As U.S. Debt Soars, Dollar May Lose Reserve Status

European debt problems have received a lot of media attention, but it is the debt problem in the U.S. that is far more likely to precipitate a global crisis.

Former U.S. Treasury official Lawrence Goodman sounded the alarm recently when he noted that investors are shunning low-yielding U.S. Treasuries, forcing the Fed to buy “a stunning … 61% of the total net issuance of U.S. government debt.”

His view that ballooning deficits and excessive debt put the U.S. economy and markets at risk for a sharp correction also explains why recovery is so weak and why trillions of dollars remain sidelined.

The other dimension to the story that may trigger the next financial crisis is the loss of the reserve currency status of the U.S. dollar.

What saved the greenback after Nixon removed the U.S. dollar from the gold standard in 1971 — ending the post-war Bretton Woods international financial order — was the status of U.S. dollar as the reserve currency of the world.

This began with Saudi Arabia agreeing in 1973 to accept only U.S. dollars as payment for oil in exchange for U.S. protection of the Saudi monarchy and its oilfields. By 1975, the reserve currency status of the U.S. dollar was firmly established, with OPEC members agreeing to trade only in dollars. Trading of other commodities came to be priced in dollars, which reinforced the reserve currency status of the dollar.

Central banks around the world have maintained disproportionately large reserves of dollars to facilitate trade, which enabled the U.S. to print excessive amounts of its currency with seemingly little inflationary consequences.

The reserve currency status of the dollar has also allowed Americans to import more than they exported, to consume more than they produced and to spend more than they earned.

But all that is about to change. The U.S. dollar is already being abandoned by a number of countries in favor of the Chinese yuan.

In December 2011, Japan and China agreed to dump the dollar and trade in yen and yuan. China’s trade with Vietnam, Thailand and Russia is now settled in yuan instead of dollars.

In January, the 10 nations of the Association of Southeast Asian Nations (ASEAN) strengthened the linking of their economies with those of China, Hong Kong, Japan and South Korea with a $240 billion equivalent non-dollar credit agreement, thus moving further away from the dollar.

Elsewhere, while Iran’s nuclear energy development program gets scrutinized, few realize that Iran is circumventing dollar-based trade sanctions. As of March 20, Iran started trading oil in currencies other than the dollar. India has agreed to settle 45% of payments for Iranian oil in rupees, with gold as an additional payment option.

The recent U.S. threat to impose sanctions on India, China and South Korea for refusing to reduce their oil imports from Iran may only drive expansion of non-dollar-trade regimes. The BRICS nations — Brazil, Russia, India, China and South Africa — which have had stronger economies than the U.S. and Europe since the 2008 financial crisis, are asserting themselves.

On March 29, the China Development Bank agreed with its BRICS’ counterparts to eschew dollar lending and extend credit to each other in their own respective currencies.

The erosion and loss of the use of the U.S. dollar as the reserve currency means less demand and more dollar selling by central banks around the world, which in turn causes inflation as the dollar weakens against other currencies.

Worse, the demise of the dollar’s reserve currency status at the same time that federal debt compounds to new heights creates a perfect storm, making a collapse of the dollar closer than most Americans realize.

Let’s hope the anticipation of new leadership coming in November buys time for an orderly transition.

Powell is a senior fellow at the Discovery Institute, an adjunct at the Competitive Enterprise Institute and a managing partner at RemingtonRand LLC.