THE DOLLAR: MEAN OF EXCHANGE, UNIT OF ACCOUNT AND VALUE RESERVE
This will be the heart of the new letter I am writing. I was waiting for this moment, assessing the dollar. I’ll start with the conclusion: I think the dollar is not going through a crisis, as people say, and that the Federal Reserve (FED) has not issued enough yet. It is true that there’s a trust crisis, which may cause the dollar to devaluate even more regarding today’s levels, however I don’t see any reason to run and be worried about it or believe it’s going to lose its international status.
In this section I will analyze the dollar’s role in the world and explain why I’m not that alarmed. I’ll start with a technical analysis and then I’ll throw myself into my dear fundamentals.
Today’s scenario from a technical analysis viewpoint
The U.S.Dollar Index broke the bottom it’s been having since May in 80 and started dropping, now it broke again August’s bottom and continues this downtrend. The currency devaluation took place. Today’s index is 76.48. If you pay attention, the chart has 5 dotted lines (I’m getting along with technology more and more!). The first one indicates the floor broken in July, around 80 points. The second line shows July and August, around 78 (bottom it broke a few days ago). The third line is where I think the values are going to be for a while, around 76.5 points of the index. And finally the fourth and fifth lines indicate the range in which the index was trading in the first half of 2008, between 72 and 74 points.
Where is it heading now? Will it stay trading around 76.5 points, will it appreciate for trading between 78 and 80 points or will it go to find values of the first half of 2008? Of course, I don’t know the answer.
What is a reserve currency?
“A reserve currency is a currency which is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. It also tends to be the international pricing currency for products traded on a global market, such as oil, gold, etc.” Wikipedia.
The dollar is the major reserve currency of the world. 64 percent of world central banks’ reserves are dollar-denominated assets (bonds, Treasury notes, etc.) or paper dollars. However, the dollar is not the only reserve currency in the world; the Euro, the Yen, the Pound and the Swiss franc enter this category as well.
What is a global monetary standard?
“Monetary standard often refers to the intrinsic value embadded in money in a monetary system. For something to be a monetary standard, it must first and foremost be a global currency –widely used as a “unit of account”, a medium of exchange and storage of value by all nations. Most importantly, the global monetary standard can be linkened to a crucial nominal anchor which not only regulates both the pace and scale of money creation, but also dictates general price levels.” Chen Zhao.
We’ll go through the last century. From the beginning of the 1900 the World worked pretty well under a global monetary standard called gold bullion standard. It told us that all bills (fiduciary money) were backed by a certain amount of physical gold. During that time all goods and services were translated into this relative price against the intrinsic value of gold. Gold was used as a means of exchange, as value reserve and besides it regulated the making of money (new gold discoveries caused inflation). During WWI the gold standard started to teeter and disintegrate because belligerent governments were printing money to finance themselves without being able to redeem it in metal. The world was going from war to war, and at the end of WWII, in 1944, this monetary standard was substituted by the gold exchange standard (in the famous Bretton Woods) –here’s the creation of the International Monetary Fund (NYSE:IMF)-. This new monetary system set the value of a foreign exchange in terms of a determined gold quantity and the issuer of the foreign exchange guaranteed to return to its possessor the amount of gold it represented (it had been established that all currencies were to be exchanged for dollars, which was of free conversion regarding gold, it had an exchange rate of $35 per ounce).
The consequence of this second system is that the dollar (a fiduciary currency) was put at the same level of gold and it started being a global monetary standard. At that time, the U.S. owned over 70 percent of the world’s gold reserves, for which it was credible that it could guarantee its currency conversion with the precious metal. There was an interesting detail in Bretton Woods’ system: the discretionary creation of money was allowed. The U.S. issued dollars without taking into account the amount of gold it represented –it didn’t concern them much, there was so much trust in the currency that believing that everyone were to ask for gold at the same time was unimaginable. In the long run, it did happen: president Johnson spent too much, the Vietnam war demanded another huge expense and then, Charles de Gaulle (French president at the end of the ‘60s) appeared saying something like this, “guys, I think the U.S. is issuing more dollars than the amount they represent in gold”. To sum up, in August 1971, Nixon was forced to end the gold exchange standard.
Why is the dollar the current monetary standard?
After the collapse of Bretton Woods’ agreement in 1971, the world was so used to the dollar that people kept using it. From the distance is easy to say that they were absolutely drunk (they were using a fiduciary currency as a monetary standard which didn’t have intrinsic value). However, this was a natural consequence for a world which is in constant learning: 27 years ago, the world used dollars as a monetary standard and main reserve currency and the world needed a reference currency to regulate the creation of its own money. At that time, the U.S. was the major economy in the world (and quite dominant): it controlled around 15 percent of global trade, represented over 30 percent of the world product and the market capitalization of its companies represented over 65 percent of the world’s market capitalization. By default and lack of currencies which could compete with the U.S., the world continued to use the dollar as a monetary standard (though it doesn’t have the backing of an intrinsic value as the gold any longer).
Nowadays, (the next data I took it from McKinnon “demand and supply economies”, BIS, IMF, OECD and MSCI):
· 90 percent of interbank transactions outside Europe are made in dollars.
· The dollar is the main reference currency for primary commodities.
· The dollar is the major intervention currency used by governments to influence the exchange rate of their own currencies.
· The dollar is the chief value reserve, standing for more than 60 percent of foreign exchange reserves of central banks.
· The U.S. represents over 30 percent of the world’s product (nominal GDP as percentage of world nominal GDP).
· Market capitalization of U.S. companies represents over 55 percent of world companies’ capitalization.
