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BFI Capital
November 29, 2018

When the US Dollar Loses Its Reserve Currency Status

From a reader:

"If the U.S. were to lose its reserve status, which I think is in the process of happening... what would be some of the repercussions? How would this affect the average Joe? What happened to Britain when the pound lost its status? And do you agree it would then result in a very steep drop in the U.S. dollar?"

This is an excellent question. We must be guided by both theory and history, since it has happened before, but as we'll see, never under the conditions we have today. It's also good that the question comes now, when so many are questioning investing in gold or silver.

Answering this question gives me a renewed appreciation for believing that, regardless of the short-term price actions, you want to own precious metals. Central banks are quietly buying gold even as the price has been weak. The dean of central bankers, Paul Volcker, has just written in his central bank language about the need for gold, even if he doesn't come right out and say it in normal language. At the same time, central banks are quietly and often vastly increasing their gold holdings, taking advantage of recent price weakness.

First of all, you start your question by asking "If the USD were to lose its reserve status". To me, it is a question of "When" and not "If". The US dollar cannot be the world reserve currency forever. No one rang a bell when it became the reserve currency, and I wouldn't bet too much that a bell will ring when it loses it.

But no nation has kept that status forever. There are certain things we know. Once attained, with the power that comes with it, no nation has ever been able to resist abusing that power to the point where it has been inevitably lost.

The longest 'reign' that any such currency has ever had would be the Byzantine Empire's 'Bezant'. It lasted about 1,000 years, from about 450 to 1453. And since the rulers of that Byzantine Empire thought of themselves as Greek, and thus inheritors of the Greek tradition of sound money, you can make the case that with the interregnum of the Roman mess – the Romans could never keep a stable currency for long – with this interruption they'd view it from about 500 B.C. to about 1450. or nearly 15 centuries.

The US, sadly, resembles Rome in monetary matters far more than it resembles Greece.

What happens to people and nations when the reserve currency status is lost?

We know much from seeing what happened to Britain when it lost the title to the American dollar. But we also know that there have been and will be important differences.

The first most important thing that goes with having your currency being the world's reserve currency is that you can borrow all you want in your own currency, and then create more of that currency to pay it back. The second-best thing about it is that the most important things in the world are priced in terms of that currency.

Think of oil, but that's only the thing that stands out the most. When Saudi Arabia was formed in September of 1932, the British pound was the reserve currency, but on its last legs. Thanks to Winston Churchill, who believed that the greatest currency on the globe had to be tied to gold, he put the pound back on the gold standard in 1926. It had gone off of gold in 1914 when it went to war.

But also "thanks" to Winston Churchill, he put the UK back on the gold standard at the same exchange rate that had existed in 1914. It was as if the horror of World War 1 had never existed. That war, which the British were encouraged to think that they had won, was not truly a victory. And this 'misconception of oneself' had bad consequences. In the same way, the US today is not looking clearly at itself. If it did, it would see a bloated nation killing itself through abuse of painkillers. On top of that, the country is full of people who truly think that they are smarter than everyone who doesn't agree with them.

Normally, you get over that after you grow up. But in many ways, the US inability to face hard truths fits a nation of children. And just as opiates only really cover up the deeper problems, America's deeper problems are being papered over.

And here is where a reserve currency has made it easier to go along the road to bankruptcy while driving the nicest car, a car that it has borrowed money to own:

A reserve currency makes it possible to borrow money in your own currency. First you borrow money and have the debt denominated in your own currency and have foreigners lend it to you until they decide otherwise. And that's when the problems really begin to be seen by all.

America itself will not change, or make the changes needed. Americans are far too busy being angry at each other. It's easy to pretend that they can continue to borrow in their own currency just as they have been doing for decades. Changes will happen – be put in place – by non-Americans.

Every time you hear of Russia and China and Iran trying to come up with a new payments system that does not include the US dollar, this is another canary chirping. These nations are feeling their way through to an alternate system. What will draw out the changes is that there is no single nation ready to take on the crown of reserve currency. The USD is still the most important currency on earth, but this is only because no other currency exists in the minds of the rest of the globe.

The lack of a gold backing

In Paul Volcker's new book, he repeatedly proclaims that this current system is not sustainable. Although he does not say it, he strongly implies that the problems stem from having the US dollar backed by no "numéraire". That's the word he chooses repeatedly. What it means is that one thing that all the other currencies are defined by.

