What Will Replace The Dollar?

by: Shaun Connell

The World Economic Forum has reported that the mainstream view is that we're headed toward a world reserve currency basket, explaining:

"The widespread view is that the world is moving toward a multi-polar currency system based on the euro, dollar, and yuan, but each of these currency areas faces the need for significant internal adjustments that constrain their future international roles."

This is one of the most important trends to watch, as I pointed out in my very first article here at Seeking Alpha, entitled The Age of the Dollar is About to End.

In the article I agreed with the majority of world central bankers who concluded that the dollar's reserve status would be incredibly hurt within 10 or so years. Within 30, assuming a new trend doesn't change everything, the dollar will be but a shell of its former reserve self.

The real question is, of course, what will be the next reserve currency? Here we'll look over the requirements and see which currencies are the major contenders.

Criteria for Reserve Currencies

The main attributes of reserve currencies, from the first link and source listed at the start of his article, are:

  • A large economy for currency user stability and options.
  • Reserves are held with currencies used for major transactions or trades.
  • Liquidity across financial instruments with large markets.
  • Fiscal and monetary policies guaranteeing low inflation expectations.
  • Reliable rules and code framework for stability.
  • Strategic purposes.

In light of why different countries hold different reserve currencies, it should become immediately obvious why the dollar is king of the hill and just recently had yet another surge - it meets every standard with flying colors that other currencies can only dream of.

The biggest dangers, of course, are the 4th and 6th criteria - low inflation and the strategic purposes. I'll discuss both below.

Why the Dollar Will Be Replaced

The dollar will likely be replaced for a couple of reasons, both which I discuss more in depth in my "age of the dollar" article.

The first is that of inflationary weakness. The long-term fiscal outlook for the US is weak at best, with the entire US economy becoming progressively more dependent on welfare and structural problems that require massive spending, requiring more and more decreasing marginal productivity of the debt.

In the last couple of years, the national debt has hit $5 trillion more. The impact has been fairly mute.

The Fed is also been working to increase the money supply, though the impact has been far less damaging than the fiscal problems, at least in terms of future inflation. The Fed's impact has been mostly just meddling in a way that prevents a much needed full recession.

Even Ben Bernanke has noted the long-term fiscal problems of the US is dim at best, urging Congress to act to get the debt under control. As the Fed essentially monetizes over half of US debt every year - and more of it every year - the impact will eventually be inflationary to the extent of undermining the dollar even compared to other cruddy currencies.

What Will Replace the Dollar?

As mentioned above, the future likely won't have some one currency rise up to smack down the dollar. There will likely be plenty of different competitors who will gain stronger reserve statuses, and eventually there might even be a basket of sorts.

The Euro
The euro isn't a current candidate for rather obvious reasons. If they get over the current euro crisis they'll instantly be my favorite to "win," but I don't see how that will happen in the medium future.

The Yuan
The yuan is increasingly becoming powerful compared to the dollar the last several years. The currency has been freed up quite a bit recently, with the government letting it float more freely against other currencies.

The Brookings Institute has released a study concluding that the yuan will be a reserve currency within the decade to the extent of greatly diminishing the dollar.

The Swiss Franc
This should be obvious to most, but I've received questions about this several times in the past. The franc absolutely can't be the reserve currency because the economy is too small, there are too few francs for it to be functional, and it's just not economically possible.

Swiss francs have historically been great assets, and if they weren't trying so hard to devalue the currency, I'd be as bullish as I was a year or so ago.

Gold and Silver
I'd love to see this happen, but we'll see. Gold (NYSEARCA:GLD) is currently far too volatile - ups and downs - to be a candidate. I love gold, but most big banks don't.

Still, we'll see. The last couple of years have seen a resurgence in interest in the metal, but that doesn't mean it'll be treated as an actual reserve currency.

Basket of Currencies
This looks like it'll be very possible. If the euro survives well, then a basket of dollars, euros, and yuans could be an alternative to the US essentially being able to be the economic bully on the block. I think most know that China would appreciate putting the dollar down so as to require US deficits to be put in check.

In the end, we'll see. I don't think the transition will be dramatic like many hyperinflationary predictions are, and it could take 10-20+ years to see this occur. At the same time we could see the opposite happen if there's a new fiscally sound political revolution in the US - but I won't hold my breath about that.

What This Means for Investors

The implications for investors should be fairly simple: be prepared for the general decline of the dollar, and expect the long-term fiscal leeway the US has to disappear. Eventually, we won't be able to abuse our "reserve status" like it's some sort of huge low-interest credit card.

This means every portfolio should have some sort of long-term inflation hedge built in, whether it's a small bet like TIP or gold (GLD) and silver (NYSEARCA:SLV).

If you're in the stagflation camp and expect to see long-term inflation, then you might want to look into buying a house now, as interest rates are incredibly low, and any real level of inflation will essentially make loans received now almost free over time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I own physical gold and silver.