strong export income earner).
Since 1970, the U.S. has been consistently had a deficit of trade balance (see chart 3). Just like an average household/company, when one buys more than one sells, one has to finance the differences by borrowing or/and depleting its saving. Having the status of world reserve currency brings tremendous valuable economic power to the U.S. The country has the power to borrow & spend a lot because it can simply print its money, and be accepted by the world. The United States has been accumulated significantly large foreign debt (see chart 4). Good news for the U.S. and not for the others, the debt is in the US dollar, so the U.S. can print the money to pay off the debt. However, too much debt without accompanied by economic real growth may bring the end of a glorious era.
To make it worse, since 1971, President Nixon announced that the US dollar was no longer link to gold anymore. Thus, now, a dollar is just a piece of paper-backed entirely by the faith of the FED and its policy. A country’s savings can be in form of gold or its foreign exchange reserve. Even though, the U.S. holds the biggest gold reserve, from 1971, the quantity of US gold reserved remained unchanged, while Russia and China have slowly built theirs (see chart 5).
Gold is not the only a country’s only savings. Central banks can hold foreign-currency debt assets (bonds) to diversify their savings. Currently, the U.S. has depleted its reserve which is vulnerable to not having “the global money” (see chart 6). The United States still remains powerful only because US dollar is the global reserve currency and can print the “global money”, yet extremely fragile if it lost its reserve currency status.
The Possibilities for The Future
During political chaos and economical downfall, the world anxiously awaits and plans for the next step. We will address the possibilities for the global reserve currency:
#1 Nothing to Worry in Modern Monetary Theory
Even though the future of the United States seems bleak from conventional belief. There is an opposing view called Modern Monetary Theory (MMT) which argues a country that can produce its currency cannot be compared to the average household/company. These governments can never “run out of money” or be default because they can just print money to pay their debt.
In this view, the fiscal deficit (which continuously persists in the U.S.), will not be a problem anymore. Fiscal deficit happened when government spending > government income (taxes and non-debt capital). In normal economic theory, the difference between spending and income is called national debt (borrowing money). However, MMT folks argue that the government does not technically borrow the money; the government creates money whenever it spends. The government just needs to be able to manage and intervene in the flow of money in the market.
To those who are worried about inflation, the MMT economists also take the inflation problem seriously. To understand the theory, imagine a bathroom sink. The faucet represents the government's ability to create more money. The bucket is the market in the economy, while the water is the money. According to MMT-supportive economists Mitchell, Wray, and Martin Watts, taxes are used to maintain the functionality of government-issued currency and to control inflation. If there is an excess of money (inflation), the government can slow the flow of the dollar (slowing rate of spending) or open up the drain (collect taxes).
Most MMT folks agree that the FED should keep the interest rate 0%, so the fiscal authority (Congress and the president) can come and intervene. Economists Arjun Jayadev and J.W. Mason see that this like a normal economic model with a switched role: to combat inflation, the government can raise taxes instead of increasing interest rates.
This might work if the demand for money is very high, so the government does not need to drain the money through taxes. However, it gives Washington sole power over the economy and politics in the country. This solution contradicted with why FED was created as an independent entity: to maintain sovereignty against the politician’s interest. Another issue is that not every country can implement this strategy. Each country has a different size of sink. This policy might be beneficial to the U.S., but harms dollarized economy countries like Indonesia. Dollarized economy means that Indonesia has external funding which makes BI’s monetary policy is seen closely tied to the United States Federal Reserve.
#2 China, Rising Dark Knight
Currently, China has the most probable chances to overthrow the United States and get the throne of global reserve currency. China already has the largest economic trade and the highest foreign central reserve (see charts 2 & 6). The Belt and Road Initiative program gives loans to emerging countries. Even though China’s gold reserve is comparatively small to US, it continued to accumulated gold at an aggressive rate (see chart 5).
Through Yuan CBDC (Central Bank Digital Currency), China might be the first country to eradicate physical cash. The People’s Bank of China (PBOC) has been working continuously to develop digital yuan since 2014 to compete with private digital cash (Ant Group’s Alipay and Tencent’s Wechat Pay). Fan Yifei, deputy governor of the PBOC, emphasized the need for CBDC because cash and coins were not easy to use, easily counterfeit, and (because of its anonymity) could be used for illicit purposes.
As a communist country, China has a notorious reputation as a strict authoritarian to its citizens and likes to observe and monitor through its modern technology. West countries which prioritize freedom, privacy, and democracy might be cautious and skeptical towards its digital yuan. Especially CBDC does not necessarily mean transparency like Bitcoin or other public blockchains. CBDC might use a different type of private DLT (Digital Ledger Technology). A private DLT means only a few parties have access to the blockchain. The issuer (government) will able to track every movement of its currency. If this is the case, the government can easily monitor every good you purchased and the parties you received/ sent the money.
#3 Back to Gold Standard Era
Back to the gold standard might happen because, from history, the world has repeatedly used and abandon gold. If a currency is pegged to gold, the government cannot spend excessively, have a huge debt, and print money out of nowhere. However, even though the U.S. has stagnant gold reserves since 1970, United States still owned the biggest gold reserve in the world (see chart 5). If the world back to the gold standard, most the countries’ currencies would be devaluated, but still, the U.S. dollar would be the most powerful money. The dollarized countries will get heavily affected and bear the consequences. The current situation is different from the last time when the USD pegged to gold (after world war 2). At that time, there is a transfer of wealth and power from the British (old wealth) to the United States (new wealth). Right now, there are no changes in both wealth and power. Instead, poor countries might have to bear the consequences of the United States’ consumerism.
#4 Bitcoin, The New Asset Class
In the chaos and the tipped of revolution, the world needs a new neutral asset class that would reboot the whole economy, which does not monopolize by one country. Bitcoin which has the characteristic of gold might be the solution to the world's need. With a fixed supply of 21 million, a growing market cap at an exponential rate, and an immutable tamper-resistant asset, Bitcoin teases the countries which always economically colonized by the United States.
Recently, the president of El Salvador, Nayib Bukele propose to make Bitcoin legal tender. People would see this as a brave or maybe naïve move when we see the volatility of Bitcoin. However, countries that adopt the U.S. currency or “dollarize” their economy like El Salvador have been struggled to trust their local monetary system. The reason some countries dollarize their economies is that, throughout the decades, USD is seen as a more stable and trustworthy currency. It is the global reserve currency after all. However, looking at the U.S. & global current situation and how the FED has been experimenting with its monetary policy since the 2008 global financial crisis, these small and vulnerable countries become anxious and started looking for possibilities to save their own countries.
The future remains unknown, especially with the global pandemic. Everything is possible whether the United States will preserve its global currency reserve status, overthrown by China, come back to the gold standard, or be replaced by a new asset class. But one thing for sure, change is the only permanent thing.
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