Throughout human history, multiple nations were trying to dominate and influence others through military means. However, the most efficient tools to control other countries have changed with trade routes establishment. Currencies became one of the most powerful tools to achieve these goals. This article solely focuses on the recent history of currencies and the current global reserve currency — the U.S dollar. Eventually, we argue that the challenge for a new superpower is growing and the U.S dollar might face risks never seen before.
Dorothy Thompson once said “peace is not the absence of conflict”. Never forget there is form of peace and stability reinforced by a foundation of underlying volatility. Game theorists call this the paradox of the Prisoner’s Dilemma, and it describes a dangerously fragile equilibrium achieved only though brutal competition. The Prisoner’s Dilemma is the most important paradigm for understanding shadow risk in modern financial markets at the pinnacle of multi-generational debt cycle unparalleled in the history of finance.
In their masterwork tapestry entitled “Allegory of the Prisoner’s Dilemma” the artists Diaz Hope and Roth visually depict a great tower of civilization that rests upon a bedrock of human cooperation and competition across history. The artists force us to confront the fact that after 10,000 years of human civilization we are now at a cross-roads. Today we have the highest living standards in human history that co-exists with an ability to destroy our planet ecologically and ourselves through nuclear war.
We are in the greatest period of stability with the largest probabilistic tail risk ever. The majority of Americans have lived their entire lives without ever experiencing a direct war and this is, by all accounts, rare in the history of humankind. Does this mean we are safe? Or does the risk exist in some other form, transmuted and changed by time and space, unseen by most political pundits who brazenly tout perpetual American dominance across our screens? (Artemis Capital Research Paper)
The Bretton Woods Agreement
Reserve currencies have come and gone with an evolution of the world’s geopolitical power. There were multiple international currencies in the history of humankind, which included Greek drachma, Roman denarius, French franc and tens if not hundreds of others. However, in 1530–1640 Spanish silver dollar became the truly first reserve global currency recognized in the Americas, Asia and Europe. From 1640, Netherlands’ Dutch glider took a role as Europe’s reserve currency, but a war against the British Empire in Asia resulted in the bankruptcy of the Dutch East India Company in the late 18th century. After the tulip mania bubble, France became a republic, invaded the Netherlands, and issued the dominant trade currency of the time, Assignat, which was held from 1720 to 1815. The start of the 19th century was marked by the rise of the British East India Company, which made the pound sterling a new global reserve currency as British companies were the leaders in the industry and British insurers became the primary insurers of trade globally.
In the early fall of 1939, the world had watched in horror as the German blitzkrieg raced through Poland and, combined with a simultaneous Russian invasion, conquered the entire territory in 35 days. As country after country fell to Germany, other European members were scared that their land would be next and started sending their gold reserves to the USA. At one point, Federal Reserve held more than 50% of all world’s gold in its reserves.
As the war wound down and it became clear that the Allies would win, the Western Powers understood that they would need to come to a new consensus on creating a new global monetary and economic system. Britain’s last superpower was hugely affected by the war, as the intense bombing of Nazi Germany ruined most of the industrial cities. Other European nations, such as France, were shattered after Germany and America shells during various war points. On the other hand, the USA held most of the global gold reserves, had the best lending capacity, and had an undamaged economy.
European countries understood that sending back the gold reserves was too risky. Hence, the American dollar became a de-facto choice for a new global reserve currency. Therefore, preparing to rebuild the international monetary system, 730 delegates from all 44 Allied countries gathered at the Mount Washington Hotel in Bretton Woods to establish commercial and financial relations rules. As a result, on July 22nd, 1944, Bretton Wood Agreement was signed, making the US dollar a new WRC, and the participating nations would synchronize monetary policy to avoid competitive devaluation. In short, the agreement meant that the US dollar would be pegged to gold, while other currencies to US Dollar. Indicating that all countries remained indirectly connected to gold and could still redeem dollars for gold at a fixed rate of $35 an oz, a hard redemption peg which the US would defend.
