Bitcoin and Reserve Currencies Vol II: King Dollar
- The global financial system’s roots date back to World War II when the Bretton Woods monetary system was devised.
- Globalization is currently in a reversal trend, and US adversaries are moving away from the dollar.
- Nevertheless, thanks to the United States’ robust legal framework, established property rights, and the deepest and most liquid financial markets in history, the US dollar is destined to remain coveted by billions of people globally for the foreseeable future.
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For Financial Professionals Only
“When you come at the king, you best not miss.” — Omar Little in The Wire
How did we get here?
We left off our conversation discussing the pros and cons of Bitcoin. One of the more ambitious claims made by some Bitcoin enthusiasts is that the digital currency could become the next reserve currency of the United States. Bitcoin has many merits, but undergirding the entire global financial system is an extremely remote possibility for our country.
Pouring the Foundation: Bretton Woods
The current state of the U.S. monetary system had its foundation poured decades ago amid World War II.
Reserve currency status does not last forever
Source: JP Morgan
As the allies were battling for the soul of civilization, monetary changes were being made that still govern our current financial markets today.
Although the US dollar started its reign as the global reserve currency in 1919 after the end of World War I, it was at the now famous Bretton Woods hotel in 1942 where the skeleton of the current global monetary system was formed and the US dollar would be considered the world’s key currency.
Before Bretton Woods, reserve currencies generally meant that the country that issued the notes held gold in reserve. Paper currency and coins would represent gold, making it easier to do business. Instead of carrying around gold bars, consumers could use paper currency, which represented a value in gold.
Bretton Woods created the “pegged rate currency regime”, which meant that national currencies would establish a parity or “peg” to a reserve currency, maintaining a +1%/-1% band of the rate in their foreign exchange markets. The US dollar was chosen to be the reserve currency and is considered the world’s key currency. The US had separately agreed to link the dollar to gold at $35 per oz, meaning that foreign currencies linked to the dollar would convert their monies to gold, coining the phrase, “as good as gold”.
Bretton Woods meant that other countries would hold US dollars in reserve instead of gold with the understanding that they could convert their dollars into gold, creating the Gold Exchange Standard. The US dollar would effectively displace the role of gold under the prior policy and help form the current structure of the global monetary systems.
But what happened after the war truly transformed the world? After winning the war, the United States learned the lessons of World War II and did something magnanimous. Instead of sticking the losers with the bill, the United States invested capital into the very countries it was previously bombarding! Beyond just spending money, however, the US Army and Navy effectively occupied two of the losers of the war, Germany, and Japan.
These bases are located east and west of Russia and had strategic value to the US in containing communism. As a result of the sprawling military presence and the desire to rebuild the nations it had just defeated, the US Navy became the protector and enabler of global trade.
This system appears to be at risk of changing, due to what appears to be a break in the globalization megatrend.
A new direction
World leaders are clashing at an increasing pace. Countries were subjected to the whims of other nations during COVID-19 for critical equipment.
FROM THE ASSOCIATED PRESS “U.S. officials believe China covered up the extent of the coronavirus outbreak — and how contagious the disease is — to stock up on medical supplies needed to respond to it, intelligence documents show. Chinese leaders “intentionally concealed the severity” of the pandemic from the world in early January, according to a four-page Department of Homeland Security intelligence report dated May 1 and obtained by The Associated Press.”
But tensions were rising prior to COVID with Trump putting tariffs on China and imposing sanctions on Russia’s Nordstream pipeline project to Germany.
At a meeting in Alaska between Biden’s Secretary of State, Antony Blinken, and CCP foreign affairs chief, Yang Jiechi, tensions were high as both parties criticized each other with strongly worded public remarks. China’s leader, Xi, amped up bombastic rhetoric recently in a national address.
Naturally, these conflicts are playing out in financial markets. Illustrating the break from the status quo, Russia’s sovereign wealth fund recently dumped all dollar holdings and increased their gold reserves.
