Fading Glory: The Dollar as the World's Reserve Currency

I read a recent article on Bloomberg where the author was making the point that even though the dollar is declining, we likely have a long way to go before it is completely replaced as the world's reserve currency.

I happen to concur with that thought. Much of the world's international settlement systems have grown up for half a century around the dollar as the reserve currency, so it is unlikely this will change overnight.

There are, however, a few things that could accelerate the process. A run on the dollar by any country or group of nations that is a major holder of dollars as a part of their reserve base, Sovereign Wealth funds becoming even more aggressive than they are now in securing hard assets versus paper cash holdings, or OPEC/China deciding to divest its dollar holdings into something else, such as Euro or gold.

Another scenario that could rapidly accelerate the dollar's demise includes the continued bail-outs of financial institutions by the Fed. If we are so simple as to believe the Wall Street talking heads that we are in the clear, we are being as silly as they are. The fact is less than half of the asset losses from the sub-prime fiasco of 2007 have been reported, and through 2011 we are going to see another mortgage related scenario unfold in the form of Alt-A and ARM resets that will make the sub-prime mess look like romper room in comparison. This would have a domino effect, in that as the Fed bails out more failing financial institutions, it will multiply not only US, but Global inflation.

Such a series of events would continue to devalue the dollar, and give ever more impetus to nations sitting on vast dollar reserves to get rid of their dollars while those dollars are still worth something. This means that those dollars will start coming home. The effect of that would be increased prices in the US for everything from food to gas to electricity (if you think it is bad now, you ain't seen nothing yet!). The other effect of that would be accelerating the value the dollar, further spurring dollar holding nations to dump them.

Finally, any country that chooses to stand on its own and link its currency to a hard asset such as gold or silver would be a currency that is in high demand virtually overnight. Why stack billions in paper that is redeemable for nothing, when you can instead stack billions in paper that you can exchange for gold and silver? Our world's governments are not stupid, and that's exactly the way it would go.

The net effect of that would be of course changing gold and silver from commodity status back to monetary status. This isn't a new idea, humans have used gold and silver linked to currency or as currency for thousands of years, because it is un-inflatable (if it remains pure), and forces governments to remain disciplined in their fiscal policies. It is only in the last 40 years that we have strayed from this wisdom, and we are witnessing its effects as I write this.

Societies throughout history have oscillated back and forth between currencies redeemable in things of intrinsic value, and paper that is redeemable for nothing for hundreds and thousands of years. As inflation continues to grow, inciting food riots and civil unrest around the world, the idea of having currencies that prevent the governments of the world from inflating the world's currencies becomes ever more enticing.

This is not as far fetched as it might sound. I certainly consider it curious that China has invested so heavily into mining, mineral rights, and acquisition of operating gold and silver companies over the last ten plus years. They have made attempts at buying mega-mining companies such as Rio Tinto (RTP) through proxies, they have been running all over Africa for years buying up mineral rights, they have become the worlds largest producer of gold, and China is among the top silver producers in the world. Metals are of course important to an emerging nations economy like China's, yet gold can barely be considered an industrial metal, so why are they investing so heavily in it?

One of the primary reasons that the US Dollar became the world's reserve currency in the first place is because it was redeemable in gold.

The Chinese are not stupid people, so as with all things we must apply 'Cui Bono', or 'Who Benefits', and ask ourselves, why are they doing this? The United States has enjoyed a unique ability to run massive trade deficits for half a century and borrow money from the entire world at low interest due to its currency status. The Chinese are hungry to move into a western style standard of living, so is it so outlandish to think that they might like to enjoy the same benefits?

Could the Yuan become the next reserve currency of the world? More importantly, to those who understand how small the gold and silver markets are, is what effect would that have on the prices of gold and silver?

The results could be explosive to say the least.

Disclosure: I hold positions in SLW, HL, CDE, AUY, NXG and [SVM.TO].

Comments

[dieuwer]

Interesting thought displayed in the artcle.
Another explanation why China might have accumulated massive dollar reserves: to use as a weapon of mass destruction.
Militarily, China may be no match to the US, but dumping TRILLIONS of dollars onto the market will have to effect of grounding the US military due to instant skyhigh prices of energy products.
No wonder the US is frantically expanding the strategic reserve. They know that time will come that they no longer can afford to buy the stuf...

