Why do we live in a dollarised world?
- The dollar is dominating this year, with most other major currencies getting crushed
- This is typical of uncertain and recessionary times, when investors flock to USD
- The dollar's world reserve currency status can be traced back to a conference during WWII in 1944
Do you want to see something really, really scary? Take a look at the below graph, where I charted the performance of some of the world’s biggest currencies.
Can you spot the one that is not like the others?
Why is the dollar so strong?Copy link to section
This is actually a very predictable side-effect of the world economy going through such a struggle. As the cost-of-living spirals upwards faster than Erling Haaland’s goal tally, the economy is hurting. Central banks struggle with interest rate rises in response to this inflation, sucking liquidity out of the system. Growth is slowing, sentiment dipping and bad news strikes on the daily.
Or, in more simple terms, these are recessionary times.
I wrote in the summer about how the dollar performs counter-cyclically. I plotted the below graph showing the performance during recessions.
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The chart says it all. In times of uncertainty and recession, the dollar strengthens. Right now, we are facing uncertain times. And hence, the dollar is strengthening. Simple.
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Why does the dollar strengthen in such uncertain times?Copy link to section
The dollar strengthens when markets wobble because it is seen as the safest of all safe-haven assets. As fear strikes markets, investors flock to what is safest – and there is nothing more sturdy than the greenback in the eyes of investor.
This pattern has also been exacerbated by the difference in interest rates compared to other currencies. The US has been well ahead of Europe, the UK and most other regions regarding the Federal Reserve’s rate hikes.
The higher rates on offer in the US serve to attract more capital to take advantage of higher yields, heightening the appeal of the dollar and strengthening it even further. Additionally, high interest rates slows down the economy and cools off inflation, meaning investors anticipate the dollar inflation slowing more than others, again accentuating its attractiveness as an asset.
HistoryCopy link to section
But how did the dollar get to this point? It can actually be stemmed back to 1st July 1944, at a conference in New Hampshire that would become known as Bretton-Woods. As World War II waged on, delegates from around the world met to discuss a new economic world order.
The goal was to avoid the economic policies of post-WWI, which were viewed as a contributing factor toward WWII – most notably the collapse of the gold standard and protectionism. The aim of the conference was to facilitate long-term growth, greater co-operation between nations and an avoidance of international currency speculation that was viewed as so detrimental.
The US had by this time established itself as the premier economic power in the world. While the conference was presented as an open discussion, in reality it was the US dictating the policy with small concessions to other influential nations like the UK, whose delegation was led by world famous economist John Maynard Keynes.
Out of the meeting came the formation of the World Bank and the IMF. So too came the foundation for US dollar dominance, which is still in place today.
Keynes wanted a global central bank with a global currency called the bancor. This would not fly with the US, however, who insisted that all currencies instead be pegged to the dollar, and the dollar in turn would be pegged to gold. The US got its way.
Two organisations – the IMF and World Bank – would police the agreements to ensure all nations were compliant. The IMF in particular was set up so that the US would essentially drive all major decisions.
Gold standard falls, 1971Copy link to section
In 1971, President Nixon announced that the gold standard would be abolished as the USA’s gold reserves and vastly overpriced dollar were putting strain on the system. It was a tremendous show of strength and really showed everybody who the kind of the currency foodchain was.
From that moment to now, we have lived in a dollarised world – backed by nothing but the famous greenback.
With developing nations forced to borrow in dollar-denominated debt from the IMF, the rising dollar causes real issues – something which led to the Latin American debt crisis in the ’70s when a host of nations defaulted on debt obligations, leading to them essentially being ostracised for years from the international finance network.
This has only served to widen the chasm between the US and everybody else, and the dollar has continued to move from strength to strength. There are several countries – Ecuador and El Salvador are two examples which I have visited recently – which have been forced to abandon their currencies amid collapse. The dollar is the only natural solution. Expect Venezuela to follow once (if?) their ongoing crisis ever subsides.
Final thoughtsCopy link to section
As the economy reverberates, history tells us that the dollar will continue to strengthen until we emerge out the other side of this pain. In a dollarised world, the resilience of USD squeezes the pressure a little more on nations around the world.
My feelings on the economy are bearish and I believe the winter will be gruesome. For me, I won’t be looking to hold euros, pounds or anything but USD anytime soon. We have a long way to go before we are over this mess.
For the sake of most countries around the world, I hope I’m wrong. But history says otherwise. I guess we will see.