Article Highlights:
Establishment of the US dollar as the global world reserve currency during the 1944 Bretton Woods meetings, which gave the US the privilege of buying overseas goods with printed dollars and the US responsibility for protecting sea lanes.
US economy robust growth following WWII spurred by innovation, strong manufacturing base, and from having the reserve currency.
The process, measurement criteria, and signals of an empire’s rise and fall, as described by Ray Dalio’s animated video, The Changing World Order.
A comparison of the strengths and weaknesses of America and China and how those factors reflect the possibility of China becoming the dominant global power.
How recent Russia sanctions erode the dollar as the world reserve currency and create the possibility of high inflation and global food, energy, and commodities shortages.
In How Is Our Money Created?, I described how the US dollar is created and how it serves as the world reserve currency. As issuer of the world’s reserve currency, the US was required to print money needed by all countries for conducting global trade. However, the US garnered the ability to buy goods and services from other countries with some of that money, without exchanging goods and services in return – the aptly named ‘exorbitant privilege’ – resulting in decades-long trade deficits.
Other countries agreed to this arrangement during the 1944 meetings of global leaders and financial ministers held in Bretton Woods, New Hampshire. In return for the benefit of a gold-backed dollar being the global reserve currency, the US proposed to use its navy as a police force to keep order on the world’s seas. Since global trade is primarily conducted via overseas shipping, it was necessary to ensure the safety of commercial ships, and one primary US goal during the Bretton Woods discussions was to encourage global trade.
The Bretton Woods agreements marked a new economic world order – one officially replacing the British pound with the US dollar as world reserve currency. This meeting also gave birth to the World Bank and International Monetary Fund (IMF).
In 1944, other countries were really in no position to object to the US proposals. Nearly all European countries and Japan were severely damaged by WWII with their economies in shambles. Other Asian countries were recovering from WWII as well, and no other countries had economies of consequential scale.
Of the larger nations, only the US came through WWII with an intact infrastructure. The US also had a relatively strong economy due to manufacturing stimulated by the war effort. Furthermore, the US held more gold than every other country, which was important because all currencies were backed by gold at that time.
Looking back in history, the Bretton Woods agreements marked the beginning of the American Empire. The American economy grew rapidly into the 1950’s and beyond, allowing America to quickly dominate the world economy. In particular, the US Navy grew to a size previously unseen in prior history, expanding until it exceeded the size of all other countries’ navies combined.
Safe sea lanes created a stable period for global trade, allowing considerable interaction between countries previously more localized. This set the stage for the globalization we have witnessed over the past few decades and a decades-long period of relative global peace (no world wars).
I stumbled upon Bretton Woods in the fall of 2010 while driving through the Northeast on a short vacation following a couple weeks working in central Massachusetts. The White Mountains are home to a handful of massive hotels from the early 1900’s, one of them being the hotel at Bretton Woods. The hotel is such a large, isolated building that it has its own post office, and the hotel complex, including ski resort and golf course, for all practical purposes, comprises the entirety of the ‘town’ of Bretton Woods. Walking on the creaking wooden floors of this hotel, which is still open for guests, I reflected upon the impact of those 1944 meetings.
Following the war, the US was a creditor nation with trade surpluses created largely through sales of manufactured products. Savings were high and inflation low. There was little inflation, low government and private debt, and had a financial sector that comprised less than 4% of the economy.
During this post-war period, tax rates were around 90% on the highest income individuals. This high graduated tax rate was a factor in suppressing growth in wealth inequality. During this period, the US saw its largest growth in the middle class. A large, stable middle class is generally considered a sign of a healthy economy, especially since the largest driver of a healthy economy is small business.
In my view, large wealth inequality is probably the greatest indication of a degraded or an undeveloped economy. Wealth inequality is prevalent in under-developed countries. It calls to mind for me living in the Philippines in 1980 as a Peace Corps Volunteer.
In 1980, the Philippines was under-developed with poverty levels not seen in the US. There were masses of poor people and a few very wealthy individuals, primarily large land or business owners.
I will never forget riding on a rundown bus through the mountains, passing farmers leading water buffaloes and dodging other farmers drying their rice on one lane of the road since it dried better in the sun on concrete in that humid climate, as these were common sights; only to be passed by someone driving a Mercedes sedan. Such a stark contrast.
The high US tax rates did not sit well with 1950’s and 1960’s high earners because any earnings over $100k per year were effectively taxed at 100%. Reflecting on this time, Ronald Reagan stated that he never bothered to make more than one movie per year because his wages from subsequent movies all went to the government. His dissatisfaction was reflected during his presidency when he implemented the ‘trickle-down-theory’, a component of which significantly reduced tax rates on high earners.
Fast forward to today and we see much lower effective tax rates on the wealthy, exacerbated by loopholes, with high trade deficits, small manufacturing base, a financial sector exceeding 20% of the economy, and high public and governmental debt. All of this has led to increasing wealth inequality, and when looked at historically, these trends match phenomenon experienced in prior empires.
