As America’s public debt spirals ever further out of control – and with the expanding BRICS+ group working on a common trading currency and a rival settlement system – the question of de-dollarizing the global financial system is becoming a hot topic.
We need to look at this issue, not in terms of reserve currencies, but of flows of trade and investment. The dollar isn’t going to be ‘overthrown’ or ‘replaced’ so much as circumvented.
The patterns that emerge from this circumvention are going to have profound – and adverse – implications, not just for the US, but for the broader Western world as well.
Introduction
Though de-dollarization is going to happen, it’s not likely to involve a switchover to a basket of currencies or IMF SDRs, still less the adoption of another currency, such as the euro or the renminbi, to take over from USD. The dollar now accounts for 59% of global currency reserves, and this, whilst down from 66% in 2015, and 72% in 2001, continues to dwarf nearest rival the EUR (20%), let alone the RMB (less than 3%).
But reserve currency status isn’t the point at issue. What really matters is the currency denomination of flows of trade and investment around the world. Trade flows are likely to exit the dollar system in a piecemeal manner, starting with oil and moving on to other important commodities, and investment can be expected to follow trends in international trade.
Hitherto, the conduct of these flows in USD has conferred an enormous exorbitant privilege on the United States, and critics allege that the US abuses this privilege, not just when it indulges in enormous public borrowing to prop up its otherwise-faltering economy, but also when it “weaponizes” the dollar through the use of USD-based settlement systems to enforce sanctions on countries such as Russia and Iran.
Geopolitics aside, the critical issue is the flip-side of “exorbitant privilege”. This is the cost imposed, through the market dollar under-valuation of their output, on other countries in general, and EM economies in particular.
As we shall see, it can be calculated that the rest of the world gets only $0.54 for each dollar-equivalent of economic value that their countries produce. Put the other way around, we can calculate that the market dollar is over-valued by about 85% in relation to underlying value in the world outside the United States.
What we should expect to see is a rolling shift towards bilateral and multilateral trade and investment in currencies other than the dollar. Beginning with oil, this can be expected to move on to natural gas, chemicals, minerals and agricultural commodities. A point is likely to be reached at which most of the ‘hard’ trade (and associated investment) in energy, raw materials and commodities shifts over to non-USD transactions outside the ‘dollar fence’. ‘Softer’ trades may follow, but at some remove from commodities.
The dynamic here is straightforward. In a global economy now inflecting from growth into contraction, national economies can get by without dollar-denominated Hollywood blockbusters and the latest gizmos from Silicon Valley, but they must have energy, chemicals, minerals and food.
Ironically, most of the raw materials needed for transition to renewable energy are likely to end up on ‘the other side’ of the de-dollarized ‘fence’, a trend which fits within some broader implications that we’ll consider later in this discussion.
The basis of the dollar system
Back in 1945, it made perfect sense to base new global trade and investment arrangements on the dollar. America accounted for 50% of global GDP, and was the world’s biggest creditor nation. There was no rival – not even the USSR – to America’s geopolitical and economic supremacy.
The Bretton Woods system, established in 1944, was the foundation-stone of the post-war economic and financial architecture. Other currencies moved around a dollar which itself was tied to gold. The major transnational institutions – which now include the BIS and the FSB as well as the IMF and the World Bank – are dollar-denominated agencies, meaning that their activities and reporting are undertaken in dollars.
But a great deal has changed since 1945. Depending on how we measure it, the US share of global GDP has fallen to either 25% or, more realistically, 15%, and America is now the world’s biggest debtor nation.
The Bretton Woods system was broken in 1971, when Richard Nixon suspended the gold convertibility of the dollar.
This meant that the dollar gained primacy in a wholly fiat system which, in theory, sets no limits on how much currency any individual jurisdiction can issue. In practice, America has direct access to a global credit system to which all other countries’ access is mediated by the markets.
America may or may not be gaming this system to political advantage through sanctions, but the US certainly abuses its primacy when it undertakes reckless public borrowing. The latest trillion-dollar increment to US government debt was added in the final fourteen weeks of 2023.
No other country – not even China – can get away with anything remotely like this. A case in point was the attempt of the British government, in September 2022, to borrow £220bn (about $330bn) to finance £60bn of household energy support plus £161bn of tax cuts to be spread over five years.
The markets stopped this plan, by selling GBP down to crisis levels, and driving the yields on gilts (British government bonds) sharply upwards. Some might argue that that particular fiscal gambit deserved to be stopped, but the point is that dollar-denominated markets pass verdicts on government policies.
America isn’t exempt from market pressure, but its public borrowing is direct-from-source, and the Fed has far more rate-determining influence than any other central bank.
