The Almighty U.S. Dollar

 Unless you were born more than 80 years ago, you have never lived during a time when the United States dollar was not the undisputed dominant currency in the world. The Bretton Woods Agreement entered by the major economies in July 1944 formally acknowledged what was already generally accepted - the dollar would serve as the world's principal reserve currency. Furthermore, it would be the currency of choice for most countries to utilize when transacting international trade. 

Per the Bretton Woods Agreement, the dollar was convertible to gold at the fixed rate of $35 per ounce. The majority of countries in turn pegged their currency valuation to the U.S. dollar. This monetary system dissolved in 1971 when President Richard Nixon terminated the convertibility of the U.S. dollar to gold. From 1971 henceforth, the dollar and other major currencies have experienced a floating exchange rate. This is a system where the currency price of a nation is set by the foreign exchange market based on supply and demand relative to other currencies.

The dollar was and remains the obvious candidate to serve as the world's primary reserve currency. Similar to the end of the Second World War, the American capital markets continue to be deep, open to the world, and highly liquid. In addition, there is a track record of stability supported by investor protections and the rule of law. The U.S. represents practically 25% of the world's $115 trillion (annual) economy. Foreign governments and central banks around the world hold dollar-denominated assets, usually U.S. Treasury securities, as reserves to manage the foreign exchange value of their currencies or to weather economic shocks. Dollar assets comprise about 60% of global foreign currency reserves, down from 70% in 2000. The next highest reserve holdings would currently be the euro at 20% of the total.

Very few Americans truly grasp the benefits and significance of the dollar serving as the world's primary reserve currency. The dominant dollar has been called an "exorbitant privilege." And it is that, and more. A generous supply of dollars combined with strong global demand allows the U.S. to borrow money at a lower cost than if the dollar was not the world's principal reserve currency. A dollar at the top of the food chain reduces the cost of imports paid by American consumers. A strong dollar induces foreign direct investment in the United States. Long-term investment in businesses and property has been significant. The dollar's reserve status allows the U.S. to export inflation to a certain extent. While domestic consumers receive vast amounts of physical products of substance, in exchange foreign exporters receive vast levels of fiat money that has a history and future of debasement. The dollar has lost 98% of its purchasing power over the past century.

History tells us the U.S. dollar will ultimately be displaced as the world's dominant currency. Since the demise of the Roman Empire, there have been more than a dozen different currencies that sat at the top of the heap for varying tenures. The Dutch guilder succeeded Spain's silver dollar and dominated for the 17th and 18th centuries,. The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 19th century and first half of the 20th century before being bumped off its throne by the U.S. dollar. There is no question that the dollar will eventually be replaced as the kingpin by either a different currency or an entirely new monetary system. The only question is when - will it be in two years, twenty years, or 200 years? I would lean toward the twenty-year scenario and I'll proceed to defend my thesis below.

Myself and many others predicted the imminent demise of the dollar in the past couple of years due to reckless, undisciplined fiscal policies and continued abuse of economic sanctions leveled on other nations by the U.S. It is time to eat some crow. I was wrong, and so were many others. We were caught-up in all the hub-bub surrounding proclamations that the BRICS' nations were about to unleash their own currency backed by a basket of commodities including gold. This may eventually transpire, but it probably is a ways off. I also failed to take into account higher interest rates in the U.S. and a robust stock market over the past two years. This induced foreign capital inflows which further supported the dollar. The fact of the matter is, currently there aren't any viable reserve-currency alternatives. The euro, Japanese yen, or Chinese renminbi are not in a position to replace the dollar. The dollar remains the cleanest shirt in a drawer full of dirty shirts.

However, over the next decade or two, unless something dramatically changes, I foresee the dollar gradually declining both in purchasing power and global importance. It may be the last man standing, but if powerful current trends continue on an unabated path, it too will tumble. Since leaving the gold standard over a half-century ago, the dollar has been kept aloft by the tax-generating ability of a growing, productive economy and a defense structure that has safeguarded the economy's strength. Cracks are beginning to widen in the foundation of the dollar. Central banks across the world have been de-dollarizing and aggressively increasing their gold reserves. Investors, both domestic and foreign, will continue to purchase U.S. Treasury debt as long as they believe they'll get their money back and that money has successfully navigated the storm of unrelenting debasement. Since I harbor little or no trust in our federal government, I suggest hedging in the form of hard assets and quality equities. If the United States moves to the point where the preferred policy is one of financial repression that allows  inflating the debt away, the market will consider and pursue alternatives to the dollar as a store of value.

