Dominant Currencies Through History: Why USD is at Risk as a Reserve Currency and What Would Replace It

dominant currencies throughout history 071717

As if we needed a friendly reminder, history tells us every dominant global currency shines brightly under the international spotlight… until it doesn’t.

The greenback has maintained its status as global reserve currency since shortly after the Second World War. It has limped through US President Nixon’s termination of gold convertibility in 1971, a historic global financial crisis emanating from the US, several asset bubble busts, and a prolonged 8+ year stretch of zero interest rate policy (ZIRP) paired with accelerated new money supply by the Federal Reserve’s QE programs.

Strategic political alliances with questionable partners at times and tragic international conflicts likely played a role in every empire maintaining dominance of its currency in global trade. This is nothing new, unique, nor surprising if viewed from a historical perspective.

Empires have gone to the greatest lengths possible, by any means necessary, to ensure global trade is conducted with their currency of choice. That is because the wealth of their citizens, businesses, and governments have depended on it.

Global demand for one’s currency ensures superior financing terms to invest in the things that increase living standards and real wealth. It also insures value preservation of a nation’s (or currency union’s) savings. With reserve currency status comes immense privilege and more room for error than enjoyed by those without it.

More room for error does not mean infinite room for error. Unfortunately, squandering wealth and credibility are much easier and faster to execute than building them. Human nature is highly cyclical and dynamic. Once an empire goes through the exhausting process of winning the hard way, it wants to enjoy the fruits of its labor the easy way.

Complacency sets in. Greed, impatience, and hubris replace the blood, sweat, and tears on which the empire was built. Short cuts become misinterpreted by common wisdom as “the new way to work smarter, not harder.” Mal-investment on unproductive activities are implemented to improve short term optics at the expense of long term real gains. Power breeds corruption. Corruption deteriorates trust in the social contract gluing a society together. The political power cycle peaks and begins to reverse.

The basis of Keynesian economics and “stimulating demand” now by stealing it from the future is inherently a product of short-cut thinking exhibited by an empire’s coddled intellectuals with no skin in the game. Why ever make difficult political decisions to prioritize finite resources or tighten one’s own belt when you can simply goose the economy for awhile longer with borrowed funds or freshly printed money?

Like the academics of previous eras, the academics of the current one have decided they have a short-cut with groundbreaking, new ideas: create new money from thin air and buy most of the bonds responsible for setting interest rates to keep rates low. Ah ha! Why hasn’t anybody else been so clever?

Of course, there is nothing groundbreaking whatsoever about demand-driven Keynesian economics. Different tactics, same tricks. There are no free lunches in economics over the long run. Eventually the long run becomes today.

Today’s central bankers and politicians have decided they are intelligent enough to increasingly control market economies better than all of those who have failed before them trying to do the same, and certainly better than a large number of diverse market participants with skin in the game from various perspectives competing for the best deals (aka, “markets”). The more things change, the more they stay the same.

Too much market intervention by central planners has some of the nastiest long term side effects imaginable, even with relatively good intentions in the short run. Unexpected losses in purchasing power, real wealth, and real wages have silently been responsible for contributing to wars and other bloody conflicts (ie. hyperinflation in Germany in the 1920s, 2011’s Arab Spring, today’s Venezuela) with fewer mentions than deserved. Nothing evaporates complacency and fuels anger like losing everything almost overnight.

When a debt situation deteriorates past the point of no return to a level of de facto insolvency, governments choose creating money from thin air to pay the bills 99% of the time rather than not paying them when presented with one or the other as the unfortunate final options on the table. This eventually, if not immediately, causes said money to lose its value.

In fact, even though the dollar is still the most widely held global reserve currency, it has lost approximately 95% of its purchasing power since the Federal Reserve was created in 1913 to manage the nation’s money supply. Throughout most of this time, the deterioration in value has been manageable because interest rates were high enough to compensate savers.

Now we have a policy of financial repression where savers are forced to lose real purchasing power on their savings without being compensated by adequate interest earnings. This has been a direct transfer of wealth from savers to debtors and government entities. That fact is yet to be fully appreciated by the public, broadly speaking.

When a currency rapidly loses purchasing power, faith and trust in its future value begin to erode even faster. Lenders of debt in said currency demand higher interest rates to compensate for the risk and expectations of additional losses in value.

