An economic truth I revisit periodically is that every fiat currency (a medium of exchange without intrinsic value or without backing by a commodity with intrinsic value, such as gold) will eventually became worthless.
The oldest fiat currency still in circulation, the British Pound Sterling, dates from 1694. Since then, an additional 774 fiat currencies have been created. About one-quarter of them are still around, but most no longer exist. They failed due to hyperinflation, war, politics, monetary reform, or a combination of these factors. And the pound has lost about 99.5% of its original value relative to gold.
One example of a failed fiat currency you’ve probably heard about is the old German mark. In 1914, when World War I began, the mark was worth about $4.20. As we know, things didn’t go well for Germany in World War I. By the time Germany capitulated in 1918, the mark had lost nearly 50% of its value. It fell from 4.2 to 7.9 marks per dollar.
But that was only the beginning. By the end of 1919, the mark-dollar exchange rate fell to 48 to 1. By the first half of 1921, it was 90 to 1. By the end of 1922, it was 7,400 to 1. In early 1922, you could buy a loaf of bread for 160 marks. But by the end of 1923, that same loaf cost 200 billion marks. Meanwhile, the USD to mark exchange rate fell to 4.21 trillion to 1.
Yet, leading German economists of the day insisted there was no inflation. They argued there was actually a shortage of circulating currency. And to deal with the shortage, the printing presses ran 24 hours a day to produce more paper money.
The dollar, which is just another fiat currency, will eventually follow a similar path. It’s already lost almost 99% of its value relative to gold since its creation in 1792.
Still, the dollar’s role as the world’s “reserve currency” has been remarkably resilient for the last 75 years, despite a $24 trillion federal deficit now growing at a rate of $4 trillion annually, $200 trillion in unfunded obligations, and a central bank holding nearly $7 trillion of increasingly dodgy assets.
The dollar’s pre-eminent status came about as a result of a 1944 conference in Bretton Woods, New Hampshire. At the meeting, a group of finance ministers and other high-ranking officials from 44 countries declared that henceforth, the dollar would be “good as gold.”
It was a logical choice back then. In 1944, America had the world’s largest industrial capacity and unlike most other countries participating in the conference, hadn’t been devastated in either world war. The dollar was already the world’s most popular currency; declaring it to be “good as gold” was a logical – but also fateful – step.
The Bretton Woods system declared that nations could no longer demand gold from their trading partners to settle debts, but central banks could exchange their dollars for gold from the US Treasury at a fixed price of $35 per ounce.
Unfortunately for the rest of the world, Uncle Sam couldn’t abide by this deal. By the 1960s, deficit spending to finance the Vietnam War and the “War on Poverty” spurred inflation. Central banks accumulated more and more dollars and started to demand that the Treasury redeem them for gold at $35 per ounce. To avoid depletion of US gold reserves, in 1971, President Nixon suspended the dollar’s convertibility into gold.
You might think this would have ended the dollar’s free ride. But it actually entrenched its status. Without a mechanism for central banks to exchange dollars for gold, they were forced to accumulate dollars. Because so many global transactions were settled in dollars, businesses in every country needed to exchange local currency into dollars to pay debts and transact business.
The domination of the dollar is so complete that more than 60% of global currency reserves held by central banks are dollar denominated. More than one-third of global GDP comes from countries that have adopted the dollar as either an official (e.g., Ecuador) or parallel (e.g., Panama) currency. And nearly 90 countries keep the dollar in a tight trading range with their local currency (e.g., Hong Kong). And, just like the old German mark a century ago, economists today talk about a “dollar shortage.”
With dollar superiority apparently entrenched, it’s understandable that American politicians have found ways to weaponize the dollar’s reserve currency status against Uncle Sam’s enemies. Thus, one of the ways the US enforces sanctions against its long list of enemies is by locking adversaries out of the global dollar clearing system.
Uncle Sam also penalizes countries and foreign businesses that trade with their list of enemies. For instance, in 2017 Treasury Secretary Mnuchin warned China it would face being cut off from the dollar clearing system if it failed to adhere to UN sanctions against North Korea. In 2018, the Treasury imposed a $1.3 billion penalty against French bank Société Générale S.A. for violating trade sanctions against Cuba. Yet, Uncle Sam denies that it uses the dollar as a weapon.
Not surprisingly, countries targeted by dollar sanctions don’t like it. That effort has taken on new urgency as Uncle Sam turns on the money spigot to fight the economic side effects of COVID-19. No foreign central bank wants to be holding dollars when the greenback goes the way of the old German mark.
Russia and China have agreed to increase trade using their own national currencies. The EU has developed a global payments system designed to allow EU companies to do business with Iranian companies without exposing themselves to US sanctions. As well, over 40 central banks are considering the introduction of blockchain-based digital currencies that would avoid dollar clearing delays and US sanctions.
The most recent pronouncement calling for a dollar replacement came last week from Shanghai Gold Exchange (SGE) President Wang Zhenying. Wang proposes a new super-sovereign currency to that would replace the greenback. In a thinly veiled swipe at US efforts to weaponize the dollar, Wang says the new currency would be designed to ensure that no one country can freeze the international assets of another country.
It’s anyone’s guess if these efforts to dethrone the dollar will be successful, or when. But one thing is for sure. The dollar is fated to join the long list of fiat currencies that have been debased out of existence.
It’s only a matter of time. Make sure you’re ready when it comes.