Matters of cost
The way the dollar-denominated system works can be illustrated by reference to oil. Any country wishing to import oil must first earn or buy the dollars needed to settle this trade, and the oil exporting recipients must, for want of alternatives, put their receipts into a world financial system denominated in dollars. The US not only has privileged access to the global credit system but could even, in extremis, simply create (“print”) the dollars needed for imports, whether of oil or of anything else.
Is there a cost, to this dollar-denominated system, for countries in the WOUSA (the World outside the United States)? It’s arguable, not just that there is such a cost, but that this cost is exorbitant.
In considering the cost of dollar privilege, we need to draw a clear distinction between finance and economics. Whilst financial transactions between currencies necessarily take place at market rates, there’s an alternative (and more meaningful) convention when it comes to making international comparisons and calculating global economic aggregates.
This is PPP conversion into international dollars.
PPP means “purchasing power parity”. If, for instance, the same product or service sells for £10 in Britain and $15 in America, the PPP GBP exchange rate for that particular item is $1.50. The greater meaningfulness of PPP conversion is reflected in its use for the calculation and forecasting of global GDP. If it’s confirmed (by the IMF) that the world economy grew by 2.5% last year, that will be a PPP-based measurement.
In Western countries, PPP rates are seldom very far from market ones, but very different circumstances apply in much of the EM world. In 2022, Russian GDP (of 153tn roubles) translated to $4.8tn in PPP dollars, but only $2.2tn at market rates. Similarly, Chinese dollar GDP in 2022 was $29.9tn (bigger than the American economy) in PPP terms, but only $17.9tn in market dollars.
If, for purposes of comparison with the US, we converted the defence budgets of China and Russia into market dollars, we’d be understating how much those countries are really spending on pay and procurement undertaken in local currencies, because we’d be using a misleading basis of currency comparison.
For our purposes, the point about drawing a clear distinction between finance and economics when using these different FX conventions is that what the FX markets think about a currency isn’t economic ‘fact’.
PPP gives us a much more meaningful measure of the comparative size of economies, and therefore provides important information about different countries’ roles in the global economy.
This is illustrated in Fig.1.
Taking provisional data for 2023 in market dollars, global GDP was $103tn, or $77tn in the WOUSA economy. But WOUSA GDP in international (PPP) dollars was far higher than this, at $143tn PPP.
What’s important here is the international purchasing power of countries other than the US. They produce local-equivalent GDP of $143tn, but would get only $77tn for it in the theoretical event of selling it all on forex markets.
In other words, every PPP dollar-equivalent of WOUSA GDP is priced at only $0.54 in market dollars.
These countries aren’t, of course, going to “sell” their GDP on dollar-denominated markets, but conversion into dollars at market rates exerts a major influence on their economic standing, particularly when it comes to borrowing and investment. This also has a bearing on bilateral and multilateral trade and investment flows between countries.
The application of PPP enables us to calculate the rate of exchange between the market dollar and its international counterpart. The market dollar has been weakening on this basis (Fig. 1D), but the exorbitant privilege of the USD remains substantial.
Fig. 1
Starting with oil
There’s no reason, in principle, why countries shouldn’t agree to settle bilateral or multilateral trades in currencies other than the dollar. China, for instance, can buy oil from Saudi Arabia, and pay for it in renminbi, riyals or a combination of the two. Such trades could even be settled in gold.
The BRICS+ group is well on its way to doing exactly this. The accession, effective 1st January, of Iran, Saudi and the UAE to a group which already includes Russia means that BRICS+ accounts for getting on for half of all global oil production and an even larger proportion of the international trade in petroleum.
Regular readers will need no reminder about the geopolitical importance of energy in general, and petroleum in particular. Those who want us to ‘just stop’ the use of oil have yet to tell us how we’d manage without tractors, combine harvesters, food delivery trucks or ambulances. It would be tricky to mine, process and transport steel, copper or lithium – or any other commodity needed for transition to renewable energy – if we had to rely entirely on shovels, mules and human labour.
There’s a strong environmental case to be made for reducing discretionary (non-essential) consumption of oil by, for example, driving less and flying less. But such choices are likely to be imposed upon us anyway, as the costs of energy-intensive necessities rise within a contracting economy.
In the world as it was and still is, oil remains a vital commodity.
America won the Pacific war because the US had oil, and Imperial Japan, despite seizing the Dutch East Indies, did not. Germany might have emerged victorious from the European war had she seized the oil fields of the Near and Middle East. This made Malta the “hinge of fate”, because forces based on the island seriously disrupted supplies to the Afrika Korps.
In more recent times, the imposition of the OAPEC oil export embargo in response to the 1973 Yom Kippur war caused crude prices to almost quadruple in a matter of months. This plunged much of the world into the chaos of severe inflation, sharp rate rises, fuel rationing, power blackouts and industrial unrest, the latter caused by workers demanding pay rises sufficient to keep up with the soaring cost of living.
