This month, Peter Mallouk and Jonathan Clements explain what it means to be a reserve currency and give their take on whether the dollar’s days as the largest reserve currency are numbered, what a loss of status could mean for the U.S., and how you can hedge your risk. Plus, learn why you shouldn’t wait to create a “my Social Security” account.
Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!
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Jonathan Clements: Hello, this is Jonathan Clements, Director of Financial Education for Creative Planning. With me is Peter Mallouk, President of the firm, and we are Down the Middle.
Peter and I would like to welcome you to our 50th podcast. Every month it seems investors find something new to worry about. What are they concerned about these days? Lately we’ve seen the revival of an old worry about the U.S. dollar and specifically its status in the global economy.
For almost eight decades, the dollar has served as the world’s reserve currency. Indeed, global central banks hold about 60% of their foreign exchange reserves in U.S. dollars. The holders of these dollars get a currency that’s prized for its stability. What does the U.S. get in return? Among other things, it means healthy demand for U.S. treasury bonds and hence lower borrowing costs for our national debt.
Over the past six months, the U.S. dollar has been somewhat weaker in the foreign exchange market, but the decline hasn’t been huge. So Peter, what do you think is driving today’s concerns about the dollar status of the world’s reserve currency?
Peter Mallouk: Every five years, I get a lot of questions around the dollar falling apart and us losing the reserve currency status, but I’m telling you, the last 30 days, probably more than my entire career combined, this has really moved to the forefront and is an issue for a lot of people. It’s actually a little bit of a complex topic. And so just for those of our listeners that aren’t really familiar with currencies, which would be most of them, I just want to explain what a reserve currency is and why it’s important. And then let’s talk about is the U.S. going to lose its reserve currency status?
And basically a reserve currency is just the currency that the world basically agrees that they all trust. And so they tend to do business in that currency. Today, about 60% of business is done in U.S. currency. People feel like if you have one country, Indonesia, trading with another country, Malaysia, they might trade in dollars because they both trust that the dollar is going to hold its value, or if they don’t trade in dollar, they will convert to dollars.
Basically, the world looks at the dollar the way hundreds of years ago people looked at gold. And what the reserve currency allows is exactly what you said at the beginning. Because the whole world trusts the dollar more than any other currency, it means a couple things to the U.S.
One, when we want to go borrow a bunch of money because we’re spending like drunken sailors, people will loan us money because they trust the value of the dollar and they’ll loan us money at a lower interest rate than others. Because we’re the reserve currency it’s like having a credit card with a couple percent interest rate. Sure, congress and president are going to go bonkers with a 3%, 4% credit card. That’s what you get for being the reserve currency. And so it matters to Americans in the sense that when they do business, they don’t have to change back to the dollar. They’re doing business in the dollar even when it’s international most of the time. And the country can borrow at very low rates.
Now, what’s in it for the world? What’s in it for the world is the world wants to have a currency that it has confidence in, that when they buy and sell things, they’ve got something that’s going to hold its value. So that’s basically how it works.
Now, what do you need to be a reserve currency? Nobody woke up one day and named the U.S. dollar king. What happens is the world is looking for certain things. One, they’re looking for political stability. They are looking for a currency that’s backed by a big, strong growing economy that’s got very transparent financial markets, a legal system that has some credibility, a country that pays its debts. It’s looking for all those things. Well, guess what? That’s the United States. The United States is more capable of doing that than anywhere else.
Now, the other thing worth pointing out is there’s not only one reserve currency. I think we talk about this like it’s the dollar and there’s nothing else. As you pointed out, about 60% of business is done in the U.S. dollar, and there has been a decline. 15 years ago it was 70%, and some business is done in euros, some in Japanese yen, and then everything else makes up a very, very tiny fragment. But the U.S. is the dominant force here.
So what’s happened that’s created this conversation recently where people are concerned about the dollar losing its reserve status? I think we really look back to when Russia invaded Ukraine, the U.S. took a lot of actions against Russia, and one of them is we kicked them out of a system that allowed them to convert to dollars. We used our status as a reserve currency nation as a geopolitical weapon, which is another advantage of having the reserve currency. If you’re the reserve currency and you get mad at Iran, you can cut them off from the international system. If you get mad at Russia, you can cut them off from the international system.
Now the irony of that is every time you cut a country off, you encourage the rest of the world to go, “Wait a second, forget about our military and our cyber and all this stuff. We’re at the mercy of the United States because the U.S. has the reserve currency.” It puts them in a very weak position. And when the world saw us do that to Russia, you saw China and other countries get very concerned and they’re trying to find coalitions to trade in different currencies. And I think that’s what’s really brought this to the forefront.
I think there’s some credibility to this, which makes people nervous because there have been plenty of reserve currencies before the United States. The U.S. has been the reserve currency for almost 80 years. Before that, Great Britain for about 130, France for about 95, the Netherlands for 80. No one stays on top forever. So you combine, there’s a lot of countries on earth that do not like the United States now for a lot of different reasons. We’ve weaponized money. We can argue about whether that was smart or not. One of the advantages of being the reserve currency again is you can weaponize money. The disadvantages, when you weaponize money, it makes people not want to use you as the reserve currency.
