The Past, Present and Future of International Reserve Currencies:

Is the Dominance of the US Dollar Sustainable?

By

Matthew Del Bel Belluz

A thesis proposal submitted to

Dr. Greg Tkacz

Faculty of Economics

April 2, 2015

In partial fulfillment

Of the requirements for the degree of

Joint Honours Bachelor of Business Administration and Economics

Gerald Schwartz School of Business

St. Francis Xavier University

Antigonish, Nova Scotia

1

Table of Contents

Abstract…………………………..…………………………..…………………………..………………………….3

(1) Introduction…………………………………………………………………………………………………4

1.1 What Makes the Dollar #1?………………………………………………………………………...…...4

1.2 Exorbitant Privilege of the United States…………..……………………………………………...6

1.3 Thesis…………………………..…………………………..…………………………..………………………10

(2) The Past: The Emergence of the Dollar as the Dominant World Currency..13

2.1 Gold-Sterling Standard: The Rise of the Dollar…………………………..……………………

13

2.2 Bretton Woods System: Dollar Dominance Begins…………………………..………...……15

2.3 The Fiat IMS and the Birth of a New Reserve Currency…………………………………...17

2.4 The Financial Crisis of 2008: The First Sign of Unsustainability………………………19

(3) The Present: Alternatives and Threats to the Dollar Today……………………...21

3.1 Composition of Official Foreign Exchange Reserves………………………………………..21

3.2 Why the Dollar Retained its Role After the Crisis……………………………………………22

3.3 The Euro, the Only Current Alternative to the Dollar………………………………………23

3.4 China, the IMF, the UN and the SDR……………………………………………………………….25

3.5 Quantitative Easing and Why US Inflation Remains Normal……………………………29

3.6 Derivatives: Growing Markets Make for Growing Risk……………………………………33

3.7 The War on Gold: Market Manipulation to Maintain Currency Legitimacy……….34

(4) The Future: Decline of the dollar…………………………..…………………………………...37

4.1 The Rise of China and the “Multi-Polar” Reserve System………………………………...38

4.2 The Economic Apocalypse and a Return to the Gold Standard………………………...45

4.3 The Petrodollar, Defending Exorbitant Privilege………………...

…………………………..52

(5) Conclusion: Is the Dollar’s Role in the IMS Sustainable? …………………………..61

Bibliography…………………………..…………………………..…………………………..……………..…64

2

Abstract

This paper seeks to answer whether or not the role of the United States (US) dollar

in the international monetary system (IMS) is sustainable. The US dollar is the most

important monetary asset in the world; as a result, the dollar also makes up the

majority composition of global international reserves. Through our analysis, we

determine that the dollar’s role in the IMS is unsustainable for the primary reason

that the size and liquidity of financial markets in other countries will one day rival

those found in the US. We also determine that the current IMS that places a single

currency at its center is also unsustainable, because it leads to global disparities in

balance of payment accounts and encourages central banks to engage in potentially

destabilizing monetary policies. While the dollar may lose its status as the global

reserve currency of choice, we predict that it will remain an important reserve

currency nonetheless. This is because the US will do anything in its power to ensure

the dollar remains important in global markets, particularly in commodities such as

oil. In the next 10 years, as long as the Euro Area recovers from its debt crisis and

pursues the creation of fiscal unity between member countries, we will see the euro

composition of reserve currencies increase, decreasing the share of dollar reserves.

Similarly, if the Chinese renminbi attains international reserve status, we will see

the renminbi become a significant portion of international reserves, leading to a

smaller role for the dollar. If the euro and renminbi fail to diversify international

reserve currencies, it is possible that the next US financial crisis could cause a

violent shift away from the dollar towards safe assets such as gold. We find this an

unlikely scenario however, and conclude that the international reserves will

differentiate away from the dollar, but will not replace it outright.

3

(1) Introduction: Understanding the Role Of the Dollar

Before we discuss how the dollar became the dominant international reserve

currency, it is important to analyze what benefits the US receives on account of its

currency being the most important in the world. First we will analyze why the dollar

is considered so important in international trade and finance, then we define

exorbitant privilege and how it affects US balance of payments.

1.1 Why is the dollar #1?

The US dollar is the most liquid, the most widely accepted and the most

widely used currency on the planet. It is the most used currency in settling and

invoicing international trade settlements, including imports and exports that never

touch US shores. All principal commodity exchanges such as oil and gold use dollars

to quote their prices. Over 85% of all foreign exchange transactions worldwide are

dollar transactions.1 Many countries base the value of their currency off the dollar,

as countries wish to base the value of their currencies off the currency most used.

Because of its importance in international trade and finance, countries around the

world have accumulated massive reserves of American dollars to maintain their

exchange rates by intervening in foreign exchange markets, and as a form of

insurance based on the fact that the dollar is regarded as the safest currency to hold

in the world. According to the International Monetary Fund (IMF), the US dollar

makes up just over 60% of the world’s total foreign exchange holdings.2 This

1 http://www.bis.org/publ/rpfxf10t.pdf

2 http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4

4

percentage has remained remarkably stable since the 2008 financial crisis, which is

interesting considering it was the United States that is primarily blamed for the

global recession that resulted. Its widespread use, and majority component of

international reserves makes the dollar the single most important monetary

instrument in the world today. The dominance of the dollar in international trade

and finance is generally attributed to the Bretton Woods system implemented in

1944, which began the widespread pegging of foreign currencies to the dollar and

the creation of the IMF. The United States was the largest importer in the world at

the time, the main source of trade credit, held over half the world’s manufacturing

capacity, and held the majority of the world’s gold.3 Therefore it made sense that the

dollar be at the center of the new global monetary system after the breakdown of

the old system because of the Second World War.

But what made sense in 1944, makes less sense now according to many

economists. The United States today is no longer the largest exporter, third to China

and the euro-area (if counted as a single entity).4 The United States is also the source

of less that 20% of foreign direct investment, down from over 80% between 1944

and 1980.5 The US is simply less dominant economically now than it was 50 years

ago, so why then is the dollar still the most held reserve currency in the world?

Academics, investors and economists worldwide have researched the answer to this

question. Despite many varying views, there is one central characteristic that they

all agree gives the dollar its global currency status. The primary reason for dollar

3 Mishkin, Eakinds (2003, pg. 349)4 http://data.worldbank.org/indicator/BX.GSR.GNFS.CD5 Eichengreen (2011, pg. 2)

5

dominance in the world today, is that the US has the most liquid and largest

financial markets in the world. There is no other currency that gives investors and

central banks alike as much freedom to purchase, borrow, lend, invest and divest in

what they want, where they want and when they want as the dollar. The treasury

market in the Unites States is the largest and widely regarded as the ‘safest’ debt

market in the world. Government issued debt such as US Treasury bills and bonds

make up the majority of foreign reserves held by central governments because they

earn interest. US debt is so liquid, and markets so large, that central governments

can very quickly convert their dollar debt into usable cash when they must correct

their balance of payments, intervene in foreign exchange markets, or react to a

crisis.

1.2 The Exorbitant Privilege of the United States

The prolific use of the dollar in international trade, debt and investment

transactions and settlements has given the US what some call a monopoly on money,

in that it is the only country capable of creating the lifeblood of the world economy.

Not surprisingly, this ‘world money’ status of the US dollar, gives the US several

advantages for its citizens, businesses, economy and government. These advantages

are categorized as the exorbitant privilege of the United States. The phrase

“exorbitant privilege” was coined in the 1960s by Valéry Giscard d’Estaing6 the then

French Finance Minister and future President of the French Republic. D’Estaing

complained of the United State’s ability to run a permanent balance of payments

deficit, without having to worry about a balance of payments crisis. In other words,

6 Eichengreen (2011, pg. 40)

6

the United States could continuously import more value from abroad than it had to

create domestically, because it had a monopoly on the underlying asset which value

was denominated in internationally. For a foreign country to acquire $100, it would

have to sell something worth $100, whereas the United States can simply print a

$100 bill at virtuously no cost.

Despite only 13 countries in the world officially pegging their currencies to

the dollar today7 the US still derives many benefits from its importance. For

American tourists, the widespread acceptance of dollars spares them the

inconvenience and cost of having to exchange their currency when travelling

abroad. Similarly, US exporters receive payments in the same currency that it uses

to pay their workers, suppliers and shareholders. A foreign exporter would have to

exchange those dollars for their domestic currency, incurring additional costs and

risks associated with fluctuating currency exchange rates. Banks in foreign

countries accept deposits in their currency, but make loans in dollars exposing them

to exchange rate risk as well. To mitigate this risk, foreign banks use derivative

contracts to hedge against exchange rate movements, but this is an added cost of

doing business, and something American banks are largely spared from. These

benefits however, are petty compared to the most controversial form of exorbitant

privilege, which is the enormous and consistent negative external balance of

payments of the US.

Source: World Bank Data

7 http://www.investmentfrontier.com/2013/02/19/investors-list-countries-with-fixed-currency-exchange-rates/

7

Other countries need to keep their current account balances close to zero, or

else they could face a balance of payments crisis. Looking at Figure 1, we see that in

2013, the United States had a current account deficit of -$400 billion. This means

that in 2013, the US imported $400 billion dollars more than it exported. As we can

see, the exorbitant privilege of the US is very significant.