It was (and remains) unfortunate that some politicians were able to persuade voters that the hardships of the seventies were caused, not – as was in fact the case – by two successive oil crises, but by ‘leftist’ (Keynesian) government policies and the malign influence of organised labour.
The events of 1973-74 may have faded into memory and political-economic folklore, but it’s worth remembering that much of the world is only ever two seaway closures away from a re-run.
Winners and losers in a divided world
More prosaically, there’s no reason why BRICS+ countries shouldn’t extend their non-dollar trade from oil into natural gas, chemicals, minerals and agricultural commodities, or why other countries, within or outside an expanding BRICS+ group, shouldn’t do the same.
Where trade and investment are concerned, the BRICS+ member nations don’t need to wait unless and until they have a fully-formed settlement system, or a common currency usable in the superstores of Shanghai or the coffee-shops of Riyadh.
They can get on with non-dollar trade right now, and have enormous incentives for doing exactly that.
Dollar hegemony, then, isn’t likely to be ended by a replacement currency or currencies, but by the successive splitting-off of important trade flows from the dollar-denominated system.
The danger in this, from an American and Western perspective, is the division of the global economy into two parts, where “we” (the West) have all the Hollywood blockbusters and Silicon Valley gizmos (and most of the debt), whilst “they” have all the oil, natural gas, chemicals, minerals and foodstuffs.
That would put “us” on the wrong side of new patterns in global trade.
This is a particularly disturbing prospect for a Europe which doesn’t have America’s resource wealth, and can no longer import energy from Russia.
But America should be, and perhaps is, concerned that its privileged access to debt capital, and to comparatively cheap dollar-priced commodity supplies, is becoming time-limited.
WHY THE RENMINBI COULD BE ‘THE LAST FIAT STANDING’
“It’s easy to be the last man standing – if all the others commit suicide”.
Although this isn’t one of the sayings of Confucius, it applies now with particular force to the Chinese renminbi – after all, to what currency, other than the RMB, can the world turn when each of its major rivals seems determined on self-immolation?
In Britain and America, economic and financial policy have long had all the hallmarks of self-destructive intent. Both countries believe that it makes sense to ship value-productive industries (such as manufacturing) out to lower-cost countries overseas, whilst trying to turn themselves into low-wage economies whose main profitable activity involves moving money around. The UK has driven debt upwards relentlessly, for the sole and senseless purpose of buttressing property prices which have already been over-inflated far beyond the point of affordability. America has binged on credit in an equally self-destructive effort to replace shock-absorbing corporate equity with inflexible debt, the result being a stock market which has become nothing more than a proxy for Fed monetary largesse.
Both countries seem now to have been driven to the point of policy despair. The American government is bent on injecting yet another $1.9 trillion of borrowed-out-of-nowhere money into the economy, whilst the Bank of England seems to be giving serious consideration to committing a symbolic currency surrender through the introduction of negative nominal interest rates. Both are deluding themselves about the real condition of their economies, with Britain, at least, seemingly persuaded that all will be well if consumers can only be induced to go on a spending-spree with money that they don’t have.
Britain and America have been described as “two countries divided by a common language”, but the operative definition now is that they are united in a shared commitment to economic fanaticism. It’s one thing to believe, mistakenly, that the economy is a wholly monetary system unconstrained by natural resources, but quite another to believe, as well, that the road to prosperity lies through the perpetual spending of borrowed and newly-created money.
Donald Trump may have coined the phrase “Make America Great Again”, but nobody can beat the British authorities when it comes to fatuous slogans. First there was the abolition of “boom and bust” during the biggest asset bubble in history. Next came “help to buy”, whose real meaning was ‘help young people to get deeply into debt to prop up the housing market’. Original thinking may be at a premium in Britain’s corridors of power, but the slogans keep coming.
In current circumstances, there’s something almost prurient in using the energy-based SEEDS economic model to evaluate the British and American economies, so let’s keep this brief. In the United States, prosperity per person turned down twenty years ago, falling from $48,850 (at 2019 values) in 2000 to $45,460 in 2019. Over that period, each person’s share of government, corporate and household debt rose, again at constant values, from $96,000 to $163,000. The ratio of debt to prosperity in America had risen to 360% at the end of 2019 – and probably at least 425% now – from 196% back in 2000. Government expenditures, on a per capita basis, rose by nearly $6,000 (37%) over a period in which prosperity per person declined by $3,240 (-6.6%).
Estimates for 2020 suggest that the prosperity of the average American declined by 8% last year, with only the most modest recovery in prospect before the gradual – but relentless – downtrend resumes. Using fiscal and monetary policy to boost financial demand whilst the supply of prosperity erodes is a recipe for inflation.
