Lead – Up to the G-20 Meeting in Seoul: What Happens If U.S. Dollar Loses Reserve Status? ·
How big a deal is the loss of the dollar’s reserve status?
by Eric deCarbonnel
In the last week we have learned that:
1) The Fed is planning 15-fold increase in us monetary base
2) A U.N. panel says the world should ditch the dollar
3) Zimbabwe has ditched the US dollar in favor of the Rand
4) China and Russia are rethinking the dollar’s status as the world’s reserve currency
With the US monetary base expanding at a breathtaking pace and nations around the world worrying about the value of their US holdings, the dollar looks virtually guaranteed to lose its status as the international reserve currency. This begs the question: how big a deal is the loss of the dollar’s reserve status?
To answer this question, lets first calculate just how large are the dollar holdings of foreign governments. From the CIA’s world Factbook, below is a ranking of countries by reserves of foreign exchange.
(amounts in billions)
Rank Country Foreign Exchange Reserves
1 China $1,534
2 Japan $954
3 Russia $476
4 India $275
5 Taiwan $275
6 Korea, South $262
7 Brazil $180
8 Singapore $163
9 Hong Kong $153
10 Germany $136
11 France $116
12 Algeria $111
13 Malaysia $101
14 Italy $94
15 Thailand $87
17 Libya $80
18 United Arab Emirates $77
19 Turkey $77
20 Switzerland $75
21 United States $71
Total = $6,898
According to Wikipedia, at the end of 2007, 63.90% of the identified official foreign exchange reserves were held in United States dollars. Therefore, total dollar reserves at the beginning of 2008 were about $4,408 billion (63.90% of $6,898 billion). However that is not the end of the story, as we still need to account for stabilization funds or Sovereign Wealth Funds. Wikipedia explains:
Foreign exchange reserves are important indicators of ability to repay foreign debt and for currency defense, and are used to determine credit ratings of nations, however, other government funds that are counted as liquid assets that can be applied to liabilities in times of crisis include stabilization funds, otherwise known as sovereign wealth funds. If those were included, Norway and Persian Gulf States would rank higher on these lists, and UAE’s $1.3 trillion Abu Dhabi Investment Authority would be second after China. Singapore also has significant government funds including Temasek Holdings and GIC. India is also planning to create its own investment firm from its foreign exchange reserves.
For more, the Market Oracle explains sovereign wealth funds.
Sovereign Wealth Funds
June 30th, 2007
Central banks have traditionally kept their reserves in relatively low-yielding, highly liquid government securities, agency debt, money-market instruments and bank deposits. The most current official IMF figure for official worldwide foreign currency reserves is US$5.89 trillion [Worldwide foreign currency reserves increased by about 1 trillion over 2007]. At US$1.35 trillion, China holds the world’s largest pool of official reserves, followed by Japan with US$911 billion and Russia with US$403 billion.
In addition to these reserves, market estimates for the total value of Sovereign Wealth Funds (SWF) run as high as US$2.5 trillion. This compares to US1.6 trillion for hedge funds. These are state-owned and operated funds, comprising of financial assets such as stocks, bonds, or property not included in the IMF figures. The use of these funds enables large reserve holders to invest in higher yielding instruments.
With around 40 percent of stabilization funds invested in the US, the dollar holdings of sovereign wealth funds are around $1,000 billion (40% of $2,500 billion). After combining the numbers from foreign exchange reserves and stabilization funds, the dollar holdings of foreign governments are about $5,385 billion. Meanwhile, as you might have noticed from the CIA’s ranking above, the United States holdings of foreign currencies is around $71 billion.
Implications of the loss of the dollar’s reserve status
As the dollar loses its reserves status, at least half of the world’s $5,385 billion dollar reserves will be sold off and replaced with other currencies (yuan, euro, khaleeji, gold, rand, etc…). The US, with its $71 foreign reserves, will not be able to do anything to counteract this mass exodus from the dollar. With outflows of this magnitude, the dollar’s value will collapse to a fraction of where it is now.
The process of foreign nations extracting themselves from the dollar is not going to be pretty. The likely impacts are:
1) The dollar’s value will plunge as investors see the writing on the wall and jump ship.
2) US credit markets will collapse. As the dollar fall, a mass exodus from credit market will begin. Investors sitting on toxic securities will sell at fire-sale prices to escape the currency depreciation.
3) The fed’s balance sheet will explode beyond all reason. In response to the mass exodus from credit markets, the fed will buy trillions worth debt in a desperate attempt to hold interest rates down. Unfortunately, the more debt the fed buys, the more quickly the dollar will fall, and the more panicked the credit selloff will become.
