18 November 2008

The Dollar Trap Part II: Mutually Assured Financial Destruction

The current structure of the remnants of the Bretton Woods agreement with the US dollar as the dominant reserve currency is not sustainable unless the rest of the world is willing to accept a form of neo-colonialism.

The developed nations are holding approximately 70% of their reserves in US dollars.

The rest of the world knows it must find an acceptable substitute for the dollar as the reserve currency.

The US does not wish to change the status quo for several reasons.

First, it provides an automatic funding mechanism for incredibly large budget deficits that would collapse without this mechanism.

Additionally, the US economy has become badly distorted, with an outsized financial sector as a percent of GDP created to manage its artificial reserve construct.

Change will be painful for all. Yet change must and will come, even as the US resists that change and uses a type of Mutually Assured Financial Destruction policy to maintain its hegemony.

No one wishes to make the 'first move' to the exit, since it will cause a severe depreciation of their dollar reserves, and possibly provoke clandestine and military action by the world's sole superpower.

And yet, the inching to the exits is underway, and the world holds its breath in case a shift occurs that will precipitously unravel 37 years of financial imbalance in a global economic earthquake.

The dollar will either be saved with a new formal structure, with more fiscal and political overtones to support an otherwise unstable monetary regime, or it will be decimated.

It would be naive to think that the US financial planners do not see this and are not using it to their advantage.

One can always count on a reversion to the mean. We just cannot know when it will happen, or how, or in what period of time.

When it comes it will come quickly like a lightning strike, with a terrific thunderclap heard around the world.

US Debt has grown to be about ten percent of World GDP (excluding the US) which is without historic precedent.

Approximately thirty percent of US debt is being held by non-US entities, in particular foreign central banks.

The Developed Countries are holding approximately 70% of their reserves in US Dollars. The Developing Nations have less exposure on a percentage basis.

Above Charts from "Is the US Too Big to Fail?" by the Reinharts at VoxEU

Total US Dollar Credit Market Debt Now Stands at 350% of GDP. This cannot be sustained. Certainly a certain portion of credit will be written off in defaults. But notice that the strategy of the US is not to make structural reforms but to try and restart the debt creation engine. This will require continued subsidies from foreign sources with waning appetites for US debt that can never be repaid.

Above chart courtesy of Ned Davis Research.