The Coming War to Defend the Dollar’s Status as a Global Currency

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By Ron Hera

Given the history of the U.S. dollar, it now seems likely the eventual end of its reign as the world’s preeminent currency will be marked by war. Most likely with Iran.
 
This article does not take a side in that drumbeat to war. It simply seeks to expose the conflict’s economic pressures so you can make up your own mind.
 
Wars are expensive, both in terms of lives and treasury. The history of the dollar is closely linked to our nation’s military activity, with each war corresponding with an increase in the U.S. money supply.
 
The latest conflict in Iraq, for example, is estimated to have cost as much as $4 trillion. And the negative impact of that outlay is now being exacerbated by challenges to the global supremacy of the dollar.
 
That’s one of the main reasons U.S. politicians are clamoring for war with Iran, which refuses to sell its oil for U.S. dollars, thereby undermining our currency’s global preeminence. That status gives the U.S. tremendous influence over the global economy and insulates our own economy from destabilizing price spikes, like the current run-up in global oil prices.
 
If barrels of crude from the world’s third-largest oil exporter were traded in U.S. dollars, it would moderate the price we pay for them and ease pressure on the U.S. economy, as well as extend the dollar’s world reserve currency status  and give the U.S. economic leverage over Iran’s largest oil customers – China and India.
 
The mainstream news media is already preparing the American public for war with Iran with an unending stream of reports about the dangers of the Islamic Republic’s nuclear ambitions. Television news reports emphasize the possibility that Iran will immediately attack a nuclear-armed Israel when its researchers develop a nuclear weapon, despite the risk of such an exchange wiping out both nations.  It also has been reported that Iran might carry out nuclear strikes on U.S. soil using intercontinental ballistic missiles (ICBMs), although Iran neither possesses neither nuclear warheads nor ICBMs. 
 
In fact, there is little hard evidence that Iran is currently building a nuclear weapon, although its leaders seem fully aware that no nuclear power has ever been invaded in a conventional war. Historically, nuclear weapons are a deterrent to invasion, rather than an offensive weapon, with the exception of the U.S. attacks on Japan that ended World War II.
 
North Korea, which has its own nukes, is a perfect example of this scenario. The Hermit Kingdom’s nukes have insulated its despotic regime from outside intervention.
 
To hear the current economic drumbeat for war you have to understand something called the Bretton Woods Agreements, which shaped currency exchanges after World War II, and the relationship between the U.S. dollar, gold and oil.
 
The Breton Woods Agreements
 
Breton Woods was created in 1944 by 44 nations to stabilize currency exchange rates by tying them to the dollar, which was still backed by gold at that time. This made the dollar the dominant mechanism for international trade settlement – establishing it as the world reserve currency.
 
The massive outlays of capital needed to pay for the Korean War were followed six years later by even more currency printing in support of the Vietnam War. The Federal Reserve’s broadest measure of U.S. money supply – called M2 – rose 222% to $935.1 billion in the 16 years between April 1975, when the Vietnam War officially ended, and April 1959, when the money supply was just $290.1 billion.
 
The costly and prolonged conflict in Vietnam helped precipitate the end of the Bretton Woods system in 1971, when the U.S. stopped backing the dollar with gold.
 
The dollar became a weapon in the Cold War between the U.S. and the former Union of Soviet Socialist Republics. By the time the Soviet Union collapsed in December of 1991, the U.S. money supply had expanded to $3.3748 trillion – up 260% in the 16 years since 1975.
 
The pace of U.S. money supply expansion slowed after the end of The Cold War, climbing just 58% between December of 1991, when it was $3.3748 trillion, and the 9/11 terror attacks of September 2001, when it was $5.3406 trillion.
 
The 9/11 attacks were followed by U.S. military intervention in Iraq and Afghanistan, which continues today. U.S. money supply has expanded 83% during that period to its present $9.7858 trillion.
 
The loss of value in the U.S. dollar caused by this expansion has led to permanently higher global commodity prices, in combination with rising demand for raw materials from emerging economies, like China and India. The two most populous nations on the planet account for about 35% of all humans on planet Earth.
 
Higher crude oil prices, in particular, have put pressure on the U.S. economy, which is putatively in a gradual recovery from the recession that began in 2007.
 
At the same time, international trade has begun to move away from the dollar, threatening its world reserve currency status. 
 
Bretton Woods re-established the price of gold at the pre-war level of $35 per troy ounce, which was deflationary at the time. However, there was nothing in the agreement to prevent the U.S. from issuing more currency than was backed by gold other than the threat of a run on our gold reserves.
 
The Bretton Woods system worked as intended for roughly 17 years. 
 