But the way I look at the dollar is it’s the cleanest shirt in the dirty laundry. Yes, it’s got all its problems. We spend like crazy. We weaponize it. Countries don’t like us for a variety of reasons. But if we’re not going to be the reserve currency, there has to be an alternative. Well, it’s not going to be the euro. I mean a lot of people aren’t sure the European Union is even going to be a real thing 10 years from now. So I don’t see the world clamoring to have the Euro. And we all talk about China. Chinese currency right now is 2.7%. No one trusts it. The system’s not transparent. It’s missing a lot of the pieces that are required of a reserve currency, which is being really able to count on an open, transparent financial system.
And so I think there’s a real narrative here and there are real problems with the dollar, but there is no alternative. We are nowhere near having an alternative currency. It’s impossible to imagine that happening anytime in the near future. Investors can find a hundred other things to worry about besides this.
Jonathan: So Peter, one of the things that is mentioned in this discussion is some sort of global digital currency or a Federal Reserve-backed global digital currency. Do you think that’s in the cards?
Peter: I think that’s inevitable. So I almost consider this a completely different topic, and that’s around the digitization of money. So I do think that when our grandkids are watching movies years from now, they’re going to watch people passing around cash and coins the way we look at horse and buggies. It’s just going to be unimaginable to them that you actually went in your pocket and you grabbed money.
I think we’re going to head to digital currency and all the good and bad that comes with that. I mean, that’s a whole other thing. The good is obvious. It’s simple. We could track things. Taxes are easier and so on. You kill a lot of industries that thrive on illegal activity. The bad being the government knows everything that you’re doing. We saw in some other countries, again, doesn’t matter what side of the aisle you’re on. The reality is we’ve seen countries like Canada weaponize currency against their own citizens.
And so if a government can see everything that’s happening all of the time, they can control and freeze accounts as well. And so it’s going to be a very interesting world when all of that happens. But again, we’re decades away from that and we’re even further than that from the U.S. losing its currency reserve status.
Jonathan: So the bottom line here for investors, Peter, you’re concerned about dollar status as a global reserve currency. If worse comes to worse, what do we see? We see weakness in the dollar in the foreign exchange market?
Peter: Here’s what’s interesting about this is, you know what? We talked about Great Britain being the last to lose its reserve currency. Its economy’s doing great. Their quality of life is better. Their stock market has had insane returns since they lost their reserve currency. The world goes on. You don’t lose it and crumble to ashes. Your cost of borrowing goes up because people would rather lend money to the country that has the reserve currency and then you can’t spend like a drunken sailor as much. And maybe that’s not so bad.
But in general, in general, the probability of this happening is very close to zero anytime in the next few decades. And the consequences to investors are not as extreme as it may seem. The answer is very clear. If you’re worried about it, you should be globally diversified, which we recommend anyway, not because of this issue but because there are a thousand things happening all the time that are unpredictable. We don’t want all of our eggs in one basket.
So if you’re only U.S., you should have a lot of large companies because a lot of those companies get their earnings overseas. And if you’re not just large companies, you need to have some global exposure, make sure you diversify away these risks. So if you feel like worrying about them, it can be a fleeting worry because you probably have the new reserve currency country in your portfolio.
Jonathan: In other words, whenever the question comes up, am I worried about this risk, the answer is make sure you’re diversified.
Peter: That’s always the conclusion.
Jonathan: That’s always the conclusion. So talking to conclusions, Peter, we’re at the end of our podcast. It’s time for the financial wellness tip of the month. What do you have for me, Peter?
Peter: So I would tell people to look at your portfolios and make sure that you’re not missing tax harvesting opportunities. It’s early in the year, but we had the market go up, but a lot of stocks went down. It was a very interesting first quarter to the year. If you just look at the index returns, it was positive, but hundreds of stocks that make up major indexes declined. It’s easy to want to ignore your statement and assume there’s nothing to harvest. But if you’re a do-it-yourselfer it’s a good time to look at things. How about you, Jonathan?
Jonathan: So for my tip of the month, Peter, I’d advise people who haven’t done this already to create My Social Security account. You can just put those words, “My Social Security” into Google, and you’ll find out how to do it. And by setting up a My Social Security account, not only will you have access to a treasure trove of information about your potential benefit down the road, but also, and this is important, you’ll protect your account from being scammed by somebody else.
One of the dangers out there is that somebody else will set up My Social Security account for you before you do, and then apply for benefits on your behalf. So if you don’t want that to happen, make sure no later than the day before your 62nd birthday, when you can potentially apply for Social Security, that you set up this My Social Security account so that you control who has access to that information and who can claim benefits, because down the road you want it to be you. So that’s it for this month, Peter.
This is Johnathan Clements, Director of Financial Education with Creative Planning. I’ve been talking to Peter Mallouk, President of the firm, and we are Down the Middle.
Disclosure: This show is designed to be informational in nature and does not constitute investment advice. Different types of investments involve varying degrees of risk and there can be no assurance that the future performance of any specific investment or investment strategy, including those discussed on this show, will be profitable or equal any historical performance levels