4) US interest rates will soar, despite (or because of) the fed’s efforts.
5) Countries around the world will be hurt badly by the dollar’s decline. These countries include:
A) Nations which are heavily dependent on US exports: Japan, Mexico, etc…
B) Nations with large dollar reserves: Japan, China, Gulf oil states, etc…
C) Nations which receive large amounts of US foreign aid: Israel, Egypt, etc…
D) Nations which rely on remittances from citizens working in the US: Mexico, India, etc…
E) Nations which use dollars as their official currency: Liberia, Panama, etc…
F) Nations which have large amounts of dollars in circulation: Central and South America (especially Argentina), Eastern Europe, etc…
6) Some nations will see benefits from the dollar’s decline. These countries include:
A) Nations with large gold reserves: EU zone, Switzerland, etc…
B) Nations which owe dollar denominated debt will see that debt wiped out: Iceland, African nations, etc…
C) Nations with stable currencies: EU zone, Switzerland, China, etc…
7) World politics will be greatly altered. There will be considerable anger at the US from nations hurt by the dollar’s fall. The US will lose influence in Asia (mainly China).
US retailers will get crushed. As the dollar falls, the cost of imports for retailers will increase, but the American consumer will be unable to afford these higher prices. Competition between desperate retailers will force them the sell inventory at below cost, creating massive losses. Retailers most heavily dependent on imports (ie: Wal-Mart) will be the first to go under. Eventually as more and more retailers go bankrupt, the few survivors will be able to raise prices enough to cover costs, and the sector will stabilize at a fraction of its current size.
9) American lifestyles will change radically. The end of cheap oil, low interest rates, and deficit spending will mean a lower quality of life and higher taxes.
10) The price of gold and other precious metals will explode.
11) The US will experience hyperinflation.
The main problem with the US dollar started between 1980 and 1988 Under Ronald Reagan:
Main articles: Presidency of Ronald Reagan, Domestic policy of the Reagan administration, and Foreign policy of the Reagan administration
Reagan’s approach to the presidency was somewhat of a departure from his predecessors; he delegated a great deal of work to his subordinates, letting them handle most of the government’s day-to-day affairs. As an executive, Reagan framed broad themes and made a strong personal connection to voters. Unlike fellow Republican Richard Nixon, Reagan was not nearly as concerned with the day-to-day details of executive governance, which he delegated among subordinates.
On March 30, 1981, Reagan was shot in Washington DC by a disturbed young man named John Hinckley. The president was rushed to a hospital and recovered after a few weeks, with Vice President Bush managing the administration in his absence. Hinckley was ultimately ruled to be insane and was placed in a mental institution rather than prison.
Reaganomics and the 1981 federal budget
See also: Reaganomics
Ronald Reagan promised an economic revival that would affect all sectors of the population. He proposed to achieve this goal by cutting taxes and reducing the size and scope of federal programs. Critics of his plan charged that the tax cuts would reduce revenues, leading to large federal deficits, which would lead in turn to higher interest rates, stifling any economic benefits. Reagan and his supporters, drawing on the theories of supply-side economics, claimed that the tax cuts would increase revenues through economic growth, allowing the federal government to balance its budget for the first time since 1969.
Reagan’s 1981 economic legislation, however, was a mixture of rival programs to satisfy of all his conservative constituencies (monetarists, cold warriors, middle-class swing voters, and the affluent). Monetarists were placated by tight controls of the money supply; cold warriors, especially neoconservatives like Kirkpatrick, won large increases in the defense budget; wealthy taxpayers won sweeping three-year tax rate reductions on both individual (marginal rates would eventually come down to 50% from 70%) and corporate taxes; and the middle class saw that its pensions and entitlements would not be targeted. Reagan declared spending cuts for the Social Security budget, which accounted for almost half of government spending, off limits due to fears over an electoral backlash, but the administration was hard pressed to explain how his program of sweeping tax cuts and large defense spending would not increase the deficit.
Budget Director David Stockman raced to put Reagan’s program through Congress within the administration’s deadline of forty days. Stockman had no doubt that spending cuts were needed, and slashed expenditures across the board (with the exception of defense expenditures) by some $40 billion; and when figures did not add up, he resorted to the “magic asterisk”–which signified “future savings to be identified.” He would later say that the program was rushed through too quickly and not given enough thought. Appeals from constituencies threatened by the loss of social services were ineffectual; the budget cuts passed through the Congress with relative ease.
