The US$ is the world's reserve currency and has been since the Bretton Woods agreement of July 1944. The purpose of the agreement was to regulate the international monetary system by setting up rules, institutions and procedures. It brought about the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD). They are today part of the World Bank.
Under the Bretton Woods system there was an obligation on each country to adopt a monetary policy that maintained its exchange rate by tying its currency to the US dollar, which was convertible into gold at a fixed rate of $35 per ounce. This system remained in place until August 1971, when the US unilaterally terminated the convertibility of the US$ into gold. Thus began the era of floating exchange rates. All currencies became fiat currencies.
Today the world is "buried" in debt. The US is the most indebted nation in the world with $16.5 trillion of official debt, plus "off balance sheet" or unfunded liabilities estimated to be between $70 and $100 trillion. Most economists agree that the US will never be able to repay these debts. The only way out is to attempt to inflate the debt away through currency devaluation. This has helped to set up the current era of currency wars.
Not only is the world buried in debt, the global financial system has become increasingly unstable. Since August 1971, the world has gone through a series of financial crises. They were seen in 1973-1974 (oil, US$ becomes the petrodollar); 1979-1982 (oil, high interest rates); 1987 (stock market); 1992 (British pound); 1997 (Asian contagion); 1998 (Russian default, Long Term Capital Management); 2000-2002 (high tech/internet, 9/11); and 2007-2009 (subprime loans, banking crisis).
Each crisis has been more intense than the last. It takes ever-increasing amounts of debt to purchase an additional dollar of GDP. The result has been that debt in the major economies - the US, the Euro zone, Japan - has reached unprecedented levels. The current ratios of public plus private debt to GDP for the major economies are as follows, with public debt to GDP in brackets: US 290 (102); Japan 512 (226); United Kingdom 512 (87), Germany 278 (83), Italy 314 (121), France 346 (86), and Canada 276 (85).
Of that group, only Canada and Germany currently hold an AAA credit rating. The United Kingdom, the US and France have all been dropped to AA+ while Japan is down to AA- and Italy is BBB+. A number of them including the US are on negative credit watch for potentially further downgrades.
In the 42 years since the world came off the gold standard there have been four major US$ crises. Throughout the 1970s the US$ fell against the other major currencies as measured by the US$ Index. Overall the US$ Index fell about 34%. That ended in 1980 when Fed Chairman Paul Volcker hiked the Fed Funds interest rate to 20% to beat back the inflation of the 1970s (and collapsed the gold market). A severe recession followed. Between 1980 and 1985 the US$ Index roughly doubled. The US$ became severely overvalued and the Plaza Accord of September 1985 between the US, Germany, Japan, France and the UK agreed to devalue the US$. From 1985 to 1992 the US$ Index fell by about 50%.
What became known as the Reverse Plaza Accord occurred in 1995 between the US, Japan and Germany, to bail out the Japanese economy and undo the distortions of the Plaza Accord. The purpose this time was to depreciate the value of the yen. The US$ Index gained about 50% from 1995 to 2002.
The last US$ crisis got underway in early 2002 when the US, following 9/11 and in the midst of the High Tech/Internet crash and recession lowered interest rates sharply and set about reducing the value of the US$. From 2002 to 2008 the US$ Index fell 40%.
Since 2008, the world has been in what in hindsight may become known as a period of currency wars. Over the past four years there have been numerous ups and downs for the US$ Index. This has been driven for the most part not so much by any strength in the US$ per se but rather by weakness in the other primary currencies: the yen, the euro and the pound.
Brazil's finance minister Guido Mantega first mentioned currency wars in September 2010. Russian and Chinese officials echoed the feelings. The US$, the world's reserve currency, has no basis of value. None of the major currencies (or any others for that matter) has any basis in value since the US ended the dollar's convertibility into gold in 1971. That is the very definition of fiat. The currency is whatever the government says it is. History has shown that ultimately all fiat currencies fail.
The US$ remains a major component of official foreign exchange reserves. But it is falling. In 1995 US$ securities made up 44% of all FX reserves. Today it is at 34% of reserves, while the euro has gone from nothing to 14%. Over 90% of global trade is carried out in the four major currencies.
The Chinese are now challenging that as an Asian currency bloc emerges, anchored by the Chinese Yuan. Many Asian countries are already decoupling from the US$ and moving to the Yuan. This is a direct challenge, even a threat, to US$ supremacy as the world's reserve currency. The Chinese have also called for a return to some semblance of a gold standard and have been actively building their gold reserves.
The major western economies and Japan are all mired in slow growth or recessionary conditions. While the US officially reports a growing economy, John Williams of Shadow Government Statistics (www.shadowstats.com) shows otherwise - that the US has been in a recession since 2000 only leaving it briefly in 2004. Japan has suffered a series of rolling recessions since 1990. The Euro zone has experienced recession conditions for the past number of years.
A number of Euro zone countries are experiencing abnormally high unemployment near 25% (Spain, Greece) and extremely high youth unemployment over 50%. This in turn leads to political instability as witnessed by the recent Italian election. The UK is the same, since many of its banks blew up in the 2008 financial crisis. Austerity measures being forced on numerous Euro zone countries are backfiring as the population effectively revolts.
Potential austerity is coming to the US as well with the "sequester". Effective March 1, 2013 the US could be facing $85 billion in cuts that could cause unemployment to rise further. To put that in perspective, however, the $85 billion is less than 10% of the forecasted budget deficit of $900 billion. Still, if the Fed's goal for QE is to lower the unemployment rate to 6.5% as they have stated huge budget cuts may only make unemployment worse, not better. The official unemployment rate in the US is 7.9% (U3).
Japan has recently become more aggressive in devaluing the yen. Since September 2012, it has fallen over 18%. The Japanese government does not hide the fact that they want to devalue it in order to improve their competitive position and increase exports. This forces the Euro zone to do the same to protect their position, and should eventually force the US to follow as well. Yet at the recent G20 meetings the ECB's Mario Draghi dismissed talk of currency wars. To do otherwise could have set off another financial crisis.
All the major western economies are following the same path of quantitative easing (QE). QE is meant to buy time, in the hope that their economies might improve. It is a form of currency devaluation as it puts more money into the financial system, in the hope of encouraging economic activity. It first came about after the US and Japan in particular had already lowered their central bank interest rate to zero. All the major western economies have negative real interest rates, as their rates of inflation are higher than interest rates. This is a form of financial repression.
In a world overburdened with debt, the only sector with the capability to expand their balance sheets is government. Corporations may be sitting on billions in cash, but in an environment of uncertainty and low growth that cash remains on the sidelines and investment remains low.
But governments are running up against the debt wall. That leaves them only one choice, and that is to devalue their currencies, monetize the debt and inflate their way out of crisis. That sets up the "beggar thy neighbour" policies that plagued the world during the Great Depression, the last major period of currency wars.
The new currency wars are still at an early stage. To escape devaluation, the smart money could increasingly move into hard assets, particularly gold. Gold has a 3,000-year track record as money. The current fiat currency experiment is only in its forty-second year. The experiment is teetering and the end game may soon be upon us.