Beaing-the-dollar

Should the US throw the towel?

And the first one now

Will later be last

For the times they are a-changin’.

From “The times they are a-changin’” (1965), by Bob Dylan.

Saying the US dollar will eventually lose its status as the world’s main reserve and trade currency is nothing new. But recently there have been a number of developments that could accelerate the process. Put simply, the USA has succeeded in upsetting a lot of increasingly powerful countries at more or less the same time, which must be a first. As a result, more and more steps are being taken to reduce the use of US dollars in the global economy. This could have major implications for the USA, and for investors everywhere.

Bob Dylan’s song may be half a century old, but it has stood the test of time. After all, one thing we can guarantee with 100% certainty is that things are always changing. Sometimes in small ways, but often in massive ways.

The USA is by far the world’s most powerful country. According to data from the International Monetary Fund (IMF) it was 19% of the world’s economy (GDP) in 2013, despite a population of just 4.4% of the global total of 7.2 billion.

(Note: although the USA’s GDP is still the largest, in relative terms it peaked some time around 1950, when it was about 28% of the global total. It has continued to grow in absolute terms, but the rest of the world has grown faster overall. This is something I expect to continue over the long run.)

“…USA’s economy [is] just a little bit larger than the combined economic size of all the 28 countries in the European Union (EU).”

This makes the USA’s economy just a little bit larger than the combined economic size of all the 28 countries in the European Union (EU). China is the second largest individual country, at 15% of the world economy. After that there is a big drop to India (6%), followed by Japan (5%) and Germany (4%).

(Note: these figures use “purchasing power parity” GDP, which can be thought of as a measure of the volume of goods and services swilling around an economy, taking account of cost of living differences in different countries.)

This economic power is reflected in military spending. According to figures from the Stockholm International Peace Research Institute, the USA spent US$640 billion on its military in 2013. That was nearly 37% of the world’s total military spend, and as much as the combined spend of the next nine countries.

Clearly it’s expensive maintaining an estimated 700-800 military bases in 63 of the world’s countries. But empires are expensive things, which, of course, is why they usually self destruct under the burden of cost.

The USA also has highly developed financial markets. The US stock market was 40% of the global total by value at the end of 2013, according to the World Federation of Exchanges. In addition, the US bond market is around a quarter of the world by value, and over a third of international bonds are issued in US dollars. International bonds are those issued in a country in a foreign currency or by a non-resident issuer (borrower).

It’s no surprise then that the US dollar is the world’s most important single country currency (the euro is also important, but it’s used by 18 countries as their domestic currency). According to the Bank for International Settlements (BIS) 87% of all foreign exchange currency transactions involved the dollar in 2013.

“…60% of foreign exchange reserves controlled by global governments are held as dollars, or invested in dollar denominated investments…”

Also around 60% of foreign exchange reserves controlled by global governments are held as dollars, or invested in dollar denominated investments such as bonds and stocks.

It’s difficult to get data on how much global trade is transacted in dollars. But since foreign exchange reserves are a by-product of countries selling things for dollars, such as oil, iron ore or manufactured goods, the fact that the dollar share of reserves is so high points to a large amount of dollar trade.

(The mechanics are too complex to explain here in full today, but please take my word for it. As an aside, and although physical cash is only a small percentage of total money in the world economy, estimates suggest that between 40% and 70% of all physical dollar notes by value are held outside the USA.)

So it’s clear the dollar is extremely important in both the real economy and in the financial investment world. And, just like anything else, prices of currencies depend on the relationship between supply and demand. If too many fiat currency units are created in relation to demand, or if too many people want to sell their units at the same time, the price will fall relative to other currencies.

There is a high global demand for dollars to be used in trade and investment. This allows the US to create a large supply of dollars without the value collapsing suddenly.

However it’s worth remembering that the dollar surely loses value steadily over time, as do all fiat currencies. The following chart shows the dollar versus gold since 1900. I calculate the dollar has lost 97% of its value relative to gold since the gold standard was fully abandoned in 1971.

US Dollar vs Gold since 1900:

The dollar has lost aproximately 97% of its value relative to gold since the gold standard was fully abandoned in 1971

This ability to create large amounts of dollars means the USA can buy more from overseas than it sells abroad, which shows up as a large trade deficit. Plus the US government can borrow and spend much more than it receives in tax income, which shows up as a fiscal deficit.

“…if demand for dollars collapses then the buying power of the dollar will collapse as well. American businesses and consumers will find it less attractive to spend more than they earn…”

Put another way, if demand for dollars collapses then the buying power of the dollar will collapse as well. American businesses and consumers will find it less attractive to spend more than they earn to buy imported goods, and the American government will find it harder to borrow money to fund excessive government spending.

There’s nothing especially new in anything I’ve said so far. But there have been a number of significant recent developments that look set to accelerate the erosion of dollar dominance in the world. In fact the dollar is under attack from a several different directions at once, some of which are may surprise you, as you’ll see in Part II. As Bob Dylan sang, the times they are a-changin’.

Part II will take a closer look at how the dollar has already lost huge value to its likely replacement, and what’s happening right now that could speed up the process. I’ll also take a quick look at history to see what happened the last time that a currency lost its dominant status in world trade, and what that can tell us about today.

 

Stay tuned OfWealthers,

Marco Polo
marcopolo@ofwealth.com