 The recession of 1982
By early 1982, Reagan’s economic program was beset with difficulties as the recession that had begun in 1979 continued. In the short term, the effect of Reaganomics was a soaring budget deficit. Government borrowing, along with the tightening of the money supply, resulted in sky high interest rates (briefly hovering around 20 percent) and a serious recession with 10-percent unemployment in 1982. Some regions of the “Rust Belt” (the industrial Midwest and Northeast) descended into virtual depression conditions as steel mills and other industries closed. Many family farms in the Midwest and elsewhere were ruined by high interest rates and sold off to large agribusinesses. Only inflation was immediately curbed by Reagan’s fiscal programs.
Although Reagan would later win reelection in a historic landslide in his 1984 presidential election, his approval ratings plummeted in the worst months of the recession of 1982. Democrats swept the mid-term elections, making up for their losses in the previous election cycle. At the time, critics often accused Reagan of being out of touch, content with telling stories about his movie days, appearance, sound bites, and slogans. For example, by 1982, former Budget Director David Stockman, an ardent fiscal conservative, wrote, “I knew the Reagan Revolution was impossible–it was a metaphor with no anchor in political and economic reality.”
Yet, the recession stretched well back into the 1970s, and had its roots in President Johnson’s deficit spending and the oil embargoes, well before the Reagan economic program. Moreover, the performance of the U.S. economy under Reagan compared favorably to Margaret Thatcher‘s Britain, which had been consistent in its application of a monetarist regime (a tight monetary policy and a tight fiscal policy, which resulted in deflation in the midst of depression).
Unlike Thatcher, Reagan combined the tight-money regime of the Federal Reserve with an expansionary fiscal policy. Following the recession of 1982, high government spending was one of the factors that contributed to strong growth (4.2 percent per year in the period 1982-1988). With the simultaneous reduction in tax rates, it also drove up the deficit significantly.
Another factor in the recovery from the worst periods of 1982-83 was the radical drop in oil prices due to increased production levels of the mid 1980s, which ended inflationary pressures on fuel prices. The virtual collapse of the OPEC cartel enabled the administration to alter its tight money policies, to the consternation of conservative monetarist economists, who began pressing for a reduction of interest rates and an expansion of the money supply, in effect subordinating concern about inflation (which now seemed under control) to concern about unemployment and declining investment.
By the middle of 1983, unemployment fell from 11 percent in 1982 to 8.2 percent. GDP growth was 3.3 percent, the highest since the mid-1970s. Inflation was below 5 percent.
Deficit spending, the dollar, and trade
Following the economic recovery that began in 1983, the medium-term fiscal effect of Reaganomics was a soaring budget deficit as spending continually exceeded revenue due to tax cuts and increased defense spending. Military budgets rose while tax revenues, despite having increased as compared to the stagnant late 1970s and early 1980s, failed to make up for the spiraling cost.
In his first term, Reagan continued to demand increases to the defense budget of up to 10 percent a year. Congressional committees, meanwhile, investigated charges that the $1 trillion of U.S. military spending in Reagan’s first term bought surprisingly little, pointing to alleged Pentagon mismanagement. In the 1980s, for example, nearly 50 of the largest U.S. defense contractors came under investigation for overcharges and other criminal malfeasance.
The 1981 tax cuts, the largest in U.S. history, also eroded the revenue base of the federal government in the short-term. The massive increase in military spending (about $1.6 trillion over five years) far exceeded cuts in social spending, despite wrenching impact of such cuts spending geared toward some of the poorest segments of society. Even so, by the end of 1985, funding for domestic programs had been cut nearly as far as Congress could tolerate.
In this context, the deficit rose from $60 billion in 1980 to a peak of $220 billion in 1986 (well over 5 % of GDP). Over this period, national debt more than doubled from $749 billion to $1,746 billion.
While deficit spending has value as an economic stimulus, and assisted the recovery in the post-1982 Reagan years, the dimension of the budget shortfalls of the 1980s left interest rates high and the dollar over-valued, causing investment and exports to suffer and, consequentially, increasing the U.S. trade deficit.
Since U.S. saving rates were very low (roughly one-third of Japan‘s,) the deficit was mostly covered by borrowing from abroad, turning the United States within a few years from the world’s greatest creditor nation to the world’s greatest debtor. Not only was this damaging to America’s status, it was also a profound shift in the postwar international financial system, which had relied on the export of U.S. capital. In addition, the media and entertainment industry during the 1980s glamorized the stock market and financial sector (eg. the 1987 movie Wall Street), causing many young people to pursue careers as brokers, investors, or bankers instead of manufacturing and making it unlikely that any of the lost industrial base would be restored any time soon.
