Kind of like Star Wars all over again

Remember SDI? There's a good chance you don't because as soon as Ronald Reagan announced his plan to develop a nuclear weapons defense laser shield, his opponents mocked the program, calling it "Star Wars" rather than using its proper name, "Strategic Defense Initiative," or "SDI." In effect, SDI broke the back of the Soviets and ushered in a new world order with the United States as the sole superpower. There's another acronym you might want to get familiar with: SDR. Like SDI, SDR could become a catalyst that causes a major shift in world power---a shift away from the dollar as the world's major reserve currency.

SDR stands for "Special Drawing Rights," which is an international quasi-reserve currency created by the International Monetary Fund in 1969 for governments around the world to use in financing deficits. The IMF was created in 1947 following the Bretton Woods agreement made in 1944 among World War II allied nations. The agreement signed at the Mount Washington Hotel in Bretton Woods, N.H., created an international monetary system with the gold-backed U.S. dollar as the world's reserve currency. Is your brain melting down already? OK, let's slow down with the details. Suffice it to say that SDR is a form of international currency dealt out to international governments by the IMF comprised of a basket of currencies consisting of the dollar, the euro, the pound sterling, and the Japanese yen. Good enough for now?

"Wishing," you're saying, "why should I care?" Good question. Keep your eyes on the news as we witness the potential decline of the dollar and the world's wealth. At the G-20 summit in London in March, the IMF decided to raise money by issuing a never-before-seen bond---a bond backed by, you guessed it, SDRs. Last week China fired a financial shot across the bow of the sinking ship U.S. Treasury. It announced that it wants to buy up to $50 billion in bonds backed by SDRs. Russia wants $10 billion and so does Brazil. Again, "Wishing, why should I care?" We Americans should care because China and other foreign nations have been financing our massive deficit spending by buying our U.S. Treasury bonds. They hold about $2 trillion in dollar-denominated reserves, including about $700 billion in U.S. Treasurys. Bottom line: China is getting tired of the spending shenanigans of our Congress and the financing frivolities of the Federal Reserve that could lead to a massive devaluation of the dollar.

Imagine this: China is holding $2 trillion in dollar-denominated reserves. We, of course, pay China interest and principal in dollars. Because the Federal Reserve is creating a massive amount of dollars out of thin air to jump-start the economy, bail out Wall Street and Detroit, etc., and because the United States has an $11 trillion deficit and another $100 trillion or so in unfunded liabilities, the U.S. dollar could drop in value significantly, generate inflation like we've never experienced . . . and depreciate the value of China's holdings. What would you do if you were the governor of the central bank of China? Hmmm, maybe you would tell the United States to get its financial house in order. Maybe you would call for the end of the dollar as the world's dominant reserve currency and suggest that the dollar be supplanted by SDRs. And maybe you would start to diversify your government bond purchases away from U.S. Treasury bonds and into alternatives like SDR bonds. China is doing all these things. Can you blame them? Please keep this move by China in perspective. They are not acting radically. They are trying to protect their financial holdings. If they move too dramatically from the dollar they stand to lose a lot of money quickly. China is moving, but moving cautiously.

By the way, it's a bit ironic that China called for the end of the U.S. dollar as the world's reserve currency on March 23---the same day that Ronald Reagan announced SDI in 1983.