[syruppy]

For sure China is doing things that cannot be done in the U.S., e.g., adding every year the equivalent of the UK's entire nuclear energy production, mining coal--and buying coal from the US--and of course using coal to make energy, builidng oil refineries too. A oil refinery has not been built in the in the US in 30-years.

The left in the US is anti-business, anti-religion, anti-personal liberty. The left in China is just the same, except that, it isn't anti-business.

[lowem]

Add to that the moves by Venezuela, Russia and Iran away from conducting USD-based oil trading and suddenly you have the Euro, the Ruble and perhaps even the Yen emerge as strong "petrodollar" competitors.

[User 101825]

Is it possible the maligned USD may become the currency backed by gold?

When gold dropped to under $300 and the world embraced the "strong" USD perhaps gold was quietly being re-purchased. When, finally, an audit is done on Fort Knox it may well be there's a lot more there than suspected and a "gold-backed" new USD will arise, like a phoenix, once again.

Debts, of course, will be in "old USD's" and left to fend for themselves.

[marxbites]

Economic Freedom and Interventionism
Ludwig von Mises

Reprinted from the New York World Telegram & Sun, May 7, 1951.


19
Inflation

The government provides a part of the funds required for rearmament by inflation, that is, by increasing the quantity of money in circulation and the amount of bank balances subject to check.

The unavoidable consequence of inflation is the emergence of a general tendency of all prices to rise. If the government had procured all the money it needed for rearmament by taxing the citizens, the increased demand on its part would have been counteracted by a drop in the purchases of the taxpayers. The expanded military consumption would have been neutralized on the market by a restriction in civilian consumption. But with inflation the additional demand of the armed forces comes on top of the non-decreased demand of the public and makes prices soar.

What the bureaucrats have in mind when talking about "fighting" inflation is not avoiding inflation, but suppressing its inevitable consequences by price control. This is a hopeless venture. The attempt to fix prices at a lower rate than that which the unhampered market would determine renders unremunerative the business of some producers; that is, those operating at the highest costs. This forces them to discontinue production.

Wartime Experience

Inflation, in conjunction with price control, brings about scarcity. Housewives remember very well what happened in World War II with meat, butter, eggs, and many other articles under the regime of the Office of Price Administration. Yet price control has been re-established.[1] If Congress does not let the present price control law expire on June 30, as scheduled, the country will very soon experience anew not only all the hardships of inflation, but also all the evils created by the vain attempts to conceal these hardships by price control.

Economists know very well that there is only one means available to prevent a further rise in all commodity prices, namely, to end inflation entirely. If the government obtains all its funds from the public and stops increasing the quantity of money in circulation and borrowing from the commercial banks, prices will remain unchanged, by and large, and there will not be any need for the activities of a price dictator.

But the administration does not want to stop inflation. It does not want to endanger its popularity with the voters by collecting, through taxation, all it wants to spend. It prefers to mislead the people by resorting to the seemingly non-onerous method of increasing the supply of money and credit. Yet, whatever system of financing may be adopted, whether taxation, borrowing, or inflation, the full incidence of the government's expenditures must fall upon the public.

With inflation as well as with taxation, it is the citizens who must foot the total bill. The distinguishing mark of inflation, when considered as a method of filling the vaults of the Treasury, is that it distributes the burden in a most unfair way, overcharging those who are least able to bear it.

A Semantic Trick

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase.

They put the responsibility for the rising cost of living on business, This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the Office of Stabilization and Price Control is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury goes on with inflation.

------------------

[1] After the outbreak of the Korean conflict in June 1950, President Truman was authorized under the Defense Production Act (signed September 8, 1950) to "stabilize prices and wages." This price control law was revised several times and extended until April 30, 1953. Eisenhower, who had become President in January 1953, did not request a further extension and it was allowed to expire.

20
Inflation: An Unworkable Fiscal Policy

In dealing with problems concerned with the economics of mobilization, it is first of all necessary to realize that fiscal policies have reached a turning point.