The timing of a policy shift to financial repression is difficult, if not impossible, to predict. I expect it will be implemented over time in different phases. Along with financial repression, I foresee the Federal Reserve Bank pursuing and implementing a central bank digital currency (CBDC). There is no stopping the digital train. We are heading toward a cashless society. Most governmental parties claim CBDC will work as a supplement to fiat money with cash still allowed as an option in the payment system. I don't believe this for a minute. Central bank digital currencies will allow governments to exert more control over their citizens and facilitate complete oversight over all financial transactions.

Before I wander off on that tangent and go on a rant, I should tie a bow on this blog posting and speculate as to the probable successor to the U.S. dollar. At some point, there will be a global financial meltdown that will make the Great Financial Crisis (GFC) look like a Sunday school picnic. The major economies - United States, China, Europe, Japan - will gather somewhere and eventually agree on a new monetary system. The U.S. will no longer be a hegemon; the world will be multipolar; and globalization will be on the upswing again. At that point, I see the establishment of an international digital currency. Of course, I've been wrong before in the arena of making predictions.

A Political Pivot, And Where The Economy Goes Next

 "It's the economy, stupid" is a phrase widely associated with Democratic strategist James Carville in 1992 in the run-up to Bill Clinton's successful 1992 presidential election against Republican incumbent, George H.W. Bush. As is often the case, the condition of the U.S. economy in 1992 (recession) was the primary reason Bush was not re-elected. Although immigration no doubt played a role in the 2024 election cycle, the Republican Party's sweep of the White House and Congress can for the most part be attributed to a surge in inflation and an economy that was portrayed as strong but was extremely weak below the surface. It's a well-worn adage, but people do tend to "vote with their wallets."

The Biden Administration and their co-conspirators in the mainstream media consistently presented the economy as a vibrant juggernaut hitting on all cylinders. This political spin could not have been further from the truth. Both inflation and unemployment rates were significantly higher (by 30%-50%) than the numbers reported by the Bureau of Labor Statistics (BLS). The antiquated models and inaccurate surveys used for determining those statistics are seriously flawed with subjective assumptions superseding objective facts. The cumulative inflation (at least 25%) that accrued between January 2021 and December 2023 especially took a toll on the family budgets of low and middle-income earners, and they have yet to recover. Besides a massive revision (downward) of 818,000 new jobs created in the 3rd and 4th quarter of 2023 and 1st quarter of 2024, the trend lines showed ongoing declines in full-time jobs in the private sector. The only job growth was an increase in part-time and government jobs. These are not signs of a healthy economy.

The U.S. economy was widely predicted to fall into recession in 2023. When this didn't come to fruition, many predictors claimed their timing was off a bit but that it would happen in 2024. It appears that  recession call was erroneous as well. So what happened? Why has the economy remained in growth, chugging along like the Energizer Bunny? There are two primary reasons that explain this surprising growth in the economy. The first one is the sheer abundance of liquidity that has been sloshing around the financial system for practically two years now. Although the Fed claims to have tightened conditions via boosting the Fed Funds rate in 2022 and 2023, and by implementing Quantitative Tightening (QT), the data and facts paint a different picture. The National Financial Conditions Index (NFCI) generated by the Federal Reserve Bank of Chicago shows non-stop, increasing levels of liquidity from March 2023 through the current point in time.

The other main reason triggering unexpected growth in the economy was unprecedented fiscal stimulus. The federal deficit in 2023 was $1.7 trillion, equal to 6.3% of Gross Domestic Product. The federal deficit for fiscal year 2024 was $1.8 trillion, equal to 6.4% of GDP. Deficits at this level traditionally are only seen during periods of war and economic recession. Simply stated, they are unsustainable and a threat to the long-term viability of the United States economy. Federal spending as a percent of GDP has also skyrocketed. For fiscal year 2024, government spending represented almost 35% of GDP. This binge of spending goosed the economy with many cynics believing it was done for political reasons.

Trump's victory in the recent presidential election, combined with the Republicans taking back the Senate and retaining a slim majority in the House, has seemingly revitalized the optimism and even animal spirits in the business and investment communities. While it is possible that the new administration and Congress will be able to thread the needle in terms of policy decisions, I do not share a high degree of optimism. I believe Trump is walking into an economic shitstorm and his proposed policies for the economy will only serve to exacerbate the problems.

