At the moment, the US dollar is the reserve currency for the world. But this shifts over time. Different people hold different opinions. Will it be the US dollar (USD) for a long time ( i.e., the remainder of this century)? Will sovereign governments become so over-extended, eventually resorting to a hard backing as it’s done for thousands of years? That usually means anything like gold. To a lesser degree, silver, a commodity that is not subject to broad swings in supply. Or will it be a hybrid currency, as the special drawing rights of the IMF, also known as SDRs?
As of 2020, the US Federal Reserve has a sort of “weak monopoly” on the process of creating global money. The USD is used internationally for various purposes, such as central bank and sovereign wealth funds holding foreign exchange reserves, import invoicing, international debt, and global payments.
Approximately 60 percent of reserves worldwide are in US dollars. During the downturn and the coronavirus, the Fed was able to give money and credit to stabilize the economy and markets (although imprecise and slow).
But, since the Fed is the US’s central bank, most of those dollars go to US entities. Nonetheless, the amount of dollars owed worldwide is roughly 4x higher internationally than in the US. That is globally squeezing a lot of people, companies, and governments. This is particularly true while earning income when owing in dollars (or any foreign currency) in their domestic currency. They get squeezed when the foreign currency goes up in comparison to the domestic currency.
But with the long-term financial situation in the US, there is a possibility that its reserve status will be threatened. Ultimately you can only consume what you are making. Making so much currency and debt can help fill the funding gaps in what needs to be done today. However, it generates new IOUs that will never be paid for.
These countries tend to be major lenders at the start of a new debt cycle (different from the normal business cycle) when there are few debts. When this continues, average cycle-wide interest rates begin to decline when governments become more indebted. With these raising questions about how the economy can meet its debts at the same time, there is less space left for stimulating the economy, new political leaders and central bankers will contend.
Moreover, when major debtors default, they force governments to bail them out because it would be more costly to let them fail than save them.
Governments eventually get into big problems that are much bigger than those experienced by individuals, corporations, and other entities.
In other terms, the government is a major debtor and effectively bails itself out by generating liquidity and credit. And by devaluing it in the process (not necessarily in the short term if there is a demand for it).
People remember politicians more often not because of how much they were financially efficient (e.g., managing budgets and the like), but because of their spending. It’s easy for rulers and leaders to run up debts that aren’t due until long after their reigns or terms are over, making it tempting to act like that. It is then up to those who come after them to deal with an increasingly indebted situation where there is progressively less room for error.
Governments will ultimately want to make money over the alternative of having many defaults and financial pain.
Countries struggle with their financial issues in three primary ways:
- Budget cuts
- Higher taxes
- Money printing
In cases such as coronavirus or any huge funding gap created by a crisis, you can not shore up your finances through austerity or hikes in taxation. If you try that at the necessary rate, it won’t accomplish much. If you’re a politician, you know that the most important thing is to provide the money and credit to fill in the gaps. Even if the debt and long-term obligations created by the expenditure will not be paid back over the long run.
So, when they can, they inevitably go with the third one (printing money). And for the US, if you have the top reserve currency in the world, it’s a no-brainer, but if your finances are poor and you’re potentially insolvent on an asset/liability basis, then you’re in danger of putting it at risk.
That is essentially a matter of currency. What’s money’s worth?
Does the IMF’s SDRs hold any promise?
Debt problems keep coming and going. There was the Great Depression, and then World War II, which created the Bretton Woods program (1944), which saw the US become the most powerful superpower globally and the US dollar as the reserve currency of the world.
This lasted until 1971, when the USA dropped the gold standard. Over the next decade, inflation issues in the US continued as monetary policy was run too loose. Every cyclical high and every cyclical trough in interest rates was lower than the previous one as of 1981.
Every successive widespread bailout comes at a cost, with less stimulant available.
First, the principal way to promote credit growth was to lower short-term interest rates. During the Great Depression and again in 2008, a secondary way of doing so was to reduce long-term interest rates, quantitative easing (QE). As longer-term assets also saw their spreads squeezed relative to short-term interest rates, that eventually ran out of space.
After that, as we are doing now, there is a cooperation between fiscal and monetary policy, among other initiatives, with credit guarantees, direct payments. This is monetary policy in its third form. It was necessary by the conditions, with the coronavirus-related downturn worse than in 2008 in terms of overall economic activity decrease. Since the response was more immediate and serious, markets didn’t drop quite as high.