High interest rates make it more costly for individuals to make large purchases or maintain their living standards in a cyclical economic downturn. High rates make it more difficult for new businesses to form and for existing businesses to expand. Most importantly, high rates make it terribly difficult for indebted governments to continue spending more than they collect in taxes, or even to pay back previous debts.

Yet, sometimes higher interest rates are exactly what is needed in order to ensure a moderately painful period of belt tightening rather than a full blown crisis or economic collapse down the road. This in return helps attract investment capital seeking higher rates of return to a struggling nation (or region) in need of it, thus creating demand for the beleaguered currency once again and completing the cycle.

This, anyways, is how it is supposed to work in a market-based economic system: self-correcting periods of relative economic strength and weakness with a bias toward long term wealth creation. This holds true even in hybrid economic systems where governments intervene to nudge economies in the direction of desired political outcomes without excessive force or explicit price controls.

But that is not the modus operandi in the current Keynesian global central banking regime. We have seen one experimental intervention policy after another enacted essentially in coordination by advanced economy central banks in order to keep the economic flame flickering and avoid another global recession. Economic nature has not been allowed to run its course with natural corrections in recent years, with few exceptions.

Equity volatility is at all-time lows. As in, forever. The Bank of Japan is buying stock ETFs at multi-year high prices, is forcing a negative interest rate at the short end of the debt curve, and is even manipulating the shape of the curve deeper out by instilling an unlimited bond buying program to keep 10 year JGB rates at precisely zero while there is no apparent recession to fight. The European Central bank is printing 60 billion euros per month and spending some of the money on bonds that have negative yields.

One would naturally wonder why central bankers have spent so much precious monetary ammo and political capital fighting the natural business cycle during a period of time in which the economic indicators are looking quite strong overall? They have explicitly pledged to do “whatever it takes” on a number of occasions to prop up the banking system and keep interest rates ultra low long past a time of actual crisis.

The answer is frightening: there is way too much global debt without the growth to support it and another major recession in several advanced economies could expose an insolvent global monetary system. What would happen if in a recession the US returned to $1-2 trillion dollar deficits with no end in sight and debt-to-GDP already stretched near maximum sustainable levels? If the deficit already looks increasingly bloated during a time of quasi full employment, and political dysfunction is preventing anything sensible from correcting course on the ship before it is too late, what does “too late” look like?

The Keynesian groundwork has been laid in the public discourse already. There will almost certainly be so-called “helicopter money” policies enacted by emergency decree during the next recession–direct coordination between the government and the Fed to monetize debt with no questions whatsoever about what is going on.

The Fed will create money to purchase not only financial assets, but will back the US Treasury with newly created money so it can cover its bills without technically “defaulting.” Financial repression will be relentlessly pursued to stop people from getting their money out of the banking system because private savings will be used to bail out unsustainable public debt one way or another. Either you spend it quickly to “stimulate demand” or watch it’s value diminish before your eyes.

If ever used, helicopter money will end USD’s reserve currency dominance reign.  It would no longer be trusted as a store of value, to the extent it even is now. The only way to effectively enact such heavy handed policies is through financial repression, limiting the use of cash, and quasi currency controls because otherwise there would be a massive run on the financial system. Everybody would try to get rid of their fiat currency deposits at the same time to instead acquire other assets that are superior stores of value.

Competing non-fiat assets would then be under the spotlight and removed as an option similar to how FDR made it illegal for private citizens to own gold in 1933 by executive order. People literally went to jail for owning gold. That type of policy would surely spark a much harsher public backlash this time around, resulting in at least a partial departure from the current USD dominated post-Bretton Woods monetary system.

The only way to prevent this from happening is for the US to ignite sustained GDP growth above 3% while gradually reducing debt-to-GDP over time.  Or, the government chambers could join together to enact unpopular budget cuts on things like entitlements and military spending, without diminishing tax revenues. Seeming how the same legislators have already made a mockery of the supposed hard cap budget sequestration enacted in 2013 by largely ignoring it, as well as publicly declaring that it will let its own healthcare system fail due to current political dysfunction,  the hill to climb seems steep for the greenback to remain the dominant reserve currency.

Contrary to the graphic at the top of this post, the Chinese yuan is not necessarily going to be a better alternative to the dollar. China’s debt problem might even be worse than the US’s. Traditional “paper” fiat currencies in general are highly subject to central bank oversupply and deteriorating faith in traditional institutions globally.

