Something Wicked this Way Comes – The Beginning of the End for the US Dollar?

The once mighty US dollar has been facing some tough times recently. The global financial crisis, budget deficit, quantitative easing, and the 2013 government shutdown have all taken a toll on the mighty greenback. With declining confidence in US treasury securities, and rapidly decreasing currency value, is it time for the world to have a new reserve currency?

Some countries have become fed up with the way the US has handled its budget decisions. Calls for a new reserve currency are growing stronger and stronger by the day.

The first US dollar was issued in 1785, but it wasn’t until the end of World War II, that it was given reserve currency status. Prior to World War II, the British pound was the world reserve currency. Countries held pounds instead of gold because they were confident that the Bank of England would exchange money for gold at a fixed exchange rate at any time.

Then, in 1944, the Bretton Woods agreement was instigated. The agreement led to the creation of the International Monetary Fund (IMF). Currencies would be pegged to gold and it was the IMF’s responsibility to intervene when an imbalance in payments arose. During this time, the US dollar was given reserve currency status, as it was a major international currency pegged to the gold standard.

In the late 1960s, the first signs of trouble emerged. Although, the US Federal Reserve had agreed to trade gold at $35 per ounce, they hadn’t held enough gold reserves to meet their outstanding liabilities. Countries all over the world withdrew gold until the Fed’s gold reserves reached an all-time low. The Fed could no longer uphold the $35 per ounce exchange rate.

On September 1971, the US abolished the gold standard; the US dollar became a fiat currency (e.g. it wasn’t backed by any commodity).

Given that the ‘gold guarantee’ of the British pound and the US dollar made them attractive as reserve currencies, one would have ordinarily expected the US dollar to have lost its reserve currency status after the removal of the gold standard.

Luckily for the US, this didn’t happen. It still maintained reserve currency status due to the fact that it was the currency of a large trading nation, and it was believed to hold its value against commodities over time. It wasn’t until the aftermath of the global financial crisis (GFC), that doubts were cast upon the reserve currency status of the US dollar.

The GFC saw the US bail out its largest banks with government revenue. The economic downturn and loss in consumer confidence which followed shocked the whole world. The Federal Reserve began ‘quantitative easing’ in late 2008, it bought out billions of dollars worth of Treasury securities in order to increase lending and money supply in the economy.

Such a policy is only likely to be effective in the short-run.

In the long-run, the increases in money supply will lead to rapid increases in inflation. If this were to occur, it is unlikely that the US dollar will maintain its value relative to commodities – which was originally one of its biggest appeals as a reserve currency. On top of this, China has expressed great displeasure in the way the US has handled its budget decisions. China’s displeasure reached a peak when the US government shut down because of their inability to pass a budget on time.

Talks of a change to the reserve currency are nothing new. A 2010 report by the United Nations Conference on Trade and Development called to ditch the US dollar as the major reserve currency. Instead, the report suggests the alternative as IMF special drawing rights (SDR), a reserve asset used as a unit of payment on IMF loans, made up of a basket of currencies.

The report supported the idea of permitting emissions of international liquidity, such as these SDRs, to create more stability in the global financial system.

Russia and China go a step further by supporting the idea of creating a new independent currency as the new reserve currency. The problem with having a sovereign currency as the reserve currency is that its value is strongly affected by sovereign debt. Furthermore, other countries have to closely monitor the monetary policy of the country with the reserving currency.

Whatever is agreed, it does look like the beginning of the end of the US dollar as the reserve currency. The high levels of government debt, the political gridlock, and chances of high inflation indicate a turbulent path ahead for the US dollar.

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