Weekly Column

Moody’s US Debt Downgrade Re-Ignites De-Dollarisation Fears

After Moody’s downgrade of US Debt, from the top notch of AAA down to Aa1, fears about the solidity of the US dollar as the international reserve currency have re-emerged. Especially because it has become clear that China has continued to offload US debt, and is now the third foreign holder of US Treasuries, behind Japan and the UK. We have written an entire book, Smart Money, about the path to digital de-dollarisation, as China continues to build its infrastructure for the digital Yaun across the countries of the Belt and Road Initiative/Digital Silk Road, which involves 150 out of 195 countries, representing 50% of the world’s GDP and 75% of the world’s population. So, we won’t discuss this further in this column.

Instead, we want to discuss how long and complex the passage from one monetary hegemon to the next could be, as was the case for the British pound when it was substituted by the US dollar as the world’s reserve currency in 1944.

By the end of the 19th century, the US had already overcome the UK in terms of industrial production, putting the conditions in place for the US dollar to replace the UK pound as the global reserve currency. At the same time, the UK seemed to be at the apex of its fortunes. It was the country where the industrial revolution had taken place, it was at the centre of the largest empire ever built, and it was the global financial centre. GBP was the international reserve currency, with a system based on the gold standard. The vaults of the Bank of England were what Fort Knox is today for the US.

But things were not as rosy as they seemed at first glance. A second industrial revolution (this one deriving from electricity, rather than steam and steel) had occurred. Germany had re-unified and started its ascent as an economic super-power. The British empire had over-extended (including through the victorious Opium Wars against China), and public debt had remained elevated since the Napoleonic wars.

The situation precipitated in WWI. Germany tried to change the European equilibria and break the alliance between UK and France (the Entente Cordiale of 1904), allying with Austria and Italy. The war erupted. The UK had to fight on too many fronts and ran out of money in 1917. This was a critical year, because Russia withdrew from the war (given the October Revolution) and the US entered the war.

In 1918 the war was over: Germany and the central empires had lost and the UK had won, but it was clear that without the US this would not have occurred. The US returned to the role of regional power on the other side of the Atlantic, returning to an isolationist position. The UK tried to re-establish the old system (colonies, the gold standard, domination over Europe via the Versailles treaties and war reparations) and re-adopted a new version of the gold standard, called gold-exchange standard, in 1925 after the Genoa conference of 1922.

Under the gold-exchange standard, participating countries were encouraged to substitute foreign exchange in dollars or pounds for scarce gold, while the central reserve countries (the UK, US, and later France) were holding reserves only in the form of gold. The advantage of this compared to the gold standard was that only a few countries had to hold gold reserves, which had become scarcer due to the war, reparations, etc. The problem was that the UK re-entered the system with the same exchange rate of pre-WW1, which proved too high, hence deflationary.

In the US, these were the go-go years of “The Great Gatsby.” This bonanza ended with the 1929 stock market crash and the subsequent crisis, which led all countries to abandon the gold-exchange standard by 1931. In Germany Hitler won the election of 1933 and WW2 ensued a few years later. Towards the end of the war, the Bretton Woods conference took place in 1944. The well-known battle between British economist J.M. Keynes and the US representative is H.D. White was won by the latter, and the US Dollar emerged as the new reserve currency.

The US created a new gold-exchange standard based on the dollar (35 USD for 1 ounce of gold, and all other currencies linked with a fixed exchange rate to the USD). In 1971 Nixon ended the link to gold and introduced the system of fiat currency. Along with his trip to China in February 1972, globalisation begins. With Liberation Day of April 2^nd,  this era is now over, and the long transition out of the US Dollar dominance is beginning instead.

One needs to remember that it took 27 years to move from the GBP dominance (in 1917) to the establishment of the new global reserve currency (1944), with two world wars and a great depression in the middle. And the conditions for this to happen had matured already decades before, at the end of the 19th century. So, those who say that they don’t see the US Dollar losing its reserve status are not wrong in the sense that it won’t happen all at once. As Hemingway said about bankruptcy, it will occur “gradually, then suddenly.” It will be a long and tortuous process, but it is a process that has already started.