In the Bitcoin community, we often hear the U.S. dollar called an “exorbitant privilege.” Namely, that the U.S. benefits disproportionately from the dollar’s reserve currency status. This article will detail why the current financial system has, in fact, been a burden on the United States, why the fiat dollar system is ending and what that means for the future of Bitcoin.
First, what is a global reserve currency? In short, it is the currency that governments and large international entities like central banks hold to facilitate global trade, credit, accounting and often to back their own currencies. The U.S. dollar holds this position today.
The dollar’s reserve status was officially established in the Bretton Woods Agreement of 1944. Since the U.S. was the only major economy left standing after World War II, it was only natural that the U.S. dollar would be agreed upon to anchor a new system. According to Bretton Woods, major currencies were pegged to the U.S. dollar, which in turn was pegged at $35 per ounce of gold.
This system initially served the world well, enabling rapid rebuilding after WWII, especially in Europe, Japan and several emerging markets. It was also an integral part of the fight against communism. Countries were welcomed into this system of international finance and trade as long as they were willing to side against the Soviets. However, the Bretton Woods design soon ran up against limitations. The gold backing restrained the dollar’s supply, despite the demand for currency around the world growing exponentially. Enter the Triffin dilemma.
The Triffin dilemma was first articulated in 1959 by Robert Triffin. The main idea is, when a currency is used as an international reserve, domestic constraints clash with international demand. The high demand for dollars and the limits of gold on the supply create an incentive for the U.S. to run large trade deficits and debase the currency. If that were the end, it would be that simple, but a new incentive breeds a market reaction as well.
Despite what many bitcoiners and macro pundits think, 1971 was not a particularly pivotal year. The famous events of that year, namely the Nixon Shock, were a natural progression, a recognition of the reality in the financial system established years before. By the time the Triffin dilemma became generally recognized in the 1960s, it was already being solved. The market always finds a way.
Instead of needing the Federal Reserve or U.S. government to meet international demand by printing and exporting dollars to the world, banks everywhere could do it for themselves by making dollar-denominated loans. This is how all credit-based fiat is printed, in the process of a loan. The Eurodollar system formed as a global interbank system and had unofficially replaced Bretton Woods prior to 1971.
The Eurodollar System
The Eurodollar is the current financial system consisting of off-shore U.S. dollars and dollar liabilities that are not beholden to the Fed or U.S. government policy. Enterprising bankers solved Triffin’s dilemma by printing dollars outside the U.S.
These off-shore (or shadow) dollars trade one-to-one with actual U.S. dollars, because, well, they are U.S. dollars. In a quirk of credit-based fiat money, it is printed in loans denominated in that currency. A commodity-backed money is either fully backed or not. There is a measure of the commodity in a vault somewhere, and an objective ratio of currency to backing that shows debasement. But credit-based fiat has nothing to distinguish a dollar created by a bank in the U.S. from one created by a bank in, say, Singapore.
The Eurodollar system had its roots in the late 1950s, and grew with the insatiable demand for dollars that trade deficits couldn’t meet. By 1970, the off-shore Eurodollar supply held by central banks was larger than the official overseas dollar supply (see chart above).
This emerging financial system was completely missed in the early days because it didn’t fit into economists’ models. The Eurodollar system remained unstudied for years with only a few brave economists risking their careers to look into things that didn’t fit into the reigning models. By 2020, the Bank for International Settlements’ (BIS) estimated there to be $12.7 trillion in measurable USD-denominated debt originated and held outside the U.S. However, this is only a small piece, because it doesn’t consider derivatives, chains of custody, currency swaps, or other shadow products, making the effective sum many times higher. That’s why it’s called “shadow banking,” we don’t know the true extent of their balance sheets.
As long as the loans can be serviced, the system will keep ticking along. That means these loans must be productive and yield cash flow greater than principal and interest of the loans. Since money in this credit-based Eurodollar system is constantly revolving debt, the smallest interruption in the web of trust and credit ratings can cause a financial crisis.
Eurodollar And Free Trade Subsidy
If the Eurodollar’s elasticity was the right hand of the dollar, open access to most of the world’s markets was the left. Countries being secure from regional wars and their goods having access to almost all markets is a historical anomaly. Prior to the middle of the 19th century, integrated markets as we know them today did not exist, and until WWII, international trade was concentrated to a few goods and trading partners within…
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