Indicators of the Dollar’s Decline
The Fall of a Global Reserve Currency
In my last post, I explored Nik Bhatia’s framework of ‘Layered Money’.
I concluded with the following passage
… the US Dollar system relies upon trust that the US Government is a creditworthy entity able to manage its money supply and repay its debts.
Time and time again, they’re failing at this mission.
This is not to say that the US Dollar will not remain the global reserve currency for the foreseeable future.
But viable alternatives are beginning to spawn, which could mark the beginning of the end for government-issued fiat currencies.
I’d like to now build on this discussion by examining the glaring signs that our global US Dollar system is tiring.
We’ll unpack
- The Fed’s (relative) loss of control over USD issuance; and
- The Fed as a lender of only resort
These aren’t the most exciting topics you’ll ever read about, but they set the stage for a future where programatically scarce digital monies become commonplace.
Yesterday, at a book store, I came across this beast of a hardcover coffee table book. Probably a fitting addition with everything going on at the moment…
Let’s dive in.
The Fed has lost control of US Dollar Issuance
In the 1950s, at the beginning of the Cold War, the Soviet Union was unable to avoid US Dollars.
In order to import vital materials and goods, the Soviet Union was forced to make payments in the more stable and globally accepted US Dollar.
Since the dollar was overseen by the Federal Reserve, and sending Dollars over to Uncle Sam wasn’t a viable option (for Cold War reasons etc.), they deposited their US Dollar Reserves at European banks.
These banks then began to trade these dollar deposits using money market instruments.
This fact is fundamental to the story. I don’t have Margot Robbie in a bubble bath to explain, but hopefully the following will suffice.
Money Market Instruments
Money market instruments are used as a proxy for cash.
They are an instrument representing a claim on ‘safe’ assets like US Treasuries, bank deposits, and other money market instruments.
Banks create a single, liquid security, backed by these stable assets.
You buy these when you don’t want to hold lots of cash on your balance sheet.
In the US, the FDIC insures bank deposits up to $250,000 US Dollars.
For large institutions with several million dollars in cash at bank, it is extremely risky to hold it in fiat.
To reduce risk, these institutions purchase money market instruments as a cash equivalent.
This way, institutions don’t actually have to hold cash as a deposit at the bank. It helps to reduce counterparty risk when holding money at the bank.
Back to the US Dollar
Back to the main story — European banks were lending out US Dollar deposits in the form of money market instruments.
As a result, they were issuing new layers of money. These new layers represented a claim upon the Dollar holdings at European banks — Eurodollars.
By issuing Eurodollars, European banks began to issue second and third layer US Dollars outside the control of the Federal Reserve.
The Fed began to lose control of US Dollar issuance. This made it more difficult to control the money supply.
Centralised monetary systems depend upon predictable and monopolistic control over issuance of new currency.
If currency can be indirectly minted by foreign banks, the Federal Reserve loses control of its own currency.
Lender of Only Resort
You’ve probably heard of the concept ‘lender of last resort’ — a phrase which means, ‘if you’re greedy and f up, but you’re big enough or have lots of customers, the government will bail you out’.
Following the Global Financial Crisis in 2008, global money markets are now highly dependent on the Federal Reserve the bail them out.
The whole system has become entirely beholden to The Federal Reserve’s support.
Yet despite the dollar system’s fragility that has been exposed over the past dozen years, the dollar is more deeply entrenched as the international monetary system’s fulcrum than ever.
The world is seemingly trapped inside a dollar denomination and is hankering for a monetary renaissance.Each crisis seems to be unraveling more quickly than the previous one as the system becomes dramatically more fragile.
Since US Treasuries exist as the only first layer money, the Federal Reserve is now the lender of only resort.
They are the only entity with complete control over first layer issuance.
As we’ve explored above, this isn’t entirely the US Government’s fault.
Once monetary claims were abstracted away from scarce metals like gold, foreign economies became overly reliant upon the Dollar system.
They began to issue new layers of money using their Dollar deposits as collateral.
This interdependency has amplified counterparty risks.
A general rule of thumb is — the more counterparties involved, the greater the risk that the entire stack of cards comes crumbling down.
If one part of the system begins to break, the US Government is forced to intervene and stabilise the dollar.
It’s like gluing the foundations of the building together and hoping the whole thing doesn’t collapse.
Despite good intentions, global reliance on the Federal Reserve has proven ineffective.
We need a monetary renaissance in which first layer money is immutable.
For all I care, allow shenanigans and ponzis to rise and fall within higher layers of money, but do not compromise the sanctity of the base layer.
Wrapping Up
The US Dollar system is beginning to show its wear and tear.
The US Government is losing control over monetary issuance internationally, and is increasingly intervening to keep the system upright.
The debt ceiling continues to rise higher and higher as the US prints money to support its economy and support the global monetary system.
At some point, interest rates will be lowered to support interest payments on the national debt, and the whole cycle repeats itself.
It is unclear which straw will break the camel’s back, but the camel’s definitely on its last legs.
