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Much hand-wringing is taking place over the reduction or possible loss of the dollar’s reserve currency status. That’s a bit ironic since the whole concept of a reserve currency is no longer valid in a system of floating exchange rates.

Under the dollar-exchange system established at Bretton Woods, New Hampshire after World War II, countries committed to keep their own currencies in a narrow band around a par value expressed in U.S. dollars. No reserves were needed to offset upward pressure on the domestic currency since the monetary authority could sell their own currencies for dollars in theoretically unlimited amounts. But to offset downward pressure on the domestic currency, a reserve currency was needed to purchase and support the domestic currency. A country’s ability to defend its currency from downward pressure was thus limited by the amount of the currency held in reserve. Since the parity was expressed in dollars, it was convenient to use dollars as the reserve currency.

The U.S. commitment was to peg the dollar to gold at a rate of $35 per troy ounce by standing ready to buy or sell gold at that rate with foreign central banks or Treasuries. (That official rate was later changed to $42.22 when we devalued the dollar.) Other currencies were pegged to the dollar by exchange-market intervention while the dollar was pegged to gold the same way. Therefore, all currencies were indirectly tied to gold.

Under the “rules of the game,” a country’s policymakers were supposed to follow policies similar to what would happen automatically under a pure gold standard. If their currencies came under upward pressure, they should permit domestic economic expansion and/or inflation to correct the imbalance. Downward pressure on the domestic currency should prompt a policy tightening to correct the underlying imbalance while dollar reserves were used in the meantime to defend the peg.

Theoretically, the Bretton Woods arrangement was supposed to simulate a real gold standard where inflows or outflows of gold were allowed to raise or contract the domestic money supply. That was easier to do when domestic expansion was called for. Expansion is fun. It was less easy when contraction was called for. It was common for countries to “sterilize” the gold outflows and counteract their impact on the domestic economy.

In the early postwar period, and the early years of the Bretton Woods system, the world was starved for dollars and most countries gladly accumulated dollars in their reserves. This was a sweet deal for the United States because it meant we could buy real goods and services on world markets and pay with money unlikely to be redeemed in gold.

Over the years, however, the world accumulated as many dollar reserves as it needed and increasingly wanted to exchange some of them for gold, which they had the right to do. The United States, however, was not eager to lose gold; so it pressured its trading partners to continue holding dollars without demanding gold. “You don’t really want gold, do you?”

The dollars had been supplied to the world through deficits in the U.S. balance of payments and comparable surpluses by our trading partners. From our viewpoint, having the dollar used as the reserve currency was like playing poker with IOUs that the other players were willing to accept during the game and did not present for “redemption” after the game was over. (“There’s time enough for counting with the dealing’s done.” Kenny Rogers)

Eventually, the accumulated U.S. deficits had supplied more dollars than our trading partners wanted to hold. At the same time, U.S. policymakers did not want to follow the rules of the gold standard game and tighten policy to improve the balance of payments. So, President Nixon broke the last link between the dollar and gold in 1971 and we went on a system of floating exchange rates.

Under floating exchange rates, the exchange rate itself is supposed to trigger the internal economic adjustments necessary to restore and maintain equilibrium rather than changes in domestic policy. The rule of floating exchange rates is to let the market determine the exchange rate without policy interference. Let the float be clean. Policies to influence the exchange rate would dirty the float and would be considered inappropriate.

With no pegged exchange rate to defend, and with sporadic intervention considered inappropriate, there is no need for a reserve currency. Reserve currencies are a feature of fixed exchange rates, not floating rates.

Part of the angst over the potential loss of the reserve currency status of the dollar is really over the use of the dollar as a transactions currency in much of the world and in certain markets, particularly the oil market. There is now a long-standing tradition of pricing oil in dollars even if the United States is not a party to the trade. That means that a decline in the exchange value of the dollar makes oil effectively cheaper—good for buyers, bad for sellers. Of course, what has been happening is that oil sellers raise the nominal price of oil to offset the decline in the value cause by dollar depreciation. This peculiar relationship does not apply to most other commodities.

Pricing goods in dollars is a separate issue from the use of the dollar as a reserve currency.

Our reserve-currency equivalent is gold, which to my knowledge is setting in Ft Knox, on the books at $42.22 per ounce, the last official pegged price before the link was cut. And you thought all the gold was in a bank in the middle of Beverly Hills in somebody else’s name!

Source: The Dollar as a Reserve Currency