Financial recklessness is something in which Britain is fully competitive with the United States. Prosperity per person turned down later in the UK than in America, but has deteriorated more rapidly, falling by 10% between 2004 (£26,280) and 2019 (£23,560). Over the same period, debt per capita rose by £23,000 (38%) in real terms, and public expenditures per person by 14%. Worse still, British exposure to the global financial system, as of the end of 2019, stood at 10.8x GDP, equivalent to 15.2x prosperity. Aside from Ireland and Holland (both of which are far smaller economies), anyone in search of more extreme exposure to the world financial system would have to look at financial asset ratios in tiny economies like Singapore and the Cayman Islands.
This is the situation in which Washington is committing itself to yet more borrowed stimulus, whilst London thinks it makes great sense to proceed with a vastly expensive new rail project, together with anything else that can absorb huge amounts of money that can be conjured out of the ether, quite possibly at the cost of even more saver-punitive rates of interest.
Neither the US nor the UK seems to realise that boosting demand (through stimulus) at a time when you can do little or nothing to replace lost supply is an implicitly inflationary form of behaviour. Both Britain and America have multi-trillion gaps in future pension provision, which we can estimate at about £8tn in the UK, and $37tn in the US. Both have student debt on which large-scale default (politely known as ‘forgiveness’) seems highly likely. Neither government seems to realise that granting rent and debt payment ‘holidays’ creates huge strains for lenders and landlords. Both are watching their commercial property sectors spiralling into an abyss. In an ominous portent of the shape of things to come, the British regulator has now approved an increase of 9% in the ceiling on the combined cost of domestic gas and electricity.
If, just for a moment, we put tact aside, we can remind ourselves that Britain (with its obsession with “light-touch” regulation) and America (with the creation of “weapons of financial mass destruction”) were the main architects of the “global” financial crisis. Both now favour a “reset”, seemingly unaware that the opportunity to reset the system came – and went – during 2008-09. That was when adherence to market principles would have preserved monetary credibility at the cost of sharp falls in the (purely notional) prices of assets such as stocks and property.
To be sure, this would have been accompanied by defaults, which would have been very costly to remedy. Even so, recapitalisation of the banking system might have been cheaper than what has happened since, and what still lies in the future – after all, the debts which were kept in the ‘performing’ category in 2008-09 are no more capable of repayment now than they were back then.
It would have been far better, of course, if neither Britain nor America had embarked on the preceding, decade-long debt binge without which the GFC wouldn’t have happened at all.
The situation now is one in which both countries have handed themselves over to the theory of the magic money tree, seemingly unaware that money itself commands value only as a ‘claim’ on the goods and services for which it can be exchanged. The recipe of ‘produce less, spend more, and delude ourselves by inflating asset prices’ has never been a formula for success. An objective observer, perhaps visiting from a distant planet, would see no logic whatsoever in owning American dollars or British pounds. Both countries seem to have persuaded themselves that soaring stock and property prices aren’t signs of systemic inflation, and don’t understand that pouring new credit and new money into faltering economies can have only one possible outcome.
If our interplanetary visitor was looking for a viable alternative to USD and GBP, he or she might be tempted by EUR or JPY. Neither, though, really holds up under objective scrutiny. The euro is a political dream-currency, built on the economically-illiterate idea that one can combine a single, “one size fits all” monetary policy with nineteen different sovereign budget processes. This means that the role normally played within currency areas by ‘automatic stabilisers’ has to be filled by contentious, ad-hoc aid and a dysfunctional clearing system. Even before the onset of the pandemic crisis, the BoJ had used newly-created money to buy up more than half of all JGBs (Japanese government bonds) in existence, to the effect that central bank assets already exceeded 100% of GDP by the end of 2017.
During 2020, it seems that QE equated to about 29% of prior-year GDP in Japan, 25% in the Euro Area, 15% in the United States and 14% in Britain, for an average of 20%, which compares with barely 3% in China. We can be certain that there’s a lot more money creation to come from the Fed, the BoE, the ECB and the BoJ – but not from the PBOC.
With the US and the UK seemingly bent on “print to oblivion”, the EUR resembling the financial equivalent of a camel (“a horse designed by a committee”) and Japan deeply committed to ‘monetisation to the nth degree’, our imaginary visitor from outer space might seem to be running out of options. Having rejected cryptos – and after casting a considering eye at precious metals – his or her choices seem to have narrowed to just one.
That “last fiat standing” is the renminbi.
It seems quite clear that China, alone amongst the major currency areas, is committed to sound money. Beijing appears determined to mute the siren calls of Anglo-American style financial “innovation”, and even to allow SOEs to default at scale, if that’s the price that sound money now carries.
Surplus Energy Economics 