The London gold market, which was closed during World War II, reopened in 1954. By 1961, upward pressure on the price of gold prompted the establishment of the London Gold Pool by the U.S. Federal Reserve and major European central banks, including the central banks of the United Kingdom, Belgium, France, Italy, the Netherlands, Switzerland and West Germany. 
 
The London Gold Pool defended the $35 per troy ounce price through interventions in the London gold market, but upward pressure on the price of gold grew. In July of 1962, Americans were forbidden by then president Kennedy to own gold abroad by Executive Order 11037. 
 
French president Charles de Gaulle publicly denounced the U.S. for abusing the world reserve currency status of the U.S. dollar in 1965.  The London Gold Pool collapsed in March of 1968 after France withdrew from the group, setting off a surge in gold demand that caused the London gold market to shut down for two weeks.
 
By 1971, the U.S. had leveraged its gold reserves to the breaking point to finance the escalating War in Vietnam. The expansion of the U.S. money supply caused the U.S. Consumer Price Index (CPI) to increase by more than 6% in 1970 and it remained above 4% in 1971. 
 
When U.S. President Nixon “closed the gold window” in August 1971 and instituted price controls, the Bretton Woods system ended, leaving the world with an ad hoc floating exchange system. 
 
U.S. gold holdings fell from approximately 20,205 ton at their peak during World War II to approximately 8,134 tons in 1971. In February 1973, the U.S. devalued the dollar and raised the official dollar price of gold to $42.22 per troy ounce.  By June of the same year, the market price in London had skyrocketed to more than $120 per ounce.
 
Today, gold is considered an apocalyptic currency – a hedge against a worldwide economic collapse. Its value has surged in recent years, as the global economy has come unhinged, with June futures reaching $1,660.30 on April 11. That’s a 508% increase from the $273 paid for an ounce of the yellow metal in 2000.
 
Although annual CPI inflation was below 4% at the start of 1973, it rapidly accelerated and reached 9% at the start of 1974. With the last vestiges of gold backing having been removed from the U.S. dollar, Americans were once again allowed to own gold as a hedge against inflation. 
 
Against a backdrop of runaway U.S. dollar inflation, Arab members of the Organization of the Petroleum Exporting Countries – along with Egypt, Syria and Tunisia – proclaimed an oil embargo in October of 1974. Officially, U.S. support of Israel in the Yom Kippur War was the reason for the embargo. Unofficially, it was also a challenge to the un-backed dollar’s position as a currency for global oil sales.
 
After the end of the Yom Kippur War in 1974, OPEC members, including Iran, began to accumulate hundreds of billions of devalued U.S. dollars due to current account surpluses linked to rising oil prices. Arab “petrodollars” were recycled into U.S. Treasuries, invested in financial markets around the world and loaned to commercial banks.
 
By 1979, when Muslim clerics took control of Iran, oil prices had roughly quadrupled and the price of gold was increasing rapidly. Then Federal Reserve Chairman, Paul Volcker raised the federal funds rate – the rate banks charge one another for overnight loans – to an average of 11.2% in 1979. With inflation running rampant along with oil prices, the higher lending rate was the only way banks could continue to serve borrowers.
 
CPI inflation soared to 13.5% in 1980 and the stagnant U.S. economy slipped into recession. Meanwhile, the price of gold hit $850 per troy ounce and oil prices averaged $37.42 per barrel – more than 10 times the $3.60 average of 1971.
 
In a desperate bid to save the U.S. dollar, Volcker increased the funds rate to an unprecedented 20% in mid 1981, pushing the prime interest rate to a usurious 21.5% by the middle of 1982. Volcker’s radical intervention eventually succeeded in taming inflation and restoring confidence in the U.S. dollar. It also undermined oil, gold and silver prices.
 
The Committee to Flood the World
Post Volcker, the Fed’s dilemma was how to bring down interest rates and manage inflation without increasing the money supply to support U.S. federal government borrowing during the Cold War. 
 
The first key to the solution was to look at inflation strictly in terms of its effects on prices and not as an increase in the money supply, which is a function of interest rates. When interest rates are low, prices tend to rise because the money supply expands more quickly, thus the second key was to de-couple prices and interest rates. 
 
The third and final key was to manage consumer inflation fears. The CPI was altered to make prices appear more stable, but de-coupling prices and interest rates was a more difficult problem because global commodity prices are not entirely under U.S. control. Ultimately, managing the CPI required managing global commodity prices, especially the price of crude oil.
 
A crucial breakthrough in economic theory occurred in 1988 with an article in the Journal of Political Economy called “Gibson’s Paradox and the Gold Standard.” The article by Robert Barsky and Lawrence Summers showed that the price of gold was inversely correlated to interest rates.
 
Since gold is not industrially consumed in significant quantities, the price of gold changes relative to the value of major currencies. Specifically, the price of gold had proven to be a barometer of U.S. dollar inflation since 1971. More importantly gold and crude oil prices tend to correlate.
 
