On this day 50 years ago, one of the momentous events in the 20th century took place.
But unlike others frequently told in schools – fall of Berlin wall, Deng Xiaoping opening China, NASA moon landing, the pill, Hiroshima, the Great Depression, Bolshevik revolution, Ferdinand assassination, Wright brothers flight etc – what happened on 15th August 1971 is a story that isn’t very well known.
US president Nixon announced that the US dollar would no longer be backed by gold. From that day on, the dollar became a fiat currency. Meaning, it only has value because a powerful authority says it has value.
Despite this, and somewhat remarkably, the dollar has maintained its throne as the ultimate store of value.
But what makes the world put trust in this paper currency backed by nothing?
With increasing interest in decentralized finance and inflation fears from the Fed overprinting, revisiting this topic seems more relevant now than ever.
The history of money is a complicated and controversial one. In my previous post summarizing Debt: The First 5,000 Years by David Graeber, we saw that that history has alternated between periods of money and credit paradigms.
This post will focus more on the 20th century. We will oversimplify three different global monetary systems: the Gold Standard system (pre-1944), the Bretton Woods system (1944-1971), and now the Petrodollar system (1974-present). And also cover where we might be heading.
1. The Gold Standard System (Pre-1944)
By the late 19th century, most major currencies followed the gold standard. This meant that their currencies were pegged to and convertible to gold. Every dollar printed had to be backed by its equivalent value in gold. Effectively, paper money represented a promise to deliver gold.
This was a net positive development in the history of finance. It brought discipline to governments. It prevented hyperinflation by stopping governments from printing money out of thin air.
One structural feature of the gold standard system, however, was its sensitivity to trade deficits. A country with high net exports would accumulate gold. While countries with high net imports would drain its gold reserves, putting it at risk of economic stagnation. However, this state should be self-correcting. A recession would devalue the currency, making exports competitive, and imports expensive, thus reversing the trade deficit. We’ll go into this more later.
During World War I (1915 – 1918), the major European powers briefly suspended the gold standard. But returned to it after the war. Meanwhile, the US continued to accumulate masses of gold throughout the 1920s and 1930s. Especially as its European Allies repaid its WW1 debts to the US in gold.
During the Roaring ’20s, lots of debt was created to buy speculative assets. As the US Federal Reserve tightened monetary policy to curtail this speculation, the bubble finally burst in 1929. The Great Depression began.
All major nations were forced to suspend their gold pegs. Britain in 1931, the US in 1933, and France in 1935.
The US even went so far as making gold ownership illegal, forcing all citizens to sell their gold to the government (at a set price of $20.67 per ounce) via the Gold Reserve Act in January 1934.
Additionally during World War II (1939 – 1945), many countries shipped their gold to the US for safekeeping.
Consequently in the decades leading up to 1944, the US built up the world’s largest gold reserves.
2. The Bretton Woods System (1944 – 1971)
July 1944. The Allies had just landed in Normandy, and WWII victory was only a matter of time.
The Allies met in Bretton Woods in the US to discuss a new global monetary system for the post-war world.
Given that the US held 2/3 of the world’s gold reserves, countries agreed to fix their currencies to the US dollar. Since USD was fixed to gold, pegging to USD was an indirect way of maintaining the gold standard, without the hassle of having to hold physical gold.
This meant that any US dollars held in reserves could, at any time, be exchanged for gold. At an agreed fixed rate of $35/ounce.
Foreign exchange rates would also be fixed, and could not be changed without special permission from the newly established International Monetary Fund. The World Bank is also established in this Bretton Woods conference.
In more modern times, we saw the rise of reserve currencies: currencies which are widely recognized and accepted outside the origin country. For example, the Dutch guilder in the 1600s, and the British pound in the 1800s. But these predecessors to the dominant dollar weren’t truly global reserve currencies. They were just widely recognized and accepted currencies. The US dollar would become the first ever truly global reserve currency.
For the first decade or two, the Bretton Woods system seemed to work fine.
But by the late 60s, structural weakness in the system began to show.
US trade balance was heading south. Americans were spending more on imports, such as German and Japanese-made automobiles.
Making matters worse, the US ramping up spending on the Vietnam War and domestic social programs. The Tet Offensive in January 1968, in particular, conveyed that the US was losing the war.
