Rise And Fall Of Nations And Reserve Currencies
March 17, 2011 by Daniel Zurbrügg
Among the “must reads” for people trying to gain insight into the long-term structure of economical developments is Mancur Olson’s book, The Rise and Decline of Nations, published more than 30 years ago. Olson was a great economist and social scientist who showed how interests and incentives of individuals drive and influence the development of a country. This often results in a less than ideal resource allocation and over time can result in very harmful effects for a country that can even lead to a complete collapse.
Olson’s findings help us to understand the problems of many Western nations today and how they will face a lot more headwinds in the future. Chronic overspending and changing demographics will cause many Western nations to “fall” or at least enter a period of deep structural change, thus bringing along many painful adjustments.
While today’s structural problems among Western nations are different than they were a decade ago or even centuries ago, the fundamental reasons that lead to a decline of a nation have not changed at all since the fall of the old Roman Empire, the breakup of the Soviet Union or other troubled economies. However, today’s situation is more complex because of globalization.
Now the U.S. and Europe might be at the start of a long-term decline and with it their currencies, both of which are the world’s most important reserve currencies. The chart below shows that the importance of the United States dollar, measured as a percentage of global currency reserves, has been steadily declining since the late 90s.
Almost 90 percent of the world’s currency reserves are held in U.S. dollars and euros, both of which are at risk to face a long-term structural devaluation. In light of this, it is obvious that a growing number of investors and governments with net currency reserves would like to diversify away from these two reserve currencies.
There are clear signs that this rebalancing has already started and that the combined percentage share of the two largest reserve currencies is going to fall further. How low can this go on in the next five or even 10 years is the question? My honest answer is that I don’t know, but I believe that even a shift of 15 percent to 20 percent would be enough to exercise serious downward pressure on these two currencies for years to come.
Besides the shift in the distribution of reserve currencies, which will have an impact on the value of individual currencies, there is another interesting development happening. The U.S. dollar seems to lose its role as a “crises” hedge; that means that even in times of falling markets or geopolitical turbulence, the greenback is not able to benefit, at least not as much as it used to, meaning investors are not looking to move funds back into the dollar in a flight for safety and liquidity.
Let’s look at the two recent examples: The first one is the situation in the Middle East and Asia, where tensions have been spreading in the last couple of weeks. The chart below shows the currency exchange rate AUD/USD. The Australian dollar is widely used as a carry trade by investors because of the significantly higher yields in Australia. So recently, despite the devastating damages by the flooding in Australia and the very serious tensions in the Middle East, the exchange rate AUD/USD remained relatively flat.
The second example is from the terrible events in Japan in the past week. Despite the potentially far-reaching consequences of these events, the U.S. dollar has not been able to benefit because investors seem to be reluctant to move money to the U.S. dollar even when things look more uncertain.
And not to forget, in the case of the Japan earthquake, it was the third largest economy in the world that got hit along with the Japanese yen, one of the major currencies. It’s indeed very interesting and maybe even a bit surprising that the U.S. dollar has not been able to benefit much from this. It certainly tells a lot about the fundamental weakness of a currency.
The Chinese Premier Hu Jintao recently said that the era of a U.S. dollar-dominated currency system is coming to an end and that this will force a change to the international currency system. The recent structural weakness of the U.S. dollar and the euro shows that we are moving in this direction and that we are probably in a late stage of development of today’s world currency system.
The rise and fall of a nation and its currency follows a very long and powerful underlying cycle with very unique dynamics. While sound economic and political leadership can certainly dampen the negative effects, each prospering society will eventually enter a period of slow growth or even stagnation. Also with the rise and fall of nations comes the structural appreciation or devaluation of these nations’ currencies. Depending on where they are in terms of their long-term economic cycle, it has very important implications for investors.
Today’s problems in Japan, Western Europe and the United States have a lot in common and, while we all hope for things to change to the better, it’s wise to prepare for the worst. In this case, that means a prolonged period of disappointing economic growth, large and growing debt burdens and increased social economic tensions between different nations and even within each nation. Even the tensions and the political turmoil in the Middle-East and the Northern African region can, to some extent, be attributed to such an underlying structural cycle. Things can only get so bad until people have nothing to lose anymore and start taking control of their own destiny.
In light of the comments above and the lessons learned from history, today’s financial and economical problems in the West need to be seen in a different context. The weakness of currencies like the euro and the U.S. dollar might not just be a temporary phenomenon, but much more likely the early phase of a long-term structural adjustment that will include below average growth and a devaluation of their currencies versus many other major currencies, including many emerging market currencies.
In regards to all of this, I think the question that we need to ask today is whether the current debt crisis in the U.S., Europe and other major economies is really indicating that things will worsen from here and that we have moved beyond the point of no return.
I think the problem today is that governments have spent way too much money in the last couple of decades and that today’s highly alarming debt burden in many countries are only the tip of the iceberg. Some people might argue that the debt in percentage of gross domestic product is really quite manageable but the problem is that on top of the current debt, we need to take into consideration unfunded future obligations that will drive up the government’s debt level even more. This is especially bad for some Western nations like Spain and Italy, who have a rapidly aging population and therefore fewer and fewer young people that can support retirees.
The conclusion of this article is that investors need to rethink their investment strategies, especially with regards to their currency allocation. The two dominant reserve currencies in the world, the U.S. dollar and the euro, are both showing signs of structural weakness, might both face significant devaluation in coming years and this will result in increasing money flows to countries that experience faster economic growth and lower debt levels. This will clearly be a benefit for emerging market currencies and currencies of major economies that have less structural problems.