The deficits were keeping interest rates, although lower than the 20% peak levels earlier in the administration due to a respite in the administration’s tight money policies, high and threatening to push them higher. The government was thus forced to borrow so much money to pay its bills that it was driving up the price of borrowing. Although supply-siders promised increased investment as a result of top-rate and corporate tax cuts, growth and investment suffered for now in the context of high interest rates. In October 1987, a sudden and alarming stock market crash took place, but the Federal Reserve responded by increasing the money supply and averted what could have been another Great Depression.
Perhaps more alarmingly, Reagan-era deficits were keeping the U.S. dollar overvalued. With such a high demand for dollars (due in large measure to government borrowing), the dollar achieved an alarming strength against other major currencies. As the dollar soared in value, so American exports became increasingly uncompetitive, with Japan as the leading beneficiary. The high value of the dollar made it difficult for foreigners to buy American goods and encouraged Americans to buy imports, coming at a high price to the industrial export sector. Steel and other heavy industries declined due to excessive demands by labor unions and outdated technology that made them unable to compete with Japanese steel imports. The consumer electronics industry was one of the worst victims of dumping and other unfair Japanese trade practices. By the end of the decade, it had virtually ceased to exist.
The U.S. balance of trade grew increasingly unfavorable; the trade deficit grew from $20 billion to well over $100 billion. Thus, American industries such as automobiles and steel, faced renewed competition abroad and within the domestic market as well. The auto industry was given breathing space after the Reagan administration imposed voluntary import restraints on Japanese manufacturers (allowing them to sell a maximum of 1.3 million vehicles in the US per year) and imposed a 25% tariff on all imported trucks (a lighter 3% tariff was put on passenger cars). The Japanese responded by opening assembly plants in the US to get around this, and in doing so were able to say that they were providing Americans with jobs. The VIR was repealed in 1985 after auto sales were booming again, but the tariffs remain in effect to this day.
The enormous deficits were in large measure holdovers from Lyndon Johnson‘s commitment to both “guns and butter” (the Vietnam War and the Great Society) and the growing competition from other G7 nations after their postwar reconstruction, but it was the Reagan administration that chose to let the deficits develop.
While Reagan was in office, charges of an executive “power vacuum” and a low presidential attention span were probably not entirely partisan in nature. Some fiscal conservatives and Democrats criticized Reagan for the extent of deficit spending, often focusing on the lack of oversight of defense expenditures. In January 1985, prominent conservative columnist William Safire, alluding to George H.W. Bush‘s charges that Reagan was advocating “voodoo economics” in the 1980 race for the GOP nomination, stated in The New York Times Magazine that “Reaganomics is giving voodoo a bad name” and that the “United States has lost control of its financial markets to foreigners.”
Reagan appointed three Supreme Court justices during his administration. The first was Sandra Day O’Connor in 1981; a centrist and the first woman on the SC and the second was Antonin Scalia in 1986, a conservative. His third appointment in 1987 was marred by controversy, as the initial choice, Douglas Ginsberg, withdrew his nomination after admitting to marijuana use in college. The next choice, Robert Bork, was pulled after attacks by Senator Ted Kennedy and liberal activists who charged that he wanted to outlaw abortion and throw out civil rights laws. Reagan finally settled on the moderate Anthony Kennedy. Both Kennedy and Scalia remain on the Supreme Court as of 2010; O’Connor retired in 2006.
The National Debt, 1940 – 2009
The debt reached a peak during WWII (More on this later), but the government managed to pay a lot of it off. The amount of debt has increased every year since 1960, and starting in the mid 70’s, grew at an astonishing rate.
Per-Capita Debt, 1950 – Present
Population growth was pretty steady. We had 152,271,417 people in 1950, and we have 294,676,169 today. The per-capita debt, then, not surprisingly looks pretty much like the other chart. Whenever the debt levels out, there should be a sleight downward pull as the population increase and the debt level stays the same.
Annual New Debt, 1941 – Present
This was a pretty simple calculation (this year – last year) . It shows how much new debt is created each year. This isn’t the same as deficit (income – expenses), but the two numbers are closely related. This number gets added to the debt each year.
Annual New Debt, 1980 – Present
Now this paints an interesting picture. Just look at the peak spending under Bush Sr. 431,989,899,919.78, and the least spending under Clinton, 17,907,308,271.43. That’s 4%, or a 1 to 24 ratio.
The national Debt, which cannot be seen by my copied-in charts, has risen from $1 to $3 Trillion from 1980 to 1988, and form $3 Trillino to nealry $12 Trillion by July 2 2010. Gold would be $4000 an ounce by now if the IUMF were not selling every precious ounce they have to keep the US dollar form being an also-ran in the derby of value, or, if you will, winning “going away” in the race to see which currency will be buried first by those crafty Chinese investors. Instead of buying gold, which would end the dollar’s run, they are buying GOLD MINES. Smart eh?