Although the Fed can literally create capital, even if it’s discreet and not well received, this comes at a price.
Countries will bail out on themselves. But they are paying for it over the currency channel, long-term.
Several weeks ago, the US Congress passed a $2.2-$2.3 trillion stimulus package called the CARES Act. It contained 350 billion dollars in loans from small companies, which can be forgivable if it helps pay workers. Due to demand, the funding was drying up fast.
The legislation also calls for the Treasury to recapitalize the Federal Reserve to $425 billion. The Fed is a central bank (bank of commercial banks) and functions as a bank. It can use this new capital to purchase other collateral sources to help fund the recovery, including corporate credit, mortgages, municipal bonds, and other assets.
They turn to the International Monetary Fund (IMF) for countries with limited demand for their currency (and consequently low demand for their debt). The organization, which has about $1 trillion of balance sheets outside its liquidity buffer, saw at least 120 countries reach out for help.
Turning to the IMF = Printing of Special Drawing Rights (SDRs)
Special drawing rights (SDRs):
Special Drawing Rights (SDRs) is an accounting unit and not an individual currency. The weightings and currencies used are based on the number of reserves held globally and the international exports level. There can be a re-evaluation of the basket every five years (i.e., all weightings and currencies). The renminbi, introduced in November 2015, went into effect next October.
In 2008, the use of SDRs was relatively small (approx. $250 billion). It took a long time to issue them (August 2009), after the crisis had already blown past the worst part and nearly a year.
Because of the virus-related impact, more of the world turn to the IMF for help, meaning greater de facto demand for SDRs. The world that was going into the Covid-19 crisis was never that indebted. Problems with the balance sheet get magnified when revenue drops.
Countries with reserve currencies can create money. But it also means starting the recovery from a high debt base. This makes it harder to increase government spending and take tax increases as the expansion ensues. It also means a lot of near-term pain when creditors are not paid, and businesses cannot meet their expenses, leading to asset sales, defaults, and financial markets falling.
The creation of SDRs normally involves issuing them by IMF members in proportion to their voting rights within the IMF. But this also means countries such as China and Iran, which have tension with the US, would be part of an IMF bailout package. This is part of the reason the US doesn’t want to issue new SDRs.
As any crisis deepens or begins to affect new countries, pressure on the IMF increases.
The problem has no technical limits on printing money, but at the same time, it is not costless. It places more strain on the IMF and its own printing exercise. Particularly as its authority is greater, the Fed only has direct recourse to US individuals and businesses.
China may have its own requirements for taking money from the IMF, a decreased USD position in the SDR. China already accounts for 11% of the SDRs (mostly due to its global trade position) with just 2% global reserves.
Can SDRs be the next reserve currency?
Special drawing rights (SDRs), a form of hybrid currency of existing national currencies, are unlikely to replace USD as the top reserve currency given the IMF’s technical status as the last-resort lender.
The country with the highest national income usually has the top reserve currency in the world. This also usually means they have the most powerful military globally and are technically superior in several other respects.
Yet, we are in a world where the overall debt stands at over $300 trillion against a GDP of around $90 trillion pre-corona. Considering a decline of about 20 percent, debt commitments are now around four times the global annual profits. If, in addition to this, you consider debt-like commitments in the form of pension, health insurance, and other unfunded commitments, it is much higher, depending on the discount rate used to capitalize these obligations. But in the US alone, you get non-debt (but debt-like) bonds, which alone amount to $300 trillion north.
Such tasks – most of which include individuals obtaining anything without creating something – are ultimately an exercise in money printing. The amount of revenue collected at the federal level does not account for the expenditure. Let alone the increasing wave of obligations that come due.
It’s a game of trust, in the end. IOUs are currency and debt. Needless to say, too many IOUs contribute to crises.
Throughout history, governments only select commodity-based currency systems when they are compelled to do so. Unconstrained monetary structures have driven them to “print” many it to satisfy their debt burdens. They eventually abandon commodity-based structures or adjust the conversion when they don’t allow the money production that crises demand. And, over time, governments oscillate between the two. Nonetheless, currency regimes tend to work successfully for decades. Or sometimes for over a century, meaning that these watershed moments are not frequently reached.
This is why many investors use gold as a currency hedge against unacceptably low real rates and as an alternative to rarely occurring forms of tail risks (e.g., currency shifts). But they repeatedly happen throughout history, often enough for investors to hear about them in select countries (e.g., Venezuela, Zimbabwe).