He watched as the US slowly at first and then all at once, stopped being defined in terms of gold, with all other currencies defined in terms of the USD. Now, there is the USD defined in terms of nothing.

There must be a "numeraire", and if you look this term up in Wikipedia you find this: "Since the value of one unit of the numeraire relative to one unit of itself is 1, the price of the numeraire is always 1."

In other words, what the world's currencies need is to be defined, directly as under a gold standard or indirectly as in the Bretton Woods system where only the USD was defined in terms of gold. If you read between the lines of Volcker's book, the only thing that the world has come up with that is an unchanging value is a specific weight of gold.

Any other way, such as the world has had since 1971, only results in massive borrowing, since there is nothing to stop it short of currency collapse.

The International Monetary Fund tried to come up with a numéraire called Special Drawing Rights. These worked about as well as their inelegant name suggested, since they were really based on nothing solid.

But if you kept borrowing money from others that you yourself can create more of to repay, you will continue to do so unless stopped by those others, or enough of them to make a difference.

The rest of the world is slowly working itself overtime to see if there is any alternative to the USD. There is the regional currency, the Euro. But no one sees this as anything other than a purely regional solution. Moreover, it is only as strong as its weakest link.

You can’t borrow from yourself forever

You see where I am going with this. It is only a matter of time before the US ability to borrow its own currency ends. If it cannot borrow its own currency that it can create to pay back, then there really is only one alternative that is accepted by all nations. There is only one true 'numéraire'.

When its back is up against the wall, Venezuela has turned to the one thing it owns that is worth anything. That's the gold that has been held in the vaults of the Bank of England. But the BOE will not return it. Why? Because it believes that the government leaders will line their own pockets with it rather than use it to truly help the country.

On one hand, people are outraged that Venezuela cannot get its own property. But deep down, everyone believes that if released, the gold would go into the pockets of a favored few.

I'm getting ahead of myself here. There is a reason why central banks all over are buying gold more than they ever have before. Hungary increased its holdings by 1000% recently, and Russia now owns more gold than it ever had under the Soviet times. They are all preparing for a time when the USD loses its reserve currency status.

What will happen to the “average Joe”?

What will happen to Joe? The answer is, what has been happening to him since 1971. Joe’s standard of living will continue to decline. The decline was covered up at first with the entry of women into the workforce. But this can only go so far.

Now everyone who wants to work is able to work. What is left? Elderly people putting off their retirement or simply working longer without retirement until they drop dead as the US life expectancy declines each year.

Younger people still living at home because they can't afford otherwise. Increasingly poorer people try to keep up appearances by borrowing. What's next? Putting younger people to work instead of colleges which are more and more seen as a waste of money?

In the UK, as the pound lost its reserve position, it declined by stages from nearly $6 per pound in 1926 – a rate far too high – to, at last for a short time in March of 1985, almost $1 ($1.05, and it would have been lower and at par with the USD, had Mrs. Thatcher not begged Reagan and Volcker to support it above $1; another tidbit from the new Volcker book, as he was Fed chairman at that time).

The pound has since then acted just like another currency. Because Republican presidents can get away with a cheaper USD in a way they'd scream if Democrats tried to get away with, it was no surprise that you see the pound rise from $1.40 in 2001 to $2.10 in 2008, the exact years of the Bush administration.

British Pound vs. US dollar – 1996 to 2018


Then, as it became apparent in late 2008 that the Democrats would win the White House, the pound plunged, because markets realize that Democrats cannot get away with cheaper USD, so it wasn't so much the pound falling as the USD rising. But that stopped in early 2017, just as Trump became president. Under Obama, the pound fell from $2.10 to $1.20. and the USD rose. Since Trump became president, the pound rose from $1.20 to $1.40, and has now corrected about half that rise to $1.30.

Trump wants a cheaper dollar, but so does every other country.

But going back to your question, Britons born around 1900 lived to see in the winter of 1974-75 a Britain that cut electricity use back to three and four days per week. As children they were taught that much of the world was red on the map: that color connoted the Empire. But when they made it to their 70s, the Empire was gone, and currency exchange controls made it hard for them to travel outside of the UK. The popular saying circa 1975 was "We once ruled the waves but now we just waive the rules".

And I have to stress that starting in the 1920s, the decline of the pound's reserve status was cushioned by the rise of the US and its dollar. The Fed realized that Churchill's return to the gold standard was based on a 1914 exchange rate that valued the pound much too high. So starting in 1926, but really getting underway in 1927, the Fed inflated the USD so that the difference in the two exchange rates would not be so glaring. In "America's Great Depression", Murray Rothbard calls this one of the causes of that Depression. By the time, in early 1929, that the Fed stopped inflating so much and drained reserves from the system, a crash in the stock market became inevitable, but then wrong-headed moves made that stock crash into a Depression.