The ability for the United States to run a continuous negative international

investment balance, and still earn income on its net position, has been described as

the ‘Income Puzzle’. Over 12 papers have been written on the subject, and the most

recent one published by the Board of Governors of the Federal Reserve System in

2013 combines the findings of all previous papers on the subject. Its findings

conclude that the United States can earn income on a negative investment position

with the rest of the world because of persistent return differentials, between US

2005 2006 2007 2008 2009 2010 2011 2012 2013

-900000000000

-800000000000

-700000000000

-600000000000

-500000000000

-400000000000

-300000000000

-200000000000

-100000000000

0

100000000000

Figure 1: US Current Acount Balance VS Global Average

Average

United States

United Kingdom

Net

Bal

ance

($

Bil

lion

s)

8

foreign investment, and foreign investment in the US.8 Because foreign

governments, banks and firms value the convenience of dollar securities they are

willing to pay more to obtain them. For debt securities, a high price translates to a

lower yield, meaning that investors are willing to accept lower interest rates in

order to satisfy their demand for Treasury securities that are so liquid they’re seen

as cash equivalent. This has a very substantial effect on the United States. The

interest that the US must pay on its foreign liabilities is two to three percentage

points less than the rate of return on its foreign investments.9 The US can run an

external deficit in the amount of this difference. This allows the US to import more

than it exports and consume more than it produces year after year, without having

to worry about becoming indebted to other countries. This phenomenon has also

been used to explain the ‘paradox of capital flows’ and the huge accumulation of

dollar reserves by developing countries in the last 15 years. The paradox of capital

flows is that capital from poor countries which could receive higher returns

domestically, is instead invested in the United States, as a tool for controlling

exchange rates (which is a very important component of the export centric growth

model adopted by many developing countries), and as a form of insurance, the need

for which was made apparent during the Asian Financial Crisis of 1997.10

In recent years, foreign governments have become increasingly perturbed

with this obviously asymmetric financial system. Since the 2008 financial crisis

there has been increased criticism and scrutiny of the dollar dominated IMS. The

8 Curcuru et al., 20139 Habib, 201010 Bibow, 2010

9

main question on economists’ minds is whether or not the dollar-centered system is

sustainable. A growing body of research has shown clues as to dollar’s future role in

the world. Developing country governments are crying out for change. Powerful

international organizations such as the United Nations (UN) and IMF are discussing

what a new IMS would look like without the dollar at its center.

1.3 Thesis

This paper looks at the role of the dollar in the international monetary

system through the lens of sustainability. The question this paper seeks to answer is

whether or not the dollar’s dominant role in the system is sustainable. We define the

system as sustainable if the dollar will retain its position as the highest weighted

component of international currency reserve assets worldwide for the next 10

years. The system is defined as unsustainable if the dollar is likely to be replaced by

another currency as the dominant international reserve asset in the next 10 years.

Three books that have been published on the subject of the sustainability of

the IMS are The Big Reset by Willem Middelkoop, Exorbitant Privilege by Barry

Eichengreen and The Death of Money by James Rickards. The three books provide

different perspectives on the current state of the international monetary system.

Barry Eichengreen is an economics and political science professor at the

University of California, Berkley. His book, Exorbitant Privilege, provides an in depth

history of the dollar’s role in the world and predicts a future where the dollar must

10

share its role as the dominant international reserve currency with the euro and the

renminbi.

Willen Middelkoop is a Swiss investor that has been studying international

monetary policy for over 10 years. His most recent book The Big Reset, discusses the

importance of gold as a base for deriving the value of currencies. His book makes the

argument that the massive build up of debt and printing of fiat currencies, especially

the American dollar, has poised the world for a dramatic shift away from the dollar.

James Rickards is an American lawyer and author. Rickards has worked as an

advisor for the Department of National Defense where he was involved in the

development of a program called “Project Prophecy” that could predict terrorist

plots by analyzing insider trading taking place leading up to an attack. He is also a

lecturer at John Hopkins University and at the School of Advanced International

Studies. Rickards believes the world is headed towards economic ruin and that a

new IMS will be created based on the gold standard.

The framework for this literature review is the story of the American dollar.

We will begin by analyzing the history of the dollar’s role in the IMS. We will then

look at the alternatives to the dollar today, and explain why the dollar still

comprises the majority of foreign exchange reserves as of 2015. Finally we will look

at the future of the dollar’s role in the IMS and determine whether or not its

11

dominance can be maintained. As the history of its role in the IMS unfolds, the

differing views of the authors will be compared and contrasted with one another.

The central argument of this paper is that the US dollar’s role in the IMS is

both unsustainable and sustainable. It is unsustainable because the dollar will no

longer make up over 50% of foreign exchange reserves. The future IMS will not

place a single currency at its center, as it has in the past. We find the dollar’s role

sustainable however in that the dollar will still make up the majority of

international reserves, if only slightly. The reduction in the international importance

of the dollar will result from 2 potential sources:

1. The Eurozone and China will have debt markets that can rival those of the US

in the next 10 years resulting in multicurrency reserve system.

2. The global economy will undergo a serious crisis in the next 10 years caused

by unrestrained money printing policies, debt and derivative growth,

resulting in a loss of confidence in the current IMS and the dollar’s role

within it.

Despite it’s reduced importance, we find that the dollar will most likely still be the

most important reserve currency because of the US’s ability to control the currency

pricing of major commodities, primarily oil

(2) The Past: The Emergence of the Dollar as the Dominant World Currency

12

In this chapter, we will outline how the dollar became the dominant reserve

currency it is today. We will begin with the creation of the Federal Reserve in the

early 1900s during the gold-sterling IMS. Then we will look at how WWI and WWII

helped increase the importance of the dollar through the implementation of the

Bretton Woods system. We will conclude with the rising importance of the Euro and

how the 2008 financial crisis affected dollar reserves.

2.1 Gold-Sterling Standard and the Rise of the Dollar

The story of the dollar begins in 1913, with the creation of America’s central

bank, the Federal Reserve. After the financial panic of 1907, it was decided that the

United States needed a central bank to help stem and prevent crises in the future.

The Fed was officially created in December 1913. The bank would have a monopoly

on the creation of dollars, and would be owned privately by Wall Street banks. At

the time the world was using the gold standard IMS and the British pound sterling

as the international reserve currency of choice. The United States, despite having

had the largest economy in the world since the late 1800s, was still almost

completely dependent on the pound for settling international trade and financial

transactions. The US dollar was hardly used internationally. World War 1 (1914-

1918) changed everything for the dollar. According to Eichengreen (2011, pg. 35), it

rose from obscurity in 1913, to completely overtaking sterling and reigning as the

dominant international reserve and trade currency by 1925. Its meteoric rise is

attributed to the strong international market making efforts of the Fed- encouraging

the development of international branches of US banks and multinational

13

companies. And the political and economic instability brought to Europe as a result

of the war.

The great depression (1929-1939) saw a systemic reduction in foreign

reserve holdings as a result of declining international transactions and trade. Thus,

it also saw a large reduction of the international role of the dollar. In 1933, the US

and Britain left the gold standard freeing the printing press and allowing for greater

implementation of expansionary monetary policy. With less foreign borrowing and

less commitment to defending exchange rates, there was little incentive for

countries to hold large reserves of international currencies. American dollars were

sold off in larger numbers than the pound. It is noted by Eichengreen (2011, pg. 37)

that the most important reason for sterling regaining its lead as an international

currency was Commonwealth countries maintaining their reserve holdings in

London. The practice was a result of political solidarity and imperial prerogative.

The US, not being an imperial nation, did not have the same support structure as

Britain. It is important to note that it was political forces that allowed sterling to

retain its dominant international role. This is a recurring theme in the study of

international monetary policy; politics often play just as great a role as economics

when it comes to international currency reserves. It would take another major

political event, World War 2 for the US dollar to finally solidify its place on the

monetary throne.

2.2 Bretton Woods System: Dollar Monopoly Begins

14

World War 2 (1939-1945) was the bloodiest and most expensive war in the

history of the world. It also created economic and political turmoil in Europe. The US

experienced a considerable accumulation of gold from several countries including

the UK throughout the war amounting to over half of the total amount of gold in the

world. In 1944, with the European economy in a state of disarray and the end of the

war approaching, a conference was held in Bretton Woods, New Hampshire to

decide the future of the global monetary system. The United States used its status as

the largest economy, the largest creditor nation, the largest gold reserve holder, and

its victory over the Axis powers as immense leverage in creating a new economic

world order that placed the US at its center.11 The Bretton Woods conference also

gave birth to the IMF, of which attendant countries would join to help ensure

economic stability in the future. The plan would mean all participating countries

would abandon their currency’s link to gold and fix their exchange rates to the

American dollar. The issue was that by the end of the war, Europe and Japan didn’t

have the dollars needed to purchase imports from the US and commodities priced in

US dollars. The solution was the Marshal and Dodge plans, the former for Europe

and the latter for Japan. The plans involved giving Japan and Europe billions of US

dollars to help them rebuild their economies and export sectors so that they could

begin importing abundant goods and needed supplies from the United States. The

world powers agreed to the plan and the new IMS as long as the United States dollar

was backed by gold at $35 an ounce. Thus solidified the American dollar as the new

world currency, the value of which all others were based.