This war and deficit weakened US economy hurt the fundamentals of the US dollar. This in turn dragged down other countries’ currencies pegged to it.
Foreign countries who had trusted in the US dollar were becoming aggravated. France under Charles de Gaulle started to convert its billions of USD into gold.
“In the late 1960s, US public sector deficits were negligible by today’s standards, but large enough to prompt complaints from France that Washington was exploiting its reserve currency status in order to collect seigniorage from America’s foreign creditors by printing dollars, much as medieval monarchs had exploited their monopoly on minting to debase the currency.” – Ascent of Money, Niall Ferguson
Doubts began to brew on whether the US could honor its promise of gold convertibility. Global faith in the US dollar was in rapid decay.
“By midsummer [of 1971], the dollar problem began to reach a breaking point. There were reports that Europeans wouldn’t accept dollars from American tourists. The global monetary system was in the process of breaking down…” – Principles, Ray Dalio
Under this pressure, on the 15th August, 1971, US president Richard Nixon announced that the US dollar would no longer be pegged to gold.
Just like that the dollar became a fiat currency. A currency whose value is backed only by state power. “This piece of paper is worth a dollar because I said so.”
At first, the suspension of gold convertibility was to be temporary. But it soon became permanent.
While war and trade deficits accelerated the collapse of Bretton Woods, it wasn’t necessarily the upstream driver. The system had a structural design flaws from inception.
At first, US gold reserves (red solid line) exceeded foreign liabilities (blue solid line). But by the mid 60s, foreign liabilities had surpassed US gold reserves. This was the true crossover point when the US could no longer keep its gold convertibility promise.
“The system had an underlying flaw that when left unaddressed brought the system down. It was never truly sustainable as designed. There was no way that the US could maintain enough gold to back all of its currency for domestic use, and simultaneously back enough currency for expanding global use as well (which was the part that was redeemable).” – Lyn Alden, Fraying of the US Global Currency Reserve System
Some called out these structural problems. Robert Triffin and John Maynard Keynes among them. Keynes proposed an alternate system called the Bancor. This would center around an international unit of account backed by gold as well as a basket of major currencies. This would be a more balanced system with a neutral settlement mechanism, rather than relying solely on a singular currency.
In the wake of the dollar debasement, there was a high degree of uncertainty on the global monetary system.
Every currency in the world suddenly became a fiat currency. Every currency now only had value because its government declared it to have value.
Now, within countries, governments can control what currency is to be used, how much of it there is, what value it is etc. But between countries, the universal medium of exchange must be what the majority is willing to accept. Or forced to accept by the hegemonic powers.
This is a problem when every currency is a fiat one. Why should businesses and governments in other countries accept pieces of paper as a form of payment? Paper which can be printed infinitely by foreign governments. Paper which represented nothing more than a promise which could so easily be broken.
Countries were doubtful about the dollar, but there wasn’t much alternative either.
Rather than lose its throne in the center of the global monetary system, however, the US found a way to force other countries to continue using dollars as the reserve currency. How?
The gold standard pivoted to black gold.
3. The Petrodollar System (1974 – present)
3.1. Establishment of the Petrodollar system
In October 1973, the Yom Kippur War broke out between Israel and its Muslim neighbors: primarily Egypt and Syria.
From October 1973 to March 1974, Arab OPEC members (Organization of Petroleum Exporting Countries) imposed an oil embargo on the West, as retaliation for supporting Israel in the war. Oil prices jump from $3 to $12 per barrel in the last 6 months of 1973.
While the US backed Saudi Arabia’s enemy Israel in the war, US-Saudi relations were never completely hostile. Throughout much of the 20th century, their relationship was built on mutual needs.
The US needed Saudi Arabia’s oil.
Saudi Arabia needed US military protection against its true arch-rival, Iran.
In a landmark agreement in 1974, Saudi Arabia (and other OPEC members) agreed to sell its oil exclusively in USD. In exchange, the US guaranteed security in the region.
This meant that any country that wanted to import oil would first have to obtain USD to pay for it. Either by exchanging their currency for dollars. Or by earning dollars directly by selling their exports in dollars.
This was a clever self-reinforcing design to force the adoption of the US dollar as the global reserve currency. All without being backed by gold.
3.2. Petrodollar recycling
On top of that, any excess dollars accumulated by oil exporters would typically be used to purchase US Treasuries to earn some interest.
