by Shah Gilani courtesy Money Morning

Last week I was asked by a Wall Street Insights & Indictments reader about a new challenge to the U.S. role in the global economy that few are considering.

It’s a dominant role we’ve held since the latter part of World War II. And for 70 years it’s gone largely unchallenged.

Until now.

The question isn’t complicated, but it will be disturbing to some…

The Question No One Has Been Asking

The question was one begging to be asked, and I’m glad one of our WSII readers put it out on the floor? Here it is:

“I have a question which, as far as I know, has never been raised. Perhaps you can offer a viable answer.

In 1944, at the Bretton Woods Conference, the dollar was made the reserve currency for the world. This suggests to me that there are perhaps trillions of dollars floating around out there that are having little or no effect on our economy. I read that China is now trying to install the yuan as the new reserve currency, or at least at some point in the future, international trade will be done with other currencies.

What effect will that have on our dollar? This is something I’ve been thinking about for the past several months, wondering what we should be doing to prepare for that development. It seems to me that at some time in the future, all of those dollars will be repatriated, and yet no one that I know of has even raised the question.

Does that mean that I have it all wrong, or are people just too afraid to consider the possibility?“

To answer, first let me address what happened at Bretton Woods and what a “reserve” currency is, because understanding how a currency war will play out requires a look at past efforts to avoid one.

How the Dollar Became King

In July 1944, with World War II still raging, but with an end to the devastation in sight, the 44 Allied nations, led by the United States, met in Bretton Woods, New Hampshire. They planned to hammer out a policy to “govern monetary relations among independent nation-states.”

The allies needed a financing mechanism to rebuild their countries and economies. And they needed a stable “global currency” to take the place of different currency regimes prone to competitive devaluations leading to economic disruptions.

Although John Maynard Keynes, a vocal and influential British economist at the time, proposed the “bancor” as a new world currency unit, the United States prevailed. The dollar became the “anchor” currency around which fixed exchange rates would be established.

The U.S. prevailed not only because it was by far the strongest ally. It also had the only viable economy paired with the means to help finance recovery. By that time the dollar was also the only currency still backed by gold.

Because the dollar was “reserved” by gold, the term “reserve currency” came into existence. But reserve currency means more than backed by gold, which is important to understand since Richard Nixon ended the dollar’s convertibility into gold on August 15, 1971.

A reserve currency is first and foremost a currency that has the full faith and backing of its issuing government.

It is perceived by investors to be a “store of value” because it is backed by a strong government, is safe from confiscation, and is governed by the trusted rule of law in the issuing country. For those reasons, a reserve currency is held in significant quantities by governments and institutions as part of their foreign exchange reserves and is commonly used in international transactions.

In essence, Bretton Woods’ establishment of the dollar as a reserve currency meant the end of the gold standard for the world.

Since currencies were now “pegged” to the dollar (which could until 1971 be exchanged in the U.S. for gold at $35 per ounce), adherence to a peg would necessitate buying or selling dollars by a home country to maintain mandated exchange rates. Gold was no longer the basis of any currency’s “value,” and the dollar became king.

Over time Bretton Woods broke down and currencies began to “float.” That means currencies are valued relatively. The value of the British pound to the Japanese yen, for example, is a relative value. This means the value is based on how many parts of a unit or how many units of one currency it takes to buy a unit of another currency.

Every currency is “valued” in the open market every day against every other currency to establish what one currency is worth relative to another currency. Or, how many units of currency or goods and services a unit of one currency buys relative to another currency.

This Trap Threatens to Send Us Spiraling

The US dollar is still the world’s reserve currency. But it faces increasing threats. One threat is its own doing; it’s called the “dollar trap.”

Precisely because the dollar is the world’s reserve currency, it is in high demand. One reason other countries want to hold dollars, besides their reserve status and their perceived store of value, is because by buying dollars, countries can change their exchange rates.

The typical path countries want to take is to devalue their currencies to make them cheaper on global markets. That way it takes fewer units of another country’s currency to buy a unit of a currency being devalued. That “competitive devaluation” makes the devaluing country’s exports cheaper. Export growth is what drives many economies, especially emerging markets and most especially China. But the same is true of Germany and the United States.

If a country wants to increase its exports by making them cheaper, rather than lowering the price of them, they devalue their currency, which makes them cheaper on a relative basis. Countries drive down the value of their currencies by actually selling them.

Currencies always are valued in pairs. You cannot sell a currency to drive the value of it down without “buying” another currency on the other side of the trade. If you sell a currency, let’s say you sell Chinese yuan. (Note: You often hear “renminbi” in place of “yuan,” but both are names for China’s currency. Renminbi is the name of the currency, as in British sterling, and yuan is a unit of currency, as in the British pound.)

Whoever is buying your yuan has to pay you in another currency. Most of the time in a devaluation, the home currency is sold and dollars are bought. That’s the dollar trap.

Countries devaluing their currencies are selling them for dollars. They end up with massive amounts of dollars, which don’t pay any interest, so they use their dollars to buy U.S. government treasuries. Treasuries are a proxy for the dollar and pay interest.

The dollar trap happens as countries buy U.S. bonds, driving down their yields, which in turn keeps U.S. borrowing costs at rock bottom. Cheap borrowing let’s U.S. legislators and administrations run huge deficits. Huge deficits in turn will eventually undermine the value of the dollar.

The trap turns to a nightmare if dollar holders (government bond holders) lose faith that the dollar will continue to be a store of value, which it will become less of if it is sold off widely and depreciates as a result of global selling. Dollar depreciation affects holders who are losing money by sitting on a depreciating asset and in turn will sell their holdings in a possible death spiral for the dollar and the U.S. economy.

Enter the Chinese.

The Dragon Is Vying for Dominance

The likelihood of the dollar trap turning into a dollar collapse any time soon is remote. Although at some point, it could happen.

The death spiral scenario is based on the Chinese currency replacing the dollar as the world’s reserve currency. In theory, as the Chinese economy grows (it’s now the second largest in the world), and China increasingly transacts in yuan as opposed to dollars or euros, there will be more yuan in the global marketplace.

If enough yuan are free-floating and available as an international medium of exchange, the Chinese could dump their trillions of dollars in dollar reserves, crashing the dollar and throwing its reserve status out the door.

It’s not time to worry… yet.

China needs financial market reforms, and to liberalize capital flows into and out of the country, and they need political and institutional legal framework reforms. They need all of that before global trading partners would ever consider the renminbi as a reserve currency.

That said, the United States is facing an aging population, a declining workforce, growing debt, and the emergence of global players. There’s no guarantee the dollar’s reserve status will stand the test of time.

For investors looking to profit from currency wars and any change in reserve currency status, there will be plenty of time to tee up blockbuster trades to make a killing on the death of the old world order.

It happened at Bretton Woods, and it then happened when Bretton Woods broke down. Another massive shift is next.