Reserve currencies: the Pax Americana in finance

The global reserve currency is what the world calculates and trades in during normal times, and where it seeks refuge in times of crisis. The present reserve currency, the US dollar, has its peculiarities, such as the fact that it is not backed by any precious metal. Yet it is largely those peculiarities that make a change in the current global currency regime unlikely anytime soon.

Video: Christian Gattiker, Head of Research and Investment Solutions, talks about the importance of reserve currencies

Americans have good reason to be proud of their currency: the US dollar is the only currency in the world that is universally accepted. Walk into any bar on this planet, however dodgy or remote, and you will likely find the bartender willing to accept your US dollar cash (unless it is fake, of course). This is part of what it means for the US dollar to be a global reserve currency. People the world over are aware of its value; they calculate in dollars, they trade in dollars, and unlike many other exchange rates, they are aware of how their local currency trades against it. The US dollar is also a shadow currency in many places. In some crisis-tricken emerging economies, in particular, it is a lifeline for consumers whose assets are expropriated by their regimes.

The safe haven
There is more to being a reserve currency, however, than being the currency of choice worldwide for calculating and trading. In times of crisis, creditors use the reserve currency as a ‘safe haven’ to avoid the pitfalls of expropriation and outright loss of capital in their home markets. In normal times, this is the task of the local lender of last resort, i.e. domestic central banks. In times of crisis, however, trust in domestic central banks is most often gone and investors turn to the lender of last resort in the world reserve currency, i.e. the US Federal Reserve System (Fed). This partly explains why the financial community is so obsessed with what the Fed does. Since it is the lender of last resort to the world, the last thing one wants to see is the Fed in trouble. That is what happened in 2008. Since then, however, the Fed has made a remarkable comeback.

A brief history of reserve currencies
More seasoned readers will know that the US dollar has not always been the centre of the global financial system. There have been many other reserve currencies in the past, some of them lasting for much longer than the US dollar has so far. Most past generations lived with one dominant reserve currency  in their known world. The Athenian drachma was the US dollar of antiquity, later revived in the modern period. Perhaps better known is the Roman silver denarius, featured in the Asterix comics as sesterces, with four sesterces making one denarius. The denarius sunk itself, for reasons we will explore later, and was replaced by the Byzantine solidus and the Syrian dinar until the late 10th century.

With trade picking up in Europe in the Middle Ages, the 13th century saw the rise of the Genoese genovino and the Florentine fiorino. These were, in turn, replaced in the 15th century by the Venetian ducat, reflecting the city’s rising merchant power in the Mediterranean. The ducat’s predominance was later challenged by the Spanish sil-ver coins (e.g. the Castilian marivedi) that flooded Europe from Spain’s overseas colonies. There is in fact an ongoing debate as to whether these coins amounted to a currency, as they were solid silver and not open to political instrumentalisation (e.g. currency debasement).

Whatever the assessment, the long wars across Europe bled the Spanish Empire dry and set the stage for a century of Dutch dominance and the ascendency of the guilder as the measure of value in European trade. The 18th century, for its part, saw the rise of the United Kingdom as global superpower and with it of the pound sterling as reserve currency. In the 20th century, finally, the pound gave way to the US dollar.

Wrapping up 2,000 years of currency history, we conclude that most generations lived with a dominant reserve currency and only few generations saw a change in reserve currency. A very crude calculation suggests that there have been fewer than ten reserve currencies in the last 2,000 years, with an average duration for each currency of more than 200 years. Roughly, then, only one in 12 generations saw their monetary anchor change globally.

Case study 1: Ave Caesar – Denarii Morituri Te Salutant (‘Hail Caesar, the doomed denarii salute you’)
As the world’s super-power, the Romans ruled over the Mediterranean and parts of the Middle East, exporting their legal, administrative and financial systems (in most cases, at the point of a spear). Their currency, the denarius, had been introduced in 211 BC and was rapidly gaining importance. Yet this posed unprecedented problems, since the currency was physically backed by metals. At inception, a denarius was the equivalent of 10 pounds of bronze. Yet the demand for the currency outpaced the supply, which was naturally limited by mining capacity. The Roman treasury therefore faced a stark choice: either let market forces reign or debase the currency. Had the market taken care of the supply/demand imbalance, the result would have been an endless increase in the real value of the currency, since demand growth vastly outweighed supply. This, in turn, would have led to an endless fall in prices, i.e. deflation. One denarius, for example, would have bought more and more loaves of bread over time.

The alternative was to reduce the metal content of the coins. This is what we economists call ‘currency debasement’. A modern way of – some say, code for – currency debasement is ‘quantitative easing’. Instead of printing limitless amounts of money, the central monetary authority can just reduce the metal content of the coins indefinitely.

Chart 1: The Roman denarius – quantitative easing at its best (or worst) in Roman times Source: Global Financial Data, Howgego (1995), Julius Baer

Looking at chart 1, it is not hard to guess what the Romans went for: currency debasement. This solved the problem of metal shortage by stealth, without setting the real economy on a path of ever-lower prices for goods and services. After the early debasements BC, the Roman currency switched to the silver-backed denarius. As you can see on the chart, the silver content started at almost four grams per coin. After a wave of debasements during the first century AD, there was an era of relative stability between AD 96 and AD 190. This was the time when the ‘five good emperors’ ruled. (According to Niccolò Machiavelli, these were Nerva, Trajan, Hadrian, Antoninus Pius, Marcus Aurelius.)