11 Mishkin, Eakinds (2003, pg. 349)

15

With a now constant demand for dollars around the world, countries ran

trade surpluses to accumulate their dollar reserves. By the 1950s the dollar

shortage was over, and an inherent problem in the system was exposed. The dollar

was supposed to be as good as gold, but foreign-held dollars were now becoming

larger than US gold holdings. This was a major sign of the Bretton Woods system’s

unsustainability. With no other country able to rival the financial and goods markets

of the US, the only real alternative to the dollar was gold; no other currency could

compete. It was called the Triffin Dilemma, and its solution was what Middelkoop

(2014, pg. 136) describes as an international gold market manipulation effort called

‘The Gold Pool’. By pooling their gold reserves, the Fed along with 7 other European

central banks were able to defend the $35 gold price through interventions in the

London gold market. The gold pool is recognized as one of the first examples of

international gold market manipulation; a phenomenon some believe still exists

today. It was around this time, that the term exorbitant privilege came into use. The

French labeled the Bretton Woods system as abusive and dangerous, and

championed a return to an independent gold-based system. A more sustainable

solution was needed and so the IMF created the Special Drawing Right (SDR). The

SDR would come to be known as paper gold and would be issued periodically by the

IMF in order to provide countries with the additional reserves they needed to

expand their trade and payments without acquiring more dollars. The SDR was

composed of a basket of currencies from the member countries of the IMF. The SDR

solution was not implemented until 1970, and by then it was too little too late. The

Bretton Woods system now faced a much larger problem; the massive dollar

16

printing operation by the US in order to finance the Cold War, particularly in the

Vietnam conflict. As a result, the dollar had become grossly overvalued at $35 an

ounce and after a few devaluations, the system collapsed in 1973.12

2.3 The fiat IMS and the Birth of a New Reserve Currency

The end of the Bretton Woods system marked the beginning of a new IMS. It

is the same system that we use today. It is a system in which money is not backed by

gold or the US dollar; it is backed by the economic stability and production of the

country from which it originated. The new system would allow the values of these

fiat currencies to float freely against one another. The US ending the Bretton Woods

system was essentially equivalent to a default. Interestingly, after a brief period of

volatility in dollar value, demand for dollars around the world increased, and as

outlined by Eichengreen (2011, pg. 64) by 1977 the dollar portion of international

reserves peaked close to 80%. Some economists, including Middelkoop (2014, pg.

81), believe that it was OPEC’s decision to price their oil exports in US dollars in the

early 1970s that allow the dollar to regain its strength so quickly.

High inflation in the United States during the 1980s caused dollar

composition of international reserves to plummet below 50%. By increasing the

interest rate to 20%, dollar holdings around the world rose again and by 1990 it had

rallied back to 65% of global reserves.13 From the end of Bretton Woods to the turn

of the 21st century, despite huge devaluations and economic instability in the United

12 https://www.imf.org/external/about/histend.htm13 Eichengreen (2014, pg. 64)

17

States, no other currency was able to take its place as the dominant reserve

currency. The reason is the same as it was in the 1940s and as it is today; no other

currency on earth can rival the markets of the US. The US has had, for the better part

of a century, the largest and most liquid asset pools in the world and the largest

economy in the world. The dollar was completely unrivaled in its usefulness

internationally until 1999, when a new currency, backed by an aggregate economy

that was larger than the US was created.

Currency instability in the 1980s and a desire for Europe to become more

economically integrated led to the signing of the Maastricht Treaty in 1991. The

treaty called for the creation of a new currency to be used across Europe and called

the Euro. The Euro has since become the second largest reserve currency asset in

the world. Making up just over 20% of the world’s allocated reserves. Europe’s

combined economy is larger than the United States’, and there has been a decline in

US dollar reserves since its implementation. From 1999-2008, dollar reserve

holdings decreased approximately 5%.

2.4 The Financial Crisis of 2008: The First Sign of Unsustainability

In 2008, the global economy was shook with the largest financial crisis since

the Great Depression of the 1930s. With the United States at the center of the global

credit meltdown, the dollar’s role internationally should have been threatened

18

considerably. According to Eichengreen (2011, pg. 97), stability is the most

important characteristic of a currency that is widely used in international

transactions. Therefore, nothing poses a greater threat to a currency than a financial

crisis. All three authors contend that 2008 should have been a turning point for the

US dollar. The crisis proved that US financial assets were not safer simply because

they were issued in dollars. It exposed that the US had been lying about the credit

worthiness of their complex mortgage backed securities, purchased around the

world because of their AAA rating. It also raised suspicions as to whether the US

would try to inflate away the massive debt burden placed on the system as a result

of the stimulus policies of the Fed.

The 2008 financial crisis is similar to the Triffin Dilema in the 1960s in that

they were both the first signs of the unsustainability of their respective IMS. With

the newly formed euro providing a practical alternative, it seemed likely that there

would be a migration away from the dollar by importers, exporters and central

banks.

Source: US Department of the Treasury

19

Interestingly, the result was the complete opposite. The dollar strengthened

against the Euro and other currencies as central banks and investors around the

world continued to purchase US treasury securities in the wake of the crisis. In fact,

as shown above in Figure 2, foreign holdings of Treasury securities increased at a

much faster rate in the years directly after the crisis compared to the years before

the crisis.

Since 2008 there has been little to no movement away from the dollar in terms of

international reserve holdings, or for invoicing and settling trade agreements. A

recent study discussed by Eichengreen (2011, pg. 123) shows that almost 75% of all

imports from countries other than the US are still invoiced in dollars.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140

1000

2000

3000

4000

5000

6000

7000

Figure 2: Foreign Treasury HoldingsB

illi

ons

$

20

(3) The Present: Alternatives to the dollar today

In this chapter we outline several theories as to why the dollar has continued

to hold its dominant position despite the 2008 financial crisis. We begin by outlining

where currency reserves stand today, then move into some alternatives to dollar

reserves. We conclude this chapter by looking at the unstable monetary and

regulatory policies of central banks around the world and how possible gold market

manipulation is the reason investors aren’t moving to safer assets.

3.1 Composition of Official Foreign Exchange Reserves

Before we look at alternatives to the dollar, we must look at where currency

reserve standings are today. Figure 3 shows the most recent IMF data on foreign

reserves.

Source: IMF COFER Data

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 20140%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Figure 3: Composition of Official Foreign Exchange Reserves

Euros

Other

U.S. dollars

22%

16%

62%

21

As of the most recent IMF reports, the dollar comprises just over 62% of the

world’s reserve currencies. The Euro makes up just over 22%, and all other

currencies combined make up about 16% of total allocated reserves. In the last 15

years the dollar has lost 10% of the total composition, indicating a gradual shift

away from the dollar by central banks around the world. Since the financial crisis,

the dollar has lost about 2% of the total weighting.

3.2 Why the Dollar Retained its Role After the Crisis

There are 3 key explanations for why the dollar has retained its role in the

world economy. The first is that the US is still the largest economy in the world, and

it still has the worlds largest and most liquid financial markets. All three authors

agree that liquidity and size of financial markets is the ultimate determinant of the

dominant reserve currency. The second is what Eichengreen (2011, pg. 124) calls

“advantage of incumbency”. Advantage of incumbency is essentially the same thing

as a network effect, in that something becomes more valuable as more and more

individual parties use it. If most exporters are invoicing in dollars, individual

exporters have an incentive to invoice in dollars as well. This creates value for the

exporter as it limits fluctuations in their prices relative to competitors. For central

banks, if other countries are stabilizing their exchange rates using the dollar as an

anchor, it makes sense for individual central banks to do the same. As mentioned

before, this requires a stockpiling of dollars to intervene in foreign exchange

markets, and a stockpiling of dollars usually comes in the form of Treasury

securities.

22

The third factor is that there is still no good alternative to the dollar. There

are 7 official reserve currencies recognized by the IMF. These are the US dollar, the

Canadian dollar, the Australian dollar, the Japanese yen, the British pound sterling,

the Swiss franc and the Euro.14 Market size and liquidity are two very important

characteristics for a reserve currency, and in these two aspects, the countries of

Canada, Australia, Japan, Britain and Switzerland are simply too small to compete.

This leaves the euro as the primary contender to the dollar. The Euro Area exports

nearly twice as much as the United States and has a larger GDP, but the euro still

only accounts for 22% of foreign reserves.

3.3 The Euro: the Only Current Alternative

Eichengreen (2011, pg. 134) points to two key reasons why the Eurozone

cannot replace the dollar at this time. The first is that the euro area’s bond market is

both smaller and less liquid than the US. The larger issue however, is that the euro is

a currency without a state. It is the first ever currency not backed by a government.

Without a united fiscal policy, the Euro Area has continued to experience instability

in its member countries, and managing these problems requires cooperation

between its member countries, which cannot be assured. Eichengreen’s solution for

increasing the euro’s use amongst its trade partners, is the creation of an emergency

financing mechanism that can make decisions quickly when crisis occur, and

policies that will increase monetary and fiscal union between countries. These

actions should improve economic stability and thus increase confidence in the euro

14 http://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4

23

leading to its more widespread use. Because institutional reform is predicted to be

slow, it is predicted that the euro’s rise as an international currency will be slow.

Given Russia’s recent economic sanctions on the European Union (EU) and

increasing political tensions in the area, it is possible that there could be further set

backs for the euro in the near future. Russia is one of the Euro Area’s biggest trade

partners and a deterioration of this relationship would hurt the euro. Eichengreen

does expect however that the Euro will continue to gain market share amongst EU

member countries not part of the Euro Area. The EU is also developing stronger ties

to non-EU countries to the south and east. Until the Euro Area moves deeper into

political integration and develops a bond market that can rival the liquidity of the

US, it is very unlikely for the euro to rival the dollar as a global currency.

Rickards (2014, pg. 137) also sees the euro as a potential dollar substitute.

