Much has been written lately, including by me, about the coming rejection of the dollar as the primary reserve currency of the world’s most important central banks.
My prediction is based upon two things: one, that the Federal Reserve is controlled by inflationist politicians whose main goal is to monetize the federal government’s vast annual budget deficits; and, two, that the rest of the world is getting fed up with holding ever more fiat dollars of decreasing purchasing power. In the first instance, as long as the Fed can get away with printing dollars that ultimately are used to purchase federal government debt, there is no reason for it to cease federal debt monetization, or for the federal government itself to balance its budget.
In the second instance, it is in the self interest of the rest of the world to find an alternative to being robbed by loss of the dollar’s purchasing power. In short, if the Fed does not stop debasing the dollar, its status as a reserve currency will continue to erode.
If the Fed wants the dollar to remain the world’s reserve currency of choice, it must raise interest rates rather than create more money and the government must slash its spending to avoid imposing higher taxes. If it chooses neither of these, or in such small increments as to make little difference, then I fear the dollar is doomed as the world’s primary reserve currency.
What Is a Reserve Currency?
Central banks hold reserves in order to facilitate international trade. Individuals and companies within a monopolized currency area (either an individual nation or some region, such as the euro zone) must exchange their local currency for some other nation’s currency in order to import goods and services. Likewise, individuals and companies within a monopolized currency area must convert foreign currency to local currency in order to pay their local suppliers for producing goods and services that are sold abroad and for which they were paid in foreign currency.
They do this through the central bank. Alternatively, individuals and companies may decide to conduct these exchanges in a third currency, one that is accepted in most of the world. Since the end of World War II, the US dollar has performed this role, meaning that the world is willing to hold dollars (or dollar denominated assets, such as US Treasury bonds), that circulate outside the borders of the US. Over time, this led to the eurodollar and the petrodollar markets.
But simply saying that the world has preferred to hold US dollars does not explain why it preferred to do so. We have lost sight of the fact that there were real reasons for the eurodollar and petrodollar markets, which transcended some mystical faith in the dollar and the US. The world simply had recognized that the dollar was the most marketable currency to hold, I believe mainly for both geopolitical (i.e., US military dominance) and economic (i.e., the size and success of the US economy) reasons. But now those reasons are evaporating, creating an opening for some other, better currency.
Is There Any Better Reserve Currency?
The market wants a currency which retains its purchasing power and can be exchanged readily for the most varied real goods, services, and assets. As long as nations issue fiat currencies, only a nation with a large internal market will find that its currency is accepted as one of many reserve currencies. If no one else will accept that currency, it always will be accepted in the monopolized currency zone of the central bank that issued it. For example, it is possible that the eurodollar and petrodollar markets could end, forcing holders of US dollars to exchange them for goods and services in the one part of the world that must accept dollars.
The American market is huge, offering lots of choice; whereas, a smaller market, such as Singapore or Russia, would have fewer assets, goods, and services for exchange against the Singapore dollar or the Russian ruble. Much has been written of late that Russia, whose economy is one tenth the size of the US, wants to end what it calls the dollar’s “special privilege.” But there is a natural limit on the demand by central banks to hold Russian rubles, because Russia exports mainly commodities and few goods or services. Furthermore, property rights in Russian companies and other assets are not seen by the market to be as secure as those in Western countries. China’s yuan might fare better than the ruble, because China exports many more goods to the West than Russia; thus, holders of yuan would have somewhat more confidence that they could find readily marketable goods in exchange for yuan.
Gold Backing Adds to a Currency’s Marketability
But there is one step that small market countries or those with questionable dedication to defending property rights could take that would enable them to make their currencies attractive to hold nonetheless. They could tie their currencies to gold. Gold backing provides two important assurances to potential holders. One, gold cannot be inflated at the stroke of a key on a central bank’s computer; therefore, the currency could not be (as easily) debased and would retain its purchasing power. And, two, gold is acceptable intrinsically anywhere in the world. The holder of a gold backed currency can look beyond ultimately exchanging his currency in the issuer’s monopolized currency zone; he can exchange the currency for gold and spend it on real assets, goods, and services anywhere in the world.