World leading economy cycle part 2. Reserve currency

 Although the reserve currency is the most important and easiest indicator of a leading economic country, it is one of the laggard indicators. Currencies act as a medium of exchange. Reserve currencies are the largest single components of the world's central banks and other financial institutions in their reserves and the most important individual trading instruments. Now the US dollar is the most important. It accounts for about 60% of the reserve currencies. The second most important reserve currency is the euro, which accounts for about 20%. Others come far behind in single-digit positions. If you count gold as your reserve currency then it is the third most important. The position of the dollar as the main reserve currency is the result of World War II and subsequent international agreements.

There are three requirements for a reserve currency: it must retain its value in the eyes of the people, it must be an accepted trading currency around the world, and it must be accepted by governments, central banks and other financial institutions. Currencies retain their value better as central banks retain them as additional reserves. There should be enough, but not too much, reserve currency in circulation. Its position may be lost if the latter occurs. Mainly a large-scale war or a failed repair of the destruction of a long debt cycle can lead to the loss of the position.

The values of the trading currencies must not fluctuate excessively as they move between the parties. The less the value of a currency fluctuates, the more suitable it is for trading. A currency is only suitable for trading if its value is believed by both parties to the trade. Large fluctuations erode credibility. When credibility is lost, the currency is mainly suitable for wiping the back if it does not have real estate in the back. Confidence can be lost without a warning or little by little. Large fluctuations occur when there is not enough currency in the market.

Regulatory approval is required. This means, among other things, that it is up to the central banks to increase and decrease the money supply. It means that the reserve currency acts as an instrument of power for the authorities that govern it. Therefore, Bitcoin or any other privately managed virtual currency will never achieve reserve currency status. This will never be said out loud by any central bank or government. Cryptocurrencies will be banned if they threaten the status of the former. The reason given is something else such as use as an instrument of crime or environmental damage. The increase in the market share of virtual currencies will lead to bans.

The world's largest economic power is practically always found in the country that dominates the most popular reserve currency. For example, the United States may choose to exclude any actor that uses their dollars in trade. In addition, the country has the most decision-making power, e.g. At the World Bank and the IMF. The reserve currency cycle usually has three stages:

1. Extensive agreement on new reserve currency + coupling to real assets like gold
2. Decoupling and switching to a free currency
3. Depreciation compared to the new reserve currency

The change in the reserve currency requires a global crisis or a massive debt crisis in the country administering it. They may cause the value of the reserve currency to collapse. In most cases, this has been the first situation. In most cases, it requires a massive debt crisis. The global crisis is almost always a major military conflict. It does not always mean a loss of reserve currency. In a war, the ruler of the previous reserve currency goes into war with another major country, causing the new ruling country to become the most powerful country in the world. An agreement on a new reserve currency often allows for the largest share of votes in global economic organizations. For example, the United States has the largest share of votes in the IMF.

An agreement often initially involves tying money to real assets, such as precious metals. A certain amount of money equals a certain amount of them. Money may not be in circulation more than an equivalent amount of precious metal. In the first phase of the current cycle, one ounce of gold was equivalent to 35 US dollars. The good thing about the arrangement was that it was harder to produce inflation because it was difficult to increase the amount of gold and thus the amount of money. The downside, again, was that the amount of gold could not be increased enough compared to the growth rate of working-age people. In other words, more people entered the market than money. The solution is problematic in the long run and may limit economic growth.

The previous solution lacks sufficient flexibility in terms of the value of the currency. Before long, the state managing the reserve currency will move to the second stage, i.e. scrap the link to real assets. The United States did so in 1971. This increases long-term inflation and may cause short-term inflation to accelerate. In addition, the price of real estate pegged to the reserve currency will increase because the price used for pegging is likely to lag behind its real value. Stock prices will also rise, at least in the long run, as the amount of money grows even faster and some of it is transferred to shares.

Inflation rose in the 1970s, but that was not the only reason for it. It was also affected by OPEC's actions. The money supply is based on a decision by a central bank or other financial authority to print the amount it deems necessary for the reserve currency. The price elasticity of the reserve currency is increasing. This is the best way to act in theory. It works for a long time, but not indefinitely. It's easy to go too far. In the end, the result is the loss of reserve currency status.

World leading economy cycle part 1. Rise to the top

A leading economic country dictates the basic rules of the world economy. Others have to follow them if they want to cooperate with it. They are more likely to run into financial difficulties if they try to deviate from the rules it creates. They can also ensure that weaker economies do not catch the lead. The United States has been acting ruthlessly for a long time. The same is expected from the nation that dictates the rules next time. The cycle includes three phases: rising to the top, staying there, and falling. Operating at peak includes a reserve currency cycle. The leading country changes after the country has gone through the cycle. This is as natural an event as the rain in England. The duration with its stages is about a century. The rise and peak are slow, but the decline is fast compared to them.

