This might seem a frivolous question, while the dollar still retains its might, and is universally accepted in preference to other, less stable fiat currencies. However, it is becoming clear, at least to independent monetary observers, that in 2018 the dollar’s primacy will be challenged by the yuan as the pricing medium for energy and other key industrial commodities. After all, the dollar’s role as the legacy trade medium is no longer appropriate, given that China’s trade is now driving the global economy, not America’s.
At the very least, if the dollar’s future role diminishes, then there will be surplus dollars, which unless they are withdrawn from circulation entirely, will result in a lower dollar on the foreign exchanges. While it is possible for the Fed to contract the quantity of base money (indeed this is the implication of its desire to reduce its balance sheet anyway), it would also have to discourage and even reverse the expansion of bank credit, which would be judged by central bankers to be economic suicide. For that to occur, the US Government itself would also have to move firmly and rapidly towards eliminating its budget deficit. But that is being deliberately increased by the Trump administration instead.
Explaining the consequences of these monetary dynamics was the purpose of an essay written by Ludwig von Mises almost a century ago.[i] At that time, the German hyperinflation was entering its final phase ahead of the mark’s eventual collapse in November 1923. Von Mises had already helped to stabilise the Austrian crown, whose own collapse was stabilised at about the time he wrote his essay, so he wrote with both practical knowledge and authority.
The dollar, of course, is nowhere near the circumstances faced by the German mark at that time. However, the conditions that led to the mark’s collapse are beginning to resonate with a familiarity that should serve as an early warning. The situation, was of course, different. Germany had lost the First World War and financed herself by printing money. In fact, she started down that route before the war, seizing upon the new Chartalist doctrine that money should rightfully be issued by the state, in preference to the established knowledge that money’s validity was determined by markets. Without abandoning gold for her own state-issued currency, Germany would never have managed to build and finance her war machine, which she did by printing currency. The ultimate collapse of the mark was not mainly due to the Allies’ reparations set at the treaty of Versailles, as commonly thought today, because the inflation had started long before.
The dollar has enjoyed a considerably longer life as an unbacked state-issued currency than the mark did, but do not think the monetary factors have been much different. The Bretton Woods agreement, designed to make the dollar appear “as good as gold”, was cover for the US Government to fund Korea, Vietnam and other foreign ventures by monetary inflation, which it did without restraint. That deceit ended in 1971, and today the ratio of an ounce of gold to the dollar has moved to about 1:1310 from the post-war rate of 1:35, giving a loss of the dollar’s purchasing power, measured in the money of the market, of 97.3%.
True, this is not on the hyperinflationary scale of the mark – yet. Since the Nixon shock in 1971, the Americans have been adept at perpetuating the myth of King Dollar, insisting gold now has no monetary role at all. By cutting a deal with the Saudis in 1974, Nixon and Kissinger ensured that all energy, and in consequence all other commodities, would continue to be priced in dollars. Global demand for dollars was assured, and the banking system of correspondent nostro accounts meant that all the world’s trade was settled in New York through the mighty American banks. And having printed dollars to ensure higher energy prices would be paid, they would then be recycled as loan capital to America and her friends. The world had been bought, and anyone not prepared to accept US monetary and military domination would pay the price.
That was until now. The dollar’s hegemony is being directly challenged by China, which is not shy about promoting her own currency as her preferred settlement medium. Later this month an oil futures contract priced in yuan is expected to start trading in Shanghai.[ii] Only last week, the Governor of China’s central bank met the Saudi finance minister, presumably to agree, amongst other topics, the date when Saudi Arabia will start to accept yuan for oil sales to China. The proximity of these two developments certainly suggest they are closely related, and that the end of the Nixon/Saudi deal of 1974, which created the petrodollar, is in sight.
Do not underestimate the importance of this development, because it marks the beginning of a new monetary era, which will be increasingly understood to be post-dollar. The commencement of the new yuan for oil futures contract may seem a small crack in the dollar’s edifice, but it is almost certainly the beginning of its shattering.
America’s response to China’s monetary manoeuvring has always been that of a nation on the back foot. For the last year, the yuan has been rising against the dollar, following President Trump’s inauguration. Instead of responding to China’s hegemonic threat by increasing America’s role in foreign trade, President Trump has threatened all and sundry with trade restrictions and punitive tariffs. It is a policy which could not be more designed to undermine America’s global economic status, and with it the role of the dollar.
In monetary terms, this leads us to a further important parallel with Germany nearly a century ago, and that is the contraction of the territory and population over which the mark was legal tender then, and the acceptance of the dollar today. The loss of Germany’s colonies in Asia and Africa, Alsace-Lorraine to France, and large parts of Prussia to Poland, reduced the population that used the mark without a compensating reduction of the quantity of marks in circulation. Until very recently, most of the world was America’s monetary colony, and in that context, she is losing Asia, the Middle East and some countries in Africa as well. The territory that offers fealty to the dollar is definitely contracting, just as it did for the German mark after 1918, and as it did for the Austro-Hungarians, whose Austrian crown suffered a similar fate.
