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Gold, Cigarettes, Kilowatt Hours, and the U.S. Dollar

A recent thread "What Will Replace the U.S. Dollar?" on a  LinkedIn forum on the global economic crisis, has discussed various serious and fanciful proposals for replacing the U.S. dollar as the world's reserve and trade currency. One of these is to use kilowatt-hours or carbon emissions credits or a currency backed by them. The original idea is attributed to Arthur C. Clarke, of "2001: A Space Odyssey" fame.

Carbon emissions credits or kilowatt hours are a poor medium of exchange for the same reason that cigarettes or rare wines or tulip bulbs or even barrels of oil are: they are unstable and they have utility apart from their value as units of account. Until we have batteries capable of storing all the electricity generated and a much more efficient electric grid, a kilowatt hour produced but not consumed is lost forever. You can't save it and use or spend it tomorrow. And because of transmission loss, a kilowatt hour generated in California is something less than a kilowatt hour when it reaches New Jersey.

If used as currency, even if you can overcome the storage and transmission problems, every transaction based on the kilowatt-hour becomes a decision about consumption. Do I use it to keep my refrigerator cold, or to spend on something else? Once consumed, a kilowatt hour - like a cigarette - is no longer usable as currency.

This is why we typically use something stable and unsuited to most other purposes as currency. Gold bars and coins fit the bill remarkably well. They don't biodegrade, and apart from dentistry, they have few other practical applications. Silver, copper, and platinum, because of their many industrial uses, are much less useful as currency. The huge stone wheels used on the island of Yap are also a good currency, since they meet another important standard: it is not easy to make more of them.

It is possible to make (or extract and refine) more gold, but the high cost of digging new mines limits the potential rate of increase of a gold-based money supply. This is where fiat money - paper or strings of zeroes and ones on a computer screen backed by "the full faith and credit" of a government - becomes problematic. Highly-indebted governments are tempted to inflate their way out of their debt. If your currency is worth only 10% of its previous value then so is the amount you owe. This solution, poetically known as "debauching the currency," does not work so well for savers, creditors, and pensioners, who end up getting only 10 cents on the dollar, like the General Motors bond-holders. Germany did this in the 1920s and Zimbabwe earlier in this decade, though instead of 10 cents it was more like one-billionth of a cent.

Remember the phrase "sound as a dollar?" We don't often hear that any more, and we are likely to hear it even less now that Presidents Bush and Obama, having super-sized the national debt, have all but guaranteed future inflation.

Neither our government nor any other is likely to return to the gold standard any more than they will adopt electric power as a new backing for the money supply. As individual investors, though, we have a number of options. We can buy gold, of course. We can short the dollar, though in favor of what? We could even start to collect rare wines and fine art. There may be plenty of good reasons to put up a wind turbine in your back yard, but giving yourself a hedge against inflation or a perpetual money-making machine is probably not one of them