Digital blockchain assets such as bitcoin could be a viable alternative or complement to traditional fiat, at least eventually, but related businesses such as cryptocurrency exchanges could be targeted heavily in an intensified financial repression regime. It is still very easy to imagine demand for digital assets surging exponentially higher than supply with or without a helicopter money scenario taking place in the future.

The next official reserve currency is likely to be plural. SDRs, or Special Drawing Rights, are currency units composed of several major currencies that the International Monetary Fund (IMF) is increasingly highlighting as a better solution than USD for bank reserves. The problem with SDRs is that they are still based entirely on fiat currencies and are also centrally controlled, leaving them politically vulnerable and prone to perpetual devaluation.

The monetary system will become increasingly decentralized as a natural response to too much centralized planning reliance and risk concentration. SDR’s and even government sanctioned crypto assets will include USD in the global financial system, albeit with a diminished role from its current dominance in energy commerce and bank reserves.

On an individual level, diversification into prime real estate, land, precious metals, and crypto assets should perform well in real terms during a future recession. As mentioned in several earlier posts, Assist FX does not expect an imminent near term recession. Nonetheless, it would be a good idea to do some planning and perhaps gradually accumulate assets on a regular interval able to outperform traditional fiat currency bank deposits should you see the same risks that we do longer term. We are closer to an economic peak than a trough at this stage of the credit cycle.

Odds of a recession occurring in the next 1-3 years are likely about 50-55%. Beyond 3 years the odds increase dramatically as it becomes apparent full monetary normalization is no longer possible absent an unexpected renaissance of productivity and growth in an aging demographics world.

We are past the point of no return yet not quite to a dead end. That leaves us with an ideal opportunity to assess risks realistically now and plan for an uncertain future where USD could lose its dominant reserve currency role in the world and instead become part of a diversified currency basket mainly featuring SDR’s.

What the Market Overlooked in the Personal Consumption Expenditures Report

  • Most market analysts are pointing to the slight miss in May’s headline year-over-year PCE deflator reading of 1.4% vs. 1.5% expected and 1.7% previous.
  • What has been overlooked by most are the strong back-to-back personal income figures of 0.4% m/m in May and 0.3% m/m (revised from 0.4%) in April. While April was revised a tick lower, May’s rebound capped off an impressive two month gain of 0.7% in personal incomes.
  • This runs counter to the prevailing sentiment that the Phillips Curve is broken and wages are not picking up or at least holding their own.
  • The Fed has shifted focus recently, as they often do on a discretionary basis, to focus on financial stability after the epic run up in mega cap tech names, equity  valuations, and market complacency suggested market psychology was fostering an unhealthy rise in market bubble dynamics.
  • The core Fed FOMC members are now willing to overlook taming inflation for the time being as a 15% fall in the energy complex drags down PCE and CPI for the next few months. They still believe continued labor market tightening toward what is deemed to be “full employment” will eventually boost wages and keep inflation expectations on a steady projectory. Other central banks are following suit.
  • Assist FX sees the recent central bank turn toward slightly less dovish rhetoric as supportive of a more sustainable recovery. While asset valuations are still stretched and in bubble territory on a longer term basis as regularly discussed on this site, letting some pressure out of the “everything bubble” is actually productive overall.
  • Letting asset valuations and house price-to-income ratios skyrocket unchecked by a tightening reaction function in monetary policy would be one major catalyst capable of changing our S&P500 bias to negative as prices become increasingly stretched like pulling a thinning rubber band.
  • Assist FX sees moderate Fed action to trim asset purchase reinvestments in September with another 25 bp Fed Funds target increase in December.
  • Our equity, fixed income, and USD bias remains neutral.

Inadequate Historical Valuation Measures and What Comes Next in This Monetary Bubble Investing Frontier

  • Market analysts far and wide continue to pound their fists on the table daily about overstretched equity valuations (and many other assets for that matter) putting risk markets in dangerous territory ripe for an imminent sizable correction, or worse.
  • Indeed, global risk markets are tremendously overvalued by almost any historical measure. It takes a heroic effort of wishful thinking to believe otherwise.
  • If we take a look at the S&P500 as one prime example, 18 out of 20 of the most widely followed valuation measures are flashing “overbought” with red blinking lights. Four of the measures indicate an S&P500 at least 50% overvalued, historically speaking.

