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The Dollar Standard or Global Depression

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Is the US Dollar about to be replaced as the key international reserve currency? Will the Dollar Standard give way to a SDR Standard or a Chinese Yuan Standard? Will The Gold Standard make a comeback? No. No. No. No. Despite growing concern – verging on hysteria in some cases – none of those things is going to happen. There is no replacement for the Dollar in sight. That does not mean, however, that the Dollar Standard could not break down. It very well might. But, if it does, there is nothing that could replace it as the foundation underpinning global prosperity. If The Dollar Standard fails, a severe and protracted global depression will follow.

I call our current international monetary system The Dollar Standard. When we discuss an international monetary system, what we are really talking about is how international trade is financed. To understand the nature of The Dollar Standard it’s necessary to understand how international trade and monetary affairs used to work before The Dollar Standard evolved. So, let’s start by taking a look at The Dollar Standard’s predecessors, The Gold Standard and The Bretton Woods System.

Under The Gold Standard, international trade was paid for with gold. Under The Bretton Woods System, it was paid for with Dollars pegged to gold at a fixed exchange rate. Under The Dollar Standard, international trade is paid for with Dollars that are not backed by anything or, more often, it is financed with credit – credit that generally takes the form of dollar-denominated credit instruments such as US government bonds.

Under both The Gold Standard and The Bretton Woods System, international trade had to balance. That is because if one country bought more goods from other countries than it sold abroad, then it had to pay for its trade deficit with its gold or with Dollars that were as good as gold (i.e. convertible into gold). Consequently, it would be left with less money than before and, if its trade deficit persisted, it would run out of money completely. Those constraints meant that countries had to be careful not to buy more than they sold.

In contrast, The Dollar Standard has never operated within those “old-fashioned” constraints. Countries can buy as much as they want from other countries regardless of how large their trade deficit grows, so long as they can persuade their trading partners to accept payment (for the goods they sell) in the form of fiat money, i.e. money that is not backed by gold or anything else.

Under The Gold Standard and The Bretton Woods International Monetary System, trade between nations had to balance. Under The Dollar Standard, it doesn’t. This was something completely new. Beginning around 1980, the United States began running very large trade deficits for the first time. By the mid-1980s the US Current Account deficit grew to 3.5% of US GDP. By 2006, it peaked at 6% of US GDP. That year, the United States bought US$800 billion more from the rest of the world than it sold to the rest of the world.

Those deficits set off an extraordinary global economic boom as US demand allowed other countries to pursue a strategy of export-led growth. That arrangement ushered in the age of Globalization and completely transformed the size and structure of the global economy. China went from rags to riches practically overnight because of its trade surplus with the United States, which exceeded US$340 billion last year alone.

The Dollar is now the key international reserve currency because the United States’ trade deficits have flooded the world with Dollars. Between 2000 and 2014, the total stockpile of Foreign Exchange Reserves held by the world’s central banks jumped from US$2 trillion to US$12 trillion, more than 70% of which are held in US Dollars.

The Dollar is not about to be unseated; nor is The Dollar Standard about to be overthrown. The global economy lives or dies based on the amount of liquidity the US trade deficit provides. Any replacement would have to pump even more liquidity into the global economy than the US trade deficit does. There is no mechanism through which that could happen. China has a huge trade surplus every year, rather than an deficit. So, it’s not throwing Yuan liquidity into the global economy. Special Drawing Rights (SDRs) exist only on such a minuscule scale that they are almost completely insignificant as a form of global liquidity. More SDRs could be created by the IMF, but only with the approval of the US Congress. But the US Congress is never going to allow a very large allotment of new SDRs to occur.

So, the world is stuck with Dollars and The Dollar Standard. There is now a global recession because the US Current Account deficit has corrected sharply since 2008. It is no longer providing enough liquidity to make the global economy grow. Unless that changes soon, chances are high that this global slump is going to become significantly worse.

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Original publish date: October 15, 2015

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