Sunday, August 1, 2010

The Dominance of the US Dollar - 2

This post is the second and final one in this series. In the previous post, we observed the history of how the US dollar came to dominate world trade, and how it became the global reserve currency. In this post, we shall see how the US dollar is instrumental in America's supremacy as a global powerhouse, and how the US struggles to keep it as the world's preferred reserve currency. Most importantly, we shall also see why the US dollar cannot be replaced by any other currency, as the global reserve currency.

We may summarize the points made thus far :-

1) A currency note is an IOU (I Owe You), and acts as a receipt of debt.

2) Under normal circumstances, i.e. between individuals and businesses WITHIN a country, a currency note cannot be redeemed later for hard goods and services. So, your milkman cannot come your house and demand your cricket bat in lieu of the very Rs. 100 note that you handed him last evening. He will instead circulate the same note to buy some goods elsewhere --- essentially, he is circulating debt.

3) However between nations, this does not happen. Currency obtained after trading internationally used to be sent back to the country of its origin in lieu of gold. How much gold a unit of currency of a particular nation could buy was settled by international consensus.

4) After World War-II ended, the economies of many countries had collapsed. But the US was far less affected and emerged as the only strong "survivor". So, many nations including the UK, France and Germany agreed to borrow US dollar debt and circulate it internationally. The debt would be returned in gold to the US Federal reserve.

5) Also, newly formed oil-rich nations like Saudi Arabia and Iran decide to accept dollar circulation. They wanted American exports and technology from firms like Boeing, GE and DuPont. So, they were sure that if they presented them with dollar notes that fell into their accounts, they could be redeemed for imports from the US.

6) Other countries that wanted oil from these middle east nations, too started accumulating US dollars. These were India, China, Malaysia, etc. Besides, whenever a nation had any dollars left after all their import (like oil) were met, they could -- in principle -- get those dollars exchanged for gold from the US Federal Reserve (equivalent to our RBI).

7) However, the US dollar was backed by gold. In effect, as mentioned in point 6) any nation which had a surplus reserve of dollars in its possession, could redeem them for gold from the US Federal Reserve. This was in accordance with the principle that every medium of exchange must be a universal and valuable commodity. The price of gold was also fixed at $35 an ounce.

As we saw earlier, after WW2 only the US seemed to be in a position to lend to the world in order to revive the economies of other countries. We may recall from our last discussion that after WW2, the US was the kind of "last man standing". Its finances were still robust and industry was the most mature. This was unlike UK, France and Germany, which were ravaged in the war's aftermath and financially almost bankrupt. Japan was on the brink of being a failed state after two nuclear weapons were dropped on Hiroshima and Nagasaki. So these countries lent heavily from the US (in dollars), and later had to repay the US back their debt in gold (or even dollars accumulated from favourable trading elsewhere).

Now the question arises, that as the economies of the world grew and trade grew, how was the supply of dollars maintained ? Now the world economy could not actually grow on the fixed dollar supply that the US had "let loose" globally. Economies must (and do) grow over the long term, and a growing economy must have a growing money supply to facilitate the growing exchange of goods & services. Here the US consumer -- relatively unscathed after WW2 -- came in. The American consumer started demanding cheap goods and commodities. So, crude oil was imported from the middle-east, textiles from Asia and cheap electronics from Japan and Taiwan (Later cars also. Toyota, Honda et al). In this way more dollars entered into circulation in the global economy.

Now we may recall our discussion from Part-1 of this series on how exchange rates between any 2 nations are determined. After WW2, most nations needed imports from the US of heavy machinery, power plants and technology to rebuild their nations. In return, they "clamoured" to export cheap commodities like oil, textiles and electronic items to the US consumer. This led to the US dollar strengthening against almost all currencies globally. In effect, the US was actually taxing the world for rebuilding it after the war. This was very beneficial for the American economy, as it could import commodities at cheaper rates for its consumers, and export hi-value goods at the prices that the US fixed. This led to not only windfall profits, but in accelerating the development of industry and consumer behaviour in the US. This phenomenon is in play even today. In fact, since most nations competed amongst themselves to export to the US, this exacerbated in the US imports becoming even more cheaper.