Empires have their cycles, and the US empire is no exception. Since history has a way of repeating itself, it is wise to study prior empires, their strengths, their mistakes, and their social and financial progression.
Recently, Ray Dalio, founder of hedge fund Bridgewater Capital, shared a video exploring the rise and fall of previous empires, focusing on their monetary system. Dalio is a financial innovator and because of the success of his hedge fund, the wealthiest resident of Connecticut. This video is based on his recent book, The Changing World Order: Why Nations Succeed and Fail.
The basic premise of the book, and his animated video, is that the cycles of empires occur because of features of those empires, and are intricately tied to their monetary systems. In this video, he explores the following topics:
Changing world order as empires rise and fall.
Role of gold for balance of payments between countries.
Process of currency devaluation.
How to measure the power of an empire.
The typical path of an empire’s rise and fall.
The creation of wealth inequality within and between countries.
Consequences of having the world reserve currency.
How currency devaluation undermines empire.
What happens next?
Dalio proposes the American Empire is in decline, citing a number of factors that are hard to refute. The extraordinary money printing during the pandemic places America on the downslope of Dalio’s Big Cycle curve as seen below, probably somewhere in the red ellipse. The decline began around the time of the financial crisis of 2007-2008 and accelerated over the past two years.
Per Dalio, this pending transition portends China replacing the US as the dominant world power. But will it? There are other factors at play in this cycle that were not of concern in previous transitions; for example, limitations on resource availability, climate instability, and energy restrictions. Let’s compare some of the factors at play.
China strengths:
Education – China places significant emphasis on higher education and has caught up rapidly with the developed world over the past couple decades. During my time working there it was clear that competition for higher education was intense, much more intense than here in the US.
Manufacturing capacity – China clearly is ahead in this area.
Infrastructure – China has developed arguably the most extensive array of infrastructure anywhere, ever. Having seen it, I can say that it is a bit hard to describe its scope. Furthermore, since it was centrally planned, it is often more efficient than in the US. The best example of that is their high-speed rail system. I have used it on many occasions. It is fast (up to 180 mph), cheap, on-time, and with extensive national coverage. Amtrak’s system is more like a toy train in comparison. The US has aging infrastructure and an advanced financial system. China is largely the opposite.
Trade surplus - China has a large, positive trade balance, whereas the US has a large deficit.
US Strengths:
Demography – largely due to heavy immigration, the US has a relatively young population, which is a necessary component to a strong and growing economy. China, because of its (now ended) one-child policy, has an aging population, a high percentage of which will be moving into retirement age in about a decade. China has little-to-no immigration, and from what I saw, most young couples are still having one child, or maybe two.
Energy resources – the US has the capability of being oil independent due to its shale resources. China must import the majority of its oil. The US has even more extensive natural gas and is an exporter, whereas China must import nearly half its natural gas. Both China and the US have extensive coal deposits; however, coal usage is being curtailed around the globe due to climate issues. Lastly, the US has the most nuclear plants of any country. China, however, is in the midst of a rapid nuclear plant buildup, while US plants are aging. On balance, the US is in a more self-sufficient energy position than China.
Innovation – the US is heralded for its innovation. Silicon Valley is renowned in this regard. I see this as an inherent outgrowth of our liberal democracy, as captured in the US Constitution, intertwined with a populace that over centuries immigrated here to seek a better life. China has none of these.
During my work in China, I was told a story by a co-worker of a contest where a group of Americans and group of Chinese were challenged to build the best paper airplane. The Americans individually created a paper airplane, then compared each’s creation to one another, then chose the best. The Chinese researched paper airplane designs as a group, found the best design they could, then attempted to collectively improve it. I don’t know who won the contest, but this story perfectly encapsulates the Chinese mindset for innovation.
I saw this approach myself played out on an almost daily basis while there. I realized that someone like Steve Jobs, whose personal behavior was outrageous at times, could never have invented the Apple products in China. More likely, he would have been ostracized and minimalized. On the other hand, Chinese are very good at building iPhones and other technologiesFood resources – the US is one of the largest food exporters in the world, and furthermore has more navigable waterways for shipping than any other country by a wide margin, which greatly lowers transportation costs. The US is easily food secure. China, on the other hand, imports food. Almost the entire eastern one-third of the country is mountainous, similar to the Appalachian Mountains, and only the valleys can be easily farmed. The northwestern part of the country is largely desert. Chinese are creative in how they raise food, growing it nearly everywhere I visited (I was exclusively on the east coast), and eat a very diverse diet that allows for growing of food plants in areas that are not mechanically harvested.
These are just some of the major factors. Other factors are more balanced. For example, based on my observations, work ethic is similar in the two countries. Chinese are not afraid of long work hours, especially small business owners. Also, less-educated younger Chinese willingly work factory jobs. Americans are more innovative in how they work, and this can produce greater efficiency.
