Turning Away From the Dollar

European debt problems have kept financial markets on edge during much of the last two years, but it is the debt problem in the United States that is far more likely to precipitate a global crisis.

Recently, Lawrence Goodman, a former crisis-prevention analyst at the U.S. Treasury, sounded the alarm that investors balked at low coupon rates last year, forcing the Fed to buy “a stunning … 61 percent of the total net issuance of U.S. government debt.” His view that ballooning deficits and excessive debt put the U.S. economy and markets at risk for a sharp correction also explains why the recovery is so weak and why trillions of dollars remain sidelined. The other dimension to the story that may trigger the next financial crisis is the loss of the reserve currency status of the U.S. dollar.

What saved the greenback after Richard Nixon removed the U.S. dollar from the gold standard in 1971 — ending the postwar Bretton Woods international financial order — was making the dollar the reserve currency of the world. This began with Saudi Arabia agreeing in 1973 to accept only dollars as payment for oil in exchange for U.S. protection of the Saudi monarchy and its oil fields. By 1975, the reserve currency status of the dollar was firmly established, with all OPEC members agreeing to trade only in dollars. Trading of other commodities has followed suit, which reinforced the dollar’s reserve currency status.

Central banks around the world have maintained disproportionately large reserves of dollars to facilitate trade, which enabled the United States to print excessive amounts of its currency with seemingly little inflationary consequences. The reserve currency status has also allowed Americans to import more than they exported, to consume more than they produced, and to spend more than they earned

But all that is about to change.

The U.S. dollar is already being abandoned by a number of countries in favor of the Chinese yuan. In December, Japan and China agreed to dump the dollar and trade in yen and yuan. China’s trade with Vietnam, Thailand, and Russia is now also settled in yuan. In January, the 10 nations of the Association of Southeast Asian Nations strengthened the linking of their economies with those of China, Hong Kong, Japan, and South Korea with a $240 billion equivalent nondollar credit agreement, thus moving further away from the dollar.

Elsewhere, while Iran’s nuclear energy development program gets scrutiny, few realize that Iran is openly circumventing dollar-based trade sanctions. As of March 20, Iran started trading oil in currencies other than the dollar. India has agreed to settle 45 percent of payments for Iranian oil in rupees, with gold as an additional payment option.

The recent U.S. threat to impose sanctions on India, China, and South Korea for refusing to reduce their oil imports from Iran may only drive expansion of nondollar trade regimes. The BRICS nations — Brazil, Russia, India, China, and South Africa — which have had stronger economies than the United States and Europe since the 2008 financial crisis, are asserting themselves. On March 29, the China Development Bank agreed with its BRICS counterparts to shun dollar lending and extend credit to one another in their own currencies.

The erosion and loss of the use of the U.S. dollar as the reserve currency means less demand and more dollar selling by central banks around the world, which in turn causes inflation as the dollar weakens against other currencies. Worse, the demise of the dollar’s reserve currency status, at the same time that federal debt compounds to new heights, creates a perfect storm, making a collapse of the dollar closer than most Americans realize.

What’s needed now is new leadership in Washington that has the courage to implement serious budget and entitlement reform and defend the dollar.