Now an important sequence of events occurred in the late 1960s. The US was running huge losses in maintaining the Vietnam war. The expenses were so huge that the US actually printed hundreds of millions of currency notes (simply IOUs as we saw earlier) to finance its loss-making operations in Vietnam. Simultaneously, the American consumer who was proverbially "spoilt for choice" for cheap imports, was consuming much more than any past precedents. The US imports now outstripped its exports by a wide margin; or in other words, it began to run trade deficits.

At this juncture, nations (after seeing this worsening financial situation) began demanding gold from the US Federal Reserve in exchange for the excess dollar reserves that they'd accumulated. In 1971, the then US administration under President Richard Nixon decided that there are not enough gold reserves to pay the nations, which were presenting them with excess accumulated dollars. So he declared that the US dollar was no longer convertible to gold. Hence, in an unprecedented move the basic principle of a medium of exchange was broken :- there was absolutely NO central commodity like gold, which remained a medium of exchange, or against which, all trade between nations could be determined.

Hence, in a de facto manner, the US in 1971 pledged the rest of the world that instead of physical gold, the US dollar was a literal IOU. Recall our example from Part-1 of the milkman, who would later come back to you with the very Rs. 100 that you gave him to demand ANY physical good in your possession, such as your old cellphone. Similarly, after 1971 the nations who possessed dollars did so with the understanding that these dollars could be redeemed for US exports that they'd need. The US being a world-leader in technology, would almost always have hi-tech exports to provide any developing (or even developed) nation. However, much unlike the reassurance of the dollar being backed by gold, this requires a reassurance --- rather, a huge leap of faith --- amongst all nations that choose to hold US dollar reserves, which is that the US is, and will continue to be an economic 'powerhouse', and would be the global "engine" in terms of hi-tech exports, goods and services, in return for commodities and other cheap produces (natural or artificial) that these nations may offer the US. It must be noted that since 1971, this has held to be true largely. The reader may appreciate the magnanimity and sheer accuracy of this trust that has held steadfast amongst most nations, like India, China, Malaysia, the middle-east, the Africas and Latin America since 1971.

To see the above from another viewpoint, we may hypothetically suppose that all nations decide that the currency of Fiji become the world's global reserve currency. Now the Fijian government will print currency notes to import all the imports that it has ever "dreamed". However, leave aside any gold, Fiji would have absolutely nothing to provide in return in hard exports to the nations that would've accumulated its currency to a "glut". Political pressure may force Fiji to sell or mortgage all its islands and the resources under them (if any) for the next few centuries, in return for the super-extreme trade deficit that it may incur. This example enforces the explanation of the preceding paragraph that a nation whose currency is used as a reserve currency, must not only have robust hi-tech exports to offer in massive quanta, but also generate good faith in the rest of the world, that it can indeed shoulder such a responsibility.

The above also answers why NO other nation's currency can actually be used as a reserve currency. It was suggested that the Chinese Yuan be an alternative to the dollar. However, this country's exports consist mostly of textiles, cheap toys, home appliances and electronic items. In sharp contrast, the US exports passenger aircraft, Google, hi-tech construction machinery, nuclear power plants, Coca Cola, and Walmart. It is thus clear as to which country is clearly the global engine, nay, the engine of most of the civilization, and which country's exports are just meant to service the lower-priced segments of the global populace. {However of late, the Euro is indeed emerging as a strong contender to replace the dollar, because as a block the European Union too can provide a good faith investment in terms of hi-tech exports and other goods & services. Also, the oft-repeated conspiracy theory that the US simply prints paper dollar notes to pay for its export deficits, and thus cunningly "fools" the world, is not correct. The Central Banks of all countries which keep dollar reserves, do so on the good faith mentioned above. Most importantly as discussed above, the currency of just any country can't be used as the global reserve currency.}

This as we note, may be termed as the power of the US dollar. A dollar note is thus not just an IOU. It is a "promise" of value to be returned in the future, on the good faith that the US will keep advancing and will definitely have tangible value, in the form of goods & services, to provide in the future. This forces most countries to export a significant portion of their exports to the US. The US in turn, produces high-tech exports like aircraft, nearly all drugs and defence hardware for the global market. India for example, exports cheap software services, call-center services, textiles, iron ore and generic drugs to the US. In return, we purchase millions of Apple products, Intel products, aircraft for our airlines and McDonalds to name just a few. In the next 5 years, this list will include an estimated $50 billion worth of nuclear power plants, and $20 billion of cutting-edge defence hardware.

