Recently by Simon Black: A Look Back, and Some 2011Predictions
Without a doubt, the existing global financial system depends on the widespread use of fiat currencies issued by insolvent governments. The wealth of the worlds large financial institutions requires that there be currencies with sufficient size and circulation to absorb massive capital flows.
The current system is based primarily on the dollar; with a $14 trillion economy, the United States was for years the only country in the world with a sufficient money supply and financial infrastructure to take in the preponderance of the worlds wealth.
It is for this reason commercial loans, commodities contracts, international reserves, and cross border settlements have traditionally been denominated in US dollars.
Competing reserve currencies arose with the advent of the euro and Japans post-war rise; while the dollar has continued to remain dominant, these three are the only currencies which have the necessary supply and credit rating.
With trillions of dollars floating around the global financial system, managers are constantly making capital allocation decisions, moving funds in and out of various instruments. The reserve currencies play a big role in this because unallocated capital is frequently parked in their bond markets.
For example, large corporations or banks that are sitting on billions of dollars in cash typically purchase short-term US or European government bonds because the low default risk.
End The Fed Best Price: $2.18 Buy New $5.68 (as of 09:55 UTC - Details)
The dollar, euro, and yen have bond markets of such size that getting liquid is never a problem, even for billions of dollars. There is always a market for treasury securities, hence they are considered cash equivalents.
You couldnt do the same thing in the Kingdom of Bhutan with its tiny $3.5 billion economy. If you tried to move $100 million into Bhutan, its currency (the ngultrum) would spike. In the US, Europe, and Japan, $100 million barely registers a blip.
Over the last few years, though, the confidence has begun to fade quickly, and the reserve currency issuing governments are starting to be viewed with increasing skepticism.
The thing thats missing right now is an acceptable alternative. Theres really nothing out there in large enough scale to withstand massive capital flows, and as I have written before, the game is now one of judging the least worst of these three major currencies.
In what seems to be a 6-month cycle, the dollar and euro have been jockeying for the u201Cworst of the worst title; markets focus on Greek woes for a few months, then turn their attention back to California and Obamanomics.
With Bernankes 100% certainty and nonsensical economic numbers coming out of the Americas Ministry of Truth (Newspeak: USMiniTruth), we seem to be back in a period where the markets are more concerned with Europe. I think that Japan will be called to the carpet before too long as well.
As such, in an almost ritualistic cycle, financial markets are shifting funds around these currencies the analogy I like to think of is like a series of buckets.
Imagine three buckets and an increasing volume of water. Capital allocators are essentially dumping the contents of one pail into another from the dollar bucket into the euro and yen bucket, and from the euro bucket back into the dollar bucket.