I’ll be explaining the history of this currency, the situation we are faced with today, and what this implies for our future.
This post is lengthy, and can be difficult to comprehend if you're a beginner investor, but I've made it as digestible as possible and I highly recommend that you read through the entire post.
Disclaimer: I am not a macroeconomist, or a forex expert. Even if I were, that would not imply that I would be able to accurately predict the future of a currency and the financial markets. This is for educational purposes only. Invest and trade at your own risk.
- The entire world has been complaining about the difficulties that the USD has been causing as a key currency.
- While there were benefits to having the USD as a key currency, this also meant that the US economy would take a smaller portion of the global economy, and that their trade competitiveness and employment rates would be negatively affected.
- While the USD as a key currency provides benefits to major conglomerates and financial institutions, it causes problems to the average working-class people, instigating polarization and conflict.
- While the USD’s status as a key currency remains solid, with increasing economic and political cost, the US would have reasons to voluntarily give up on this status.
- Nixon gave up on the gold standard, Trump abandoned most international agreements. As history demonstrates, the USD could also be taken down from its place as a key currency as well.
- During the mid-19th century, around the first world war, the United Kingdom’s Poud Sterling played the role of a key currency.
- Back then, they used the gold standard, in which the currency was backed by gold .
- In other words, if you took cash to the bank, they would exchange it for a certain amount of gold .
- Around the UK’s end of its heydays in 1914, they were losing competitiveness due to massive gold outflow. (Since they use the gold standard, a trade deficit indicates gold outflow)
- They halted the gold standard during WW1, and in 1925 attempted to bring it back.
- But in doing so, they made a big mistake of using the same rates at 1914.
- As a result, this lead to a even bigger, and faster outflow of gold from the UK, which ultimately led them to give up on their key currency status.
- With the UK as the debtor, and the US as the creditor, the power dynamics shifts, and in 1944, the Bretton Woods system is established.
The Bretton Woods System
- This system defined all currencies in relation to the US Dollar , which itself was convertible to gold , effectively making the USD the world currency, as every other currency was pegged to it.
- There were signs of this new system potentially being established.
- Individuals were legally prohibited from owning gold from 1933
- The allied forces moved their gold to the US, in order to keep it safe.
- With 70% of the world’s entire gold stored, the Bretton Woods system and the gold standard was implemented. (35 Dollars for an ounce of gold )
The Triffin Dilemma
- But there is a problem that comes with being a key currency, also known as the Triffin Dilemma
- The USD becoming a key currency means that the entire world needs to use the dollar.
- This means that the US needs to supply USD to the entire world.
- But, if they print more USD for supply, the value of the Dollar drops.
- If they don’t do so, in order to maintain the value of the Dollar, there won’t be enough Dollar for international trade
The Fall of the Bretton Woods System
- In the 1950s, with the emergence of the Japanese and European economy, the US faces a balance of payments deficit.
- The US’ government expenditure increases significantly due to their War on poverty and the Vietnam war.
- With the credibility of the USD begins to deteriorate globally, the world begins to change their dollars into gold .
- The US faces a bank-run like situation, and Nixon abolishes the gold standard, implementing the fiat currency policy.
Then why do we still use the USD?
With the Gold standard, we were assured that we’d get an ounce of gold for $35. If fiat currency isn’t backed by a commodity, and is based on credit, what motivates us to continue using it?
In order to figure out why, it’s important to look at what happened between the US and Saudi Arabia.
- In 1933, not only did the US ban civilian ownership of gold , but they also established their diplomatic relations with Saudi Arabia.
- US company Standard Oil of California obtains permission for the exploration of crude oil in Saudi Arabia (its subsidiary company is now Saudi Aramco, an oil company with the largest market cap in the world)
- Then came World War 2.
- Saudi Arabia wanted to remain neutral during WW2, but with Italy’s attack on the country, they had to find a country they could rely on.
- The US realized the strategic importance of oil around this time, and decided to remain good friend with Saudi Arabia.
- In 1970, the US’ aid to Saudi Arabia amounted to $16 million.
- After the gold standard was abolished in 1971, the US’ aid to Saudi Arabia increased by 20x, reaching $312 million.
- In 1974, William Simon, a former bond trader from Wallstreet, goes to Saudi Arabia to conclude a secret agreement
- The agreement states that the US would provide military aid to Saudi Arabia, and import their oil .
- In return, Saudi Arabia would purchase US Treasury Bonds.
- This agreement was made secretly, due to the US’ relationship with other Middle Eastern countries, and Saudi Arabia secretly purchased US Treasury Bonds over 41 years.
The Petrodollar System
- Hence, the Petrodollar system was born. (Petroleum + Dollar)
- This is a system, simply put, allows the US Dollar to be loosely backed by oil .
- The US found a way to force other countries to use the USD by setting oil prices in USD.
- This means that if Japan were to purchase oil , they would first have to exchange Japanese Yet (JPY) to USD.
- As the Bretton Woods System falls, the USD is able to maintain its status through this new system.
Why did Saudi Arabia purchase US Treasury Bonds?
- If Saudi Arabia doesn’t purchase US bonds with the USD they received, this leads to an increasing amount of Dollar in circulation, devaluing the currency significantly.
