3 Nov 2020 | World Economy
It must not be forgotten that today’s practices in domestic and international commerce trace their origins back to those first fundamentals adopted to escape the limitations of barter. Equally, that the Greek and Romans developed, then applied these principles on more significant scale than was to be repeated for nearly a millennium. If medieval Europe’s banking system mark the beginnings of more contemporary practices, it was Britain’s leadership in global Industrialisation that led them to maturation. Essential to the latter was the universal adoption of the gold standard—replacing silver for many countries including the United States—in turn paving way for dominance by the pound sterling.
In order to appreciate where these dynamics are changing in the twenty-first century—and their significance—we must understand the pragmatics that underscored the sine qua non of this original reserve currency:
We must also appreciate that each of these elements evolved over time to propel the pound to its unique role and have never been fully replicated nor achieved since. So, while many of the elements listed above undergird the reserve dollar, clear differences do exist. The latter—most especially the move into a totally fiat currency—are critical to understand since they distill into something the far more vulnerable; strength built on perception. Esse est percipi. In 2020 the dollar dominates because the dollar dominates. It is this element based on residual carryover that marks both strength and Achilles' heel. Central here is the ecosystem of the dollar as a stable, cross-border payments system. This is what gives the dollar it’s power, and it is what will end that power. Encouraging the latter is the fact that the system is neither neutral nor benign.
As a de facto monopoly it gives the United States government:
Considering the original reserve currency requirements covered in our opening section. The first quarter of the twenty-first century marks an era in which America has lost its previously overwhelming dominance in economic size, trading significance and comparative military might.
We suggest this is now evolving into systemic weakness. The US dollar has lost 12 per cent of its value against leading currencies since April 2020, but what makes this decline rather different from previously sharp undulations are the underlying structural shifts which suggest this is going to become a systemic and on-going trend. This threatens a key asset of the dollar, stability. This is real enough given the $7 trillion of quantitative easing (currently equal in value to half of all the gold ever mined) now threatening potentially significant inflation. What amplifies the global impact of this danger are the major structural differences between the pound as dollar as reserve currencies. The latter currently accounts for 58 per cent of all central bank assets, when the pound held a similar proportion in 1952 it did so in a time when 70 per cent of these assets were held in gold. In 2020 that figure is more than reversed—with obvious implications for the dollar’s vulnerability. While, with political will the impact of these challenges could be delayed, a more immanent threat comes from the potential of digital and blockchain technologies to evolve into a politically neutral, stable, cross-border payments system outside the dollar.
It is this potential in particular, that is driving the interest of China and other nations in pursuit of the digital currency option. We especially note:
Notwithstanding China’s successes, it is evident that the dollar is set to remain the dominant global reserve currency for some time, but that ending its dominance is far from impossible. The lesson of sterling is that once in situ it takes a sustained and relentless flow of unfavorable circumstances to dislodge it. Seven years after the Second World War sterling still accounted 60 per cent of global reserves, with the dollar a poor second at 30 per cent. In the end it was a combination of the 1968 devaluation and the 1970s oil crisis that witnessed the pound’s fraction of total foreign currency reserves fall from a third to less than three per cent in ten years. Conversely, the dollar escalated to 80 per cent before falling back to 60 per cent, a figure which seems to reflect its natural equilibrium since.
The lessons of history can only teach us so much, however. Considering the factors, we cited as the bed-rock of reserve currency status, it is clear that while China possesses economic strength and trading dominance, it lacks convertibility, the transparency of Western jurisprudence (and thus confidence) and most critically of all, a truly global commercial infrastructure. By analogy this is like having a train but no rails upon which it can run.
China’s hope—and determined ambition—is that the principles underlying cryptocurrency, blockchain and digital-fiat technologies are going to provide an alternative highway. Theoretically, the chances of this happening sooner or later are very high, and sudden changes in world events can make theory a reality in a hurry when expediency demands it. That other leading economies are pursuing similar policies to China in these regards makes a point in itself.
As to what we can conclude, at the very least we are seeing a move away from traditional global transaction infrastructures, and while the dollars’ demise as the global reserve currency seems exaggerated, China may successfully create an alternative based on collective, hegemonic alliances, relieving it of many of the perceived downsides of the dollar's dominance.