What can we learn from Roman currency history? A reserve currency is always intertwined with power (in the Roman case, chiefly military power), and natural imbalances build over time. These imbalances are designed to weaken the reserve currency, but also to erode the power behind it. Although historians may prove me wrong, I would go even further and suggest that the Roman Empire did not decline because of lead poisoning, barbarians at the gates or the overall degeneration of its culture. The Roman Empire declined when it lost control of its currency and saw its monetary base physically move abroad through trade deficits. This undermined central fiscal financing, and triggered a vicious circle of lower central spending and subsequent erosion of the taxable base.

Case study 2: God save the pound
What does Rome have to do with the United States? Plenty, I should say. I acknowledge, however, that Roman times are ancient times and that perhaps it is worth comparing the US dollar with a more recent reserve currency – e.g. its immediate predecessor, the British pound.

The British had a major geostrategic advantage given their location and access to the sea. In the second half of the last millennium, they fought the Spanish, the Dutch and the French for maritime dominance, ultimately winning against them all.

Chart 2: The pound sterling – going strong until going out of favour Source: Global Financial Data, Julius Baer

What is particularly striking about the pound sterling is the relative stability of the currency versus gold (see chart 2). In Roman terms, the British Empire was like a permanent era of the ‘five good kings’ (or ‘queens’, respectively). There were some debasements for sure (e.g. initially and during the Napoleonic wars in the early 19th century), but overall the British pound kept its value against the shadow currency – gold. It seems as if the British succeeded in circumventing the pitfalls of capital outflows by managing their overseas assets very strictly, e.g. through the East India Company. This changed drastically with the First World War: the United Kingdom had to rely on the rising new super-power, the United States, to end the conflict and was heavily indebted to it by the end. It is commonly believed that the end of the Second World War marked the end of the British pound as global reserve currency. Beneath the surface, however, the change of leadership had actually started more than 20 years earlier (see chart 2).

The lesson from the British experience is that well-managed reserve currencies can remain stable for long periods even in a physically backed currency system.

What is so special about the dollar anyway?
Having dipped into the history of reserve currencies, both ancient and recent, let us now turn to the present-day reserve currency, the US dollar. An insightful way of assessing its future possibilities is to compare it and – crucially – to contrast it with its predecessors. Like its predecessors, the US dollar meets the criteria of a reserve currency: it is the currency of trade, calculation and refuge worldwide. Unlike its predecessors, however, it is the first reserve currency not to be physically backed by a precious metal. This prompted the quip, during the Great Financial Crisis of 2007/2008, that “the greenback moved from gold standard to subprime standard”.

President Nixon had indeed abolished the gold standard in 1971, curbing the risk of seeing the US dollar debased by capital outflows to the rest of the world. Ever since, however, the long-term US dollar exchange rate has been driven by the twin deficits, i.e. the combination of fiscal and trade deficits. As can be seen in chart 3, the twin deficits (moved 18 months into the future) have been a good indicator of the future value of the dollar. The US therefore has the privilege of being the first super-power to sustainably export debt and refinance trade deficits with the world without seeing its capital base shift to its trading partners.

Chart 3: A reserve currency refinancing the twin deficits results in long-term dollar devaluation Source: Datastream, Julius Baer; GDP = gross domestic product

The dollar – still and asset-backed security?
The faint-hearted better skip this section, as we are going to discuss a very cynical argument about the US dollar. Some claim that there is still physical backing for the reserve currency – mind you, not physical gold but rather the US military. The sheer size of the US military allows the US to enforce its currency system all over the globe. So the US dollar is backed by 1.3 million soldiers, 11 air carriers, 4,000 airplanes, over 7,000 nuclear warheads, and so on. The comparison of military spending in chart 4 says it all. And there is no place to hide, as witnessed in recent clashes with Russia and Iran, where the US was able to credibly exclude various corporations and individuals from its currency system. This, by the way, is one of the reasons why we doubt that there will be a credible alternative to the US dollar anytime soon. There is simply no one else around to credibly enforce law and order on a global scale – let alone any crypto currencies out there.

Conclusion: No alternative around the corner
Some commentators eagerly forecast a ‘post-American world’ with a reserve currency system other than the US dollar. Yet most of the evidence outlined above speaks against this view. The US dollar is the first global reserve currency not backed by physical assets in the traditional sense. If at all, it is backed by the US’s status as world hegemon. This allows the US to export debt as backing for its currency and use its hard power as a credible enforcement threat. With the twin deficits as the main driver of this monetisation, the proof of the pudding is quite simple: if the US decides to retain its present status, its currency will weaken beyond this cycle as the twin deficits are set to rise again.

On the other hand, if the US pursues an increasingly isolationist policy, as it has done recently, the twin deficits will fall and the US dollar will strengthen structurally. This, in turn, would lead the US to curb defence spending, which currently accounts for around 4% of economic output, as a military of its present size would no longer be needed in ‘splendid isolation’. Not a very appealing scenario, particularly for the US Republican Party.

Chart 4: The US dollar – a currency backed by defence spending Source: Stockholm International Peace Research Institute, CNBC, Julius Baer

If the US did in fact relinquish its status as world hegemon, its trading partners would have no alternative but to look for another reserve currency. Given the time lag in past reserve currency replacements, it is hard to imagine China stepping in before 2030 or even 2040 (if this is its aspiration at all, which I doubt). At the same time, the rise of crypto currencies would not fill the ensuing void in the world economy. That would only happen if future generations were to run their businesses in a completely different manner from the way the past 100+ generations have done so. Though possible, it would take considerable time to gather tangible evidence for a change of this magnitude.

Until further notice, therefore, the US dollar will remain what it has been for the past 100 years: the world’s reference for calculating value, executing trade and preserving wealth in global capital markets. A weaker US dollar in the next cycle (2019/2020 onwards) would be evidence for things staying as they have been throughout the last 100 years.

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