Only Gold Can Replace the Greenback As the World's Reserve Currency

At the World Economic Forum in Davos this week, George Soros warned that the subprime crisis would bring about the end of the US dollar as the world's default reserve currency. In recent years, as emerging economies posted growth rates approaching 10%, and as the US economy's share of global GDP declined, it made sense for other countries' central banks to park their reserves partly in dollars, partly in other currencies.

There are however two problems with forecasting a final demise of the US dollar.

First, central banks around the world already hold hundreds of billions in instruments denominated in US dollars. A concerted move to shun the greenback would lead to significant paper losses on current holdings, greatly damping the benefits of switching to another currency.

Second, applying Winston Churchill's aphorism on democracy, the US dollar may be the worst reserve currency, except for all those others. And here is why.

The Euro is currently riding high thanks to strength and optimism in the European economy. Although there is currently a differential in interest rates earned by holding Euros vs. holding dollars, this gap, in theory, should not be sufficient to warrant a massive move from dollar to Euro. Except for the most nimble of traders, future expectations of growth and inflation would arbitrage away any gains achieved in the near term. In addition, fantasies of European decoupling from the US economy's turmoils have been quashed in recent weeks as can be seen by the contagion now reaching the old continent's financial institutions.

The Yen is another option but the Japanese economy, like Europe's, has been supported by rising demand from emerging markets. Should the US economy weaken, demand for industrial goods from Japan and Europe will also slacken. Furthermore, Japan's management of its economy since 1990 has done nothing to commend its currency to nervous central bankers.

Meanwhile back in the United States, the Federal Reserve's frantic interest rate cutting is pushing the dollar down while fueling inflation.

Looking at all these factors together, what are central bankers to do with their reserves? Selling current dollar holdings in a massive fashion is like shooting yourself in the foot. The Euro and Yen reside in economies that are too dependent on US growth to be considered safe havens. The only clear option therefore is to place a significant portion of new reserves in gold.

Since its lows of 2001, the Euro has nearly doubled vs. the dollar, but gold has more than tripled. And there will likely be more upside. The price of gold in real terms remains significantly below its last high recorded in the early 1980s, and would need to double to match that level again. While the amount of gold available in the world has risen since 1980, its rate of growth has been dwarfed by an enormous creation of capital in the past 25 years, capital which may now look for a safe haven away from the world's wobbly currencies.

Comments

[alpha24seven:]

Nicely done. Currently presented along the same lines is this nonsense that oil will move from dollar denomination to Euro denomination. Because the Euro currently trades at near 1.50 to the dollar, this allows the EU zone to be buying oil at a steep discount. Some argue the reason that oil is this expensive in the first place is because of US dollar policy. Maybe so, but if oil were to reprice in Euros, the immediate shock would be a near 50% one day increase in oil in the EU and this would savage their economy.

Oil will not be denominated in Euros any time soon.

2008 Jan 25 12:27 PM

[Etoile Bril...:]

Get real! Trichet only has to put his hand into his crotch to realise he's got what it takes to be a Central Banker. If Bernake does the same - nada!

Based on the buckling Bernanke's peformance this week. I know what currency I would like to hold my reserves in.

2008 Jan 25 02:55 PM

[Greg Pinelli:]

The sentiment is intriguing...but poorly argued. IF..gold is to become the next "reserve currency" then, without a doubt, it will have to be led by countries that hold enormous US$ reserves..the oil Middle East and China..and that is not going to happen. By the by..Eto..whatever..is anything but brilliant..the word "crotch" means you lose immediately.

2008 Jan 25 08:59 PM

[Kunst:]

Can anyone explain to me why T-bill interest rates remain so low when the declining value of the dollar makes them a negative-return investment?

2008 Jan 27 11:21 PM