Reserve Currency….What does it Mean and Why it is Changing?

moneyThere are two characteristics of a currency that make it useful in international trade: one, it is issued by a large trading nation itself, and, two, the currency holds its value over time.  These two factors create a demand for holding a currency in reserve. (Pictured left is a billboard announcing the renminbi (Chinese Yuan) as the New World Reserve Currency…interesting they show a gold coin huh?)

Today we are seeing the beginnings of a change.  The Fed has been inflating the dollar massively, reducing its purchasing power and creating an opportunity for the world’s great trading nations to use other, better monies. This is important, because a loss of demand for holding the US dollar as a reserve currency would mean that trillions of dollars held overseas could flow back into the US, causing either inflation, recession, or both. For example, the US dollar global share of central bank holdings currently is sixty-two percent, mostly in the form of US Treasury debt. Central banks hold interest bearing Treasury debt rather than the dollars themselves. Foreign holdings of US debt currently total $6.154 trillion. Compare this to the US monetary base of $3.839 trillion.

Should foreign demand to hold US dollar denominated assets diminish, the Treasury could fund their redemption in only three ways. One, the US could increase taxes in order to redeem its foreign held debt. Two, it could raise interest rates to refinance its foreign held debt. Or, three, it could simply print money.

Of course, it could use all three in varying amounts. If the US refused to raise taxes or increase the interest rate and relied upon money printing the most likely scenario, based on current policy and political climate, the monetary base would rise by the amount of the redemptions. For example, should demand to hold US dollar denominated assets fall by fifty percent or $3.077 trillion the US monetary base or money supply would increase by eighty percent, which undoubtedly would lead to very high price inflation and dramatically hurt us here at home. In short our standard of living is at stake here based on the current path undertaken by the Federal Reserve.

So we see that it is in America’s interest that the dollar remain in high demand around the world as a unit of trade settlement in order to prevent price inflation and to prevent American business from being saddled with increased costs that would derive from being forced to settle their import/export accounts in a currency other than the dollar.

The causes of this threat to the dollar as a reserve currency are the policies of the Fed itself. There is no conspiracy to “attack” the dollar by other countries, in my opinion. There is, however, a rising realization by the rest of the world that the US is weakening the dollar through its ZIRP and QE programs. Consequently, other countries are aware that they may need to seek a better means of settling world trade accounts than using the US dollar.

One factor that has helped the dollar retain its reserve currency demand in the short run, despite the Fed’s inflationist policies, is that the other currencies have been inflated, too.  For example, Japan has inflated the yen to a greater extent than the dollar in its foolish attempt to revive its stagnant economy by cheapening its currency. Now even the European Central Bank will proceed with a form of QE, apparently despite Germany’s objections. All the world’s central banks seem to subscribe to the fairy taled belief that increasing the money supply will bring prosperity without the threat of inflation.

This defies economic law and economic reality. They cannot print their way to recovery or prosperity. Increasing the money supply does not and cannot ever create prosperity for all. What is more, this mistaken belief compounds a second mistake; i.e., that savings is not the foundation of prosperity, but rather spending is the key. This mistake puts the cart before the horse.

A third mistake is believing  that driving their currencies’ exchange rate lower vis a vis other currencies will lead to an export driven recovery or some mysteriously generated shot in the arm that will lead to a sustainable recovery. Such is not the case. Excessive money printing disrupts the structure of production by fraudulently changing the mechanics of capitalism. Capital is allocated to projects that will never be profitably completed. (TARP, Solyndra, Mortgage Debt, ect…) Bubbles get created and collapse and businesses are suddenly damaged en mass, thus, destroying scarce capital.

Because of this money-printing philosophy the dollar is very susceptible to losing its vaunted reserve currency position to the first major trading country that stops inflating its currency. There is evidence that China understands what is at stake; it has increased its gold holdings and has instituted controls to prevent gold from leaving China.  Should the world’s second largest economy and one of the world’s greatest trading nations tie its currency to gold, demand for the yuan would increase and demand for the dollar would decrease overnight.

Or, the long festering crisis in Europe may drive Germany to leave the eurozone and reinstate the Deutschmark. I have long advocated that Germany do just this, which undoubtedly would reveal the rot embodied in the Euro, the commonly held currency that has been plundered by half the nations of the continent to finance their unsustainable welfare states. The European continent outside the UK could become a mostly Deutschmark zone, and the mark might eventually supplant the dollar as the world’s premier reserve currency.

The underlying problem, though, lies in the ability of all central banks to print fiat money; i.e., money that is backed by nothing other than the coercive power of the state via its legal tender laws. Central banks are really little more than legal counterfeiters of their own currencies. The pressure to print money comes from the political establishment that desires both warfare and welfare. Both are strictly capital consumption activities; they are not “investments” that can pay a return. In a sound money environment, where the money supply cannot be inflated, the true nature of warfare and welfare spending is revealed, providing a natural check on the amount of funds a society is willing to devote to each. But in a fiat money environment both war and welfare spending can expand unchecked in the short run, because their adverse consequences are felt later and the link between consumptive spending and its harm to the economy is poorly understood. Thus, both can be expanded beyond the recuperative and sustainable powers of the economy.

We need to look at the concept of a reserve currency differently, because it is important. We need to look at it as a privilege and a responsibility and not as a weapon we can use against the rest of the world. If the dollar is to remain as the world’s reserve currency than a sound money or gold standard will have to be pursued by the United States and the Federal Reserve, if not then the dollar will join the British Pound Sterling and the rest of histories reserve currencies as footnotes of days gone by.

We all have the same interest. We all want to have the highest standard of living for ourselves and our families. A sound money reserve currency offers us the best chance of achieving our shared goal; therefore, one should not reject the idea of a gold or commodity backed standard for money as old fashioned or outdated.  Instead one should embrace and understand the freedom that system would bring the world once again.

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