World War II was very hard on the UK and by 1947 Britain was effectively bankrupt.

Throughout the years after 1914 Britain tried to live as it had before the war. It couldn't do that, and reality struck in the years after Churchill put the UK back on a gold standard that artificially valued the pound too high.

I don't think the US has to worry about going back on a gold standard that values the USD too high. Like I said before, the US is more like Rome than Greece: it has no problem seeing its currency fall. Certainly, Trump wishes the USD was much lower than it is now, and I would not bet against him.

But this time, there is no America waiting in the wings to make the transition from reserve currency to just one out of many easier. In the short term this has been good for the US, but it is so only on the surface. One of these days the US will wake up to the fact that they can no longer borrow money so cheaply. We are living in a dream world now: the US is not only able to borrow money in its own currency, which it then creates more of, but it is able to do so at interest rates so low that they are probably negative, if you take the real inflation rate into account and subtract it from the low official rates.

This can't last forever. And it comes as no surprise that even as stocks were at their record highs until recently, the average person continues to lose ground. I've been talking around it, but you can see why I think two things will happen over the next few years: that interest rates will rise and so will gold (and silver) prices. The actions of central banks around the world lately has been to quietly acquire more gold than they have had in generations.

I do believe that the central banks are doing all they can to dampen the price of gold, while at the same time they move to acquire more of it. It just makes sense. That's why the current weakness doesn't bother me. They are doing what I would advise them to do: play down the fact that they are owning more and more, and play up the low prices so that the average investor doesn't focus on gold.

I think the central bank action is all a prelude to them wanting to face what is coming with as much of the only 'numeraire' that exists. If you read Volcker's book in that light, it becomes clear. He still writes like a central banker, but if you know how they speak, the message is clear. He doesn't want to panic people into buying gold, so he uses lingo like "numeraire" instead. Not one person in ten thousand understands what he is saying, but those few are the ones with the wealth, or those who are on their way to getting it.

Losing the reserve status in slow motion

While the US dollar has been losing its reserve status in slow motion, it seems to be going crazy, as people are having trouble adjusting to lower living standards and a world that seems to go crazy, where the news of one nut killing many innocent people is sadly not news anymore.

Watching a slice of life in the UK while it lost its reserve currency status and even imprisoned people who tried to smuggle it out and get rid of it, and how crazy people had become, it is hard not to draw parallels between the UK of then and the US of today.

As to the combination of things that now face the US dollar and the US, it will take a series of dire actions such as currency collapses, starting with non-USD currency blocs and foreigners 'just saying no' to US debt to have any real reform. And when the US is no longer able to borrow in its own money, that will be a turning point.

Living standards, which will have been falling anyway, will plunge. It will be worse than what happened to the UK, mainly because there will be no one to ease America's downhill path, which is what happened during the last few transitions: Florence/Genoa/Venice to Amsterdam to the UK to the US.

Will there be a steep drop in the price of the US dollar?

To your last question, as soon as it is clear to the market that the USD is losing its reserve status you would have to expect it to plunge. In fact, I think the currency market is, together with the bond market, the most sophisticated in the world. Smart currency traders have always been at the forefront of wider political and market changes. The wrinkle is two-fold: first, the deterioration in the US dollar could take many years.

I've been hearing how the USD will lose its reserve currency status since the early 1970s. I could name many people who, if asked back then how things would be in 2018, they would be absolutely certain that the USD would have already lost that status. There is an old saying "there is a lot of rot in a country". It means that things can go bad for a long time before they truly change.

Second, and maybe more important, is that there is no substitute waiting in the wings to take the dollar's place. In past changes, you could see some other place up and coming. But I see no such place on the horizon. Instead of another government currency taking the place of the dollar, I see gold making its way back to the central stage of the monetary system. With the fall of the dollar, I can only hope that the experiment with currencies tied to nothing will end, never to be repeated again.

Chris Weber is a money manager and he has been sharing his insights with clients and readers since 1974. He regularly writes and publishes ,The Weber Global Opportunities Report, a subscription-only newsletter. With a focus on precious metals investing, the Weber Global Opportunities Report covers a variety of topics that should be of interest to Global Gold subscribers and clients as well.

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