The US and China both have large government debt and it is suspected that China has a very large stockpile of gold. In a shift back to gold-backed currencies for international trade, China might be in a better position than the US. From another angle though, there is talk in some circles of bitcoin playing a role in international trade (something I plan to address in the near future). China has banned bitcoin, but bitcoin is a natural fit with America’s technology innovation history, and America has become the major player in the bitcoin and crypto digital revolution.
Now, understanding some of the factors in play in this seemingly impending empire transition, let’s look at the potential impact of the recent Russia sanctions.
Russia has the 11th largest economy in the world, just behind South Korea and just ahead of Brazil. It is connected economically for trade through the SWIFT payment system. SWIFT stands for the Society for Worldwide Interbank Financial Telecommunication and is a system enabling financial institutions to send and receive information about financial transactions in a secure, standardized environment. Since the dollar serves as the world reserve currency, SWIFT facilitates the international dollar system. SWIFT is basically the central nervous system of the global financial system
The US controls the SWIFT system and has in the past used SWIFT as a tool (many would say a financial weapon) against North Korea and Iran to prevent those countries from using the system for trade payment. Banishment from SWIFT greatly reduced Iran’s oil exports and threw the country into a very difficult financial position with high inflation and shortages created by difficulty paying for imports.
In the case of Russia, sanctions have frozen Russia’s dollar and euro-based savings currently held in SWIFT. Using SWIFT for sanctions can backfire though, because other countries see that if they step out of line with the US government, they can potentially have their reserves frozen and be locked out of trade settlement. This creates doubts about the dollar’s safety as a global reserve currency.
Reserve currency status can be maintained only through trust. Should other countries begin to mistrust the value or availability of the reserve currency, they are likely to explore other trade payment options. This is already happening in Asia, as stated in this recent bit of news regarding the Eurasian Economic Union, which includes Russia and other nearby Asian countries such as Kazakhstan and Belarus:
The Eurasian Economic Union (EAEU) and China will develop a draft of an independent international monetary and financial system. This was agreed by the participants of the economic dialogue "A new stage of monetary, financial and economic cooperation between the Eurasian Economic Union and the People's Republic of China. Global Transformations: Challenges and Solutions", which was held via videoconference on March 11.
As explained in Dalio’s video, dismantling of reserve currency historically coincides with decline of an empire. Even though Russia’s economy is relatively small, largely because of its geographic size, Russia has more natural resources than any other country on the planet. For some countries those resources, such as wheat, fertilizer, oil, and natural gas are essential. It can be expected that these countries will not join the sanctions, and instead will work to establish alternate payment methods. India (which is not joining the sanctions) and Russia have already worked out details for oil trade payment.
So…. Why should Americans care about all of this? Well, if enough countries move away from SWIFT, the dollar’s time as reserve currency begins to wane. In the current system, US printing of dollars spreads inflation around the world. Loss of reserve currency status means excess money printing drives largely domestic inflation.
In other words, if you think inflation is high now, just wait until reserve currency status weakens. Mix that with loss of Russian resources and commodities from much of the world, and we could be looking at food and energy, among other things, becoming unaffordable in poorer countries, and increased prices and shortages in most, if not all, countries. Historically, food shortages spur revolutions - as was the case with the 2010-2011 Arab Spring.
If you are interested in a more detailed perspective on the consequences of Russian sanctions, I suggest financial expert and author Jim Rickard’s recent article The Last Straw.
In summary, holding the world reserve currency is a double-edged sword. While it allows a country to capitalize on the process of printing money and using that money to buy tangible goods as well as services, it also leads to a trade deficit, and ultimately a large amount of debt in the system since our currency is debt-based (i.e., debt is produced every time money is created, as I explained in How Is Our Money Created?.)
What I see is an approaching tumultuous time for the shared covenant of humanity because the breakdown of trade relationships is like a family fracturing. In this fracturing, the awareness of the experiences of those in other cultures begins to be lost. This separation can lead to distinct ‘othering’ between cultures. We are already seeing that here with Americans of Russian descent being marginalized, or even banned.
Much has been accomplished during the period of American imperialism to break down barriers between countries and cultures. Suspension of trade will exacerbate this loss of connection between countries and cultures.
Instead of separating, the world needs to recognize its shared needs so that all of humanity is recognized as part of one race. Collapse of any nation due to food shortage or war only serves to drag down its neighbors. Eventually national connections via trade or also via social connections, such as family members connected through intermarriage, begin to fray, leading to more discontent. We need to recognize this and do what we can to prevent it.
The next newsletter will explore in more detail where the Russian sanctions may lead us.
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Reserve Currencies Erode as Empires Decline
Stimulating article! The handwriting is on the wall for the world to move to a “single hegemonic currency”, most likely digital. What will be the basis for determining relative value? The US percent of world GDP is approximately 20%. It has a huge treasure of natural resources. Why are gold reserves often talked about as a basis of national value? How much will the dollar depreciate when it’s reserve currency status is lost?