US economy has been the most dominant economy since the end of World war 2. US dollar continues to be the store of value and haven for investors in times of risk aversion. 61% of the Forex reserves of countries are invested in dollar-denominated assets and 40% of world debt is denominated in the US Dollar, as per IMF.
US dollar was created by the Act of Federal reserve in 1913. At the time, the US had overtaken Britain as the largest economy though Britain continued to hold its sway in the world economy and most transactions continued to be done in Pounds. US dollar was pegged to Gold as were all the major currencies of the world. The US was the major supplier of military equipment during world war and imported huge quantities of gold creating the largest reservoir on the planet. Bretton wood agreement put the seal on the US dollar as the reserve currency in 1944 when all major countries linked their currency to US Dollar while the Federal reserve re-affirmed its commitment to redeem the dollar for the value of gold.
In 1971, stagflation in the US economy prompted a run on the US dollar when the demand for redemption of the dollar against gold created the risk of the US losing out on precious gold reserves. After a round of devaluation of the US dollar against gold, President Richard Nixon delinked the US dollar to gold standard. This effectively removed any limit on the supply of dollars by the Federal Reserve. The devaluation of the dollar also made US exports more competitive giving a boost to domestic manufacturing.
OPEC imposed an oil embargo on the US in 1973 as a protest to its support to Israel in the Yom Kippur war. This created long ques at the fuel stations and effectively brought the oil guzzler economy to a grinding halt. In 1979, US entered into an agreement with Saudi Arabia and oil-exporting countries wherein they agreed to sell oil only against dollars. It created an unending appetite for US Dollar by oil-importing countries like India, China
In return, US agreed to protect the House of Sauds against all acts of internal and external aggression. OPEC countries also pegged their currencies to Dollar or a basket of currencies dominated by the dollar. It helped in insulating the economies of OPEC countries from wide swings of inflation as they were importing most of the goods also in US dollar.
Current status of US Dollar and Covid 19
- US dollar continues to be the preferred currency of exchange and US continues to be the largest economy. It is noteworthy that personal consumption as a share of US GDP has risen from less than 58% in 1967 to over 70% today. Unlike other countries, US borrows its way to consumption by issuing US treasury bills which are lapped up by Central banks, Hedge Funds, etc around the world. US redeems Treasury Bills by printing currency since there is no limit on the supply of dollars after the abandonment of the gold standard. Ironically, the holder of reserve currency runs the largest trade deficit in the world at USD 616.8 Bn in 2019. US today has become akin to a consumer that maintains its momentum of consumption by increasing its debt and meeting it by printing currency. Rest of the world is also playing the game as it keeps its factories up and running, needs dollars to buy oil, and gives it the fallacy of increasing foreign exchange reserves denominated in a currency issued by a country that has an unending supply of notes. The question that we need to ask is that is it sustainable?
- Total debt carried by US has risen from USD 10 Tn in 2008 to a staggering USD 24 Tn as per Congressional Budget Office. Daily interest cost of the debt is a staggering 1 Bn USD and the debt per person in US is USD73K. As a percent to GDP, it stands at 106.9% up from 68% in 2008 when financial markets were on the brink of collapse. Further, it is 106.9.% of GDP of a country where consumption contributes 70% of the GDP funded by the largest trade deficit in the world. Debt is invariably a pre cursor to a financial crisis and the world is not a pretty place today.
- US has been at the fag end of the curve in the manner in which it is responding to the pandemic. As of the date of writing, US has 7.2 Mn cases of infections with more than 200K deaths. Different countries have followed different approaches in responding to the pandemic. While we are yet to see any meaningful analysis in terms of what would be the most optimum approach in dealing with the pandemic, US has been the worst hit. It may not be an understatement to say that the US is heading into a catastrophe that is both human and economical.
- This crisis is inherently different from the housing crisis of 2008. In 2008, the cash flows of Subprime bonds rated AAA by rating agencies around the world trickled down to zero with the collapse of the housing market. AIG which sold insurance against the default of Subprime bonds through Credit Default Swap (CDS) was staring at losses running into billions of dollars. It was bailed out by US govt which invested a staggering USD 180 Bn to prevent the collapse of the systemically important institution along with investments in major US banks to prevent their collapse. Companies today have created global supply chains to optimize on the sourcing, manufacturing and logistics costs. Covid 19 has disrupted the global supply chain in a manner that was not hitherto imagined. US has reacted to the existing crisis like how it was able to successfully manage the housing crisis of 2008. It has unleashed a Quantitative easing program for a staggering USD 2 Tn. Economists have been pleasantly surprised with the return of demand at Pre-Covid levels in some sectors but the distribution of demand is far from uniform. Companies have been responding to the loss of demand with automation and digitization initiatives which would not help in restoring employment to Pre-Covid levels for quite some time. Supply chain disruptions due to Covid-19 will not help the matters either. The huge influx of liquidity in the world economy may keep financial markets afloat for some time but will lead to inflation and devaluation of US Dollar which has been in an era of unlimited supply.
The world order is changing in ways that have not been seen earlier. It will be too early to hazard a guess on the world order post the pandemic but will essentially depend on how various countries around the world respond to it. If US fails to respond in time before it’s too late, it may impact the world order and the greenback leading to a crisis of confidence in currencies. Gold may come back in limelight and so may the cryptocurrencies. Time is yet to cast its dice!