However, despite the above comfort of the US dollar, since 1971 the US has been running enormous trade deficits year after year, because of almost "binge" consumption exercised by American consumers. Hence, there are limits to how much, or rather, how quickly the US can service its external trade deficits. Besides, Airbus of France too sells as many planes as does Boeing, and Nokia is a Finnish company. Japan is the largest seller of vehicles, and the UK and Germany make the most luxury cars. Thus, competition further impedes the speed at which the US can service its external deficits by way of its hi-tech exports.

In order to do so, the US uses political means and its military strength. It is here that OPEC countries come into picture. We have noted, that all OPEC countries began accepting (and continue to do so till today) the US dollar against their oil exports. So countries like India, China and Japan are forced to keep a significant reserve of US dollars and even American treasury bonds to finance their "voracious" oil imports. China for example, holds a record $2.5 trillion in dollar reserves and US treasury bonds. China also spends its dollars in financing mineral and oil explorations in poor African countries.

Now OPEC countries are usually autocratic dictatorships, like Saudi Arabia, Qatar, Oman, and former Iraq under Saddam Hussein. These were nearly all propped up by help from covert US intelligence agencies, and even today the US is known to maintain their (rogue) regimes. Now the dollars in the possession of OPEC countries are channeled to the US --- often on American discretion--- to buy expensive weapons, ski-resorts in the middle of deserts, and numerous other such wasteful indulgences. They are also instructed by the US to hold their dollar reserves with them and only release them under guidelines.

The strategy of the preceding two paras keeps trillions of dollars in circulation outside American soil, on hold within Central Banks in order to pay these OPEC nations (and even many other autocratic banana republics described in Part-1) so that the rate at which the US services its trade deficits, can be managed. Otherwise in literally informal terms, the US surely would not want to be "harrangued" by the Central Banks of China, India, Russia and many others who may collectively demand the resolution of the trillions of dollars that they hold.

The above also answers the question posed in Part-1 :- Why does the Indian rupee have a disfavour against the US dollar, despite India having a favourable trade balance against the US ? Its because India is in a severe trade deficit with the countries it imports oil from, and these nations are severely dependent on the US for their imports and other political ends. Hence, they demand payments in the US dollar, and India ends up partly financing their deficit vis-a-vis the US. In fact, it is an economically brilliant tactic :- Should the US dollar start falling against other currencies, the corresponding rise in the price of oil pulls the dollar back to a favourable position vis-a-vis those currencies. The prices of oil rise when the US economy falters, because OPEC nations are militarily and politically "hamstrung" by US imports and military power. When the US economy comes under a cloud, their position and purchasing power from the US reduces, thus forcing them to raise oil prices.

This may also provide for a plausible explanation for the fact that the US invaded Iraq under Saddam Hussein in 2003, soon after he declared that he was switching to the Euro while abandoning the dollar as the currency against Iraq's oil exports. The greatest opposition came from France & Germany in particular (both powerful members of the EU) and most EU nations. It is not a surprise that the so-called "coalition of the willing" who sent troops to Iraq, consists of banana republics or theocracies that hopelessly support the US dollar, like Tonga, Mongolia, Honduras, Azerbaijan, Bosnia-Herzegovina, Philippines, Thailand, etc. Australia and UK are the non-EU developed countries of note. Spain and Italy are the notable exceptions from EU-zone that also use the Euro, but have since withdrawn their troops (half a decade back in 2005).

In 2005 Iran's President Mahmoud Ahmedinejad also opened an Iran Oil Bourse, where its petrochemical products are open to export against non-Dollar currencies, like the Euro and Yen. It may thus not be a surprise that the US is vehemently opposed to Iran in most matters, whereas France and other Eurozone nations prefer dialogue with Iran.

This ends the discussion on the dominance of the US dollar as the world's global currency. Any comments and suggestions are welcome.