He points to the Euro Area’s resilience and ability to stay together despite economic

crisis, as a sign of its worthiness as an international currency. The world also

increased its share of euro reserves during the European Debt Crisis, which he

interprets as a clear vouch of confidence. Like Eichengreen, he doesn’t see the euro

rivaling the dollar until the Euro Area’s monetary union is combined with greater

fiscal union. Through the continued development of its bond market, Eurobonds will

eventually provide a deep, liquid pool of investable assets larger than the US

Treasury market. A true gold bug, Rickards (2014, pg. 137) also notes that the Euro

Area’s combined members’ holdings of gold exceed 10,000 tonnes, which is 25%

24

more than the US Treasury official gold holdings. This combination of the largest

economy, the largest bond market and the largest gold reserves holder makes the

euro likely to replace the US dollar by 2025. Once again we note that both authors

agree it is the size and liquidity of the bond market that determines the dominant

international currency. If the Euro Area continues to further integrate its members’

fiscal policies and continues to grow its Eurobond market, it is very likely that the

euro will eventually become more important than the dollar. A larger economy

usually means a larger financial market. This poses a direct threat to the

sustainability of the dollar’s status as the dominant reserve asset.

3.4 China, the IMF, the UN and the SDR

While the euro is no doubt a threat to the dollar in the long run, all three

authors believe that it is China that may pose the largest foreign risk to dollar

currency dominance today. The reason for this is that China is the largest holder of

US debt securities in the world. If China were to sell off a significant number of its

dollar reserves, the US dollar would greatly depreciate. This could trigger a wave of

selling that could lead to the demise of dollar as the global currency. All three

authors admit this is not likely to happen however, because China would suffer

considerable losses on its remaining reserves. It would also make US imports more

expensive, which would hurt Chinese exports, which China relies on for its economic

growth.

25

After the global financial crisis of 2008, China declared that it wished to

diversify away from dollar reserves. As mentioned before, there doesn’t currently

seem to be any currency that could take the dollar’s place. This explains why China

has continued to increase its share of Treasury securities. In 2009, Zhou Xiaochuan,

the governor of the Chinese central bank argued that the IMF’s Special Drawing

Rights (SDR) should replace the dollar as the world’s reserve currency.15 Other

BRICS (Brazil, Russia, India, China, South Africa) countries have also supported this

idea, as it would eliminate the exorbitant privilege of the US.

According to Eichengreen (2011, pg. 137-142) however, SDRs do not present

a likely alternative to the dollar. His reasoning rests on the limited use of SDRs. They

can be used to settle debts to governments and the IMF, but not for other purposes.

There exists no private markets for SDRs, and SDRs can’t be used to settle trade. If

governments ever wanted to use their SDRs, they would have to first convert them

into some other currency, which is inconvenient and expensive. Again, the

importance of market size and liquidity is brought up, SDRs will only pose as an

alternative to the dollar if there were deep and liquid markets on which SDR priced

securities could be bought and sold. Governments and corporations would have to

be able to issue SDR bonds, and its market would have to be just as large if not

larger than the market for dollar denominated securities. On top of that, banks

would have to accept SDR-denominated deposits and make loans using the

currency. It would require a restructuring of foreign exchange markets and financial

15 http://www.reuters.com/article/2009/03/23/china-sdr-idUSPEK18455820090323

26

institutions. SDRs are very unlikely to play a large role in the international monetary

system, let alone rival the dollar concludes Eichengreen.

Despite Eichengreen’s pessimism concerning the SDR, there are some

powerful institutions that also champion an increase in its use. Middelkoop points to

a report by the UN that calls for a new global reserve system based on the SDR. The

UN report outlines how global imbalances and large disparities between different

countries’ balance of payments played a part in the cause of the financial crisis, and

caused its widespread effect on global markets. It notes that the financial crisis may

cause countries to further increase their reserves and may in turn lead to further

imbalances.16

The easiest metric of measuring global economic imbalance is current

account surplus and deficit. In the years leading up to the 2008 financial crisis

current account disparity between countries, measured by standard deviation,

reached an all time high as shown in Figure 4 on the following page.

Source: World Bank Data

16 http://www.un.org/ga/president/63/letters/recommendationExperts200309.pdf

27

We see a large convergence of current account balances immediately after 2008. In

the years since however, they have again begun to diverge. This is a sign of stress in

the IMS, and an indication that the unsustainability of the system may not have been

corrected after the crisis. Ideally, balance of payments disparity should be equal to

zero. As we pointed out earlier, the exorbitant privilege of the US is a large

contributor to the divergence of current account balances.

There is also a 2010 IMF report, outlined by both Middelkoop and Rickards

in their books, that looks at the possibility of a new financial system featuring the

SDR instead of dollar as its anchor.17 Both the IMF report and UN report point to the

imperfections and asymmetries that result from the current system, many of which

were discussed in the introduction of this paper. The IMF report claims that the

necessary practice of reserve accumulation that is an inherent part of the current

IMS makes it “ultimately unsustainable”. Both organizations recommend reforms

that will lead to a reduction in demand for international reserves and a

17 http://www.imf.org/external/np/pp/eng/2010/041310.pdf

2005 2006 2007 2008 2009 2010 2011 2012 20130

100000000002000000000030000000000400000000005000000000060000000000700000000008000000000090000000000

Firgure 4: Global Current Account STD Deviation

28

diversification of their composition. In 2009, the IMF increased the number of SDRs

in circulation from 21.4 billion to 204 billion, valued at $309 billion.18 Because SDRs

are not considered a currency, they are not included in the IMF’s composition of

foreign exchange reserves (COFER). If they were however, SDRs would make up

approximately 5% of allocated international reserves.

In 2012 the IMF added the Canadian and Australian dollars to the basket of

official reserve assets. By adding 2 new reserve currencies and drastically

increasing the number of SDRs in circulation, the IMF demonstrates its support for a

move towards a more diversified global reserve composition. These reports by two

very accredited and important organizations add to the mounting evidence that the

dollar-centric IMS is unsustainable.

3.5 Quantitative Easing and Why US Inflation Remains Normal

Another source of unsustainability in the dollar-dominated IMS is the

unprecedented money printing policies that have been implemented in advanced

economies after the crisis of 2008. This dollar printing strategy is called quantitative

easing (QE). QE is conducted when a central bank prints money in order to buy back

bonds and assets that have lost considerable value because of a crisis. It was first

implemented by Japan in the mid 90s and has since been used by the US, Eurozone

and Britain since the financial crisis of 2008. According to Middelkoop (2014, pg.

90) From 2008-2013, central banks worldwide have created over $10 trillion of new

money. The goal of QE is lower long-term interest rates and to provide liquidity to

18 http://www.imf.org/external/np/exr/facts/sdr.htm

29

financial institutions. QE is an unsustainable policy, as it has resulted in a large

increase in government debt. This debt is not financed by other countries as it

usually is; instead it is financed by the central bank of that particular country. QE is

thus money printed to fund the deficit. US national debt has grown by about $8

trillion from 2008-2013, to $17 trillion. To put that in perspective, Middelkoop

(2014, pg. 92) points out that it took 169 years (1836-2005) for the first $8 trillion

of debt to accumulate. This huge buildup of debt has not caused the global economy

any problems because interest rates on this debt have fallen to close to 0%. In the

US, public debt as a percentage of gross domestic product (GDP) has increased from

about 65% in 2008 to over 100% today.19 While this debt level is not currently

considered a serious threat to the US economy, it leaves the US vulnerable to

exogenous shocks. If another crisis were to face the US, increasing its current debt

level to provide liquidity would be almost impossible. It is important to remember

that it is not just the US implementing these unorthodox expansionary monetary

policies. The Eurozone, Japan and Britain are also pursuing these strategies. The

result is not just a more unstable US economy, but also a more unstable global

economy.

We know however that central banks and governments are regulated in their

ability to print money and increase debt by rising inflation. Remarkably, since

quadrupling its monetary base, the US has not experienced high inflation. There are

several theories for why this is the case. Middelkoop (2014, pg. 42-45) suggests that

the reason we aren’t seeing inflation on a greater scale is because governments are

19 https://research.stlouisfed.org/fred2/series/GFDEGDQ188S

30

constantly adjusting economic data. The consumer price index (CPI) is a basket of

goods whose average rise in prices is reported as the official inflation numbers.

There are several issues with these numbers; the first is that they don’t take into

account local taxes, which have risen sharply in the US in recent years. The second

issue is that the government changes this basket of goods to “better reflect”

domestic consumption. These adjustments come in three forms: 1. Replacement of

cheaper alternatives, justified by peoples shift to less expensive substitutes when

prices rise, 2. A change from arithmetic weighting to geometric weighting, causing

product prices that rise the most to be weighted less heavily, 3. Hedonic

adjustments, which involve lowering the prices of goods to reflect changes in

quality. Another consideration for CPI misrepresenting inflation is that not everyone

purchases the goods and services in the basket, leading to bias. There are others

who agree that inflation metrics in the US are manipulated. Middelkoop (2014, pg.

44) points to a report by Crédit Agricole in 2006, which claims that the real inflation

rates in the US have been around 6.7%, similar to the growth in US money supply,

instead of the official numbers of around 2%. The US also stopped publishing M3

money supply data in 2006.

Finally, Middelkoop (2014, pg. 129) claims that official inflation numbers are

being kept artificially low by a top-secret war on gold, which cause gold prices to be

lower than what they would be without market manipulation. Governments have a

vested interest in keeping inflation numbers low because it increases real GDP

growth, and allows for greater tax revenue for the government without having to

31

actually increase taxes. But even if it was true that the US government underreports

inflation, hyperinflation is not something that can be hidden simply by changing the

model for how it is calculated. People will notice when prices rise dramatically. How

much debt can the US government create before it becomes dangerous for the

economy? Middelkoop (2014, pg. 93) turns to retired professor at the University of

Basal, Peter Bernholz to answer the question. Bernholz has studied the 12 most

sever episodes of hyperinflation and has concluded that all of them were caused by

financing public deficits through money creation, what we now call QE. The point at

which hyperinflation occurs was found to be when government deficit exceeds 40%

of its expenditures. The US reached this level in 2009, but has since brought it down

considerably. In 2015 the ratio is expected to be only 15%.20 It appears for now that

the United States is safe from hyperinflation.