This ‘petrodollar recycling’ effectively subsidizes a large portion of the US federal deficits. While other developed nations typically rely on domestic financing, the US benefits from foreign financing.
This results in global trade being dominated by US dollars. A disproportionately large flow relative to the size of the US economy. For instance, in 2018, US represented 11% of global trade and 24% of global GDP. But USD share in global economic activity ranged from 40-60% on a number of metrics (shown below).
USD dominates foreign exchange denominations, as well as foreign exchange reserves.
The chart below highlights this dominance more clearly. Slightly older data but proportions remain more or less similar today.
Initially, countries got their hands on dollars to buy oil. Over time, most international financing became denominated in dollars. Decades later today, many countries need dollars just to be able to service their dollar-denominated debts.
So now the dollar is backed by both oil demand as well as dollar-denominated debts. And this self-reinforcing network effect has proven difficult to break out of.
The manufactured demand for dollars endows the US with exorbitant privileges. While other countries have to earn or buy dollars for commodities like oil, the US can simply print them. Money printer go brrrr.
The global reserve currency status also makes the dollar stronger than it otherwise would be. Which in turn allows it to fund global military influence.
3.3. Triffin Dilemma
However the global reserve currency status comes at a price. Like its Bretton Woods predecessor, the Petrodollar system also has structural design flaws.
The global demand for US dollars under the Petrodollar system requires the US to run persistent trade deficits. These deficits provide the rest of the world with reserves.
The problem is that the desired amount of reserves held by foreign countries rises with global nominal GDP. Which means that so long as global nominal GDP grows faster than US nominal GDP, US external indebtedness grows unsustainably.
Under Bretton Woods system, growing external liabilities forced the US to draw down its gold reserves. Under the Petrodollar system, persistent trade deficits forces the US to draw down its domestic industrial base. This adds to deficits in its net international investment position and its assets become increasingly foreign-owned. So the flaw in Bretton Woods concerned the US’s capital account (net assets i.e. stock problem), while the petrodollar concerns the its current account (net income i.e flow problem). This is the Triffin Dilemma (named after the economist who outlined it).
As mentioned in the beginning of this post, trade deficits can usually be corrected by a big enough currency devaluation. This would make exports more competitive (cheaper), and imports more painful (expensive), thus reversing the trade deficit.
Most other countries have this devaluation lever. The US does not. US trade deficits are trapped by the structure of the Petrodollar global monetary system. It never gets the chance to correct itself.
3.4. Fluctuating dollar strength
Another important point to understand: the relative purchasing power of the dollar should be treated as independent from the structural properties of the petrodollar system itself.
For instance, being a dollar bear (betting on a weaker dollar) is not the same as thinking that the USD is losing its global reserve currency status.
The chart below shows the strength of the dollar relative to a basket of major currencies, represented as an index (starting at 100 in the early 70s when the petrodollar system emerged).
Throughout the 70s, the US dollar was weak after its recent gold departure.
In the early 80s, newly appointed Federal Reserve chairman Volcker raised interest rates to tame inflation. Simultaneously US president Reagan ran large deficits (cut taxes and increased spending). This caused a boom and led to a stronger dollar. A stronger dollar in the 80s particularly hurt Latin America, whose debts were mostly dollar-denominated (Latin American debt crisis.
Meanwhile in the 1980s, the Japanese economy continued to soar to new heights. Japan seemed unstoppable. In response, in 1985, Germany, Japan, UK, and France agreed to deliberately weaken the US dollar at the Plaza Accord. This allowed American and European exports to become competitive again over Japanese exports.
In 1991, the Soviet Union collapsed, leaving the US as the sole superpower. Markets opened up and globalization accelerated. While the dollar was weak in the early 90s amidst a recession, by the mid 90s it would boom again.
As the dollar grew stronger, by mid 1997, the Asian Financial Crisis unfolded. Floating the Thai baht further accelerated capital flight – the economies of Thailand, Indonesia, Philippines, Malaysia, and South Korea are hit hard for 12 months. A year later in 1998, the Russian Financial Crisis took place. All mirroring the characteristics of the Latin American debt crisis a decade earlier.
By 2000 the dot com bubble burst, the Fed cut rates and the dollar was weak again. This was followed by an emerging market boom. Acronyms like BRIC (Brazil, Russia, India, China) were thrown around a lot at the time.
