How Much Longer Will the Dollar Be the World’s Reserve Currency?

Published October 14, 2013

Editor’s note: China’s official press agency in October called for ending the U.S. dollar as the world’s reserve currency.  

In an English-language editorial, China’s Xinhua news agency said the world should consider a new reserve currency “that is to be created to replace the dominant U.S. dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States.”

China is the largest foreign holder of U.S. government debt, with about $1.3 trillion of Treasury bonds in its portfolio. China is also a huge buyer of gold. Some analysts believe China’s government is building gold reserves to create its own gold-backed currency.

This news makes the following commentary, posted Oct. 12 at the Web site, especially timely.

We use the term “reserve currency” when referring to the common use of the dollar by other countries when settling their international trade accounts. For example, if Canada buys goods from China, it may pay China in U.S. dollars rather than Canadian dollars, and vice versa. However, the foundation from which the term originated no longer exists, and today the dollar is called a “reserve currency” simply because foreign countries hold it in great quantity to facilitate trade.

The first reserve currency was the British Pound Sterling. Because the pound was “good as gold,” many countries found it more convenient to hold pounds rather than gold itself during the age of the gold standard. The world’s great trading nations could hold pounds rather than gold, with the confidence that the Bank of England would hand over the gold at a fixed exchange rate upon presentment.

Toward the end of World War II the U.S. dollar was given this status by international treaty following the Bretton Woods Agreement, with the promise that the Fed would not inflate the dollar and stood ready to exchange dollars for gold at $35 per ounce.

U.S. Called to Account

Unfortunately, the Fed did not maintain that commitment. It was called to account in the late 1960s, and to his everlasting shame, President Richard Nixon took the United States “off the gold standard” in September 1971. Nevertheless, the dollar was still held by the great trading nations, because there was no other currency that could match the dollar, despite the fact that it was “delinked” from gold.

Two characteristics make a currency useful in international trade: One, it is issued by a large trading nation; and, two, it holds its value vis-à-vis other commodities over time.

Although the dollar was being inflated by the Fed, thus losing its value vis-à-vis other commodities over time, there was no real competition. The German Deutsche mark held its value better, but German trade was a fraction of U.S. trade, meaning holders of marks would find less to buy in Germany than holders of dollars would find in the United States. In addition, the United States was seen as the military protector of all the Western nations against the communist countries for much of the postwar period.

Other Monies Being Used

Today we are seeing the beginnings of a change. The Fed has been inflating the dollar massively, causing many of the world’s great trading nations to use other monies upon occasion.

I have it on good authority, for example, that DuPont settles many of its international accounts in Chinese yuan and European euros. There may be other currencies that are in demand for trade settlement by other international companies as well. In spite of all this, one factor that has helped the dollar retain its reserve currency demand is that the other currencies have been inflated, too. For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. The monetary destruction disease is by no means limited to the United States.

The dollar is very susceptible to losing its vaunted reserve currency position by the first major trading country that stops inflating its currency. There is evidence China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China.

Should the world’s second-largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease. In practical terms this means the world’s great trading nations would reduce their holdings of dollars, and dollars held overseas would flow back into the U.S. economy, causing prices to rise. How much would they rise? It is hard to say, but keep in mind that there is an equal number of dollars held outside the United States as there are inside the nation.

Yellen’s Dangerous QE Fixation

President Obama’s imminent appointment of career bureaucrat Janice Yellen as Chairman of the Federal Reserve Board is evidence the U.S. policy of continuing to cheapen the dollar via Quantitative Easing will continue. Her appointment increases the likelihood that the demand for dollars will decline even further, raising the prospect of much higher prices in the United States as demand by trading nations to hold other currencies as reserves for trade settlement increases.

Perhaps only such non-coercive pressure from a sovereign country like China can wake up the Fed to the consequences of its actions and force it to end its Quantitative Easing policy.