[http://metaphoricalweb.ning.com/profiles/blogs/future-proof-end-of-us-dollar]
I'm going to get off the meta-trends that I've been following
throughout the week and get down to a list of things that I've been
tracking myself. I'll probably make this a regular feature - there's so
much going on right now that I doubt serious whether any one article
would cover more than a small part of it, and trends can be disrupted
(or just peter out) without actually amounting to any thing. I welcome
feedback here on what you've been watching as well, as I think the best
way you can become informed about the world is to get a different
perspective from the one you currently have.

So, without further ado:

The US Dollar is losing its status as the world's reserve currency.

First, a quick definition here: in the 1940s, a decision was made on
the part of the various world powers to establish the US Dollar as the
reserve currency for the purchase of oil. What that meant was that if
you wanted to buy a barrel of crude on the spot market, you could only
purchase it in dollars, and if you wanted to sell that barrel, you
similarly had to accept that money in dollars. This was essentially one
of the key requirements for receiving aid via the Marshall Plan,
something that was sorely needed in Europe at the time.

In essence, what this meant in practice was that a country that needed
oil (and all countries need oil) had to maintain a certain amount of
financial reserves in dollars. To get them, it either had to buy US
goods, or it had to give the US a certain amount of gold at a fixed
rate to buy these dollars, usually in the form of treasury bonds.
However, on the flip side, a country could also, upon demand, sell
their dollars back to the US for gold.

This had the immediate impact of swelling the US treasury, which was in
fact one of the things that helped the country pull out of the
depression of the 1930s. It also introduced a pernicious inflation
through much of the 1950s in the US, as the US printed more and more
such dollars in order to meet global demand. However, it also had a
darker side effect for the banking industry - it kept their ability to
leverage down to a very definite minimum, meaning they could originate
very few loans - and it increased the demand for gold globally as other
countries began to recover.

Presidents Eisenhower, Kennedy and Johnson were all forced to revalue
the currency by increasing the price of gold, but diminishing actual
reserves finally forced Nixon, in 1973, to "close the gold window" and
declare that the US would no longer honor the gold cap but would let
the dollar float. This (along with the effects that it had upon the oil
producing states) ended up forcing the energy crisis of 1974-77 and the
subsequent period of hyperinflation. It was also one factor leading to
the creation of the Euro.

Inflation was ultimately tamed by Paul Volcker, the Federal Reserve
Chair, who raised the prime lending rate dramatically in order to
attract foreign investment, a strategy, which, while leading to a
fairly severe recession in the short term, managed to accomplish the
task, restoring confidence in the American markets and laying the
groundwork for much of the long bull market that followed thereafter.

However, without some form of backing, the degree of confidence in the
dollar had largely become a function of the degree of trust in the US
economy. This trust began to be eroded in the wake of the savings and
loan scandals of the late 1980s and of the implosion of specific hedge
funds after the economies of a number of Southeast Asian countries
collapsed in the late 1990s.

However, the last decade has seen the uncertainty turn into outright
distrust as the Federal Reserve seemed to be deliberately manufacturing
bubble after bubble in an effort to sustain an increasingly shaky
financial system. The housing bubble in particular in particular had
the effect of significantly raising questions about the strength of the
dollar, and by mid 2007, the value of the dollar dropped fairly
precipitously relative to other currencies. The Canadian Loonie, for
instance, at one point briefly topped US1.10 = CAN$1.00, after started
at about US$0.74 in 2002.

This was also reflected in the price of oil at the time. While oil
prices were up fairly dramatically in Europe, they were up far more
(percentage wise) in the United States (the US has a very low gas tax
rate while Canada and most European countries have a much higher rate,
meaning that absolute measures were actually much closer). The top of
the oil speculation market came in the summer of 2007, though by the
fall, the first inklings of problems within the mortgage sector were
making themselves felt.

This isn't the place to go over the whole financial collapse between
2007 and 2009, that story is now familiar to most people. However, in
its wake, a couple of very interesting things have happened. The first
has been a massive flight to treasuries (the US Dollar) which has
caused the unwinding of most of the currency advances as investors have
moved out of equities and properties into a temporary store. For
foreign investors, the assumption has likely been that it was wise to
move out of falling markets into treasuries rather than repatriating
those funds. However, this has also had the effect of creating a bubble
in Treasuries.

However, a second factor that's come into play has been that China has
been purchasing Treasuries in order to keep their currency, the
Renminbi pegged to the US dollar in order to remain competitive in
providing goods and services. This has meant that they have ended up
purchasing roughly $1.5 trillion dollars in treasure currencies as of
2009 - money that in fact has largely been used (dubiously) for the
Iraq war and for financing the mortgage bubble in the first place.

