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What is the Dollar Standard?

2016-10-12T15:35:04+00:00

The term 'Dollar Standard' is included in the Economics edition of the Financial Dictionary. Get yours now on amazon in ebook or paperback format. Read more here...

The dollar standard came about as a result of the breakdown of the Bretton Woods agreement and international monetary system. In 1973 the U.S. (and then other developed countries) had abandoned the gold standard. The central bankers and finance ministers of the world could not reach agreement on a new standard for managing monetary relations and international trade. What emerged was a nameless new system that the nations did not officially consent to or sanction.

This de facto dollar standard received its name as the world moved away from gold as its main reserve currency and into U.S. dollars. Gold had underpinned the Bretton Woods system along with the monetary systems of the 19th century. The decision to move away from it as the ultimate backer for paper currencies had major implications for the world economy and trade.

The biggest result of the dollar standard was that it permitted the United States to finance unbelievably huge current account deficits and government spending simply by selling its trading partners and other countries its dollar denominated debt instruments. Under the previous Bretton Woods system and classical gold standards from past centuries, these additional imports that exceeded exports would have to be settled with gold.

The positive effects of this dollar standard are that it brought about globalization on a scale never before seen. This happened as the nations of the world were able to sell their goods and services to the U.S. on credit. It permitted economic growth to accelerate far more rapidly than would have been possible otherwise. This was especially the case for major swaths of the developing countries. It also served to keep interest rates and consumer prices extremely low in the U.S. Inexpensive manufactured goods could be produced with cheap overseas labor and then brought into the U.S. in dramatically growing quantities.

There are also three negative consequences of such a global dollar standard that may prove to be disastrous in the future. The first is that some international nations amassed enormous stockpiles of dollar reserves because of their financial account surpluses. This led to their economies overheating and their asset prices inflating enough to cause economic catastrophes. Asian Crisis nations and Japan are the most stunning examples of countries which suffered harm from these effects. These states escaped from the looming economic depressions thanks to their national governments taking on huge debt to bail out their banks which had gone bankrupt.

A second major problem is that the flaws of this dollar system have led to massive asset price inflation in the U.S. This resulted from America’s creditors and trading partners choosing to reinvest their surplus dollars back into assets which were dollar denominated (especially stocks, company bonds, and real estate). This constant chasing of U.S. investible assets created bubbles in the American stock markets, pushed property prices throughout the U.S. to levels that were unnaturally high and not sustainable, and helped to misallocate corporate capital on an epic level.

Finally, the dollar standard’s rapid creation of credit permitted nearly every industry to over invest. This has led to an overabundance of capacity and deflationary pressure which is reducing the profitability of companies throughout the globe.

Thanks in large part to the excess this new monetary system permitted, the U.S. economy is struggling under historically unprecedented debt burdens in government, corporate, and consumer segments. The world which finds itself overly dependent on exporting to the U.S. on credit struggles with difficult choices. They can continue the process even though they are fearful of overexposure to dollars and dollar denominated assets. They might also change dollar surpluses back into their national currencies which would raise the value of these currencies and hurt exports and overall growth. Some like China are pursuing a third way by acquiring as much gold as they can with their dollars, albeit slowly enough not to cause a rush for the dollar exits.

The term 'Dollar Standard' is included in the Economics edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.