Rickards (2014, pg. 9) also believes inflation to be a serious problem facing

the US, and the reason we are not experiencing it is because there are also massive

deflationary forces acting on the economy. The deflationary forces come from the

record low money velocity in the United States. Consumers are not spending nearly

as much as before the recession. To combat this, the United States has vastly

increased money supply through money printing by the Federal Reserve. Since the

beginning of QE in the United States, the Fed has printed over $3 trillion effectively

quadrupling the monetary base of the United States. The money printed by the Fed

has been used to purchase long-term bonds and toxic assets of the largest banks and

corporations in America. By channeling the newly printed money into large

20 https://www.whitehouse.gov/omb/budget/Historicals

32

corporations and not into consumer’s hands, the Fed has been able to avoid the

inflationary forces that usually accompany an increase in the monetary base.

Rickards claims that this balancing act between inflation and deflation cannot go on

forever and eventually one will overtake the other. Given the choice, the Fed will

always choose inflation. The massive deflationary and inflationary forces acting on

the US economy in combination with the second highest debt level in US history

lend tremendously to the instability of the US economy, and the unsustainability of

the dollar’s role in the IMS.

3.6 Derivatives: Growing Markets Make for Growing Risk

Another potential source of global economic instability hypothesised by

Rickards is the large increase in bank derivatives since 2008. There has been a

staggering increase, considering it was derivatives, namely mortgage backed

securities that caused the last financial crisis. The gross size of bank derivatives is

larger now than ever before. Today it exceeds $700 trillion, more than 9x global

GDP.21 Rickards (2014, pg. 267-270) claims that this increase has been allowed

because bankers are still using risk models that do not take complexity theory into

account. The greatest threat is counterparty failure, such as AIGs inability to pay

back all of the credit default swaps it owed in 2008. Counterparty failure causes a

liquidity crisis in financial markets and triggers a panic. He claims that financial

markets today have increased in complexity due to derivatives, making them

impossible to fully understand let alone compute. As mentioned above, Rickards is a

critic of the models used to calculate risk. He calls the value at risk model “make-

21 http://www.bis.org/statistics/dt1920a.pdf

33

believe” and unsound. Because derivative instruments can be recorded off bank

balance sheets, they do not appear from the outside to make them unstable. The fact

that the US and global derivatives markets have continued to grow unabated since

the financial crisis is another sign of unsustainability of the dollar. If derivatives

were to cause another financial crisis, the US will not be able to use QE as a strategic

response. The dollar will most likely suffer a loss of confidence as investors realize

that little was done after 2008 to prevent a financial crisis from occurring again.

3.7 The War on Gold: Market Manipulation to Maintain Currency Legitimacy

With a massive increase in global debt, excessive money printing by

governments, an ever-growing derivatives market and a call by large governments

and organizations to move away from the US dollar we see an IMS under

considerable stress. With growing systemic instability usually comes a flight to safe

assets. As the safety of dollar assets continue to come under scrutiny, the only

remaining truly safe asset is gold. Gold poses a direct threat to the American dollar

system because it provides a safe alternative. If gold is seen as valuable and useful as

a form of currency, the value of the dollar is seriously undermined, because unlike

gold, fiat money has no intrinsic value. Therefore, according to Middelkoop (2014,

pg. 129) and Rickards (2014, pg. 278) the US will do anything it can to prevent a

rush to gold. The war on gold, as they call it, revolves around keeping gold prices

artificially low. Low gold prices help keep inflation expectations low, and thus

dissuade investors from seeking out ‘hard assets’, which retain their value when

currencies depreciate. The survival of our current monetary system and the

34

exorbitant privilege of the US depends entirely on people preferring fiat money to

gold.

The war on gold is thought to have started in the 1960s, when the dollar first

became overvalued in the Bretton Woods system. In 1961 the ‘London Gold Pool’

was created in order to keep the price of gold below $35 an ounce, by dumping gold

on the open market when prices climbed too high. In 2009, wikileaks released

secret US reports from 1968, outlining a propaganda campaign to convince the

public that central banks would remain ‘the masters of gold’, and that investors

should not speculate on rising gold prices.22 Their schemes did not work however,

the London Gold Pool was disbanded later that year and the Bretton Woods system

collapsed only a few years later. Since the collapse of Bretton Woods, Middelkoop

(2014, pg. 139) claims that the IMF and United States has been working together to

keep gold prices suppressed. Though he provides no discernable proof of this.

In 1995 the Fed created a system of ‘gold swaps’, whereby gold would be lent

out to the Fed by Western central banks, which would then be sold to Wall Street

banks in order to keep the price down. Middelkoop (2014, pg. 147) claims that in

1998 Fed Chairman Greenspan is quoted to have said “Central banks stand ready to

lend out enough gold if the gold price rises”. Middelkoop claims that thousands of

tones of gold were dumped through gold swaps in the late 90s, but provides no

sources to confirm this information. In 2003, however, a lawsuit launched by gold

22 http://www.zerohedge.com/article/declassified-state-dept-data-highlights-global-high-level-arrangement-remain-masters-gold

35

dealer Blanchard against Barrick Gold Corporation and JPMorganChase shone some

light on these swap agreements. Barrick confirmed that it had borrowed gold from

Western central banks through ‘gold swaps’ at the request of the Federal Reserve in

order to sell this gold on the market.23 Today, the primary tool used by central banks

to manipulate gold prices is through derivative instruments. Middelkoop and

Rickards claim that the trading of futures contracts on the global markets sets the

price of gold. Large positions can be taken in these markets without actually having

to hold gold. Rickards (2014, pg. 285) claims that the amount of gold traded in

derivative contracts is 100x the amount of physical gold backing those contracts.

This is because gold is almost never physically traded in these transactions.

Middelkoop (2014 pg. 153) points to the fact that in April 2013 the price of gold

dropped $200 in only 2 days because of a wave of sell orders in the futures market.

A dramatic drop in price however does not mean that it’s the government

doing it. There have been many reports on gold price manipulation by investors and

analysts all over the world. There are also dozens of websites dedicated to exposing

the ‘truth’ about the government’s role in the pricing of gold. The US government

and the Federal Reserve have both denied any manipulation of gold on their parts.

Middelkoop’s theory, is that central banks around the world issuing fiat currencies

don’t want people investing in gold because it directly undermines the value of their

currencies, but the fact is that there just isn’t enough proof. Even if central banks sell

gold on the open market, there are an endless number of reasons other than to

suppress the price. Between 2009-2012, gold experienced a 60% increase in price,

23 http://www.gata.org/node/1858

36

yet there has been no surge in inflation, or a flight from US assets. In fact, there was

a flight to US dollars and treasury bills during this time. Furthermore a rising price

of gold is not going to detract from dollar reserves because gold debases all

currencies, not just the dollar. Rising gold prices are correlated with financial

instability, and so we can assume, that if the fall of the American dollar dominated

system is caused by crisis or economic instability, it is a valid argument that gold

could play a role in the new system.

(4) The Future of International Reserves: 3 Theories

In this chapter we look 10 years into the future to determine whether or not

the dollar’s role in the IMS is sustainable. We focus on three theories here. The first,

by Eichengreen, discusses a future IMS that uses the dollar, the euro and the Chinese

renminbi with relatively equal weighting. The second theory, championed by

Rickards, discusses how a collapse in the financial system will result from a loss of

confidence in the dollar and how the future IMS will be gold-centric rather than

dollar-centric. The final theory we’ll discuss focuses on an area neither author

delves very far into; the petrodollar, and how the US might defend its exorbitant

privilege.

4.1 The Rise of China and the “Multi-Polar” Reserve System

Dollar supremacy today can ultimately be explained by a lack of viable

alternatives, but a new international currency is coming. China is trying to develop

its own reserve currency, the renminbi. Aside from decreasing US exorbitant

37

privilege, if the renminbi were used widely in international transactions, China

would be freed of having to hold foreign currencies to correct its balance of

payments or aid domestic firms with foreign obligations. It would be able to simply

print more of its own currency, like the US. According to Eichengreen (2011, pg.

143) A 2008 report by the China Banking Regulatory Commission suggested that the

renminbi would become an international currency by 2020.

Eichengreen (2011 pg. 143-147) admits that the renminbi has many barriers

to overcome before it can be used as an international currency. The first is that the

renminbi is currently inconvertible, meaning that it can only be used to purchase

goods and services from China. This inconvertibility is one of the tools that allow

China to control its capital flows. They allow China to manipulate financial markets,

but they also restrict its international use. Another issue for the renminbi is China’s

‘growth model’, which revolves around keeping its currency pegged below the

dollar to ensure it sustains its export sector. Exchange rates will have to become

more flexible to accommodate a larger volume of capital flows if the renminbi is to

become convertible. China also doesn’t have a deep and liquid bond market as until

recently, renminbi denominated bonds were only allowed to be issued by Chinese

banks, which are all state owned enterprises. China has restricted the issuance of

foreign renminbi denominated bonds because it pulls savings away from

government control. Another issue is that even if the renminbi was made fully

convertible, and foreigners allowed to issue renminbi denominated bonds, the size

of the Chinese economy is still less than half that of the US at market exchange rates.

38

Therefore, the size of the bond market would not be able to compete with the depth

and liquidity of the US.