The dollar remained weak throughout the 2000s through to the early 2010s – with exception of a spike in 2008/2009 following the GFC.
From the mid 2010s, the dollar regained strength, particularly between 2014-2015 as the Fed tightened monetary policy (reduced its balance sheet). Several emerging markets consequently suffered a severe recession in 2014-2016. After peaking in 2016, the dollar weakened in 2017 – during which both US and global markets rallied. But by early 2018, the Fed began tightening again and the strong dollar prevailed. By mid 2019 however, the Fed cut rates in response to slow economic growth. This quantitative easing was exacerbated in 2020 as COVID-19 hit.
4. What Next?
4.1. Shrinking US dominance
When Bretton Woods ended, the US made up over 35% of global GDP. Now it’s less than 25%. And even less when measured in purchasing power parity (PPP) terms.
When Bretton Woods ended, the US was the world’s largest commodity importer. Today, it’s China. In fact, the US has been ramping its own oil production since the Shale Revolution in 2010. Thanks to advances in mining techniques (fracking) that allows oil that was previously expensive to extract (oil trapped in shale rock) now affordable.
As of 2020, the US is now a net energy exporter.
It simply doesn’t need Middle Eastern oil anymore. Its gradual military withdrawal from the region (including a full and sudden withdrawal from Afghanistan last month) exemplifies exactly this. I wrote more about this in Oil Geopolitics: the Shale Saga and Shifting Sands.
When Bretton Woods ended, the US was also in a Cold War with the Soviet Union. The global reserve currency status was as much geopolitically motivated as it was economic. But even after the Soviet Union dissolved in Dec 1991, the US maintained its war machine, without a clear direction or identity.
4.2. Rising China
As US dominance shrinks, China’s is certainly on the rise.
While the US holds onto its top spot in global GDP in nominal terms, China’s GDP has already overtaken the US in purchasing power parity terms (which more closely tracks commodity consumption).
China is now the world’s largest importer of commodities, oil among them of course. And this trend is likely to continue.
As Japan stagnated in the 90s, China took the baton and financed US deficits. Its mountains of “Made in China” goods ran big surpluses with the US. China then recycled those dollars into US Treasuries.
But in 2013, China slowed down US treasury bond purchases. Instead, it began investing its surplus dollars on direct foreign investments. Also launched in 2013, the Belt and Road Initiative is basically a bunch of long-term loans to commodity-rich, credit-rating-poor countries with a lot of conditions attached. The funds are to be used primarily for building infrastructure to produce and transport the commodities that China needs over the next century. And these funds are mostly dollar-denominated.
So China has been cutting its US Treasury holdings throughout the 2010s, and now it’s subsided to levels a decade ago.
Consequently, it’s now the US Federal Reserve that owns the most US Treasuries.
As Lyn Alden puts it:
That’s not exactly how the “global reserve” currency is supposed to work. It’s like a restaurant chef eating her own cooking more than her customers do.
Additionally, in recent years, global trade has been gradually de-dollarizing. For instance, the dollar has been losing its share of Russia-China settlements to the euro.
4.3. Multi Reserve System
But does this mean that the yuan is on track to replace the dollar as the global reserve currency?
Not even close.
As Ray Dalio points out, reserve currency status status lingers much longer than the height of an empire (see white line below).
And as we saw earlier, the network effects of the Petrodollar system is a hard one to break.
Perhaps a more likely scenario is a gradual transition to a multi currency reserve system. Arguably, this is already happening, reflected by increasingly de-dollarized Eurasian energy and commodity trade. As well as the declining share of USD on foreign central bank’s balance sheets.
A multi currency reserve system could take the form of a bunch of regional reserve currencies. Or the introduction of new neutral reserve currency units such as digital Bancors to facilitate global trade.
Perhaps Bitcoin or other cryptocurrencies end up with a crucial role to play here?
Either way, the new global monetary system is likely to be more decentralized than what we have now.
The Petrodollar system was a clever way to make the world run on pieces of paper whose value is backed solely on the goodwill of the US government. “This is worth a dollar because we say so.” While credit-based paradigms are common in history, never was it as globally centralized as what the US had achieved.
But as we have seen this system is under structural pressure, and it is only a matter of time until a new global monetary order takes form.
We certainly live in interesting times.
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