Wednesday, October 07, 2009

On The Dollar Losing Reserve Currency Status

My business partner and I were both horrified that yesterday, on a day when there was so much news about secretive, joint talks between Arab oil producers, Russia and China on establishing a non-US dollar reserve currency basket, the S&P500 Index didn't plummet, but rose 1.4%!

What about this potential calamity don't investors understand?

Like many other business people, I've read warnings about the loss of reserve currency status for the US dollar for decades. It's usually the same song- large deficits, inflation debauching the value of dollar assets held by foreign governments, etc.

In the past, though, no other nation held out such hope for economic growth with fairly stable regimes and legal frameworks. Next to the US, other potential reserve currencies paled in comparison.

Now, however, the threat takes a slightly different, and more credible form.

First, Arabian oil producers are viewing US military hesitancy over Iran, and potential withdrawals from Iraq and Afghanistan, with alarm.

Add to this an unprecedented flooding of the world with dollars and dollar liabilities. Despite what many talking heads my believe about current modest price deflation due to lower demand, there has never not been a relationship between excessive printing of money and subsequent hyper-inflation of said currency.

Finally, three other global powers or power blocs- Arab oil producers, Russia and China- each have a desire to see the US weakened. It's no secret that post-WWII US power has always implicitly rested on the dollar's reserve currency status.

When our own Treasury Secretary begins to talk up the use of SDRs to replace the dollar, and the US, as part of the G20, lends credibility to this move, the jig is nearly up.

This is, of course, idiocy on the part of the current US administration and its misguided new sense of multi-lateralism and global harmony.

With these forces as context, it becomes chillingly plausible that some major oil producers and a major consumer- Arabia, Russia and China- could indeed jointly agree on a basket of commodities and currencies with which oil may be purchased, none of which is the US dollar.

I'm quite familiar with what would be the counter-arguments to this development. In brief, it will be the repetition of what I, too, used to believe. That current holders of so many billions of US dollars and dollar-denominated liabilities won't dare precipitate the loss of value of their own substantial assets.

The question, now, is at what point these countries essentially choose to finally go cold turkey on the US dollar, reasoning that loss of wealth by a sudden switch to other stores of value is preferable to a few more decades of gradual erosion of value of the dollar.

Google the topic or relative currency values over time and choose any of the results you see. By many measures, be it purchasing power, other currencies, or gold, you'll see that the US dollar has fallen by at least a quarter in value in the past 8-9 years.

Now consider the massive issuance of dollar-denominated government debt in the past year, and the monetizing of that debt by our own Fed. And the coming huge inflationary spending on stimulus, health care and 'cap and trade' bills.

Any thinking person in the rest of the world is watching this and seeing a monetary train wreck ahead for the US dollar and its debt instruments.

On our current trajectory of government spending and legislation, it's not far-fetched to see a weakening of our economy, as we impose self-inflicted, crippling increases in energy prices and pollution costs, while spending money we don't have on living standards we will no longer be affording through economic growth.

Add to this the probably loss of global trade through over-priced products, again, thanks to increased energy prices and self-imposed faux pollution costs, and you come to a choice between two very bad options.

Either US tax rates will soar to previously inconceivable levels, depressing demand and wealth creation, or the crushing debt load and interest payments on said debt will result in the dollar's rapid decline in value.

All this near-term babbling about deflationary pressure on the CPI due to demand moderation misses the point.

When other major global resource players openly deny the secret talks that are obviously occurring, on the subject of replacing the dollar as oil's payment mechanism, it's finally very late in the reserve currency game for the US.

How this can possibly be seen by investors as a reason to bid up US equity prices is beyond me.


dex said...

Mr. Sceptic,

The stock market went up for the same reason it has gone up: The Fed's ZIRP/QE policies promise to give the banks even more money, which they'll likely devote to prop trading equities, corporate debt, and mortgage securities, since there isn't much demand for loans coming from credit-worthy borrowers.

C Neul said...

No, I think you are wrong.

It has nothing to do with banks, per se.

It's simply, as Roubini notes, too much money being pumped into markets by way of Fed purchases. These dollars don't go to fixed income, with such low yields.

They go to equities. And not through bank proprietary trading desks.