Eichengreen (2011, pg. 147) concludes that renminbi-denominated

securities will be most attractive to countries that trade heavily with China and

conduct financial business there, because fluctuations of the renminbi will matter to

them the most. Eichengreen’s view of the renminbi is very similar to that of the

Euro. Both will become more important in their respected regions, but are unlikely

to completely overthrow the dollar. It is viable to assume however, that as the

renminbi becomes more important in Asia, it is likely to replace dollar reserves

there more than euro reserves. This is because China holds far more US reserves, an

estimated 65% of their holdings according to Eichengreen, and because Asian

countries conduct more trade with the EU than the US, making them likely to swap

out their dollars for renminbi.24

Rickards (2014, pg. 126) also shares this view. In his book he quotes an

article by The Washington Post that reports between 2011 and 2013 Chinese

companies have invested over $20 billion in the EU, compared to only $11 billion in

the US. On top of this, China has been very vocal concerning the asymmetries of the

current IMS and the unfair exorbitant privilege the US derives from it. Middelkoop

highlights this in his book, and discusses commentary by the Chinese state news

agency Xinhua. The report calls for a ‘de-Americanization’ of the world, and

discusses the need for reserve asset diversification and the ushering in of a new IMS

24 http://ec.europa.eu/trade/policy/countries-and-regions/regions/asean/

39

that does not place a single currency at its center.25 (xinhuanet.com) A US Treasury

Department report released in 2012, using data gathered from the Chinese State

Administration of Foreign Exchange (SAFE), shows a widening gap between Chinese

US security holdings and total Chinese foreign reserves as shown in Figure 5 on the

following page.

25 http://news.xinhuanet.com/english/indepth/2013-10/13/c_132794246.htm

40

Source: US Treasury Department, Report of Foreign Portfolio Holdings of US Securities as of June 30, 2012

This data provides irrefutable evidence that although China is still

purchasing US treasury securities, it is indeed diversifying its reserve portfolio away

from the dollar. It is also worth noting that this chart indicates US reserves

representing less than 50% of total Chinese reserves. Recall that according to

Eichengreen, it is estimated that US holdings represented approximately 65% of

Chinese reserves. This is because Eichengreen’s calculation factors in the reserves

held by China’s sovereign wealth fund. This discrepancy also explains why China’s

US treasury holdings have continued to increase despite the Federal reserve data

showing a decrease in 2012.

Despite the many hurdles the renminbi must cross before it becomes an

international reserve currency, there has been considerable progress made in the

Figure 5: Chinese Total and US FX reserve holdings (Billions)

41

last few years towards renminbi convertibility and international use. Eichengreen

(2011, pg. 184-186) reports that in 2009, HSBC Holdings became the first foreign

bank to sell renminbi denominated bonds in Hong Kong. In 2010, a Hong Kong

construction company became the first company other than a bank to receive

authorization to issue renminbi denominated bonds offshore. The value of trade

settlements made after only the first year in which cross-border renminbi

transactions were permitted, more than doubled from $78 billion to $220 billion.

China has also established a market with Japan that allows for direct yen – renminbi

exchanges without having to first convert to dollars. Foreign firms in China are now

allowed to issue renminbi denominated bonds in Hong Kong and use the funds to

invest in Mainland China. Offshore renminbi can now be used to invest in China’s

stock market. The British Treasury has been granted authority to trade offshore

renminbi in London. The central banks of Malaysia and Nigeria now hold a portion

of their reserves in renminbi. Despite the renminbi bond capitalization still

amounting to only one tenth that of the United States, it is clear that China is serious

about renminbi internationalization. As its bond market continues to grow, and

capital flows continue to loosen, more and more international transactions will be

settled in China’s currency. The dollar will have to learn to share the Asian market

with the renminbi, just as it must now share the European market with the Euro.

Eichengreen (2011, pg. 148) acknowledges that it is possible, given the

massive accumulation of debt in the US and around the world since the financial

crisis, there could be a loss of confidence in the dollar resulting in a possible flight to

42

safe assets such as gold by investors and central banks alike. He dismisses however,

the argument that gold will play an important role in the new IMS. He points out

there has been a move away from gold by investors and central banks in the last

century. The reason for this is because financial instruments are more convenient

for emergency financial transactions. It is simpler to support a currency, by buying it

with reserves of dollars, then to first have to convert gold to dollars and then to the

currency. Gold must be physically exchanged in a transaction, where as currency

can be invoiced and settled electronically. Gold is therefore not highly demanded by

central banks.

Source: World Gold Council using information from the IMF

Recent data on country’s reserve gold holdings support Eichengreen’s claim

that central banks don’t want more gold. As seen above in Figure 6, Global gold

Q1 2000

Q4 2000

Q3 2001

Q2 2002

Q1 2003

Q4 2003

Q3 2004

Q2 2005

Q1 2006

Q4 2006

Q3 2007

Q2 2008

Q1 2009

Q4 2009

Q3 2010

Q2 2011

Q1 2012

Q4 2012

Q3 2013

Q2 20146%

7%

8%

9%

10%

11%

12%

13%

Figure 6: Gold as a % of total reserves

All countries

43

holdings have increased since 2008, but have been decreasing since 2012. In the last

3 years China has consecutively lowered its reserve gold holdings.

Eichengreen (2011, pg.149) concludes that the dollar-dominated IMS is

unsustainable, for the simple fact that one day, other currencies will match the

dollar in terms of the size of depth of their debt markets. The change will be gradual

and won’t take place for at least 5 years, when the renminbi is predicted to claim

reserve currency status. The primary currencies that will end the dollars reign will

be the euro and renminbi, but there could be others as well such as the Indian rupee

looking farther in the future. Despite his skepticism concerning its usefulness, he

also believes that the SDR will play a small, but still relevant role in the new IMS.

Eichengreen believes that gold will most likely not play a role in the new “multi-

polar” IMS. He proclaims, “Gold bugs are forever. But it is not obvious that one can

say the same for the monetary role of gold.”

Despite Eichengreen’s pessimism, there is a compelling argument for why

gold might play a role in the new IMS. An OMFIF report from 2010, titled “Gold, the

Renminbi and the Multi-Currency Reserve System” shines some light on the role of

gold in the future IMS. The report claims that as the world moves away from the

dollar and accumulates a more diverse portfolio of reserve holdings, that there will

most likely be substantial fluctuations in currency values. Because gold is a hedge

against all currencies, it makes sense that investors and central banks will increase

44

their gold holdings to protect themselves.26 The report does not believe that gold

will be placed at the center of the new IMS, only that it will play a larger role.

According to Eichengreen, US dollar dominance and the exorbitant privilege

it benefits from it are not something the US will enjoy forever. The system is

unsustainable because the US will continue to be less dominant economically in the

future global economic landscape. The euro and the renminbi will greatly reduce the

dollars role internationally. Although the dollar will still maintain its status as an

important reserve currency, it will lose its status as the reserve currency and may

even be replaced as the most important currency by the euro.

(4.2) The Economic Apocalypse and a Return to the Gold Standard

To Middelkoop and Rickards this view is far too optimistic. They don’t

believe that the current system will last long enough to see this new “multi-polar”

reserve system. To them, the IMS is already on the brink of total failure, and any day

now the value of the dollar is going to collapse causing a global financial crisis like

none the world has ever seen. In his book, Rickards (2014, pg. 242) proclaims

“There is no paper currency that will come close to replacing the dollar as the

leading reserve currency in less than ten years...The world cannot wait ten years for

the paper SDR, the yuan [renminbi], and the euro to converge into Barry

Eichengreen’s “Kumbaya” world of multiple reserve currencies. The consequences

of misguided monetary leadership will be on display in far fewer than ten years.”

26 https://www.gold.org/sites/default/files/documents/gold_renminbi_multi- currency_reserve_system.pdf

45

The direct cause or tipping point of the end of the dollar dominated IMS is

difficult to predict according to Rickards, but it will most likely stem from a loss of

confidence in the dollar. The root of the problem according to both Rickards and

Middelkoop, is the fact that money is no longer backed by anything of real value. The

US dollar is the most important financial instrument in the world, and its value is

derived from faith, not gold. If something were to cause a significant loss of

confidence in the value of the dollar, the dollar would cease to serve as money, and

the global financial system would collapse because so many things are valued in

dollars.

Rickards (2014, pg. 290) predicts that an American default “will come from

across-the-board inflation that will steal from savers, depositors, and bondholders

alike.” This inflation will come from a breaking of the deflationary psychology,

currently found of the American economy. Despite what the media says about the

recovering United States economy, pointing to inflation rates close to targets,

increasing housing prices, recovering stock market indexes and falling

unemployment, Rickards claims these gains are artificial, caused by financial

engineering and speculation.

“…a close examination of both shows that stock market volumes have been low, with

leverage quite high. These are indications that the rising indexes are really asset

bubbles, driven by professional traders and speculators, principally hedge funds,

and that participation by everyday citizens has been shallow. Likewise, rising home

46

prices have been held up not by traditional family formation but by investor pools

purchasing large housing tracts with leverage, restructuring homeowner debt, or

converting mortgages to rentals. Cash flows can make these pools attractive bond-

like investments, but no one should mistake this financial engineering for a healthy,

normalized housing market.” Rickards (2014 pg. 190) claims that the Fed has

managed to channel inflation into major stock indexes, creating the illusion of a

recovering economy.

If we compare the rising Dow Jones Industrial Average (DJIA) to the

increasing monetary base of the US, we do find a striking correlation.

Source: FRED data

By conducting a regression analysis on the daily change in the DJIA and the

monetary base of the US we find there is a significant correlation as shown in Figure

7. This analysis serves as evidence of a US stock index that is potentially in an

inflationary bubble.