This definitionally equals less demand for the current reserve currency.
Additionally, China has also recently started to negotiate contracts for oil in renminbi, representative of a break in the standard US dollar.
It’s significant because the US dollar abandoned the gold exchange standard in 1971, becoming a purely Fiat currency.
But one may ask, why did the US abandon the gold exchange standard in the first place? This is mainly attributed to the attempts to build a Great Society by Lyndon Johnson and the Vietnam War. These events left the US with a substantial amount of debt. France’s financial minister sensed that the US dollar was on a weak footing and started redeeming its dollars for gold. When President Nixon at the time realized that the Treasury was at risk of having all its gold cleaned out, it exited the gold standard.
Some Bitcoin enthusiasts point to egregious spending by Congress as reasons why the US dollar is at risk of losing its reserve status. Yet, that’s how we ended up with the current financial structure today!
Let’s be clear here. The US Dollar is not at risk of losing its status as the leading global reserve currency. But it is at risk of losing some share. In fact, it already has.
USD share of central bank reserves, %
Source: JP Morgan
But thanks to the United States’ robust legal framework, established property rights, and the deepest and most liquid financial markets in history, the US dollar is destined to remain coveted by billions of people globally for the foreseeable future.
Just look at how US Treasuries and the DXY Index performance both lurched higher during the initial COVID financial market panic.
U.S. Dollar Currency Index
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The pressure on the dollar eventually eased as the US Congress rushed to meet the crisis at hand, but US treasuries are still trading at higher levels than when the COVID crisis first began.
Detracting from the Dollar
While the US also has the geographic advantage of being relatively remote, many nations are building out their own spheres of influence. China’s New Silk Road and investments in Africa could end up seeing the renminbi on the balance sheets of some central banks, albeit smaller ones. As we mentioned earlier, Russia is building a pipeline to Germany to sell them cheap gas. But being dependent on Russia for energy may not be the strategically beneficial move for a nation that has also called Putin a threat while the US foots the bill to protect Europe.
Peter Zeihan, an economist and demographer, has noted the US is in a global retreat and has been since George HW Bush left office.
The European Union for its part could gain share, but their sclerotic economies are not likely to offer the dynamic investment opportunities that the US provides, perhaps limiting its threat to the US dollar.
This is what Bitcoin enthusiasts miss when they talk about the US dollar losing its status as a reserve currency. Bitcoin, and cryptocurrencies more broadly, have captured a lot of attention. While perhaps it’s less captivating, the US Navy ships patrolling the world’s oceans have enabled decades of growth and limited the impact of war on the developed world. While it’s undoubtedly not perfect, a lot of countries have broadly liked the arrangement.
The global financial system’s roots date back to World War II, when the Bretton Woods monetary system was devised.
The other big legacy after World War II was the US setting up a military and economic presence in Japan and Germany after the war in order to contain communism and build up the global economy. As a result of this system, the US Navy ensures and enables global trade to take place in a stable way.
While the system was at risk of blowing up in 1971, the US was able to stabilize the system by connecting demand for oil exclusively to dollars.
Globalization is currently in a reversal trend, and US adversaries are moving away from the dollar, and could take countries that do business with them away from holding as many dollars in reserve. Nevertheless, the American dollar is still king.
Foreign Exchange holdings as a percentage of total allocated in U.S. dollars
Source: Bloomberg. Foreign Exchange Holdings as a Percentage of Total Allocated in U.S. Dollars, Euro, Yen, Renminbi, and Other Reserve Currencies. Currencies represented in “Others”: Swiss Franc, Canadian Dollar, Australian Dollar, Great British Pound, and unclassified others (CCFRUSD% Index, CCFREUR% Index, CCFRJPY% Index, CCFRCNYP Index, CCFROTR% Index, CCFRCHF% Index, CCFRCADP Index, CCFRAUDP Index, CCFRGBP% Index). Quarterly data as of 12/30/2020.