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     Oct 4, 2012

Back to gold - eventually
By Martin Hutchinson

No less an authority than Goldman Sachs CEO Lloyd Blankfein said at the Clinton Global Initiative last week that the United States could risk its status as the world's reserve currency if congress fails to act and the "fiscal cliff" program of spending cuts and tax increases is enacted January 1.

Actually Blankfein's statement was the reverse of the truth; enaction of the "fiscal cliff" program, halving the US budget deficit at a stroke, is one of the few outcomes that could AVOID the US losing its reserve currency status. But on the assumption that the

politicians continue to misbehave after November 6, that trillion-dollar deficits continue, and the US does indeed over time lose its reserve currency status, what will a world without a reserve currency look like?

There is no relatively recent historical parallel we can examine to answer that question. The world has had the dollar as undisputed reserve currency since 1945, or really since 1939. Between 1914 and 1939 there were two reserve currencies, the dollar and sterling, with sterling more used in the 1930s than the 1920s, because that decade, once Britain went off the Gold Standard, was a period of robust health for the British economy, while the United States was mired in depression and isolationism. For more than a century before 1914, the world's undisputed reserve currency was sterling, although there were various regional alternatives.

To see a world with multiple reserve currencies, you thus need to go back to a world before sterling's sway, which in practice means before Britain's smashing victory in the Seven Years War (1756-63) took it to both military and economic supremacy.

In those years numerous currencies circulated, with their use being determined largely by their local availability. In the American colonies, for example, the greatest circulating medium was not gold (British) guineas, whose supply was very limited, but silver "pieces of eight" from the Spanish colonies, coins of 8 reals that had been minted to the same standards since a currency reform in 1497 - these remained legal tender in the new United States alongside the dollar until as late as 1857. When Long John Silver's parrot squawked "pieces of eight" it was expressing a rational preference as to the reserve currency in which its pirate horde should be denominated.

At the same time or a little later, a German currency reform of 1751 made the Maria Theresa thaler, also silver, the common currency of the German speaking world, even those parts of it that were Protestant and did not acknowledge her supremacy as Holy Roman Empress. In this case, the coin's reserve currency status spread far beyond Germany; it was minted in six mints outside the Austrian dominions, and circulated not only in Africa but also the Middle East long after Maria Theresa's death in 1780, coins minted after that date being date-stamped "1780" even though they were freshly minted.

Thus when my father first visited Saudi Arabia in 1963, Maria Theresa thalers were still circulating - doubtless many of the local inhabitants, users of the Muslim calendar, were unaware that it was no longer 1780 in the outside world! The last coiner of Maria Theresa thalers was not Austria but Britain, which finally abandoned the practice in 1962, after representations from the post-war republican Austrian government.

The dollar would lose reserve currency status, not through a sudden attempt at fiscal probity, but through a further period of current policies, trillion dollar deficits accompanied by random large-scale Fed buying of Treasuries and agency bonds. At some point, whether because of a resurgence in inflation or the dawning of doubt about long-term US solvency, international demand for both dollars and Treasury bonds would decline sharply, and the world would seek the benefits of diversification.

One such avenue of diversification would be gold, but with the world's central bankers fanatical in their determination not to consider a gold standard, this would simply drive the price of gold up to extraordinary heights, at which its price risks were so great that conservative investors would not dare hold it for more than a small portion of their assets. Accordingly the search would be on for an alternative store of value and currency in which trade could be denominated.

None of the major currently available alternatives look very attractive. Sterling is in the same pickle as the dollar; the coalition government's cuts in spending have been minimal and the Bank of England's purchases of gilts huge. The yen suffers from an overhang of government debt second only in size to those experienced by Britain at the end of the 1815 and 1945 world wars (other than debts that eventually defaulted). The renminbi, or yuan, is over-controlled by China's communist government, and in any case China's economy is full of hidden mysteries like the bad debts in the banking system.

The euro, generally fairly well managed because of the large influence of the German Bundesbank on the European Central Bank, suffers from the feckless nature of several of its Mediterranean members. In this context I have referred several times in these columns to Spain being well run, and thus not a major problem. I hereby withdraw that judgment. It never occurred to me that Spain's economically most important region, itself fiscally mismanaged and responsible for a large part of Spain's problems, would choose the middle of a financial crisis to attempt to hold a referendum on independence.

Whatever the merits of independence for Catalonia (and it is only one of the independence movements throughout Europe likely to appear now that the European Union has made the nation state appear largely redundant) there can be no question that opening the matter at this juncture is an action of gross irresponsibility and malice.

The world's reserve currencies will thus primarily be smaller units, whose importance will swell as their sponsors see the opportunity to obtain massive seignorage revenues from having their currency circulate worldwide. There are likely to be several varieties of reserve currency, each tailored to the needs of particular users.

Asset-only investors will be in despair at the difficulty of finding a unit that does not cause their assets to shrivel like icebergs under a Mediterranean sun; consequently they will demand reserve currencies that pursue Volckerite monetary policies and behave as far as possible like Gold Standard vehicles.

Entities heavily engaged in international trade will want a unit that favors neither buyers nor sellers, but pursues a middle course between the world's major trading blocs.

Borrowers will want to continue benefiting from negative real interest rates and will look for currencies with sloppy monetary policy and balance of payments problems, which are unlikely to strengthen greatly. Asset-only investors will seek to avoid these currencies, but financial institutions, with liabilities denominated in weak currencies, will be persuaded to invest in them by the salesmanship and financial engineering of Wall Street. Mismanaged currencies, with excessive budget and payments deficits, will eventually become unacceptable to international investors, but the financial machine will denominate a lot of long-term bonds in them first.

It's likely that artificial currency units, such as the International Monetary Fund's Special Drawing Right, will also be substantially used, while in some regions where trade is largely intra-regional the region's currencies may come to be used for cross-border trade even though they are not acceptable on a global basis.

It all sounds very jolly and free-market, reminiscent of the buccaneering days of the early eighteenth century, except for one factor. "Pieces of eight" and Maria Theresa thalers had a real value; they were silver coins and in the last analysis had the value of the silver contained in them. This will not be true of the multiple reserve currencies of 2015-16, which will be paper money, with only the value that confidence in their issuing countries gives them.

By definition, however a world of multiple reserve currencies is one where there is no unit of value in which complete confidence is held. While a major unit such as the dollar can survive a moderate lack of confidence, that may not be true of reserve currencies that derive from relatively small economies.

If for example the Canadian dollar becomes used as a worldwide reserve currency, the Bank of Canada will need to supply the world with Canadian dollars worth many times the value of the Canadian domestic money supply and its economy itself. No doubt Wall Street will oblige through the swap mechanism, supplying the world with unlimited supplies of Canadian dollars for which a global demand has suddenly arisen. However, the currency's position would then be highly unstable; any crisis or change of government in Canada could cause global demand for Canadian dollars to collapse, in turn collapsing the value of the world's Canadian dollars.

The 18th century was well aware of the problems a collapsing paper currency could cause; it had a healthy suspicion of US "continentals" and French "assignats". However, since the Weimar crisis of 1923 we have not experienced any such crisis in relation to a major trading currency. In a world of multiple reserve currencies, we will undoubtedly at some stage experience a collapse in which a major part of the world's trade paper and international investments becomes worthless.

At that point, with the world economy severely damaged and confidence in paper money destroyed, even the world's current central bankers may be forced, kicking and screaming, back onto a Gold Standard.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.

(Republished with permission from PrudentBear.com. Copyright 2005-12 David W Tice & Associates.) 






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