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  • Therein lies the problems with historical valuation analysis: first, it is based on backward looking data only. Additionally, valuation alone has proven to be an inadequate timing mechanism.
  • Assist FX does not see the historically overstretched valuations currently witnessed in global equities, real estate, and bonds imminently leading to a near term risk-off crash as the base case, although that is always a possibility. Valuations will likely become even more stretched first. Additionally, the current bubble investing environment might lead to a different ultimate resolution than the traditional risk-off market correction/crash many are accustomed to witnessing. We see a different range of scenarios playing out involving capital eventually being less attracted to paper/fiat based financial assets and more attracted to physical-based assets and decentralized stores of value. Imbalances may very well be resolved via asset depreciation in real terms rather than in nominal terms. An occurrence of this nature is not likely to materialize for some time, but risks are building daily as global debt pressures become less and less reversible.
  • Key question: Is this time really different? Answer: yes and no. There has never been another time in history where global central banks have been this supportive of asset prices all at once. During a time marked by real estate bidding wars and new all time highs in global stock indexes, central banks still feel the need to create more than $200 billion dollars per month from thin air to buy mortgage bonds, stock ETFs, and government bonds. Markets are rigged, but they are actually rigged to rise in order to supposedly create a self fulfilling “wealth effect” of unrealized asset gains fueling greater economic activity and confidence.
  • You can’t skirt the basic laws of market supply and demand forever. Reference Venezuela as one of hundreds/thousands of unfortunate examples involving central planners throwing a grand party on borrowed time that ends in widespread misery as soon as the bill comes due. Today’s advanced economies are not being operated with the same extreme mismanagement as in Venezuela, but less severe policy errors are impossible to ignore when cumulatively compounded over time.
  • Current state of global monetary policy: The Fed, ECB, BOJ, PBOC, BOC, SNB, RBA, RBNZ, and other central banks have enabled massive asset price inflation to grow unchecked across several asset classes, particularly in real estate and equities. They do this in the name of fighting a phantom crisis of consumer price deflation which only seems to exist in heavily adjusted inflation index data conjured up by statisticians who know the entire political and industrial complex desires the lowest official readings possible. The appearance of low inflation makes GDP look higher, wages look stronger, and government transfer payments linked to inflation indexes lower. Understated inflation indexes are to politicians and executives what Photoshop editing is to swimsuit models.
  • What many well-meaning analysts have been getting wrong is just how long this type of central planning charade can go on before supply and demand imbalances are aggressively shocked back to reality in a reversion to the mean event. That is because this is not only a function of economic mathematics but also of mass psychology. Dispassionate valuation modeling alone is not enough for a prudent money manager. One must also have their finger on the pulse of market psychology to know when the music has stopped and isn’t coming back on for a very long time during the metaphorical musical chairs game also known as investing in a bubble environment. Assist FX research indicates the music isn’t quite ready to stop–we aren’t there yet. But don’t pile into expensive asset classes with huge leverage either. Stay vigilant and nimble.

Bottom Line: Assist FX has believed for some time, and continues to believe, that central banks have “doubled down” on a quasi commitment to keep asset prices elevated by doing “whatever it takes” as their primary strategy to minimize the onset and severity of cyclical recessions. This improves the appearance of macro economic activity in the near term while adding to dangerous systemic risks longer term. It is difficult for financial markets continually pumped with newly created money and ultra low interest rates to simultaneously crash and stay down. It tends to materialize with earnings multiple expansions in stocks, cap rate contractions in real estate, and overall suppressed volatility, making nearly all asset classes appear “overvalued” for a much longer period of time than many market observers believe can occur.

Make no mistake. We are in yet another central bank inspired asset bubble that was engineered to “fix” the aftermath of the last two central bank inspired asset bubbles. The imbalances grow more pronounced with each reflated bubble because instead of having moderate, occasional recessions where the most unproductive debt is reset via bankruptcies, you have massive unproductive debt imbalances augmented much further by artificially cheap credit and financial engineering. This dramatically increases systemic risk associated with major financial crises, economic meltdowns, and complete monetary system resets. Yet, bubble environments can exist for very protracted periods of time.

Nearly everyone who thinks about these types of economic topics knows at some level, whether more conscious or subconscious, that the current central bank driven free-lunch asset holders are enjoying today are creating the types of systemic risks that endanger the global monetary system tomorrow. This will push private citizens worldwide to increasingly seek alternative stores of value for their savings. That is why demand for decentralized, alternative stores of value such as block-chain technology-based digital currencies is set to accelerate. The block-chain trend is just getting started. As for traditional financial markets, we see a continuation of the type of slow grind, nearly dead volatility asset price levitation to continue for the time being.