Is the international monetary system nearing collapse?
Yesterday, I finished reading James G. Rickards' new book, The Death of Money. It's a book that asks a lot of important questions.
The book speculates about potential future changes to the international monetary system. Today, the main reserve currency in the world — used for the buying and selling of energy, resources, and other international trade, as well as a store of purchasing power for governments, corporations, and international institutions — is the United States dollar. Over 60 percent of countries' monetary reserves are held in U.S. dollars.
This demand for dollars means that the international monetary system today is highly beneficial to the United States; French President Valery Giscard d'Estaing called these advantages America's exorbitant privilege. What are these privileges?
First, because dollars are the medium of exchange for buying resources and energy in international markets, it guarantees America easy access to resources like oil in international markets because unlike other countries like Argentina, the U.S. can never run out of dollars.
Second, it creates demand for the dollar as a trade good — other countries need dollars to participate in the international trade system, and other countries get dollars by exporting goods and services to the United States. Considering it costs the U.S. very little to produce dollars, this demand gives the United States a kind of free lunch on other countries' exports.
And third, it creates a strong market for U.S. debt. The world's need for dollars has allowed the United States government as well as American firms and individuals to borrow at lower costs, granting them an advantage estimated to be in excess of $100 billion per year.
There is no international law that explicitly decrees that dollars should be used as the world's reserve currency. It has just come about because the United States is the biggest economy and for most of the last century, the United States was a world leader in trade and a military superpower. In fact, many countries — including China, Brazil and Russia — have expressed displeasure with the status quo, and denounced the advantages America gains from the international currency system. China has even proposed the creation of a super-sovereign international reserve currency, outside of the control of any one nation to replace the dollar as the global reserve currency.
The country that has issued the world's main reserve currency has changed many times in the past five hundred years. Before the U.S., there was Britain, France, Spain, the Netherlands, and Portugal. And even in the last 100 years, the system has not been entirely stable. As Rickards notes, "[t]he international monetary system has collapsed three times in the past century — in 1914, 1939 and 1971."
So, what's next? Rickards' vision of the future is quite apocalyptic. Rickards believes that the Federal Reserve's current unconventional monetary policies, which involves trillions of dollars of bond purchases through its quantitative easing program, are propping up a parasitic financial sector that should have been partly nationalized and partly liquidated in the wake of the 2008 financial crisis.
Rickards says, "Bankers' parasitic behavior, the result of a cultural phase transition, is entirely characteristic of a society nearing collapse." He thinks this will ultimately doom the dollar: "The Federal Reserve does not understand that money creation can be an irreversible process. At a certain point, confidence in money can be lost, and there is no way to reconstitute it; an entirely new system must rise in its place."
I don't think that the current situation is nearly as bad as Rickards does. It's certainly true — as former Fed chairman Paul Volcker tells Rickards — that confidence in the U.S. dollar is the key to the dollar remaining the world's leading reserve currency. Rickards sees this confidence being perilously eroded due to the Federal Reserve's money printing. But confidence in the U.S. dollar is about more than just how many dollars there are in the system.
The Federal Reserve's money printing is a reaction to the powerful forces of deflation and mass unemployment which were set loose into the economy following the financial crisis in 2008. Quantitative easing is not about propping up the financial sector — that is at most a side effect. Quantitative easing is about encouraging investment in productive activities instead of sitting on cash or bonds. While some — including important American trade partners like China — have claimed to be troubled by quantitative easing, the policy is actually stabilizing the dollar and the U.S. economy by avoiding the trap of debt deflation (which is dangerous because it makes debts harder to repay, leading to defaults) and reducing the unemployment rate.
Yes, perhaps there are risks, including future asset bubbles and rewarding bad bankers for failure, but by failing to stabilize the dollar — and letting the economy freefall — the Fed would have taken a much bigger risk.
These risks are illustrated by the problems the eurozone finds itself in. The European system is very different than America's, with each country giving up their monetary sovereignty to a single central bank. Because countries do not control their own currency, this creates the danger of countries running out of money, and being forced to slash government budgets to avoid default. This — like the gold standard, which Rickards praises at length — is attractive to those worried about excessive government spending, because it enforces harsh fiscal discipline on governments. But this, in turn, creates other problems.
Imposing harsh austerity measures rather than engaging in quantitative easing, the European Central Bank has taken a very different approach than the Federal Reserve. Rickards is full of praise for the European model, arguing that "[the Euro] receives its staying power from a farsighted blend of low inflation, sound money, and positive real interest rates. The new Berlin Consensus has the potential to replicate the Wirtschaftswunder, Germany's "economic miracle" reconstruction after the Second World War." Yet the eurozone is mired in problems, including much weaker real growth and much higher unemployment than the United States. (The unemployment rate has even reached above 25 percent in countries like Spain and Greece.) And these problems are worsening with the entire eurozone falling closer to deflation. Europe's pursuit of a strong currency is coming at a cost of a weak economy.
And this gets to another big reason the dollar isn't going anywhere just yet: the U.S.' status as a superpower. At an economic level, the U.S. is definitely still one; its economy is more than double the size of its nearest competitor. And the U.S. remains the world's sole military superpower as well, providing the naval forces that police world shipping and maintaining military bases in over 130 countries. While the economic and military rise of other powers, especially China, may in the long run ultimately lead to the gradual decline of the dollar as the global reserve currency, that shift is unlikely to come while the United States remains a global military and economic superpower. Old habits die hard, and the world — including China — is still heavily invested in the dollar. China holds over one trillion dollars in U.S. Treasury debt, and at least two trillion dollars in cash, for example.
Rickards, of course, speculates that countries like China and other countries might be happy to take a loss on their dollars if it means ending the U.S. dollar's reign as the leading reserve currency, noting that "financial war is the future of war" and "future wars [will] be fought in an expanded battlespace that includes stocks, bonds, currencies, commodities, and derivatives." He sees a danger of Chinese or Russian-controlled hedge funds dumping dollars and U.S. bonds with the intent of causing a financial crisis for the U.S.
I am a lot less concerned by this possibility than Rickards. While we certainly shouldn't rule it out entirely, Russia and China — as holders of large quantities of dollar-denominated assets — wouldn't just be attacking their own balance sheets, they would (because financial markets are highly interconnective) be risking crashing their own financial markets, as well as risking retaliation by the U.S. The U.S. is pretty good at financial warfare itself, having thrown the Iranian economy into currency collapse and hyperinflation in 2012 by blocking Iran's access to international payments systems, giving it no way to pay for its imports.
So while I agree with Rickards that the dollar will eventually lose its status as the world's leading reserve currency — after all, no reign lasts forever — I don't agree that its collapse is nearing, and I certainly don't agree that the collapse will come as a result of the Federal Reserve's policies. If anything, by fighting unemployment and deflation, the Fed is giving the United States a greater opportunity to enjoy the benefits of having the dollar as the world's reserve currency, such as cheap imports, easy access to natural resources, and energy. The U.S. should prepare for the potential end of American hegemony by building up its national infrastructure, investing in science, and technology and education. Trying to enforce harsh fiscal discipline on itself by returning to the gold standard, as Rickards advocates, would do the opposite and end American hegemony much sooner.