The implication of Gibson’s Paradox was that interest rates could remain low as long as the price of gold did not rise. If interest rates could remain low without causing the kind of accelerating increase in the CPI which occurred in the 1970s, dollars could be printed indefinitely without spawning inflation.
 
A few years after Alan Greenspan took the helm as Chairman of the Federal Reserve in 1987 this theory was put to the test. Interest rates were slashed and the resulting increase in the money supply began to pull away from the increase in the CPI. For roughly two decades, beginning with Volcker’s success in the early 1980s, the price of gold declined while oil prices remained relatively stable, despite the fact that interest rates had come down.
 
The innovations in U.S. monetary policy developed principally by Summers and Greenspan helped the U.S. up the financial ante in the Cold War and spend the Soviet Union into oblivion, winning the arms race via expensive new military innovations and equipment. The Soviet Union collapsed in 1991 under the economic weight of competing with the U.S. in the global empire game.
 
Its fall seemed to herald the hegemony of the U.S. dollar for decades to come.
 
Instead, it bred an intellectual hubris among our top economists which helped precipitate the current global economic crisis.
 
During the 1990s, Greenspan, together with Larry Summers, who was Deputy Secretary of the U.S. Treasury, championed financial deregulation. Confident in their ideas, the so-called “committee to save the world” prevented regulation of over-the-counter (OTC) derivatives and succeeded in effectively repealing the Banking Act of 1933 (the Glass–Steagall Act), which had long regulated the speed of the banking industry.
 
Greenspan also felt that markets should be allowed to police themselves, which helped precipitate the mortgage crisis.
 
In hindsight, Greenspan held interest rates too low for too long in the 1990s resulting in the dot-com bubble. The bursting of the dot-com bubble was a shot across the bow of the “committee to save the world” but the warning went unheeded. 
 
The Federal Reserve moderated the downturn beginning in 2000 by lowering interest rates and they remained low. U.S. banks took advantage of deregulation and low interest rates to speculate and to increase their leverage, especially in the mortgage market, while hedging the additional risks in the fast growing OTC derivatives market.
 
As the resulting real estate bubble grew, the notional value of OTC derivatives exceeded $600 trillion on a global basis  – more than ten times the actual value of the global economy – and financial services industry profits expanded to 40% of S&P 500 business profits.
 
The price of gold began to move up after June of 2001, when it fell to an historic low.  Meanwhile, oil prices began to rise at an accelerating rate in 2006 that revealed a fundamental flaw in the de-coupling of interest rates from prices. 
 
The flaw was that the Federal Reserve had absolutely no control over the flow of increased liquidity resulting from its policies. The “committee to save the world” was flooding the world with cheap U.S. dollars. 
 
Increased liquidity linked to low interest rates was fueling unprecedented levels of financial speculation and increasing the risk and magnitude of asset price bubbles, such as the dot-com bubble and the housing bubble. To make matters worse, excessive monetary expansion was weakening confidence in the U.S. dollar.
 
Pressured by rising oil prices, the U.S. economy began to roll over in 2007. As the U.S. housing bubble deflated, beginning with sub-prime loans, the price of the benchmark grade of West Texas Intermediate oil hit an all-time high of $145 in June 2008. Roughly four months later, a financial crisis far larger than that of 1929 began to take place – the bursting of the largest credit bubble and monetary expansion in the history of the world. 
 
In October 2008, Greenspan acknowledged his role in the current global crisis during testimony before the U.S. Congress.
 
“I found a flaw,” the former Fed chairman conceded,” in the model that I perceived is the critical functioning structure that defines how the world works.”
 
Quantifying the Crisis
The policy responses of the U.S. federal government and the Fed to the financial crisis and to the so-called Great Recession have been radically inflationary. The Fed, which has been led by Ben Bernanke since 2005, loaned $16 trillion to financial institutions worldwide and $7.77 trillion to U.S. banks and corporations. It also purchased roughly $1 trillion worth of toxic mortgage backed securities from banks and monetized a total of roughly $800 billion of U.S. federal debt, expanding its balance sheet from $900 billion before the crisis to $2.7 trillion.
 
In the face of the most severe economic decline since the Great Depression, the U.S. federal government embarked on a $700 billion economic stimulus plan at a time of falling tax revenues. In addition to an initial $800 billion bailout package, government sponsored entities Fannie Mae and Freddie Mac were taken into receivership, making the U.S. federal government liable for roughly $5 trillion of mortgage debt. 
 
In 2009, the total liabilities of the federal government were estimated to be as high as $23.7 trillion by Neil Barofsky, then Special Inspector General for the Troubled Asset Relief Program. As a result, U.S. federal government debt increased sharply and, in 2011, the U.S. credit rating was downgraded for the first time in history.
 