The more economically developed a state is, the more it is hoping weaker states will follow the rules of the market economy. This means that more developed countries should make sure that weaker countries do not exploit practices that are unfavorable to them. This is especially true for the biggest competitors. The closer the countries are in the development cycle, the more this matters. The United States should not care about Bangladesh, but China is another matter.

The leading economy is in many ways the leader of the world economy. It has the largest share of world trade, is the most competitive, controls the main financial center, is a leading technology developer and industrial country, has the best education, a reserve currency, and has such a strong military power that it cannot be shaken by war. It is also likely to be a ruthless economic actor that will discipline other countries, if necessary militarily, if they threaten its interests.

Rise to the top

There are several roads to the top, but together they are the most efficient way to get there. Wealth can be created by harnessing domestic intellectual capital to develop the products and services that others want. It can be created by finding natural resources within its borders that can be resold to other nations at a higher price than the cost of exploiting them. In addition, there is a third way.

Imagine a country where tariffs on industrial products have averaged 40 to 55 percent for decades, the majority of the population is not allowed to vote, votes are bought, elections are cheated, and the government does not hire workers without the permission of those who bought the votes. In addition, the state economy is on the edge, the country has gone bankrupt and foreign investors are being discriminated against, especially in the banking sector, and shareholders cannot vote if they are not citizens of the country. It also has no competition law. It allows cartels and monopolies and does not care about foreigners' intellectual rights. What is this country? The answer is the United States in the late 19th century.

Lie, steal, and cheat. These three commandments of striving for the position of a ruling state in the world economy run counter to those who believe in Western values ​​and the rules of the game in a market economy. These are often necessities for those aspiring to become dominant economies. The three commandments have also been China’s means as it strives to become a leading economy. Warfare requires a bit of explanation because people perceive it mainly as a military conflict. In this context, it means e.g. a currency war, one way of which is to manipulate the exchange rate to create. In addition, it means protectionism, etc.

Getting to the top doesn’t just mean breaking the rules. It means improving the factors that are important for the economy at home. The journey to the top requires e.g. a large workload, a people whose vast majority adhere to common rules of the game, cooperation between citizens and government, high-quality education, finding new ideas from abroad, importing top foreign professionals when needed and investing heavily in the necessary infrastructure and high quality of leadership.

The above will lead to a prudent investment of capital, high productivity and the creation and the use of new competitive technologies. These will increase the country’s share of world trade which will require a strong army so that trade is not jeopardized. The above factors attract large amounts of foreign capital, which reaches the country's stock markets, foreign exchange and credit markets. Eventually, they will become more attractive than in other countries, so in the end, the reserve currency will also be held by a leading economic country. The reserve currency has its cycles.

National economic development cycle and investors

The significance of the economic cycle for the investor depends on few things. Index investors are in a particular need to understand that in addition to price. The stage and direction of the development cycle tell about the potential for long-term returns. The duration of the phases can be decades or centuries. In such a long run, the investor is often dead. The nation´s internal direction of the phase indicates about the return opportunities. A downward-going state is rarely able to change direction before moving on to the next development phase. Changes in direction require radical changes in social systems and citizens' thought patterns. Here are some examples of my estimates for countries at different stages of development:

1. Ethiopia, South Africa, Bangladesh, India, Ukraine, Bulgaria, Brazil, Bolivia, Cuba
2. Malta, Czech Republic, Slovenia, Cyprus, Puerto Rico, China mostly
3. Luxembourg, Singapore, Switzerland, Norway, Denmark, the Netherlands, Sweden, Canada, Germany, Australia, major cities on and around the east coast of China
4. United States
5. Portugal, Japan, Spain, Italy, Finland, Belgium, France, United Kingdom

My thought process was not entirely clear in which category any country should be placed. Instead, the direction of development was easier to notice. It is clear that many impoverished countries that are clearly going downhill have been rich, but whether they are impoverished or still rich is more difficult to assess. Such countries, I think, include at least Japan, Britain, Finland, and France. It is clear that the direction is downwards. The location of the countries in the second phase can also be difficult to see. As an outsider, it’s hard to see if people really feel poor. China is a difficult country to evaluate because the countryside is poor, but big cities are more prosperous. The United States is an exception because of its reserve currency status. It will allow it to become more indebted than other countries without moving to the fifth stage.

The importance of a direction to stock index investors often depends on the state. For example, the direction in Finland is downwards, but most of the large companies on the Helsinki Stock Exchange are export companies, whose results and turnover mostly come from elsewhere. The same does not apply to all other countries, such as the United States and all its indices. The Russell 2000 Small Business Index is more dependent on the direction of the state. Equity investments, mainly in companies operating in the internal market, are subject to the same rules as for equity index funds.

One of the main factors behind the change in direction is the taxation of investors. A downward trend often means tightening taxation and an upward trend. Investors in export-dependent countries need to monitor tax developments. Bond investors also need to understand where countries are and in what direction they are going. On average, the debt of improving countries is falling and that of backward moving countries is rising. Debt securities of a leading economic country are generally considered to be the best asset hedges. Their attractiveness only diminishes when the position begins to look precarious. It may then be too late to respond to maintain status.