The U.S. dollar has been the reserve currency of banks worldwide for many years, and according to the Wall Street Journal, as far back as World War II. To this day, the greenback comprises over 60% of all central bank reserve currency. With the U.S. federal government backing American debt and the clout of the U.S. economy backing the currency itself, the world economy has nothing to fear. Right? Wrong. Between the annual budget deficits of the U.S. government, the expansionary monetary policy of the Federal Reserve, and a massive balance of trade deficit by the overall economy, the dollar's once sterling reputation has faded. The U.S. government must act fast to right the ship. While foreign exchange markets have not yet fully priced these events in, the writing is on the wall.
The U.S. federal government has traditionally tied its national currency to a metal, with the exception of the Civil War period from 1862-1879, when the U.S. Treasury found it impossible to maintain convertibility. For roughly the next 50 years, the U.S. economy functioned under a true gold standard. With the exception of a few panics and crises along the way, the gold standard acted as an effective monetary structure for the nation.
In 1933, the Great Depression hit. A stock market crash of unimaginable size triggered one of the largest series of bank runs in U.S. history, causing 11,000 of the nation's 25,000 banks to go under. This pointed out a major flaw in the gold standard: the inability of the Federal Reserve to coordinate the money supply with money demand. With money demand at a historical high, the Federal Reserve was helpless to inject liquidity into the banking system. If the Federal Reserve increased the money supply, thereby lowering interest rates, capital was sure to flow out of the country in search of a higher yield. Under a gold standard, capital outflows are synonymous with gold outflow because the currency can be exchanged for gold at any point in time. The U.S. Treasury could not allow this to happen, as the dollar would depreciate if less gold were to back it.
To solve this issue, the gold standard ended in 1933. It was replaced with a quasi-gold standard, where gold convertibility was only applicable to international transactions. As a part of this system, all the gold in the United States was nationalized. This was to be the case until President Nixon's announcement in 1971. By 1973, the U.S. monetary system operated solely on a fiat currency basis.
Spend, Spend, Spend
Today, the U.S. dollar serves as the undisputed reserve currency of the world. In essence, foreign nations hold the dollar to either service debt or to pay for goods or services denominated in the reserve currency. Some of these goods are oil, gold and securities. For example, OPEC chooses to price its oil in U.S. dollars, forcing nations to hold dollars to lower their transaction costs and hedge dollar exchange risk. The same can be said for any other dollar-denominated goods or services.
The U.S. federal government, however, is crippling the stature of the dollar every day with its rapidly rising budget deficit. In 2012, the U.S. budget deficit was $1.1 trillion. In addition, as of the beginning of 2013, U.S. national debt was over $16.4 trillion. While Congress continues to approve budget deficits, the fate of the dollar begins to look more and more grim.
The Federal Reserve can always employ debt monetization to provide aid; however, confidence in the U.S. government's ability to service its debt without rampant inflationary measures is waning. If the U.S. budget deficit and national debt continue upon their current trend lines, nations, financial institutions and individuals alike are sure to move to another currency. It is only a matter of time.
The Go-To Currency of the Future
Despite its weaknesses, the euro looks the most promising. Yes, the Economic and Monetary Union (EMU) is experiencing several sovereign debt crises and needs an overhaul of its central banking system, but serious progress has been made. Despite the odds, the European Union seems to have survived its darkest hour. Already, the euro is making a push for the status of preferred reserve currency of the world.
Speculators have also listed China's yuan as a candidate for succession. As the nature of the government of the People's Republic of China is less than democratic, however, the checks and balances inherent within other governments are nonexistent. Thus, the yuan would be a risky currency with which to denominate any goods or services, let alone act as a reserve currency.
The Bottom Line
International markets conduct their transactions using dollars for a myriad of reasons. At its core, the dollar is more than just another fiat currency; it is a symbol of security. Take that away, and the euro will likely become heir to the currency throne.