The declining value of the dollar set off a global currency war in 2009 that pushed global commodity prices higher. Rising crude oil prices, which grew despite lower demand, slowed the nascent economic recovery. At the same time, high debt levels, bank bailouts, soaring government budget deficits and falling tax revenues produced a sovereign debt crisis in Europe. 
 
The Hazards of Financial Warfare
 
The U.S. has not been shy about wielding the dollar’s status as the world’s dominant currency as an international diplomatic tool.

One of the key reasons why the U.S. has yet to experience a sovereign debt crisis is that the world reserve currency status of the U.S. dollar supports demand for it and for U.S. federal government debt. However, the U.S. dollar is in the process of gradually losing its world reserve currency status as global trade fragments into autonomous trading blocks defined by other currencies, like the Euro.
 
Demand from emerging economies, particularly China, is placing upward pressure on the price of crude oil. Higher oil prices resulting from the combination of a weaker U.S. dollar and increased global demand threaten to push the U.S. economy back into recession. 
 
The five-fold increase in gold prices during the past decade suggests much higher oil prices in the future.
 
Iran, a major supplier of oil to China, lies outside of U.S. control. It refuses to sell oil for U.S. dollars, partly as a consequence of the overthrow of the democratically elected government of Iran in 1953, which was orchestrated by the U.S. Central Intelligence Agency, and partly as a consequence of current U.S. policies in the Middle East. Israel and Saudi Arabia, both U.S. allies, are enemies of the current Iranian ruling regime.
 
In March of 2012, the U.S. unilaterally removed Iran from the Society for Worldwide Interbank Financial Telecommunication system, effectively cutting it off from world commerce. 
 
However, wielding the U.S. dollar’s world reserve currency status as a blunt instrument could be counterproductive in the current international climate. If the U.S. dollar were to lose its world reserve currency status over a short period of time, a U.S. sovereign debt crisis would be certain and a catastrophic collapse of the U.S. dollar – , i.e., hyperinflation – would be possible.
 
Having taken a decision to act unilaterally against Iran, the U.S. may be forced to resort to more extreme measures to prevent that from happening if the world reserve currency status of the U.S. dollar continues to deteriorate. As the Prussian military theorist Carl von Clausewitz famously said: “war is the continuation of policy by other means.”
 
I’m not writing this article to convince readers of The Cynical Times to agree with that sentiment, but to help them better understand the complex world in which we live.
 
Of course, the U.S. does not control the oil trade solely through financial means.  With Israel as a close ally, Iraq and Afghanistan occupied by U.S. forces, close ties with Turkey, Saudi Arabia, Kuwait, Qatar and other Middle Eastern countries, Iran is surrounded by more than 40 U.S. military installations.
 
A successful invasion of Iran would eliminate the largest non-dollar oil exporter, delaying the dollar’s demise as the world reserve currency. Although a war with Iran would cause a spike in oil prices, U.S. control of Iranian oil would increase the supply of oil available for purchase in dollars, which would bring the dollar price of oil down and enhance the ability of the U.S. to subordinate the price of oil to its own economic needs.
 
Controlling a major supplier of crude oil to China and India would give the U.S. additional leverage to support the dollar and U.S. debt, as well as a means of influencing the policies and economic growth of the world’s most populous nations. 
 
The option of invading Iran to support U.S. economic stability and supremacy might have an expiration date. If Iran actually does secure nuclear weapons the risks associated with such an invasion rise precipitously.
 
More limited military actions – like attacks against Iranian nuclear research facilities, powerplants and military forces – are a less risky alternative to invasion. They could also neutralize Iran’s threat to disrupt the movement of oil tankers through the narrow Strait of Hormuz.
 
Thus, a limited U.S. military action would involve military operations on a scale not seen since the invasion of Iraq in 2003. Iran’s population of 79 million is more than twice that of Iraq.
 
A limited U.S. military action might leave a weakened Iranian regime in place after the conflict and reignite the moderate, pro-democracy Green Movement that was brutally suppressed in 2009.  Regime change from within might restore democracy to Iran after more than 50 years of monarchy and religious oligarchy. 
 
However, regime change is unlikely to result in the sale of Iranian oil in dollars or to extend its reign as the world reserve currency. A preemptive strike by the U.S. could also strengthen political support for the current Iranian regime.
 
There seems to be no political will in Washington D.C. to change course from a U.S. military conflict with Iran, despite the additional anti-U.S. sentiment such an attack would create in the region. The drumbeat to war in the mainstream news media is loud and clear and if history is any guide, the U.S. is poised to “cry havoc and let slip the dogs of war” after the 2012 election even as a large portion of our military remains mired in Afghanistan.

Ron Hera is a research analyst who helps investors profit from changing economic and market conditions. He heads Hera Research and oversees publication of The Hera Research Newsletter.