The Nixon shock
For the first few decades, the Bretton Woods system worked well. Marshall Plan was announced in 1948, providing Western European allies with over 13 billion (120 billion in 2022) in economic recovery programs. Dollar demand went up as countries wanted them to spend on American goods — cars, steel, machinery, etc. The system looked secure as the US had more than half of the world’s gold.
The cracks started to appear during the Guns and Butter era in the 1960s. After President John F. Kennedy’s assassination, Lyndon Baines Johnson became the 36th US President. Johnson further escalated the US-Vietnam war and established Medicare, Medicaid, and Head Start, government-run programs. Thus, increasing government debt massively, and dollars in the form of Treasuries started stacking up in foreign Central Bank reserve accounts. Furthermore, as Germany and Japan recovered, the US share of world economic output dropped from 35% to 27%, and a negative balance of payments with growing monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued.
In France, the Bretton Woods system was called “America’s exorbitant privilege“, as the US would never face a balance of payments crisis because their imports are purchased in their currency. Barry Eichengreen summarized this privilege: “It costs only a few cents for the Bureau of Engraving and Printing to produce a $100 bill, but other countries had to pony up $100 of actual goods in order to obtain one”. However, in 1965, then-French President Charles De Gaulle did calculus and realized that the US had issued far too many dollars; even considering massive gold reserves, it would never be enough to redeem them fully. In his infamous “Criterion Speech“, he laid out these arguments and started aggressively redeeming dollars for gold.
The global “run on the dollar” had already begun, and by 1971 money supply had increased by 10%. West Germany left Bretton Woods unwilling to revalue Deutsche Mark. Switzerland redeemed $50 million in July, while France $191 million. The pressure began to intensify on the US to leave Bretton Woods, as gold reserves were decreasing, and the United States of America would be left holding a bag of worthless dollars, backed by promises. Seeing the impending dollar insolvency crisis, 37th US President Richard Nixon announced on August 15th, 1971, that he was closing the gold window, meaning that no one would be able to redeem gold from that point.
Nixon’s speech was not received as well internationally as it was in the United States. Politically, Nixon’s speech was a great success as Americans believed that the government rescued them from price gauges. On the other hand, in December 1971, G10 countries configured a Smithsonian Agreement, which would reconfigure exchange rates on devalued dollar. However, the plan was unsuccessful. In March 1973, G10 nations called for six European members to tie their currencies together and jointly float them against the dollar, ending the fixed exchange rate system. This crisis came to be known as the “Nixon Shock“.
After the closing of the gold window, the crisis climbed, and inflation soared. The US quadrupled its grain export prices, and simultaneously OPEC countries increased oil prices. Talks about currency war started sparking, and Nixon’s administration knew that they had to do something to stop the bleeding. Therefore, legendary Secretary of State Mr Henry Kissinger architected a secret agreement with Saudi Arabia and OPEC countries. This agreement provided political and military protection to OPEC countries, while they would have to sell oil only in dollars. The petrodollar was thus born.
This agreement was genius, as all countries were forced to buy dollars to get oil, thus, artificially increasing the demand for dollars. Moreover, as dollars build up in foreign countries’ reserves, they need to be recycled, meaning they can be channelled into loans or direct investment back in the United States.
Triffin’s Dilemma and Foreign Exchange Reserves
The petrodollar system resulted in increased demand for the dollar, and the goal was accomplished but better than ever imagined. To understand this, let’s say “you” are Thailand’s government. You clearly remember the Asian Financial Crisis of 1997, when your economy was booming, while corporate and real estate sectors took massive debt, forming a giant bubble. Soon, the bubble started to pop, resulting in the bankruptcy of the largest finance company, Finance one, while one of the biggest developers in the country Somprasong Land — defaulted.
Currency traders started attacking the Thai baht’s peg to the US dollar by selling vast amounts of Thai baht. Wanting to defend it, you started using foreign currency reserves to purchase Thai baht in the forex market. However, as you reserves depleted, the speculative downward pressure resulted in devalued currency. As a result, consumers lost their spending power, while loans taken out when the currency was worth more became impossible to pay off.
