The Dollar’s Show is Not Over Yet, But the Fat Lady’s Warming Up

It is not hard to underestimate the animosity felt towards the international trade payment system that is based on the historical role in recent history of the United States dollar as the global reserve currency.

Adversaries of the United States have a love-hate relationship with the USD.  During the recent Ukrainian crisis and the short-lived sell-off of the RUB against world currencies, Russians flocked to the USD as a haven, even demanding to settle real estate transactions in USD for a short period.  However, the need to use dollars to settle trade and other transactions has government and business leaders seething, especially with the imposition of economic sanctions by the West.

The Bretton-Woods agreement towards the end of World War II created a system where global currencies were linked to the USD, which in turn was backed by gold.  However, costly global wars and an irresponsible spending spree for the welfare state or Great Society forced President Nixon to abandon the gold standard in the early 1970s.

The out-of-control spending has continued unabated by whichever party is in power.  The sovereign debt of the United States is approaching $20 trillion with no end in sight.  The situation has only gotten worse and the market is beginning to lose faith in the will or capability of the United States to make good on its financial obligations to its creditors.

The emotions of fear and resentment are working hand-in-hand against the USD to remove its status as the global reserve currency.  On one hand you have resentment against the financial hegemony the United States currently enjoys.

The use of the dollar as a trading currency around the world gives the U.S. enormous advantages that are not well understood by our reckless politicians.  There is a natural bid, or demand, for the dollar as it is used to settle accounts and trade transactions.  This puts a floor under the value of the currency as countries and businesses need dollars to conduct business.  This is why the announcement this week that Russia and China would work to exclude the dollar from their bilateral trade is so important.  The two countries will settle their transactions in their own currencies of RUB or CNY.

It is not that this initial step will jerk the valuation floor out from under the dollar.  The point is that this is one of the first steps in removing a reason to own dollars.  The consequences will be felt not immediately but years down the road as this process continues.  Other nations will follow on this path and our children will suffer the consequences.

On the other hand, we have a federal government that cannot and has no desire to stop spending money the United States doesn’t have.  This week President Obama announced executive action to basically provide a way for students to default on a majority of debt owed on student loans.  The President said, “When deciding between paying for student loans or tax breaks for millionaires, this should be a no-brainer.”  I think his statement should be rephrased.  He should have said, “When deciding between transferring liabilities from possible voters to the federal government or the taxpayer, I’ll pick the possible voters every time.”

This executive action is stunning in its scope.  Trillions more in debt will be added to the federal ledger along with ObamaCare and everything else.  The results are simply disastrous and the path is unsustainable.  This is where the other emotion of fear comes in concerning the dollar.  How can any reasonable person see the political will or ability of the United States to pay back the money an investor has loaned them?  Of course bond buyers and other entities long dollars will look for other options to preserve their wealth.

It is obvious the dollar will lose its reputation as a store of value if it hasn’t already.  It’s only a matter of time.

We should expect to see other countries work to exclude the USD from their trade settlement procedures.  We should expect to see other currencies or commodities rise to become a safe haven in the midst of all of this financial recklessness.  I haven’t even begun to discuss the Federal Reserve printing dollars like junk mail and turning the currency into Monopoly money.

Maybe the fat lady has begun to sing after all.

L. Todd Wood is a former emerging market bond trader.  His thriller novel, Currency, deals with the consequences of overwhelming sovereign debt.  LToddWood.com.