The same force that made the dollar the world’s reserve currency is working to dethrone it.
22 July 1944 marked the official conclusion of the Bretton Woods Conference in New Hampshire. There, 730 delegates from 44 nations met at the Mount Washington Hotel in the final days of the Second World War to devise a new international monetary system.
The delegates there were acutely aware that the failures of the international monetary system after the First World War had contributed to the outbreak of the Second World War. They were determined to create a more stable system that would avoid beggar-thy-neighbour currency wars, trade wars and other dysfunctions that could lead to shooting wars.
It was at Bretton Woods that the dollar was officially designated the world’s leading reserve currency — a position that it still holds today. Under the Bretton Woods system, all major currencies were pegged to the dollar at a fixed exchange rate. The dollar itself was pegged to gold at the rate of US$35.00 per ounce. Indirectly, the other currencies had a fixed gold value because of their peg to the dollar.
Other currencies could devalue against the dollar, and therefore against gold, if they received permission from the International Monetary Fund (IMF). However, the dollar could not devalue, at least in theory. It was the keystone of the entire system — intended to be permanently anchored to gold.
From 1950–1970 the Bretton Woods system worked fairly well. Trading partners of the US who earned dollars could cash those dollars in to the US Treasury and be paid in gold at the fixed rate.
Trading partners of the US who earned dollars could cash those dollars in to the US Treasury and be paid in gold at the fixed rate.
In 1950, the US had about 20,000 tons of gold. By 1970, that amount had been reduced to about 9,000 tons. The 11,000-ton decline went to US trading partners, primarily Germany, France and Italy, who earned dollars and cashed them in for gold.
The UK pound sterling had previously held the dominant reserve currency role starting in 1816, following the end of the Napoleonic Wars and the official adoption of the gold standard by the UK Many observers assume the 1944 Bretton Woods conference was the moment the US dollar replaced sterling as the world’s leading reserve currency. In fact, that replacement of sterling by the dollar as the world’s leading reserve currency was a process that took 30 years, from 1914 to 1944.
The real turning point was the period July–November 1914, when a financial panic caused by the start of the First World War led to the closures of the London and New York stock exchanges and a mad scramble around the world to obtain gold to meet financial obligations. At first, the US was acutely short of gold. The New York Stock Exchange was closed so that Europeans could not sell US stocks and convert the dollar sales proceeds into gold.
But within a few months, massive US exports of cotton and other agricultural produce to the UK produced huge trade surpluses. Gold began to flow the other way, from Europe back to the US Wall Street banks began to underwrite massive war loans for the UK and France. By the end of the First World War, the US had emerged as a major creditor nation and a major gold power. The dollar’s percentage of total global reserves began to soar.
Scholar Barry Eichengreen has documented how the dollar and sterling seesawed over the 20 years following the First World War, with one taking the lead from the other as the leading reserve currency and in turn giving back the lead. In fact, the period from 1919–1939 was really one in which the world had two major reserve currencies — dollars and sterling — operating side by side.
Finally, in 1939, England suspended gold shipments in order to fight the Second World War and the role of sterling as a reliable store of value was greatly diminished apart from the UK’s special trading zone of Australia, Canada and other Commonwealth nations. The 1944 Bretton Woods conference was merely recognition of a process of dollar reserve dominance that had started in 1914.
The significance of the process by which the dollar replaced sterling over a 30-year period has huge implications for you today. Slippage in the dollar’s role as the leading global reserve currency is not necessarily something that would happen overnight, but is more likely to be a slow, steady process.
Signs of this are already visible. In 2000, dollar assets were about 70% of global reserves. Today, the comparable figure is about 62%. If this trend continues, one could easily see the dollar fall below 50% in the not-too-distant future.
It is equally obvious that a major creditor nation is emerging to challenge the US today just as the US emerged to challenge the UK in 1914. That power is China. The US had massive gold inflows from 1914–1944. China has massive gold inflows today.
Officially, China reports that it has 1,658 metric tonnes of gold in its reserves. However, China has acquired thousands of metric tonnes since without reporting these acquisitions to the IMF or World Gold Council.
Based on available data on imports and the output of Chinese mines, it is possible to estimate that actual Chinese government and private gold holdings exceed 8,500 metric tonnes, as shown in the chart below.
Assuming half of this is government owned, with the other half in private hands, then the actual Chinese government gold position exceeds 4,250 metric tonnes, an increase of over 300%. Of course, these figures are only estimates, because China operates through secret channels and does not officially report its gold holdings except at rare intervals.
China’s gold acquisition is not the result of a formal gold standard, but is happening by stealth acquisitions on the market. They’re using intelligence and military assets, covert operations and market manipulation. But the result is the same. Gold is flowing to China today, just as gold flowed to the US before Bretton Woods.
China is not alone in its efforts to achieve creditor status and to acquire gold. Russia has doubled its gold reserves in the past five years and has little external debt. Iran has also imported massive amounts of gold, mostly through Turkey and Dubai, although no one knows the exact amount, because Iranian gold imports are a state secret.
Other countries, including BRICS members Brazil, India and South Africa, have joined Russia and China to build institutions that could replace the balance of payments lending of the International Monetary Fund (IMF) and the development lending of the World Bank. All of these countries are clear about their desire to break free of US dollar dominance.
Sterling faced a single rival in 1914, the US dollar. Today, the dollar faces a host of rivals — China, Russia, India, Brazil, South Africa, Iran and many others. In addition, there is the world super-money, the special drawing right (SDR), which I expect will also be used to diminish the role of the dollar. The US is playing into the hands of these rivals by running trade deficits, budget deficits and a huge external debt.
What are the implications for your portfolio? Once again, history is highly instructive.
During the glory years of sterling as a global reserve currency, the exchange value of sterling was remarkably stable. In 2006, the UK House of Commons produced a 255-year price index for sterling that covered the period 1750–2005.
The index had a value of 5.1 in 1751. There were fluctuations due to the Napoleonic Wars and the First World War, but even as late as 1934, the index was at only 15.8, meaning that prices had only tripled in 185 years.
But once the sterling lost its lead reserve currency role to the dollar, inflation exploded. The index hit 757.3 by 2005.
In other words, during the 255 years of the index, prices increased by 200% in the first 185 years while the sterling was the lead reserve currency, but went up 5,000% in the 70 years that followed.
Price stability seems to be the norm for money with reserve currency status, but once that status is lost, inflation is dominant.
The decline of the dollar as a reserve currency started in 2000 with the advent of the euro and accelerated in 2010 with the beginning of a new currency war. That decline is now being amplified by China’s emergence as a major creditor and gold power. Not to mention the actions of a new anti-dollar alliance consisting of the BRICS, Iran and others. If history is a guide, inflation in US dollar prices will come next.
In his 1925 poem The Hollow Men, T. S. Eliot writes: ‘This is the way the world ends/ Not with a bang but a whimper.’ Those waiting for a sudden, spontaneous collapse of the dollar may be missing out on the dollar’s less dramatic, but equally important slow, steady decline.
The dollar collapse has already begun. The time to acquire inflation insurance is now.
for Markets and Money
Ed note: The above essay first appeared in the US Markets and Money 28 May 2015. It has been updated to include China’s current gold reserves.