How a Country Loses its Reserve Currency Status

If the US government and central bank continue to undermine the value of the dollar and the independence of institutions, the moment when Americans’ currency will rapidly lose its reserve currency status will come closer,” writes economist Daniel Lacalle.

The US dollar enjoys the status of a world reserve currency for several different reasons. These include legal and investor confidence, an open and transparent market, and independent institutions that operate on the principle of separation of powers and relatively strengthen currencies.

No, a country’s reserve currency status does not come from its military power. Nobody accepted the ruble when the Soviet Union ruled over half the world. For a fiat currency to be a reserve currency, it must be widely adopted as a unit of account, means of payment, and store of value.

The problem, however, is that all of the above may be at risk. Politicians’ actions have increasingly put fiat currencies under pressure as reserve currencies. This not only undermines monetary policy, but also all other institutions based on the principle of separation of powers.

When politicians talk about the “social” use of money, they are actually saying that you have to suffer high inflation for even longer. This means that the currency is used to cover huge budget deficits by depreciating its value. This illusion is held together by the fact that citizens must always use the local currency.

This is not logical. Fiat currency, like any product or service, depends on supply and demand. Excessive supply undermines the purchasing power of the currency just as overproduction lowers the price of a product. If the demand for the currency is also weakening, it can lead to the collapse of the currency.

Reserve currency status must be protected

The moment politicians stop protecting their currency’s reserve currency status, they destroy the country they have promised to protect.

Currency destruction is the first sign of a declining country. Leaders never believe that it will end because the process is initially slow. This is followed by a sudden acceleration along with hyperinflation, and then the country is on its knees.

This happens when local citizens and foreigners no longer accept the currency as a means of payment and store of value. Initially, this slowly erodes, but later collapse occurs quickly.

Demand for national currencies disappears when governments attack the currency as a store of value and the independence of institutions while believing that nothing will change. Testing the patience of users of the currency always ends badly.

Political forces, however, believe that they can always hold citizens hostage with a currency losing its value because they can only use the currency issued by the state. This is a misconception. If a country’s citizens lose patience with a declining value currency, other methods of transactions, including barter, will be used.

If nothing has happened so far, bad policies may continue

Moreover, most politicians believe that if “nothing” has happened so far and the currency is still widely used, then the independence of institutions and the purchasing power of the currency can be undermined indefinitely. This is not true, and all empires have ended because of this illusion.

This is why modern monetary theory (MMT) is so wrong. It assumes that a country’s control over its currency is static and unchanging, giving governments the ability to poorly manage money. A country’s control over its currency can disappear very quickly – as quickly as the illusion of endless money printing.

The US dollar remains the world’s reserve currency because it has no competitors yet. The reason for this is not the Federal Reserve’s responsible monetary policy. The US government and the Federal Reserve should know that the introduction and enforcement of central bank digital currencies are also not the solution.

The only way to maintain the dollar’s reserve currency status is to increase its global demand. And it should not be forced by the Federal Reserve or the US government because it will never work.

Currently, there doesn’t seem to be any alternative to the dollar. However, this will change when someone offers something real that independent institutions have a high demand for. The US government and central bank may currently believe that there is no competition, as other fiat currencies are worse. They are right. The problem is that alternatives can come in very independent ways.

So far, the Federal Reserve has cleverly referred to the Achilles’ heel of cryptocurrencies, which is liquidity. Despite the lack of alternatives, holding the value of the currency as a reserve currency strengthens it. If this is not reflected in US government policies, the end of the dollar’s global reserve currency status will draw closer.