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The Buck Stops Here


2020 has been a year for the ages.  It doesn’t take long for any socially distanced happy hour to revert back to these uncertain times of hunkering down or masking up.  The Plandemic aside, I’m sensing a lot of pearl- clutching over the bailout & stimulus packages – namely the cost and bloating of the federal deficit.  While completely understandable, I’ve also detected some common misconceptions regarding world currencies – including the US dollar (USD).  Fair warning: wonky reading ahead.


Before we speculate on the dollar’s future, let’s rewind to its past.  We’ve all heard the terms “King Dollar” or “dollar privilege” – but how did this come about?  Look no further than World War II.  Once the US saved the Allies and won the war, the rest of the world was basically crippled & indebted.   The British Pound was replaced by the USD as the world’s reserve currency.  The US only strengthened its position in coming years through military force, economic power and political stability.  There’s a reason the US has military bases all over the world – and it isn’t international fondness.        

 

The 1944 Bretton Woods Agreement further solidified the USD’s status.  This established commerce and financing rules between the US, Japan, Canada, western Europe and Australia.  The intent was to peg their respective exchange rates to gold and prevent intentional devaluation for competitive trade agreements.  Why backed by gold?  The US held 75% of the world’s supply.   In 1971, the US unilaterally terminated pegging its currency to gold, rendering the Bretton Woods agreement negated.  Thus, the USD was just another promissory note, no longer back by gold or silver.


The 1970’s oil crisis only reaffirmed the US’ need to maintain dollar supremacy.  The US struck a deal with Saudi Arabia to standardize oil prices in USD terms (in return for military protection).  Thus, the term “Petrodollar” was born.  This system provides US financial systems with liquidity and a demand for US assets as foreign countries have to redeem their dollars.   And now you can surmise why that sheik has a helicopter pad at Lake James.


Like a husky kid with ice cream credit, the US has figured out how to abuse this currency privilege.  Policy makers realize there is almost an insatiable demand for US dollars in the form of Treasury Bills – basically glorified IOU’s.   The US has never defaulted on repayment, still maintains the most robust economy, the military still unchallenged and political stability, uh, hanging in there?  The perfect litmus test for the dollar was March 2020 when everything hit the fan.  The world sold all assets to buy King Dollar.  It strengthened against every world currency.  See the chart below – the spike higher is the demand.  As fear subsided, the dollar index has weakened with risk assets being rebought.



Big number alert.  As of June, $6.8 trillion USD was held by foreign banks and 61% of the World Bank reserves were in USD.   As for the national debt, it’s at $27 trillion and counting.   China owns around $1.2 trillion US debt.  Would they sell?  Doubtful – they’d collapse the bond market.  They have other ominous plans to unseat the US – consider reading the book: The Hundred Year Marathon - Pillsbury. 


The irony is that the US wants to retain dollar dominance but not necessarily a strong dollar.  Relative to other global currencies, a weaker dollar boosts US competitiveness – cheaper to visit and buy our goods.  A discounted dollar especially helps emerging markets with lower export prices.  But if capital inflows from abroad become too weak, there is lower dollar demand.  So, it’s really a fine line for policy makers to determine a correct equilibrium.     

 

So back to the original hand wringing – what’s the buck’s future?  While I agree that ballooning federal deficits could turn the US into an episode of My 600 lbs. Life - I don’t think that will happen anytime soon.  Low interest rates will buy the US some debt servicing and refinancing time.  And certainly, some fiscal restraint would be helpful.  But I also ask the simple question: What’s the alternative?  Chinese Renminbi? Euro? Swiss Franc? Nope – that has been proven in every global crisis.  Gold?  Paying at Kroger with that?  Crypto?  Still in its infancy and way too many uncertainties for mainstream use.  Check back with me on that one in a few years.


It’s hard to replace something with nothing.  The USD may have a bum wheel or 2 but it still dusts than the rest of the world scooters.  Since 2012, the renown Euro has fallen 30% against the USD.   And the Renminbi is pegged to 15 cents on the dollar.   The Japanese Yen is basically a rounding error to the USD: 1/100th.   If we held a Currency Olympics at our house, Michelle would be USD with the cats battling out podium spots as the Peso and Canadian Looney. I’m a Guinness beer coaster.  


My 2 cents: the US has more nefarious ways to deal with its debt - eliminate paper currency altogether and go digital.  Perhaps just do what they’ve always done: print, inflate it away & pay back debt with devalued future dollars (debt monetization).  Since 1971, the USD has lost 85% of its purchasing power while increasing the money supply 32-fold! See chart below. 



Or the US can simply continue its uninhibited spending until they get a global margin call.  


Fiscal Fitness is a publication of Houlihan Asset Management, LLC for the benefit of its clients and friends.    


Houlihan Asset Management.  Wealth Counseling/Asset Management. Copyright 2020

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