It’s remarkable how many times I get asked if the U.S. dollar will always be the world’s reserve currency. But like many such questions, the long bull market in stocks has pushed it aside. If everything is okay, why ask questions?
So I was caught by surprise when it came up recently in a client meeting. I think the main reason it gets asked is that the average person does not know why the U.S. dollar is the reserve currency, what that means, and what it would take to change it.
So let’s go back to the time when gold and silver were money. To use it, you had to carry it from one place to another. It was heavy, difficult to fractionalize, and easy to steal.
Because of these disadvantages, people started depositing their gold or silver into bank vaults. The bank would issue a receipt. When you purchased something, the merchant could accept your receipt and then take it to the bank to trade it in for gold. This was a big improvement over carting heavy metal around.
And so paper currency was born. For centuries, it was redeemable for gold.
In the 1600s, when Britain and France were fighting one of their non-stop wars, they had trouble finding enough silver to pay for weapons. Eventually, the problem was solved by countries suspending the gold standard during wartime. But that made their paper money only so much paper—not as trusted as paper backed by gold. The result was that during wars, the value of money fell. When the value of money falls, it buys fewer goods and services, which we experience in the form of rising prices, also called inflation. Inflation is another way of saying that the value of money has fallen.
When the wars ended, countries would go back on the gold standard. Once the paper money was again backed by gold, its value rose. That might sound like a good thing, but it’s not. When the value of money rises, we experience it in the form of falling prices, or deflation. When deflation is bad, it often leads to depression. The economy slows for a simple reason: if goods will be cheaper tomorrow, why not wait to buy until it’s absolutely needed?
After every major war, there has been a strong tendency for depression. The last one of these was in the 1930s.
But by the end of WWII everything changed, and it changed in 1944 in Breton Woods, Vermont. It was there that world national leaders met and—at the direction of the United States—formed a new international monetary mechanism backed by the U.S. dollar. The rest of the world went along with it, not only because the U.S. was clearly emerging from WWII as the world’s sole superpower, but because most of the other countries had spent most of their gold fighting the war. At the time, the U.S. government owned most of the world’s gold. So the previous reserve system that used gold for international trade was no longer able to function.
The dollar became the means of international trade because it was the only major currency that could be tied to gold and could always be trusted to be safe.
After the Nixon administration removed the dollar from the gold standard, the dollar continued on as the world’s reserve currency because it was still the most trusted currency in the world. It is believed that we can pay our debts and our money will always be safe because we’re the largest economy and have the most powerful military in the world.
Other nations, most notably China, would love to be in our position. But the reserve currency is always going to be the one deemed safest by most of the world.
What could change it? One possibility would be if the U.S. military fell into disrepute and was surpassed by that of another nation. But there may perhaps be another threat today. The president recently said we don’t need international trade.
I disagree with that. Foreign trade as a percent of GDP is roughly 13 or 14 percent. If we were to end all trade with foreign nations, our GDP would likely fall by more than it did during the Great Recession.
But I think it’s safe to say that we aren’t going to end all world trade. For one thing, we aren’t likely to ever grow enough coffee or bananas for our needs.
This administration seems to want to put up barriers and reverse our long-standing commitment to free trade. And that is a threat to our position as the world’s reserve currency.
As the world’s largest consumer market, we are in a unique position. If foreign companies want to sell things to us, they have to do so in U.S. dollars and lend us money denominated in U.S. dollars. But as the Trump administration erects barriers to free trade, they also open the door for China to push harder for that status.
I understand using the power of our position to negotiate better trade terms with our partners. But what we stand to gain—more manufacturing jobs—pales against what we are risking: our reserve currency status coupled with economic slowdown.
This is especially true when you consider our 3.8 percent unemployment rate. If we dramatically increase manufacturing jobs, who is going to fill those jobs? This is especially true while we are working to restrict immigration.
Hal Masover is a Chartered Retirement Planning Counselor and a registered representative. His firm, Investment Insights, Inc is at 508 N 2nd Street, Suite 203, Fairfield, IA 52556. Securities offered through, Cambridge Investment Research, Inc, a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Investment Insights, Inc & Cambridge are not affiliated. Comments and questions can be sent to firstname.lastname@example.org These are the opinions of Hal Masover and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.