· U.S. debt market accounts for, at least, 39 percent of world’s government bonds market.
No intrinsic value monetary standard versus monetary standard with intrinsic value
A fiduciary currency does not base its value on an intrinsic value, but on the statement which is money accepted by the government that issues it and, mainly, on the trust it inspires. From the material viewpoint, it’s just a piece of paper. Officially, a fiduciary currency loses its value once the issuing government stops accepting it for the tax payments. The consequence of a standard over a fiduciary currency is that its supply will be determined by fluctuations in the economies. This type of standard may enter in the so called balance of payment crisis, where the currency changes its value in the blink of an eye and loses its ability to work as a means of change or value reserve.
A monetary standard such as the gold standard adds intrinsic value to currencies, by saying that a determined amount of the currency equals a determined amount of gold (silver or another commodity could also be used as intrinsic value). The consequence of this standard is that economy and inflation distortions take place when economy growth rates differ from the growth rate from gold supply.
Nowadays, we don’t want to return to a back up intrinsic value standard (gold for example) because the price level should have to be in accordance with the stock of existing gold and its evolution would depend on new discoveries, what would have governments tied down, limiting their chances to control the economy.
Should I sell dollars then?
We made a history overview and explained some definitions to make it clear that, first of all, a reserve currency and a monetary standard are not the same. Secondly, we had to be placed in time and space to be able to appreciate the world’s position regarding the dollar. And thirdly, we had to understand the U.S. course of action. To start: there is a chance that the dollar strongly depreciates in the next few years. It might happen. However, this would not necessarily have an impact on the role of currency as international value reserve. The dollar is the main reserve currency. However, it is not the only one: there is also the euro, the yen, the pound and the Swiss franc. The role of the dollar as value reserve is not at risk. Of course, if the whole planet chooses to reduce their possession of dollars simultaneously, the consequences on the dollar could be devastating (in terms of value loss). Personally, I don’t think this will happen. Moreover, I think it is a remote possibility (although I do give room to my mind to think that the world is not vegetarian, that we make wars, that we destroy our own planet and hurt each other; the mere idea that we annihilate our savings and the ones of our countries globally running against the dollar would not surprise me much).
I’ve just read a paper by Ewe-Ghee Lim (from the FMI) who wrote it in June of 2006, under the title of “The Euro’s Challenge to the Dollar: Different Views from Economists and Evidence from COFER (Currency Composition of Foreign Exchange Reserves) and Other Data.” There he analyzes the possible future of the euro as reserve currency and currency standard. He says that for a currency to gain international status it must: belong to a big economy, have a very well developed financial system, function in a territory with political stability, possess positive externalities (coming, for example, from the current technological development of communication and economies of scale), and mainly, to have a trustworthy market value (and thus it can fulfill its role of value reserve).
Looking at the future, the role of the dollar as global currency standard could be questioned. The world is possibly going towards a currency standard shared by many currencies (dollar and euro). Moreover, if the euro survives (it is fighting a big battle, mainly against its own organization) I consider that the new currency standard will be shared between both currencies. The euro is the most used value reserve after the dollar, representing nowadays the 27% of the of the world’s central banks reserves. And it is not only used in Europe: many countries of the Middle East and Africa are adopting the euro as main currency for international exchange. The whole European Union bloke is big enough to be able to present a currency that guarantees the points enumerated above (the characteristics of a currency of international status which works as currency standard). This is not an immediate transition; at this moment the dollar is very well installed as global currency standard and main value reserve. The transition to a new shared currency standard has begun many years ago and we have many more years ahead to accomplish it. Finally, if we look even further, it could be that the global currency standard is later shared by three currencies: the dollar, the euro and the renminbi (each one dominating America and Oceania, Europe and the Middle East, and Asia correspondingly). But I don’t believe this much – I find it rather awkward to talk about what’s going to happen in 10 years or more–, moreover, it could be also that the euro turns out to be the only global currency standard and the other currencies step back (basing myself on the economists that say that a shared currency standard could not work).
"It is absolutely conceivable that the euro will replace the dollar as reserve currency, or will be traded as an equally important reserve currency.” Alan Greenspan, September 2007.
Nowadays, the greatest concern is on United States’ debt volume: the deterioration of its public finances. Such is the magnitude of the debt that a crisis over the dollar’s reliability is germinating. The utility of any governing currency standard is to regulate the rhythm and volume of money creation. Therefore, providing that prices of goods and services in dollars don’t suffer great volatility (drop or rise too much) the wellbeing of the creditor countries will not be affected. Prices of global goods fall by 20% year after year, which gives room to the FED to print much more money than it has ever issued up to now. What is more, they haven’t issued enough; if they had done so the price of goods would have already recovered. Today everybody is talking about debt, it seems like they forget about the values’ fall in the last two years: a great part of the world went into recession and if we don’t reach the depression we will have been really close to it. Prices have dropped, and a lot, and the response has to equal the level of the fall. The monetary stimulus that the FED is giving is the attempt to revitalize prices. There is now an excess of goods and services in relation to the existing money offer. The present day currency standard is the dollar, and if the authorities from the United States want to keep this standard alive they must guarantee the stability of the general prices level.
 The U.S. Dollar Index is an index created in 1973 by The New York Board of Trade (NYBOT), to follow up the dollar’s value against a basket of the other major currencies of the world. It started being measured against a 17 -currency-basket of 17 nations, after the Euro’s creation there were 12. Nowadays, the basket is integrated by: 57.6 percent Euro, 13.6 percent Japanese Yen, 11.9 percent Pound sterling, 9.1 percent Canadian dollar, 4.2 percent Swedish Krona, 3.6 percent Swiss franc.