Unpacking words from Powell
The standard of collateral approved by policymakers goes further and further down the continuum in every crisis. We start with government short-term bonds, go out to long-term bonds, high-quality corporate credit, and so on.
The Fed has gone all the way out in the coronavirus crash to high-yield ETFs, an equity product that tracks high-yield indices. Some believe that there is a legal problem with the Fed making these purchases. Although they feel it is important to support those who have been unfairly punished by the crisis effect. Powell believes that people make those sacrifices for the common good and that we need to get them through. We will, as a society, be doing that because they did not cause this to happen. Their business is not closing for anything that they have done wrong. They have not lost their job because of anything that they have done wrong.
Although this sounds fair, it’s hard to argue that investors should receive amnesty to the full extent of the risk already embedded in the stocks.
The US business had been at the highest P/E level since the tech bubble of 2000, to go along with many others. Market cap on GDP (or how financial capital is relative to real-economy capital) was already on par with the tech bubble.
Many who own BBB bonds at yields of sub-3% can not be surprised that yields were as low as they were.
The inflated financial asset prices climate was fuelled by developed market central banks purchasing more than $15 trillion in financial assets between 2008 and 2017 (and encouraging that before the crisis). Pushing investors out on the risk curve and unable to standardize or reverse such “emergency” actions.
Those initiatives must remain wider and far-reaching. Default risks are reduced, and after a certain point, basically, everything is backstopped. To eventually increase the debt more is the solution to every debt-fuelled dilemma. This has the effect of reducing capital costs even more to minimize the debt impact (i.e., debt servicing softening). This has certain consequences of supporting zombie companies (companies that cannot meet their interest obligations with operating earnings), which companies misallocate capital in the long run and the potential for long term growth. One IOU is substituted with another. On par with a Ponzi scheme as on the net, all these long-term commitments will never be paid out.
TINA or the idea that “there is no choice” (to purchase risk assets) is restored, and the next money-printing-supported bull market starts.
Countries that don’t bail out huge swaths of their economies end up looking like Iceland. Whose stock market was almost zeroed and remained 80 percent below its peak in 2007. Although this created suffering for Icelandic people and companies, it protected against moral hazard and a currency crash. As a less developed nation without a reserve currency, it’s more difficult to carry out the mentality of “whatever it takes.”
Compared to what the US has achieved with zero rates and the purchase of assets:
This is an indication of how much influence a reserve currency might have.
Central banks fortunate to have reserve currencies can “print” currency. In that regard, central banks without reserve currency countries have limited ability due to limited demand for their currencies (i.e., the debt generated by money printing).
With coronavirus blowing a hole in sales and balance sheets, central banks had to move rapidly, with little regard for the long-term consequences. Some programs are not going to work and will be wasteful. Officials find it difficult to unwind some of the programs. Central banks may use politicians to guide them to solve problems they don’t want to solve. These are all things that, over time, could erode central bank authority and question the value of money.
There is a massive demand for IMF funding, with more than 120 countries seeking assistance from the organization as a source of capital, especially for low-reserve countries. The IMF has its own currency (an accounting unit, more realistically) called Special Drawing Rights (SDRs). Even as the final-resort global lender, its account unit is unlikely to replace the US dollar as a reserve currency. It is not a currency by itself but consisting of other national currencies.
Reserve currencies will last past the point where nations and empires are thrusting themselves into poor economic long-term safety. There’s a component to the reputation. Incomes will remain high even though, from an asset and liability perspective, the country is in poor shape in the long-run. The US will never be in a position to meet its debt and long-term obligations. They will never cut enough spending or tax, as those mechanisms are limited. They have to print currency. There will be little demand for debt at home or abroad. So the Federal Reserve will have to either purchase it or directly monetize it. (Basically, without first issuing or withdrawing debt).
Countries over the course of history oscillate between commodity-based monetary systems and fiat monetary systems due to each problem. In the former case, money development depends on that a commodity’s supply is not subject to broad demand fluctuations (usually gold) or changing the commodity’s conversion rate to currency. Because under this approach, the constraints on money creation are too onerous. Countries abandon it in favor of fiat regimes after some time operating this system, where they can create as much as they want, leading inevitably to debt problems.
Although the reserve status is temporary – generally only for 75-150 years – anything like gold as an alternative form of money appears to have long-term demand over centuries. It is not flawless in any way, and it has an environment where it does well and an environment in which it does poorly. But holding it in a smaller quantity as part of one’s long-term holdings can be useful as a form of alternative cash.