20092009

20102010

20112011

20122013

20132014

20141500000

2000000

2500000

3000000

3500000

4000000

4500000

6,750

8,750

10,750

12,750

14,750

16,750

18,750

Figure 7: Monetary Base vs. Dow Jones

MON BASEDOWJ

47

Adjusted R Square Significance t - value Beta

0.039 0.054 1.962 0.23

According to Rickards (2014, pg. 291), when consumption and investment do

return to pre-crisis levels, the already overwhelming inflationary policy of the Fed in

combination with the inflationary forces of a healthy economy will cause

hyperinflation. On the other side of the coin, if deflationary forces continue for too

long, investors may lose confidence in the Fed’s ability to continue propping up the

economy with money creation. Either way, there is a loss of confidence in the value

of the dollar and thus a collapse of the monetary system. We know now that a loss of

confidence will probably not come from investors worrying about the Feds ability to

fight deflation because in November of 2014 the Fed ended QE and we’ve yet to

experience a loss of confidence in the dollar.

Rickards believes that gold will not simply supplement the dollar and other

fiat currencies in the new IMS. He argues that the world, including the US will

return to a gold standard after the next major crisis. The American economy will

experience an inflation crisis, long before a global rebalancing can occur. With an

overleveraged balance sheet the US will be unable to defend itself financially.

Because other advanced economies are also so highly leveraged, they too will be

unable to rescue the system. After the fall of the old system, gold will once again be

placed at the center of the global economy.

Rickards (2014, pg. 279-280) argues that world leaders are also predicting

this collapse and that they understand that when the system fails, currencies will

need to be placed back on the gold standard to regain confidence. Therefore, central

48

banks should be accumulating gold in order to ensure it will be able to participate in

the new system. A country that does not have enough gold reserves to back its

currency will suffer considerably. If every other currency is backed by gold, the

currency that isn’t will be considered far less value than its alternatives. Rickards

believes that the primary motive of gold price manipulation by the Fed and other

central banks is to allow the major economic powers of the world to rebalance their

gold reserves before the collapse at a reduced cost. This will provide a more even

playing field in the new IMS and will eliminate the likelihood of political conflict

resulting from implementation of the new gold standard. Rickards claims that there

is currently a scramble for gold by central banks, but recent data on gold reserves

held by central banks does not support his argument. The global percentage of

central bank reserves held in gold equaled 8% at the end of 2014. This is lower than

the percent of gold reserves held at the end of 2007, which was approximately 10%.

Despite gold’s decrease in percentage share of global reserves, the actual number of

tonnes of gold held by central banks has increased from 30,000 in 2007 to

approximately 32,000 today, a increase of about 7%. This increase makes sense

given the global financial instability that has resulted from 2008. We can not

conclude that a 7% increase in the amount of gold held by central bankers

worldwide indicates that the world is preparing itself for a return to the gold

standard, especially considering that central banks have been acquiring other

reserves (all denominated by fiat currencies) at a rate faster than they have been

acquiring gold. While on a global scale the changes in gold reserves appear marginal,

there is some evidence of rebalancing between the G20 countries.

49

Source: World Gold Council using information from the IMF

For our comparison, shown above in Figure 8, we have broken down the G20

countries into 4 groups. We see that there has been considerable selling of gold by

the ECB and Euro Area. Interestingly, the amount of gold sold by the ECB since 2000

is roughly equal to the amount of gold purchased by all the other G20 countries

combined. Other countries’ gold reserves still don’t come close to that of the United

States and Eurozone. China has doubled its gold reserves since the year 2000, but

the percentage of China’s reserves held in gold has decreased from 2% in 2000, to

1% in 2014. The evidence does not support Rickard’s claim that central banks are

“scrambling” for gold.

Q1 2000

Q1 2001

Q1 2002

Q1 2003

Q1 2004

Q1 2005

Q1 2006

Q1 2007

Q1 2008

Q1 2009

Q1 2010

Q1 2011

Q1 2012

Q1 2013

Q1 2014 -

2,000.00

4,000.00

6,000.00

8,000.00

10,000.00

12,000.00

14,000.00

Figure 8: Total gold holdings of G20 countrys

USEuro AreaBRICSOthers

Ton

nes

50

He is quick to point out that the BRICS countries and many other developing

countries have doubled their gold reserves in the years since 2008. This is true, but

the fact is they have also been drastically increasing their number of currency

reserves, including dollars. Rickards (2014, pg. 282-284) acknowledges that the

evidence found through official sources and databases is not convincing. He believes

that some countries, primarily China, have been secretly buying gold and not

reporting it. It is possible that countries have been secretly building their gold

reserves so as not to affect the market price of gold and potentially cause a

premature flight to safe assets, but he does not provide substantial proof to confirm

that this is happening. A lack of proof makes sense for his theory however, if the

most powerful countries in the world are colluding to keep something a secret, it

will be well guarded. It is here that we cross the line into conspiracy theory. There is

a saying that extraordinary claims require extraordinary proof, and it is here that

Rickards falls short. In conclusion, Rickards theory lacks the necessary evidence to

make such a bold claim. Ultimately, there is little evidence that the world is

preparing for a return to the gold standard. However, if confidence was lost in the

dollar, it is possible that the US would reinstate the gold standard as a very last

resort.

4.3 The Petrodollar: Defending US Exorbitant Privilege

All three authors mention the petrodollar in their works, but do not delve

into its true importance. The petrodollar is what I believe to be the most important

reason for dollar dominance today. Conversely, the fall of the petrodollar is also the

greatest risk to the US economy and position as the worlds leading currency issuer.

51

The petrodollar is the global phenomenon of pricing oil in dollars, which creates a

huge demand for the currency. It also explains how the US can afford such enormous

military spending. To understand the importance of the petrodollar, and its

implication for the future of the IMS, we must understand how it came into

existence.

The petrodollar system was created in 1971, when the US signed an

agreement with Saudi Arabia. In exchange for guaranteed military protection for as

long as the petrodollar was used, Saudi Arabia would price all of its oil in dollars and

invest some of its profits in US treasury securities, a system known as petrodollar

recycling. By 1975 all member countries of the Organization of the Petroleum

Exporting Countries (OPEC) were selling their oil in dollars. From 1971-1977 the

global composition of dollar reserves increased from 65% to almost 80%, it’s

highest level ever.

OPEC today is made up of 12 member countries, predominantly in the Middle

East. These countries are Iraq, Iran, Kuwait, Saudi Arabia, Venezuela, Qatar, Libya,

United Arab Emirates, Algeria, Nigeria, Ecuador and Angola. OPEC controls

approximately 81% of the world’s oil reserves and produces about 40% of the

world’s crude oil.27

The petrodollar is a large contributor to the US’s military involvement in the

Middle East. To maintain the petrodollar system, the US must protect the countries,

27 http://www.opec.org/opec_web/en/data_graphs/330.htm

52

specifically the leaders of those countries, who make the decisions concerning the

pricing of their oil. Figure 9 is a map from 2003 showing the number of US military

bases in the Middle East.

Figure 9: US Military Bases in the Middle East

Source: Zoltan Grossman

It is important to understand the relationship between US military

dominance and the petrodollar, as they are mutually reinforcing. The petrodollar

cannot exist without an enormous military capable of protecting and sometimes

coercing oil-exporting countries. The US military can only exist on this scale because

of the income generated by the petrodollar system. The windfalls that the

petrodollar system create for the US, in the form of massive demand for US dollars,

is undoubtedly a factor that contributes to the size of the US military. In Figure 10

53

we see that in 2013, US military expenditure was $640 billion. This amount is

greater than the next 9 largest military spending countries in the world combined.

Figure 10: Top 10 Military Expenditures 2013

Source: Stockholm International Peace Research Institute

We noted earlier that the exorbitant privilege of the US roughly equals its

current account deficit. This amount was $400 billion in 2013. It is very possible

that some of the income generated from the exorbitant privilege is channeled into

military spending. The reason the US can afford such enormous military spending is

because it is actively being used to maintain one of the key components of US

government income; the exorbitant privilege created through the huge demand for

US currency.

54

Over the last two decades the petrodollar has come under attack by several

oil producing countries, including members of OPEC, and opposition to the

petrodollar system has been swiftly crushed by the United States. In 2000, Iraq’s

President Saddam Hussein converted all Iraqi oil transactions to Euros.28 Three

years later the United States invaded, under the guise of looking for “weapons of

mass destruction”. No such weapons were found, Saddam Hussein was removed

from power and all Iraqi oil was reverted to being priced in dollars, the way it is still

priced today. Even Fed Chairman Alan Greenspan admitted in his memoirs “I am

saddened that it is politically inconvenient to acknowledge what everyone knows:

the Iraq war was largely about oil.”29

In 2010, Libyan President Muammar Gaddafi proposed a new pan African

currency to be used instead of the dollar for pricing their oil. In 2012, Libya

experienced a revolution, and has not spoken of a move from the petrodollar since.

Syria switched its oil transactions to euros in 200630 and the country has

been plagued by civil war since 2011. The Syrian civil war also created the current

primary military enemy of the US: ISIS. ISIS poses a direct threat to the petrodollar

system in the Middle East today, and because it is not a sovereign entity, it can dealt

with using military force.

Today, Iran is the only OPEC country that does not price its oil in dollars. In

2008 Iran created its own oil burse and began selling its oil in gold, euros, dollars

28 http://www.rferl.org/content/article/1095057.html29 http://www.theguardian.com/world/2007/sep/16/iraq.iraqtimeline30 http://www.informationclearinghouse.info/article11894.htm

55

and yen. Iran has since met strict economic sanctions imposed by the US. According

to Rickards (2011, pg. 263-264) in his book Currency Wars, in 2012 the US banned

any bank who did business with the Central Bank of Iran from participating in the

US dollar payments system; the Iranian currency, the rial, devalued by over 40%

within days of the announcement. Iran still prices its oil using multiple currencies,

but tension between the US and Iran is still high today.

