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A recent Wall Street Journal article describes the dollar as the "King" among currencies, given its reserve-currency status. It got me to thinking: Is it the King, or the King of All Moral Hazards?

Kevin Dowd, in a Cato piece entitled "Moral Hazard and the Financial Crisis," defines moral hazard this way:

"A moral hazard is where one party is responsible for the interests of another, but has an incentive to put his or her own interests first...."

New York Times Journalist Shaila Dewan defines it as "the undue risks that people are apt to take if they don't have to bear the consequences."

To illustrate the concept of moral hazard, let us think back to the days when U.S. politicians decided to bail out failing investment banks with taxpayer funds. Under more normal circumstances, and for the markets to work properly, Congress should have required these banks to fail and to bear the consequences of their actions.

Decision-makers must have reasoned that the immediate damages resulting from bank failures would outweigh the long-term damages resulting from bailing them out, in spite of the fact that a bail-out would only reward the banks' foolhardy risk-taking and encourage them to do more of it. This is a perfect illustration of moral hazard, because the decision put the risk on the backs of taxpayers, not the decision-makers themselves.

(For the sake of our argument, we shall assume that all of Congress wasn't outright bought by Goldman Sachs, et al.)

How do I get from there to the dollar? In 1944, during the Bretton Woods negotiations, the U.S. government gladly allowed its money to become the reserve currency of the world. In spite of the breakdown thirty years later of a crucial detail of the agreement (the dollar's tie to a certain weight of gold), the U.S. dollar continues to have hegemony over the other currencies of the world.

Issuing the reserve currency brings with it certain advantages: a fluid treasury-bond market allowing great flexibility in U.S. fiscal budgeting; an influx of investment funds looking for return in the form of private loans to U.S. consumers; the availability of capital for players in the financial markets and speculation (e.g., the carry trade; foreign-sourced, dollar-priced commodities; financial instruments such as swaps and derivatives).

These advantages come about because international investors in dollar reserves believe in the strength of the U.S. economy and are willing to hold onto dollars, and/or to buy American treasuries, corporate bonds, and mortgage and other securities, on the faith that America will always be healthy and financially sound. In effect, they have given us an enormous credit card.

However, reserve-currency status carries with it one major responsibility: The U.S. must maintain absolute (and not just relative) dollar store-of-value stability in the medium to long term. Why? Because the faith of international investors in the strength of America is only as strong as the will of our Congress to maintain the absolute buying power of the dollar, and only as firm as the capacity of our Federal Reserve to maintain monetary equilibrium through its control of our money supply.

Here is where moral hazard comes into play: On the debt side of the equation, dollar hegemony has allowed U.S. lawmakers to build up record national debt and tremendous quantities of federal agency debt (e.g., FHA, Fannie, Freddie) through bad short-term fiscal and regulatory choices. It has also given our Fed the option of arbitrarily increasing our dollar-based money supply in an effort to control interest rates, encourage lending, support prices, and finance the mortgage market, all in the U.S.

On the credit side of the equation, huge quantities of U.S. dollars and dollar-denominated instruments stand in the coffers of countries around the world, all based on faith in our legislators' and Fed governors' good judgment.

First, our representatives must choose to honor their responsibilities and solve the current budget crisis to maintain the world's perception (and hopefully the reality) of the dollar as a long-term store-of-value. But this is only a small step. What about the national debt? This must also be addressed if U.S. "full faith and credit" is to be maintained.

If Congress succumbs to the moral hazard of doing what's most expedient in the short term, i.e. avoiding immediate pain by allowing the debt to climb to even more dangerous heights over the coming years, the rest of the world will have good cause to begin worrying about the value of the dollars they hold.

Over at the central bank, the Fed has wracked up a tremendous imbalance on its balance sheet in an effort to carry out its mandate. However, if it cannot maneuver an orderly wind-down of assets, its failure will only erode the dollar further. Our central bankers have adopted the worst investment-banking risk-taking behavior, while Bernanke personally has engaged in moral hazard when he affirmed that he had "one hundred percent" confidence in the Fed's ability to control interest rates. If it can't, who will pay?

A crisis resulting from all-round bad American bookkeeping menaces not just U.S. citizens, but worldwide economic equilibrium. The situation has become so precarious that foreign holders of U.S. dollar reserves find themselves in the "Catch 22" of not being able to get rid of dollars without precipitating the very crisis they fear, very much like the final act of a Ponzi scheme. (See Page 11 of this IMF paper.) In other words, if they dump dollars onto the currency markets (or U.S. bonds or securities onto their respective markets), they may precipitate a panic wherein, at worst, they will find no buyers, or at best will be stuck with huge losses.

Until our budget and debt questions and Fed imbalances are resolved, savers should hold onto the only alternative store-of-value that cannot be depreciated: gold and gold-related investments. Even the central banks of the world are returning "quietly"--almost surreptitiously--to the security of gold reserves instead of U.S. dollars. Why? Because they realize that moral hazards tend to end badly.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: U.S. Dollar: The Biggest Moral Hazard Of Them All