Since the global financial crisis of 2007-2008, the global economists’ annual retreat to Jackson Hole, Wyoming, has attracted significant attention due to the tendency for central bankers to use the forum to deliver market-moving monetary policy announcements.
The class of 2019 largely broke with this tradition. Except, that is, for Bank of England governor Mark Carney’s proposal to subvert the global monetary system by replacing the US dollar’s position as the world’s reserve currency with “a global digital currency”.
Why dump the dollar?
Carney is right to highlight the issues inherent with the current system; the greenback plays a destabilising role in the world economy and increases the risks of a liquidity trap of ultra-low interest rates and weak growth.
While the US accounts for only 10 per cent of global trade and 15 per cent of global gross domestic product (GDP), half of all trade invoices and two-thirds of global security issuances are from the US.
The greenback’s role as the default global reserve currency links economies and markets’ fates to the same drivers of its value. The US economy, White House foreign policy (particularly mercantilist pursuits such as the trade war with the China) and the US Federal Reserve’s monetary policy are therefore exported throughout the world. The growing trend for governments to politicise their nations’ currencies has severe and widespread effects for global markets and economies.
Mark Carney’s suggestion represents the greatest challenge to the established financial order since the 1971 disentanglement of the Bretton Woods system.
As emerging markets conduct a significant number of their transactions in US dollars, they are forced to hold significant US dollars in reserve relative to their national currency, greatly exposing them to US dollar fluctuations as well as their own.
Emerging market economies at the mercy of US monetary policy have become known as the “fragile five” because they’re the most exposed to changes in US interest rates. Brazil, India, Indonesia, Turkey and South Africa represent 26 per cent of the world’s population and 15 per cent of global GDP.
Meanwhile, the growth in the power of the euro has not been reflected in the dollar-dominated system. The eurozone accounts for 20 per cent of global currency reserves, exceeding its share of global economic output. About 36 per cent of global payments are made in euro terms, against the US dollar’s 40 per cent. Yet 80 per cent of the €300 billion ($486 billion) of oil and gas imports into the eurozone are transacted using the US dollar, despite only 2 per cent of imports coming from the US.
Greenback’s chequered history
The greenback’s supremacy is more than 100 years old. The dominance of the US dollar waxed as sterling’s influence waned alongside that of the British Empire. The breakdown in international trade and finance in the lead-up to and following the Great Depression and Second World War led to a strong global desire for a tightly controlled system that would promote currency and political stability. In 1944, global central bankers agreed to fix their currencies to gold, which was directly linked to the US dollar by virtue of America’s control of two-thirds of global gold reserves.
The overvaluation of the dollar and the decline in the US’s three-decade-long claim to global hegemony led to the end of the system. By 1971 the US struggled to manage its budget, held less than one-quarter of global gold reserves and Bretton Woods was unwound until it officially ended in 1976. By the early 1980s all industrialised nations’ currencies were freely floating fiat currencies although the supremacy of the US dollar did not end.
Between 1980 and 1985 the greenback appreciated significantly against the currencies of the world’s next largest economies. In a bid to avoid protectionist policies demanded by US exporters, the Reagan administration engaged in the planned devaluation of the US dollar with Japan, France and West Germany by intervening directly in currency markets under the Plaza Accord.
The current politicisation of the US dollar by President Donald Trump and the highly interventionist US Federal Reserve echoes the historical issues with the country’s monetary policy in a vastly different global economy. The US has been challenged for global leadership by China and other emerging nations have caught up significantly since the post-war era.
Likelihood of revolution
Central bankers are highly skilled wordsmiths as well as economists. To perform their roles successfully, they must guide markets without rocking the boat. Carney’s comments appear revolutionary compared with previous luminaries Janet Yellen and Mario Draghi.
The macro-economic impacts of a digital currency or a pool of global currencies usurping the US dollar would be significant. And yet despite some reporting of Carney’s statements, they were not reflected in global currency trades, with the US dollar rallying against most big currencies in the weeks after the announcement.
Perhaps markets did not think he was serious, but he was nothing if not clear: “The main advantage of a multipolar IMFS [Institute for Monetary and Financial Stability] is diversification. Multiple reserve currencies would increase the supply of safe assets, alleviating the downward pressures on the global equilibrium interest rate that an asymmetric system can exert. And with many countries issuing global safe assets in competition with each other, the safety premium they receive should fall.
“A more diversified IMFS would also reduce spillovers from the core and by so doing lower the synchronisation of trade and financial cycles. That would in turn reduce the fragilities in the system, and increase the sustainability of capital flows, pushing up the equilibrium interest rate.”
Carney was a willing but unlikely contender for leadership of the International Monetary Fund, which will be decided by October 4, 2019, and is currently a one-horse race led by World Bank head Kristalina Georgieva. However, if Carney’s idea gains traction investors can expect significant turbulence in all financial markets. Execution, if any, would be crucial – Reagan’s planned devaluation of the US dollar in the 1980s was highly successful compared with the disastrous Nixon shock of 1971.
The death of the US dollar has been entertained many times; however, momentum is rising as the US’s global dominance is falling. Amid negative interest rates and dollar devaluation, global powers large and small are united in their desire to take the US’s currency weapon. The ramifications of change are wide and varied but one thing is for sure – it will not be a smooth transition and growth, inflation, and volatility are all likely to be highly variable. The potential for political conflicts would also greatly increase.
Matthew Haupt is lead portfolio manager for WAM Leaders.