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The Fed Is Bungling the World's Reserve Currency

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The mishandling is so great, in fact, that the dollar is now at risk of losing its status.

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The Fed has proven to be a terrible caretaker of the responsibilities that come with reserve currency status, even while the US economy benefits greatly from it. The bungling is so great that the dollar is now at risk of losing that status and, with it, huge benefits.

Some History

After both world wars, the US had the strongest economy. Despite FDR's removal of the US from the gold standard in 1933, the Bretton Woods agreements of 1944 established a "gold exchange" standard wherein balance-of-payments-deficit nations were to settle up with surplus nations in gold (at $35/oz.). Under this system, when gold payment settlements were made, the gold was never physically shipped but simply "moved" to the designated holding vault for the recipient country. In 1971, President Nixon removed the world from the gold exchange standard when France demanded physical delivery. Since then, the dollar has served as the world's reserve currency instead, with "trust" as the only underlying asset.

The Benefits of Reserve Currency Status

Most international transactions today occur in dollars even if neither of the transacting parties are American. For example, if Hyundai (OTCMKTS:HYMLF) of South Korea sells autos to a business in Argentina, the buyer must first convert the Argentina peso to dollars to pay for the autos. Hyundai can either hold the dollars or convert them to their home currency (won) Note that this transaction has little to do with US economic activity. Yet, it means that there has to be a lot of dollars floating around to support worldwide trade.

The reserve currency status and trust in the US dollar has resulted in the US government's ability to overspend and issue debt because of the demand for dollars in international trade.

On the other hand, when an emerging economy's government runs a large and systemic deficit, there are serious fiscal consequences. The value of the currency immediately falls, inflation occurs, and the markets force up interest rates thus impacting that economy's growth.

The reserve currency status and the accompanying trust in the currency have also resulted in the investment of excess dollars in the international system back into US Treasury securities.

Of the outstanding marketable US debt not held by US government agencies or the Fed ($11.9 trillion), $5.6 trillion is held by foreigners -- the largest two holders being China ($1.27 trillion) and Japan ($1.15 trillion).

Emerging Pressures

Of course, we've all heard stories that countries like China and Russia have been advocating that the world adopt a different reserve currency. Many dismiss China's and Russia's positions as political rants. But these gripes are legitimate, and the existing monetary and fiscal policies in the US will, eventually, move the world toward an alternative reserve currency system.

Policy Impacts

Congress certainly has, but the Fed, in particular, has been irresponsible as the caretaker of the world's reserve currency. Granted, the Fed and US never openly asked that the dollar be the reserve currency, but the US sure has taken advantage. Since such responsibility was never requested (but has been tacitly accepted), the Fed maintains that its only interest is in America's economic performance. But Fed policies, such as QE, have huge consequences offshore.

For example, when the Fed tells the capital markets that interest rates will be 0% for an "extended period," as it did in 2011 and 2012, hedge funds borrow dollars at miniscule yields and send those dollars to higher-yielding emerging market economies. The demand for the local currency increases its value vis-à-vis other currencies. The capital movements from Fed QE policies have been monstrous, often overwhelming the emerging economy's underdeveloped financial system, causing inflation in the local economy along with rising interest rates and slowing economic growth.

Last May, when Fed Chairman Bernanke used the word "taper," those huge flows, which had built up over a period of months, almost instantaneously reversed as the hedge funds raced to repay their borrowings before interest rates rose further. The result has been a collapse in emerging market currencies (India, South Africa, Indonesia). Remember, these capital flows have nothing to do with underlying economic activity but are simply capital flows caused by the policies of a single central bank: the Fed.

Conclusion

It isn't hard to see why other world players are upset with the Fed and the dollar as the world's reserve currency. In the absence of "gold" (((doesn't need to be in as the ultimate disciplinarian, which would limit money creation, and with "trust" as the only underlying asset, the Fed has been free to flood the world with dollars and manipulate capital markets, all to the detriment of emerging economies. The calls for a different system are based on economic facts and realities that cannot be denied. As a caretaker of the world's reserve currency, the Fed and its QE policies are an abject failure.
No positions in stocks mentioned.
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