It has become a common theme discussed by market observers that the US economy is apparently doing well while emerging markets (EM) are faring poorly. This article attempts to explain how this has come about. It requires some basic background knowledge to understand how the USA can have a strong currency when the federal debt is 105% of GDP and over $25.5 trillion, the annual federal deficit is over $1 trillion and the annual trade deficit is over $500 billion. Hyperinflation would be the consequence of such figures if there were not factors that make it possible for the USA to avoid having to suffer for such incontinence.
Historically the Bretton Woods Agreement of July 1944, made the US dollar the dominant global currency. The gold-based dollar became the base of international transactions, and thus it assumed a preeminent position internationally. The system came under pressure as fixed parity rates became difficult to sustain and the US gold reserves diminished as gold was drawn out. This led President Nixon in 1971 (the Nixon shock) to leave the gold standard and stop dollar redemption at $35 per ounce. Exchange rates would be floating and currencies guaranteed only by governments` power to tax their citizens.
The petrodollar system was put into effect in 1972/1973. This was basically an agreement between Saudi Arabia and the USA for the KSA to market its oil in US dollars in return for American military protection. It was worked out thanks to Henry Kissinger, the most important advisor of President Nixon.
He was National Security Advisor from 1969 to 1973 and Secretary of State from 1973 to 1977. No official documentation for this agreement is available. Other oil-producing counties followed this practice of using US dollars for their oil business with the result that the US dollar became the standard currency for practically all international oil transactions. This created great demand for US dollars.
The consequence of these developments was that Forex markets were clearly dominated by transactions in US dollars. Almost 85% of all trades involve US dollars with the euro in second place with 39% and the Japanese yen at 19% with the daily Forex market having a turnover of $ five trillion. This is only possible because there is a plentiful supply of dollars available.
Central banks hold mainly US dollars as a part of their reserves. The picture chart below gives an idea of how much different countries have as US dollar reserves. It is obvious that the Fed must have made available a large amount of dollars in order to satisfy the requests of central banks for US dollars.
The chart below shows the growth of the M2 Money Stock.
Just so that it is clear to readers what M2 is, the following explanation from Investopedia is given.
“M2 is a calculation of the money supply that includes all elements of M1 as well as "near money." M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits. These assets are less liquid than M1 and not as suitable as exchange mediums, but they can be quickly converted into cash or checking deposits.”
Another way to see the growth of the money supply is the US debt clock. Compared with the year 2000, there has been a great increase in money creation. M1 was $600 billion (rounded figure) in 2000 and is presently $3.564 trillion and growing. M2 was $4.868 trillion in 2000 and is now $14.221 trillion and growing.
It is clear that the global economy needs liquidity, and this liquidity is supplied by Fed employees assiduously clicking on their computers to produce more funds. One could simplify the whole operation by saying that the US exports dollars and receives goods in exchange. This is one way of explaining how the US dollar maintains its value despite the enormous trade balance deficit. This is an advantage of having the US dollar function as the most important international currency. There is a lot of demand for greenbacks.
The growth in the money supply after 1973/1974 due to the petrodollar system (see above) shows that more US dollars came into circulation. US dollars could thus serve as the main international currency because there was a sufficient supply of dollars available (liquidity). The GFC of 2008 was countered by QE1, QE2 and QE3, which saw the Fed (Federal Reserve Bank) increase the amount of money in circulation. There was need for liquidity so that the global economy could function. QE1 and QE2 and QE3 provided sufficient and necessary liquidity.
This was done by the acquisition of toxic paper from banks as well as the emission into the economy of large amounts of dollars by the purchase of bonds. The result was a great increase in the balance of the Fed (Federal Reserve Bank) to about $ 4.5 trillion. The QT (Quantitative Tightening) currently on the Fed's programme aims to decrease the amount of the balance, but that means taking dollar liquidity out of the system. This programme will probably be discontinued when the Fed realizes that the liquidity of the global economy is threatened.
The effects of Fed QT and a strong dollar have been adumbrated by various commentators. One result of the weaponization of the US dollar by the administration is that several countries are taking steps to avoid being put under pressure by the US dollar system. For investors, the present situation clearly suggests that staying with the US dollar should not present any undue risk. The problem is rather what is going to happen in the middle and long term. That is another subject that will be examined in a subsequent article.
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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.