Hopefully, you learned your lesson and now understand the need to hold more foreign currencies in your reserves to stabilize your currency. Essentially, if one Thailand held the dollars, the dollar’s impact would be negligible. However, under the current system, all countries hold the US dollar as the main reserve currency. Resulting in massive buy pressure on US Treasuries.
This is what France called “America’s exorbitant privilege” in the 1960s. They understood that the USA would never face a Balance of Payment crisis nor a debt crisis, as due to Central Banks and the Petrodollars system, demand for dollars will always be high. Essentially, the US can borrow cheaply and spend lavishly while the imports remain cheap and inflation is exported to foreign countries.
To satisfy dollar demand, the United States has to run a persistent account deficit, as it needs to send more dollars than it receives back. Thus, the WRC holder’s account deficit is constantly increasing, making the country unproductive. This is known as Triffin’s Dilemma: The world reserve currency (United States) has to run constant trade deficits, forcing them to be net importers.
As the dollar continued to dominate global trade through the SWIFT payment system, other countries started trading goods denominated in dollar-based contracts. For instance, when Nigeria and Chile trade metals, they will not accept Chilean pesos or Nigerian naira, as both currencies are smaller and less liquid than the dollar. De facto, according to SWIFT publicly available reports, more than half of all world trade is transacted with dollars.
This process is called Dollarization, where other nations use the dollar as a means of payment, even if they have no controlling power over a dollar. Similarly, most crypto uses stablecoins pegged to dollars, and most of the trade happens in dollars. This boosts dollar demand, and the crypto market growth could be a substitute for a petrodollar system.
The challenge for a new superpower
Through this process, the US built the most significant military in human history while fighting near-continuous wars for the last 80 years, as they borrowed cheaply and spent lavishly. However, dollar dominance is diminishing, which can be seen in global trade, where the dollar’s international role decreased from 70% to 60% in the last 20 years.
This is further accelerated by the current war, which started on February 24th, 2022, when Russia invaded Ukraine. As a response, the US, with its allies, froze the Central Bank of Russia’s reserves, effectively cutting off the country from roughly half of a war chest worth almost $630 billion (€598 billion). Hence removing Russia’s means of stabilizing their currency by purchasing rubbles with dollars on foreign exchange markets. This was a wake-up call for Russia and its main ally China to diversify their dependence on the dollar system. As a result, Russia, China, South Africa, India, and Brazil are developing a new reserve currency based on a basket of national currencies of all five nations.
Moreover, the petrodollar system faces challenges as US and Middle East tensions accelerated last year. Biden administration has not done itself any favours in being more vocal about taking a tougher stance on Saudi Arabia, not supporting their local war in Yemen, or protecting their stance against Iran and publicly accusing them of being responsible for Jamal Khashoggi’s death. As a result, Saudi Arabia was considering trading oil in yuan for its sales to China as it is the world’s largest consumer of oil, so it seems a direct match to trade in yuan instead of the dollar. However, even if China is trying very hard to maintain stability in its yuan, it is far from a reserve currency, let alone a transparent one. More elaborated on economic recession: external factors 2022 (part 2). If Saudi Arabia were to go through with this, it would mark a significant step away from historical allegiances, and the US dollar/SWIFT system would be done.
The dollar hegemony helped the United States to build the largest empire in human history, which has over 800 overseas military bases. China and its allies are challenging the dollar system’s status quo and closing the economic and power gap faster than ever. However, the main risk might be within the United States itself, and the story of Rome is one that echoes a warning through the annals of history:
A complex society, with mighty political, legal, and financial institutions, supported by a massive military, fell not to a crushing enemy invasion, but to collapse and decay from within. An elite ruling class, detached from the realities of daily life of the citizens, oversaw an empire with growing income inequality, environmental degradation, political corruption, social deterioration, and economic despair, and did nothing to stop it. (The Decline and Fall of the Roman Empire)
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The challenge for a new world power: The history of the dollar was originally published in Coinmonks on Medium, where people are continuing the conversation by highlighting and responding to this story.