Finally, we look at Venezuela. Venezuela has supported a move away from

the petrodollar system despite exporting most of its oil to the US. Venezuela today

has one of the worst economies in the world and is ranked #1 on the world misery

index.31

There is a uniting theme here. Bad things happen to countries that try to stop

pricing their oil in dollars. The petrodollar is an extremely important enabler of US

exorbitant privilege. The US will do anything in its power to protect the petrodollar

system, as it is one of the key pillars of the dollar-dominated IMS. If there were an

end to the petrodollar, there would be a massive reduction in the demand for US

dollars. This decrease in demand could cause a large enough devaluation in the US

dollar that hyperinflation and economic crisis could result. The petrodollar can be

used to explain why the US dollar is so widely used in the world today. It can also be

used to explain US foreign policy and its military activities in the Middle East. The

petrodollar and the global military dominance of the US are essential to one another.

The US will engage any enemy of the petrodollar system it can militarily. Today that

31 http://www.cato.org/blog/world-misery-index-108-countries

56

enemy is ISIS. If military force is not an option, the US will revert to financial warfare

in the form of economic sanctions. We see examples of this in Iran and Venezuela

today.

Iran and Venezuela, though significant, are relatively small compared to the

largest threat to the petrodollar system, Russia. Russia is the third largest oil

producer in the world today behind the US and Saudi Arabia.32 Russia and China

signed a $400 billion oil deal in May of 2014.33 Originally the deal was priced in

dollars as they always have been, but in late June of 2014, Russia announced that it

would be accepting payment for its oil in either rubles or renminbi.34 By not pricing

its oil in dollars, Russia now poses the greatest threat to the petrodollar system. This

is a very big deal for the US. Russia pulling out of the petrodollar system could be

the tipping point for the end of international dollar dominance. Something

remarkable happened soon after Russia announced it was going to price its oil in

rubles. As Figure 11 shows, the price of oil was cut in half over only 5 months. The

red line in Figure 11 indicates June 26, 2014. This is the day that zerohedge

published a statement by Gazprom’s (Russia’s state-backed oil company) CFO

Andrey Kruglov claiming that the company was ready to settle oil contracts in

rubles or renminbi. Amazingly, this date coincides with the last highest price of oil.

Since Russia announced leaving the petrodollar, oil has fallen steadily.

32 http://www.eia.gov/cfapps/ipdbproject/IEDIndex3.cfm?tid=50&pid=53&aid=133 http://rt.com/business/203679-china-russia-gas-deal/34 http://www.zerohedge.com/news/2014-06-26/gazprom-ready-drop-dollar-settle-china-contracts-yuan-or-rubles

57

Source: FRED data

While western media points to Saudi Arabia refusing to cut production and

decreasing demand caused by renewable energy, the real cause of the drop in oil

prices comes primarily from the US itself. In September 2014, just before the crash

of oil prices, the Institute for Energy Research (IER) released a report claiming that

the unprecedented increase in oil production by the US would influence the price of

oil. “The increase in crude oil production from January 2011 to July 2014 was 3.0

million barrels per day or about 75 percent of the increase in U.S. liquid fuels

production, surpassing the global unplanned supply disruptions of 2.8 million

barrels per day.”35 Today, the IER believes that the US has surpassed both Russia

and Saudi Arabia to become the world’s largest oil producer.

35 http://instituteforenergyresearch.org/analysis/u-s-oil-production-keeping-world-oil-price-increases-check/

2014-01-0

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2014-01-2

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50

60

70

80

90

100

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120Figure 11: WTI Crude Oil Price

Pri

ce $

US starts exporting oil

Russia leaves petrodollar

58

The fall in oil prices is caused by a large increase in supply by the United

States. It can also be attributed to the fact that the US started exporting its oil for the

first time since the 1970s Oil Embargo in July of 2014, shown by the green line in

Figure 11, coinciding perfectly with the sharp decrease in oil prices.36 The US

started exporting oil for the first time in 40 years only one month after Russia

announced it would stop pricing its oil in dollars.

Because of the very close relationship most OPEC countries have with the US

as a result of the petrodollar system, it is reasonable to assume that the US has

significant influence in OPEC’s oil supply as well. Falling oil prices produce a huge

win for both OPEC and the US in the long run. According to the January 2015 Bank of

Canada Monetary Policy report, Oil production is still economical in OPEC countries

as long as oil continues trading above $40 a barrel.37 This allows OPEC to continue

producing oil for longer than other countries. As other oil producing nations begin

cutting back on drilling and other oil operations, OPEC can continue to gain market

share and maintain it’s dominant position in the international oil trade. For the US,

falling oil prices serve as a form of economic warfare against Russia, whose

economy has suffered greatly from the falling price of oil. It also serves as a

protectionist measure for the petrodollar system. If the cheapest oil in the world is

priced in dollars, that is the oil people will continue to buy. The only way oil prices

will come down is if supply is reduced. OPEC and the US control the majority of

36 http://www.wsj.com/articles/oil-shipment-cracks-decades-old-ban-140676229337 http://www.bankofcanada.ca/wp-content/uploads/2014/07/mpr-2015-01-21.pdf

59

global oil supply, and so the price of oil is largely at their mercy. As Russia’s

economy continues to slide into recession, Vladimir Putin’s regime comes under

threat. We are already beginning to see civil unrest and protesting in Russia.

Perhaps if oil remains low enough for long enough, Putin could be forced out of

power. If oil prices return to normal before an economic crisis unfolds in Russia, the

petrodollar system will begin its decline. Oil importing countries that buy Russian

oil, predominantly in the EU and Asia, will begin acquiring rubles and letting go of

their dollar reserves in order to make their oil payments. This could mark the

beginning of the end of the dollar-dominated IMS.

We should not expect oil prices to increase any time soon however. The US is

the largest producer of oil in the world, and production is not slowing down. In fact,

the US is producing so much oil that it is running out of storage. Once production

begins to fall in the coming months and years as more and more unprofitable rigs

and projects are taken offline, the US will begin unloading it’s enormous storage

tanks, which have risen to a total of 468 million barrels.38 The US crashing one of the

most important commodity markets in the world in an attempt to punish countries

that leave the petrodollar system demonstrates that the US is desperate to keep the

petrodollar system alive. While Middelkoop and Rickards assume it will be a loss of

confidence in the dollar that triggers hyperinflation, we see now that hyperinflation

will most likely come from a decrease in demand for dollars resulting from the end

38 http://www.bloomberg.com/news/articles/2015-03-13/record-u-s-oil-glut-seen-by-iea-filling-storage-cutting-prices

60

of the petrodollar system. The US will continue to do everything in its power to

prevent this from happening.

(5) Conclusion: Is the Dollar’s Role in the IMS Sustainable?

The answer is both yes and no. We conclude that the dollar’s role as the

central currency or lynchpin of the modern IMS is unsustainable, because in the next

10 years countries in the Euro Area and China will develop financial markets that

can rival those of the US. And thus we assume that the US will no longer make up

over 50% composition of foreign reserves. However, despite the dollar not having as

large a share of COFER in 10 years, the dollar will retain its position as the most

important currency, in that it will still hold the largest majority of COFER. We

predict this because of the US’s willingness and ability to protect the pricing of

global oil markets in dollars.

In the best-case scenario, championed by Eichengreen, the IMS will gradually

shift away from dollar dominance. Within 10 years the renminbi and euro will

become just as important as the dollar in international trade and finance. The euro

will dominate finance and trade around Europe, the renminbi will dominate finance

and trade around Asia and the US will continue to be most important in the

Americas. Eichengreen’s future reserve system is largely based on the geography

and frequency of trade and finance transaction conducted between foreign

countries and the three major currency areas. The US exorbitant privilege will be

mostly lost, as the US dollar will need to compete to maintain its share. The dollar

61

will still be an important international reserve currency, but may lose its role as the

most important reserve currency if financial markets in Europe or China become

larger than those in the US.

In the worst-case scenario, prophesized by Middelkoop and Rickards, the IMS

and the dollar will experience a violent end. Global debts will lead to defaults,

derivatives will lead to liquidity crisis, QE will eventually result in hyperinflation,

investors will lose confidence in the dollar and a big reset button will be pushed at

an emergency G20 meeting, resulting in a return to the gold standard. While there is

little evidence that the world is preparing for such a collapse, it makes sense that a

gold standard be implemented as a last resort to save the global economy. The crisis

would have to be apocalyptic in scale if the world really was to revert to a gold

standard however. Regardless of its cause or probability, in this scenario too the

dollar loses its role as the most important reserve currency. The Euro Zone has 25%

more gold than the US and a larger economy. If the IMS does meet a violent end, it

will most likely be the euro that reigns in the new economic world order.

Finally we analyze the role of the petrodollar in the current IMS. We see that

currently, Russia poses the greatest threat to dollar hegemony, as it moves away

from the petrodollar system. All three authors underestimate the ability of the US to

protect its exorbitant privilege. Through our analysis of the history of the

international reserve system, we see that the US will do anything in its power to

protect its exorbitant privilege. The primary function of the US military is to ensure

62

that the petrodollar system and thus US exorbitant privilege remains intact. If the

petrodollar fails, so too may the US economy because it will create a decrease in

demand for dollars worldwide resulting in a massive devaluation of the dollar. The

US will not allow this to happen, and has recently demonstrated it is willing to do

anything necessary to protect its role as the dominant reserve currency.

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