Waking up to a Non-U.S. Dollar Reserve Currency

U.S. dollarIceland wants to adopt the dollar as its reserve currency—but it’s not the same dollar you are thinking.

Iceland suffered through a terrible financial crisis in 2008 that forced the country to make difficult decisions to get itself out of an economic mess. Thankfully, the small country has recovered and has begun to grow again.

The tiny arctic nation now wants to adopt the Canadian dollar, not the U.S. dollar, as its official reserve currency.

Even 10 years ago, dear reader, this was unheard of. Nations were beating down America’s door in order to adopt the U.S. dollar as the reserve currency that would back their local currency.

How did this change happen?

To address the credit of 2008, the U.S. government decided its response would be to print money (see: Money Printing by Any Other Name). This has led toU.S. national debt-to-GDP of over 100% and growing.

The current “official” U.S.debt is about $15.5 trillion, while U.S. GDP is expected to be about $15.0 trillion this year. Unfunded U.S. liabilities sit at about $55.0 trillion on the conservative side.

As a consequence of the U.S. becoming a highly indebted nation, Chinaand Japan, on Christmas Day 2011, decided that they were going to trade directly with each other. So, instead of converting the yuan (the Chinese currency) to U.S. dollars (the reserve currency) and then to yen (the Japanese currency), from now on Chinaand Japanare simply trading yuan to yen, skipping the use of the U.S.reserve currency.

A year earlier, in 2010, Russiaand Chinastruck a similar deal, which removed the U.S. dollar as the trading currency of choice between the two countries.

In 2000, the U.S. dollar accounted for 71.1% of all foreign exchange reserves around the world (the amount of foreign currencies owned by a country). In just 12 short years, the U.S.’s hold as the reserve currency of world countries has fallen to 61.7% of all foreign exchange reserves (source: Bank of International Settlements).

It is important to note that the U.S. dollar still holds a majority position around the world, because of its reserve currency status, but clearly the trend is declining, as more countries move away from the U.S. dollar as the world’s reserve currency.

Europe and Russia both diversified their foreign exchange reserves away from the reserve currency, and into other currencies like the Canadian dollar.

It is nothing to get alarmed about just yet, dear reader, but the trend is clearly pointing in the wrong direction forAmerica’s strong hold on the reserve currency. The U.S. dollar is the reserve currency of the world, but this privilege is not given; it’s earned.

Since our financial house is not in order because of too much debt, countries have seen fit to diversify away from the U.S. dollar as their official reserve currency. Should this continue, it has implications for higher interest rates on U.S. government debt (to attract foreign investment to buy the debt) and the loss of purchasing power for the average American consumer, as the U.S. dollar declines in value against other currencies.

One day, the U.S. could even lose its status as the world’s reserve currency. Yes, we could wake up one morning to a world where the U.S. dollar is no longer the official reserve currency.

Americans might be shocked at this possible development, but after reading the above, it wouldn’t be that much of a shock would it, dear reader? (Also see: Getting Used to Trillion-dollar Annual Deficits.)

Michael’s Personal Notes:

Out of all the possible headwinds to cause economic contraction in 2012, there is one I haven’t written about lately: oil prices.

It is estimated that, in 2011, real personal consumption—the money consumers spend on all goods and services—increased by $107 billion (source: Bloomberg).

At the same time, since October of 2011, the increase in gas prices has resulted in an extra hit to consumers’ wallets to the tune of $56.0 billion (source: Bloomberg).

Thus far in 2012, real incomes and personal spending are flat. Should these trends continue and oil prices remain at current levels, then at least half of the increase in consumer spending would be directed to paying for the higher gas prices ($56.0 billion / $107 billion = 52%).

Of course, consumers could cut back on gas consumption, but the bottom line is that if gas prices remain at current levels, GDP growth will be cut by $56.0 billion or 0.6% in 2012.

I’ve argued that two percent of last year’s GDP growth was due to inventory restocking, which will not be repeated going forward. This concept is simple to understand. If a grocer restocks his shelves fully, he won’t restock again until actual sales empty out his shelves.

So, if real GDP growth is currently at only about one percent after taking away inventory restocking, and the current rise in gas prices is taking away 0.6% of GDP growth, then we are left with 0.4% GDP growth.

This means that, if oil prices were to rise roughly $20.00 a barrel from the current $105.00 a barrel level—that is, to $125.00 a barrel—then it would wipe out the 0.4% GDP growth and just “drive” us into a recession.

These numbers are rough estimates, but they give us an idea, dear reader, of where we stand. Even if the conflict withIranwere to resolve itself tomorrow, and gas prices would drop to say $80.00 a barrel, there are still other headwinds that could drag us into a recession, as GDP growth might be nonexistent in 2012.

As of today, the conflict with Iranis at a heightened level. Despite theU.S.and other countries wanting to use sanctions and diplomacy to reach the desired goal of halting Iran’s nuclear ambitions, Israel is not waiting.

Israel has made it clear that it is growing impatient and that it will act independently of other nations if something isn’t done about Iran’s nuclear ambitions, in order to protect itself. How can the world experience GDP growth under these circumstances?

Of all the headwinds the economy faces, the persistent rise in gas prices alone could wipe out GDP growth in 2012 and lead us quickly into a recession. So watch that stock market rally and keep a close eye on gas prices—the $125.00 a barrel oil price—and Iran. They are pointing to recessionary troubles ahead.

Where the Market Stands; Where it’s Headed:

The Dow Jones Industrial Average opens this morning up 5.6% for 2012.

The bear market rally in stocks that started in March of 2009 is tired and long in the tooth. But it still has some life left to it. The stock market is not in a speculative phase as monetary policy remains very favorable, while stock market advisers are not overly bullish. I expect one more run to the upside before this rally subsides. However, for the majority of my readers, the risk in the market might outweigh the reward.

What He Said:

“Home sales down 8.4%, could be the bottom,” read the headline in last Friday’s USA Today. What do they know that I don’t? They know what realtors and their associations tell them and that’s about it. Unfortunately, the real estate news is predominately written by reporters—not real estate investors with years of experience to share. The hard facts about the real estate market in the U.S. are truly scary. How can the U.S. economy escape the hard landing in U.S. home prices? As we’ll soon find out, it simply can’t!” Michael Lombardi in PROFIT CONFIDENTIAL, January 31, 2007. While the popular media was predicting a bottoming of the real estate market in 2007, Michael was preparing his readers for worst of times ahead.