Like traditional Republicans, Trump is always looking to lower taxes. Unlike traditional Republicans, Trump never appears to be overly concerned with the level of government spending as evidenced by an increase in the national debt of $8 trillion during his first term. Besides a continuation of the 2017 tax cuts, Trump has proposed lowering the corporate income tax rate (to 15% from 21%) and eliminating certain types of income subject to personal income taxes (overtime pay, tips, Social Security benefits). While I can live with an extension of the 2017 tax cuts, the other reductions mentioned make no sense whatsoever when the national debt is at $36 trillion with projected $2 trillion annual deficits. For those believing Messrs. Musk and Ramaswamy will save the day by finding ways to significantly reduce government expenditures - I wish them well but they have an almost impossible nut to crack due to the preponderance of non-discretionary budget items. The Department of Government Efficiency, an obvious oxymoron, will garner numerous headlines and possibly even save $200 billion - $400 billion per annum with their recommendations. However, those savings will be more than offset by increased interest payments on the national debt. Insofar as actually reducing spending, please wake me up when Congress decides to tackle entitlement reform (Social Security, Medicare, Medicaid).

At this point, I'm sure the reader can discern that I have little faith in the Trump 2.0 administration and Congress being able to slow down the runaway debt train. I see annual deficits being roughly the same for the next few years with the potential for even bigger deficits in the event we experience economic contraction. While the stock market is giddy with Trump and his policies coming on board, the bond market's response has been totally the opposite. The bond market sees inflation and problems for the economy on the horizon. Since 9/18/24, the Fed has lowered the Fed Funds rate by 75 basis points (.75%). However, the current yield on 10-Year Treasuries has increased by 60 basis points (.60%) since the Fed started lowering. Basically, the bond market was telling Trump and Kamala Harris, and now just Trump, that their respective economic platforms were inflationary in nature. Thus, investors in the bond market were/are demanding more term premium before they would assume the greater risk posed by potential future inflation on longer duration U.S. Treasury securities.

There are a couple other potential economic pitfalls lurking in the weeds if Trump elects to pursue certain major policy positions espoused in his campaign rhetoric. Massive deportation of illegal aliens is one such risk to the economy. If the estimates of 10-12 million illegals in the country are accurate, large-scale deportation would be a daunting and expensive task. It also would have the potential to harm the U.S. economy. With an aging population combined with below replacement level birth rates, immigration provides an obvious solution to keep the economy in growth and provide jobs for employers. The Immigration Reform and Control Act of 1986 provides a good blueprint for offering a path to citizenship for many of the immigrants who are in the country illegally. 

The imposition of tariffs on a large scale could also potentially cause more harm than benefits to the majority of American citizens. Economists and other free trade advocates absolutely hate tariffs. And for good reason. Contrary to the claims of the President-elect, rather than hurting foreign exporters, it is American firms and consumers who are the hardest hit by tariffs on imports. While the initial bill for a tariff is paid by the importer, the financial burden shifts to businesses and consumers in the form of increased prices. In other words, tariffs are considered inflationary. It should also be noted that China appears to be the target of Trump's most severe tariffs. Is it wise to start a trade war with a competitor that is arguably on equal footing with you both economically and militarily?

My pessimism in the new Trump Administration being capable of addressing the nation's economic challenges is grounded in math. For the first time ever the U.S. government spent more than $1 trillion this year on interest payments for the national debt. Twenty cents on every dollar spent by the federal government goes to debt service. The Congressional Budget Office (CBO) projects that annual interest payments will rise rapidly throughout the next decade and exceed $2 trillion by 2034. I see nothing to question the CBO's prediction. The cumulative probability of tax revenues exploding and Congress setting aside its spendthrift ways is about 2%.

The debt problem is not a political problem that can be easily resolved. It is an arithmetic problem. Whether it be in Trump's tenure, or his successor's tenure, I predict that the government through its central bank will resort to the playbook used during the Great Financial Crisis (2008-2009). The Fed will reintroduce Quantitative Easing (QE) to expand the money supply to buy U.S. government bills, notes, and bonds. This most likely will cause a spike in interest rates as investors demand higher yields to compensate themselves for the government's balance sheet risk. This leads me to further predict the government will then implement financial repression to cap interest rates and channel funds from the private sector to itself to facilitate debt reduction. Savers will earn at rates below the rate of inflation. Also, look for the government to require banks, insurance companies, and pension plans to hold significantly larger amounts of government debt than is necessary for prudential purposes. The picture I paint is not pretty. Look to hold hard assets for some protection from the continuation of the debasement of the value of our currency.