One way to think of a treasury note is to envision it as a stock
warrant in USA, Inc. The warrant pays a dividend (interest) to the
holder of that note. When a company goes public, it sells shares in the
company, yet the company itself is worth only so much money
(essentially some percentage of its potential lifetime earnings). This
means that as the number of warrants issued rises, the individual
return on those warrants drop - the warrants become worth less. At $1.5
trillion dollars, China holds roughly 10% of the total GDP of the US.
If China was dump these holdings on the world market, the value of the
dollar would collapse overnight, resulting within six months of
extraordinarily high inflation - high double or even triple digit
inflation.

China won't do that, because it would not only make its investment
worthless, it would also completely destroy the economy of its largest
market. However, it has all but stopped its own purchases of
treasuries, and in the last month (March/April 2009) has devised a
strategy which will let it significantly reduce its own exposure to
American financial activities. It has contacted the International
Monetary Fund, and asked for the creation of an IMF bond invoking what
are called Special Drawing Privileges that essentially would make it
possible to set up direct currency exchanges with other countries -
most notably Brazil, Russia and India, which, with China, make up what
have become known as the BRIC economies. It has also created additional
currency swap agreements with countries such as Argentina, a number of
countries in Central Africa, and Indonesia. Significantly, all of these
are oil or other resource producers or act as brokers for same.

Put simply, the goal of the Chinese is very much in accord with a
number of oil producing companies in the Middle East - reducing the
historical role of the US Dollar as the global reserve currency. Given
the antagonism that the US has engendered over the last decade, there
is far more support for such an action than there ever has been in the
past, and even though it is likely that Obama's overtures will likely
mend a few fences, the real damage has been done to the trust of the
dollar. Sometime within the next 3-5 years, it is likely that a
global "reserve currency" will arise, one that consists of a basket of
floating currencies and exchange agreements rather than any single
country's currency. The US will likely be a part of that, of course,
but it will no longer be the world's bank (or the world's first
consumer) - and that has a number of potential implications for the US.

One of the largest is that the US credit card will officially be maxed
out. The US borrowing debt ceiling has been a convenient fiction for a
long time - as the US gets close to it, an act of Congress raises the
ceiling. This was done largely on the strength of expected sale of US
Treasuries. The world now has more US Treasuries than it could use, but
once a basket currency becomes the norm, there will be far more
interest in purchasing other countries' debt instruments, which means
that demand for US Treasuries will likely remain depressed for some
time.

This means that the account deficits explode, and there becomes no way
of even paying off the interest on the debt. This will result in the
reduction of the rating of US bonds. One effect of this is that
relatively soon, taxes will have to be raised, and fairly dramatically,
in order to finance any new expenditures. The US will have to raise its
own interest rates in order to attract more investors, at a time when
the economy will just begin its recovery. Defense expenditures will
have to be significantly reduced, social entitlements will have to be
renegotiated, and the ability of the government to act will be
increasingly hamstrung.

This will also mean that the Americans will have to save more. At the
moment, much of the effort in the recovery is going towards getting
Americans to spend more, to increase the velocity of money in the
system, but its becoming increasingly obvious that this isn't working.
Now the problem with saving is that while it is prudent at the
individual level, it reduces the amount of money available to create
businesses (in the short term) and reduces tax revenues that derive
from the acceleration of money in the system at the macro-level. In
other words, a savings-oriented mindset is anathema to a consumer
economy ... at least for a while.

However, my own take is that we're not going to end up going back to a
30's style "great depression", nor do I necessarily see the stark
future outlined by people like James Howard Kunstler. We're in the
midst of a major structural change in society, one fed in great part by
the profound changes in information infrastructure and additionally
shaped by a growing awareness about the fragility of the underlying
ecosystem. The consumer culture of the 20th century is failing, but
that doesn't mean that all of a sudden we should all become socialists
or communists or cogs in some oligarchical brave new world order.

What it does mean is that we're making it up as we go along. One of the
reasons for the original Bretton Woods accords was to attempt to
guarantee, as much as possible, the notion of full employment, at the
expense of inflating the currency. The reality now is that full time
employment, at least in the traditional sense, is breaking down. We
need to make some hard decisions about what constitutes a valid
standard of living - and what constitutes an excessive one. We need to
come to terms with information and reputation as forms of currency,
with virtual currencies, and with the degree to which currency reflects
value.

All of these things (and many, many more) will ultimately need to be
determined as the world adjusts to a new abstraction of currency, and
the more that efforts are made to return to an unsustainable status
quo, the longer it will take before a true recovery can take place -
and the more turbulent society will become.

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Posted By Kurt Cagle to Metaphorical Web at 5/07/2009 10:03:00 AM

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