In recent decades all nations have looked upon the income and the wealth of the more prosperous citizens as an inexhaustible reserve which could be freely tapped. Whenever there was need for additional funds, one tried to collect them by raising the taxes to be paid by the upper-income brackets. There seemed to be enough money for any suggested expenditure because there seemed to be no harm in "soaking the rich" a bit more. As the votes of these rich do not count much in elections, the members of the legislative bodies were always ready to increase public spending at their expense. There is a French dictum: Les affaires, c'est l'argent des autres. "Business is other people's money." In these last 60 years political and fiscal affairs were virtually "other people's money." Let the rich pay, was the slogan.

End of an Era

Now this period of fiscal history has come to an end. With the exception of the United States and some of the British Dominions, what has been called the ability-to-pay of the wealthy citizens has been completely absorbed by taxes. No further funds of any significance can be collected from them. Henceforth all government spending will have to be financed by taxing the masses.

The European nations concerned are not yet fully aware of this fact because they have found a substitute. They are getting Marshall Plan aid; the U. S. taxpayer fills the gap.

In this country things have not yet gone as far as they have in other countries. It is still possible to raise an additional $2 or $3 billion, or perhaps even $4 billion, by increasing corporation taxes, and "excess profits" taxes, and by rendering the personal income tax more progressive. But under present conditions, even $4 billion would be only a fraction of what the Treasury needs. Thus, in this country we are also at the end of a period of fiscal policies. The whole philosophy of public finance must undergo a revision. In considering the pros and cons of a suggested expenditure the members of Congress will no longer be able to think: The rich have enough; let them pay. In the future, the voters on whose ballots the Congressmen depend will have to pay.

Inflation, an increase in money and credit, is certainly not a means to avoid or to postpone for more than a short time the need to resort to taxes levied on people other than those belonging to the rich minority. If, for the sake of argument, we leave aside all the objections which may be raised against any inflationary policy, we must take into account the fact that inflation can never be more than a temporary makeshift. Inflation cannot be continued over a long period of time without defeating its fiscal purpose and ending in a complete debacle as was the case in this country with the Continental currency, in France with the mandats territoriaux and in Germany with the mark in 1923.

What makes it possible for a government to increase its funds by inflation is the ignorance of the public. The people must ignore the fact that the government has chosen inflation as a fiscal system and plans to go on with inflation endlessly. It must ascribe the general rise in prices to other causes than to the policy of the government and must assume that prices will drop again in a not-too-distant future. If this opinion fades away, inflation comes to a catastrophic breakdown.

The Housewife's Behavior

If the housewife who needs a new frying pan reasons: "Now prices are too high; I will postpone the purchase until they drop again," inflation can still fulfill its fiscal purpose. As long as people share this view, they increase their cash holdings and bank balances, and a part of the newly created money is absorbed by these additional cash holdings and bank balances; prices on the market do not rise in proportion to the inflation.

But then, sooner or later, comes a turning point. The housewife discovers that the government expects to go on inflating and that consequently prices will continue to rise more and more. Then she reasons: "I do not need a new frying pan today; I shall only need one next year. But I had better buy it now because next year the price will be much higher." If this insight spreads, inflation is done for, Then all people rush to buy. Everybody is anxious to reduce his holding of cash because he does not want to be hurt by the drop in the monetary unit's purchasing power. The phenomenon then appears which, in Europe was called the "flight into real values." People rush to exchange their depreciating paper money for something tangible, something real. The knell sounds of the currency system involved.

In this country we have not yet reached this second and final stage of every protracted inflation. But if the authorities do not very soon abandon any further attempt to increase the amount of money in circulation and to expand credit, we shall one day come to the same unpleasant result. It is not a matter of choosing between financing the increased government expenditure by collecting taxes and borrowing from the public on the one hand and financing it by inflation on the other hand. Inflation can never be an instrument of fiscal policy over a long period of time. Continued inflation inevitably leads to catastrophe.

Therefore, we should not waste our time in discussing methods of price control. Price control cannot prevent the rise in prices if inflation is going on. Even capital punishment could not make price control work in the days of Emperor Diocletian or during the French Revolution. Let us concentrate our efforts on the problem of how to avoid inflation, not upon useless schemes of how to conceal its inexorable consequences.