- By reaching an agreement in which Treasury bonds would be bought, the US would be able to operate with a massive government deficit.
The Fundamental Issue of the Petrodollar System
- However, the Petrodollar system also encompasses the Triffin Dilemma
- The US needs to supply USD to the entire world in order to allow countries to purchase oil
- A constant supply of USD means that the currency flows outside the country, indicating a trade deficit for the US
- As you probably know from Economics 101, when a country is at a trade deficit, it indicates that their products are relatively cheaper in the international markets
- The depreciation of the country’s currency leads to an increasing competitiveness in exports.
- But in the case of the UK, because their currency was pegged to gold , a trade deficit led to gold outflow.
- But that isn’t the case for the Petrodollar system.
- Instead of gold outflow, damage was caused to the manufacturing industries in the US.
- This is what explains the Rust Belt. Detroit, which once prospered, became a dead city.
So What Does America Gain?
- Why would the US want to keep the USD as the key currency?
- There are also major benefits to keeping the Dollar as a key currency.
- Despite the increasing supply, the value of the currency hardly depreciates.
- There are benefits to multinational companies going overseas.
- With the increasing demand for US Treasury bonds, foreign capital flows into the US
- With this, the US is able to keep the interest rate on the bonds at a low rate.
- In other words, the government is able to borrow money for a cheap price.
- With this all combined, the US’ financial industry gains a competitive edge.
Can this system last forever?
- I personally believe that this system cannot last forever, and it’s only a matter of time until we see a huge paradigm shift.
- There are mainly five reasons as to why this system cannot last forever.
1. Unnecessary Military Expenditure Post-Cold War
- The US played the role of a world police during the Cold War.
- But after the end of the war, massive military expenditure was deemed unnecessary and burdensome.
- The US continued to play the role of a world police – leading up to the Trump administration – for oil and to keep the USD a key currency.
2. The US Shale Revolution
- Then came the US Shale Revolution, in which the US significantly increased its production of oil and natural gas .
- As a result, from a country that imports oil , the US becomes a country that exports oil
- This indicates that there is no need for the US to play the role of a world police in order to secure oil .
- Ultimately, while military expenditure fulfilled three main interests of the country (cold war, oil , and USD as a key currency), it’s only left with one purpose of keeping the USD a key currency.
3. China’s Rise
- During the Bretton Woods system, the US GDP covered over 40% of the global GDP.
- Currently, it barely covers 20% of the global GDP.
- This indicates that the US needs to bear more financial instability in order to keep the USD a key currency.
- In other words, the cost of maintaining the USD a key currency increases, in relation to the country’s GDP.
- China also created the Petroyuan, which is China’s attempt to overthrow the existing Petrodollar system.
- Lastly, China was once had the largest treasury bond holdings, which indicates that they could cause a shock to the US economy by selling huge chunks of their position. (Although this would also entail that China’s remaining Treasury bond holdings would lose a lot of value as well)
- China has been exploiting the Petrodollar system’s leeway by not abiding by the conventional rules
- In the Petrodollar system, foreign countries are able to build export competitiveness, and gain USD, which they return back to the US by purchasing US Treasury bonds.
- China, instead of abiding by the rules, decided to purchase real assets and global infrastructure with the USD they gain.
- This way, the FED has to support the US’ national debt, which destroys the benefit of having the USD as a key currency.
4. Political Instability (Socioeconomic Polarization)
- As mentioned above, with the rise of American financial institutions and decline of the manufacturing industry, socioeconomic polarization is taking place, and it’s getting worse
- There’s a discrepancy between economic classes, industries, and countries.
- It’s no surprise that polarizing figures like Trump from the right, and Sanders from the left have gained interest from the general public.
5. The Fall of Labor-Intensive Industries.
- In the past, the US was no match against China’s labor power.
- But, with the 4th industrial revolution, automated robots and artificial intelligence is replacing labor, thereby providing a potential opportunity for the US to gain potential competitiveness in exports.
- They could potentially let go of the USD’s status as a key currency, allow the USD to depreciate, and gain a competitive advantage in exports.
- While it would take a long time before something like this happens, I believe that the foundations are being laid for such a transition.
For these reasons, I believe it’s highly probable that the USD will stop playing the role of a key currency.
How to Profit from this Crisis
- With massive change comes massive chaos, and the ones who are able to remain unperturbed, and make the right decisions will be the ones to see opportunity in crisis.
- I believe that Bitcoin can be one of the best ways to protect your wealth, as the USD collapses.
- For an in-depth explanation on why I think so, make sure to check out my previous post:
In summary, the fall of the USD is a question of when, not if. As to what would happen in the next decade or two, I have no clue. However, the red lights giving warning signs are certainly getting clearer and clearer. You can either risk losing everything from a crisis that might come sooner than we expected, or be prepared for a situation like that, and capitalize on a once-in-a-lifetime opportunity.
Some commenters touched on Bitcoin's potential as taking over the USD's mantle, and I do question some arguments they bring onto the table -- especially on how much they really know about the Bitcoin protocol, its community, its economy and its network effects, but that's for another day..