The relative slowness of the dollar’s decline so far should not fool us. The factors that led to the collapse of the German mark in 1923 are with us in our fiat currencies today. As von Mises put it,
“If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely.”[iii]
Updated for today’s monetary system, this is precisely how the American government finances itself. Instead of printing notes, it is the expansion of bank credit, issued by banks licenced by the government with this purpose in mind, that ends up being subscribed for government bonds. The same methods are employed by all advanced nations, giving us a worrying global dimension to the ultimate failure of fiat currencies, whose only backing is confidence in the issuers.
Now that America is being forced back from the post-war, post-Nixon-shock strategy of making the dollar indispensable for global trade, the underlying monetary inflation of decades will almost certainly begin to be reflected in the foreign and commodity exchanges. There is little to stand in the way of the global fiat monetary system, led by the dollar, to begin a breakdown in its purchasing power, as prophesied by von Mises nearly a century ago. Whether other currencies follow the dollar down the rabbit hole of diminishing purchasing power will to a large extent depend on the management of the currencies concerned.
How a fiat currency dies
The last thing anyone owning units of a state-issued currency will admit to is that they may be valueless. Only long after it has become clear to an educated impartial monetary observer that this is the case, will they abandon the currency and get rid of it for anything while someone else will still take it in exchange for goods. In the case of the German hyperinflation, it was probably only in the last six months or so that the general public finally abandoned the mark, despite its legal status as money.
Von Mises reported that throughout the monetary collapse, until only the final months, there persists a general belief that the collapse in the currency would soon end, there always being a shortage of it. The change in this attitude was marked by the moment people no longer just bought what they needed ahead of actually needing it. Instead, they began to buy anything, just to get rid of the currency. This final phase is what von Mises called the crack-up boom, though some far-sighted individuals had already acted well ahead of the crowd. Both these phases are still ahead for the American citizen. However, we can now anticipate how the first is likely to start, and that will be through dollars in foreign hands being replaced for trade purposes with the yuan, and then sold into the foreign exchanges.
Once the process starts, triggered perhaps by the petrodollar’s loss of its trade settlement monopoly, it is not beyond the bounds of possibility for the dollar to initially lose between a third and a half of its purchasing power against a basket of commodities, and a similar amount against the yuan, which is likely to be managed by the Chinese to retain its purchasing power. It will be in the interests of the Chinese authorities to promote the yuan as a sounder currency than the dollar to further encourage foreign traders to abandon the dollar. From China’s point of view, a stronger yuan would also help ensure price stability in her domestic markets, at a time when countries choosing to remain on a dollar-linked monetary policy will be struggling with rising price inflation.
There then emerges a secondary problem for the dollar. A fiat currency depends in large measure for its value on the credibility of the issuer. A weakening dollar, and the bear market in bonds that accompanies it, will undermine the US Government’s finances, in turn further eroding the government’s financial credibility. This will be happening after an extended period of the US Government being able to finance its deficits at artificially low interest rates, and is therefore unprepared for this radical change in circumstances.
As the dollar’s purchasing power comes under attack, lenders, whether they be those with surplus funds, or their banks acting as their agents, will increasingly take into account the declining purchasing power of the dollar in setting a loan rate. In other words, time-preference will again begin to dominate forward rates, and not central bank interest rate policy. This will be reflected in a significantly steeper yield curve in the bond market, forcing borrowers into very short-term financing or using other, more stable monetary media to obtain capital for longer-term projects. This, again, plays into the yuan becoming the preferred currency, possibly with a rapidity that will be unexpected.
The US Government is obviously ill-equipped for this drastic change in its circumstances. The correct response is to eliminate its budget deficit entirely, and refuse to bail out failing banks and businesses. Bankruptcies will be required to send surplus dollars to money heaven and therefore stabilise the dollar’s purchasing power. A change in the Fed’s attitude towards its banks and currency is, however, as unlikely as that of the Reichsbank subsequent to the Versailles Treaty.
Therefore, it follows that capital markets in dollars will inevitably be severely disrupted, and market participants will seek alternatives. Remember that the dollar’s strength has been based on its function in trade settlement and its subsequent deployment as the international monetary capital of choice. Both these functions can be expected to go into reverse as the trade settlement function is undermined.
Whether China will be tempted to employ the same methods in future to support the yuan as the Americans have during the last forty-three years for the dollar, remains to be seen. It may not be a trick that can be repeated. There is a great danger that a significant fall in the dollar will lead to global economic stagnation, coupled with escalating price inflation, affecting many of China’s trading partners. China will want to insulate herself from these dangers without adding to them by going for full-blown hegemony.
We are beginning, perhaps, to see this reflected in rising prices for gold and silver. China has effectively cornered the market for physical gold, the only sound money of the market that over millennia has survived all attempts by governments to replace it. Her central planners appear to have long been aware of the West’s Achilles’ heel in its monetary affairs, and have merely been playing along to China’s own advantage. As the dollar weakens in the coming years, her wisdom in securing for herself and her citizens the one form of money that’s no one else’s liability will ensure her survival in increasingly turbulent times.
Now that’s strategic thinking.
[i]Stabilisation of the Monetary Unit – from the Viewpoint of Theory ( January, 1923)
[ii] See https://www.bloomberg.com/news/articles/2018-01-01/how-china-will-shake-up-the-oil-futures-market-quicktake-q-a
[iii] Ibid. Opening sentence.
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