Taxation the Key

What is needed in wartime is to divert production and consumption from peacetime channels toward military goals. In order to achieve this, it is necessary for the government to tax the citizens, to take away from them the money, which they would otherwise spend for things they must no longer buy and consume, so the government can spend it for the conduct of the war.

At the breakfast table of every citizen in wartime sits an invisible guest, as it were, a GI who shares his meal. Parked in the citizen's garage is not only the family car, but also?invisibly?a tank or a plane. The important fact is that a GI needs more in food, clothing, and other things than he used to consume as a civilian. And military equipment wears out much more quickly than civilian equipment. The costs of a modern war are enormous.

The adequate method of providing the funds the government needs for war is, of course, taxation. Part of the funds may also be provided by borrowing from the public, the citizens. But if the Treasury increases the amount of money in circulation or borrows from the commercial banks, it inflates. Inflation can do the job for a limited time. But it is the most expensive method of financing a war; it is socially disruptive and should be avoided.

Inflation: A Convenient Makeshift

There is no need to dwell upon the disastrous consequences of inflation. All people agree in this regard. But inflation is a very convenient makeshift for those in power. It is a handy means to divert the resentment of the people from the government. In the eyes of the masses, big business, the "profiteers," the merchants,?not the Administration?appear responsible for the rise in prices and the ensuing need to restrict consumption.

Perhaps somebody will consider what I am saying here as anti-democratic, reactionary, and economic royalism. But the truth is that inflation is a typically anti-democratic measure. It is a policy of governments that do not have the courage to tell the people honestly what the real costs of their conduct of affairs are.

A truly democratic government would have to tell the voters openly that they must pay higher taxes because expenses have risen considerably. But it is much more agreeable for a government to present only a part of the bill to the people and to resort to inflation for the rest of its expenditures. What a triumph if they can say: Everybody's income is rising, everybody has now more money in his pocket, business is booming.

Deficit spending is not a new invention. During the greater part of the 19th century it was the preferred fiscal method of precisely those governments that were not then considered democratic and progressive?Austria, Italy, and Russia. Austria's budget showed a deficit yearly from 1781 on, until the late '80s of the 19th century, when an orthodox professor of economics, Dunajewski, as Minister of Finance, restored the budgetary equilibrium. There is no reason to be proud of deficit spending, nor to call it progress.

Going After Lower Brackets

If one wants to collect more taxes, it will be necessary to lay a burden greater than hitherto on the lower income brackets, the strata of society whose members consume the much greater part of the total amount consumed in this country. Up to now it has been customary to tax predominantly corporations and individuals with higher incomes. But even the outright confiscation of these revenues would only cover a fraction of the additional funds the country needs today.

Some experts have declared that it is necessary to tax the people until it hurts. I disagree with these sadists. The purpose of taxation is not to hurt, but to raise the money the country needs to rearm and to fight in Korea. It is a sad fact that world affairs now make it necessary for the government to force people who used to buy nylon stockings and shirts to shift to other du Pont products, namely munitions.

In his book on Eternal Peace, the German philosopher Immanuel Kant (1724-1804) suggested that government should be forbidden to finance wars by borrowing. He expected that the warlike spirit would dwindle if all countries had to pay cash for their wars. However, no serious objection can be raised against borrowing from the public, from people who have saved and are prepared to invest in government bonds. But borrowing from the commercial banks is tantamount to printing additional bank notes and expanding the amount of deposits subject to check. That is inflation.

Semantic Confusion

There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term "inflation" to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. It follows that nobody cares about inflation in the traditional sense of the term. As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this technological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Look at the silly term, "inflationary pressures." There is no such thing as an "inflationary pressure." There is inflation or there is the absence of inflation. If there is no increase in the quantity of money and if there is no credit expansion, the average height of prices and wages will by and large remain unchanged. But if the quantity of money and credit is increased, prices and wages must rise, whatever the government may decree. If there is no inflation, price control is superfluous. If there is inflation, price control is a sham, a hopeless venture.

It is the government that makes our inflation. The policy of the Treasury, and nothing else.

We have been told a lot about the need for, and the virtues of, direct controls.

We have learned that they preserve the individual's liberty to choose the grocer he prefers. I do not want to examine what value may be attached to direct controls from a metaphysical point of view. I only want to stress one fact: As a means for preventing and fighting inflation or its consequences, direct controls are absolutely useless.

more @: mises.org/story/2945

[David Lentz]

Also, the Fed has boxed itself in, by keeping rates low to prevent the ARM resets (most adjustable rates are tied to some Fed-related rate) from driving even more people out of their homes.

If it had to raise rates to soak up the hypothetically returning flood of dollars, defending the dollar and fighting inflation, it would be very limited in its ability to do so, as every quarter-point rate hike would generate screams of anguish from the housing sector, which is on life support for the foreseeable future.

So it would seem that inflation in spades is in the cards for Uncle Sam for a long, long while. That means commodity prices have only begun to soar.

I suspect that the Fed has a chat with major lenders who are taking advantage of its largesse, indicating in no uncertain terms its interest in seeing their inventory of ARMs replaced by some other kind of mortgage ASAP. Whether or not this is actually happening is not yet clear.

[User 30121]

Sonofabitch! Finally, someone has the guts to say all the things (you've said) that NEED saying! THANK YOU, Alex!

To 101825: Fort Knox is EMPTY! If it WASN'T, our government would NOT be SURPRESSING the price of gold, AND they (US Govt) would not REFUSE to do an audit, and provide those audit results to the American people, who have been ASKING for audit results since the 1960's. Remember when the UK's Gordon Brown, sold off their gold at rock-bottom prices and took a bath (2+billion) because of it? Who ADVISED them to do it? The US Govt did? Wanna know why? BECAUSE FORT KNOX WAS EMPTY then, too!

[the final horseman]

THOUGHT FOR THE DAY

invade africa...build power plants so gold mining can continue...refill ft. knox with this gold...put the usa back on the gold standard...nuke anyone who gets in the way...we cant even fight china...they supply components for the abrams...and this isnt even the best tank around...i think it ranks either #4 or #5

sigh...no one gets anything right anymore. at least sam's club would stop rationing rice...as if anyone really cared.

problem solved.

[Lou Thomas]

Interesting premise that China could be angling to make the yuan the new world reserve currency. Certainly I agree about the weakness of the dollar, and the article's prediction that the vast foreign holdings of dollars might finally demand their due in U.S. commodities, sparking horrific inflation, is already in progress.

However, in terms of current reserves, the Euro is the obvious runner-up and therefore, I would have thought, the main contender for the reserve currency mantle. The E.U. is now the largest economy on the planet, with the U.S. second and China a close third.

In terms of stability and openness to the outside world, the E.U. is second to none. The Chinese middle class is still at a nascent stage, and this makes China highly dependent upon exports, while Europe has well-developed internal markets, providing for less instability as U.S. consumption through borrowing finally encounters the end of its tether. Note that one sign of this is the willingness of the ECB to allow the Euro to appreciate vs. the dollar (as if they were actively, rather than passively, pursuing that reserve status advantage), while China has only very reluctantly allowed its currency to float upward within a limited range vs. the dollar.

The U.S. problem, by contrast, is that its internal markets are over-developed through the extension of foreign credit, while its productive capacity has been cored out through the export of the U.S. industrial base to unregulated foreign cheap labor havens for the past several decades. Not to mention continued unmitigated borrowing for the misconduct of two endless wars.

Politically, also, we see the E.U. demanding and getting more influence on the IMF and World Bank in particular. China is not well-positioned in that regard.

As for precious metals, I always think back to the tale of King Midas. When people need food, housing or clothing, a shiny yellow metal isn't ultimately of very great value as compared to a diverse economy that produces all of those things. Seventy percent of demand for gold is for jewelry, and at present prices people are rushing to turn in their gold pendants for cash, so ask yourself the extent to which the actual use-value of gold is determining its value under those circumstances.

For the above reasons, I see the Euro as the most likely new world reserve currency. And, in my opinion, the technical problems of transitioning settlement systems to the Euro are overrated, and will be addressed in a flurry of computer reprogramming as soon as the political issues come to a head and work themselves out.

Disclosure: 90 percent of my money is invested in canned wild Alaskan Sockeye Salmon, which makes a terrible lump in my mattress. The rest is invested in German bunds.