What a Reserve Currency Should Look Like by Patrick Barron, Mises Institute
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.
Gold Backing Only Works If …
But the risk to a holder of gold backed currency has not yet been completely removed. Two further hurdles need to be crossed. One, the holder needs to know that the issuer of the gold backed currency is not secretly issuing currency that is not backed by the commodity, what Mises calls “fiduciary media.” At the Bretton Woods Conference in 1944 the US promised to maintain a dollar to gold ounce ratio of thirty-five to one. The International Monetary Fund was established at the same Bretton Woods Conference and charged with ensuring that the US honored the agreement, but it failed to do so.
The US issued so much unbacked (fiduciary) media that the Fed suffered a run on its gold reserves as the US’s trading partners scrambled to redeem US dollars for gold at the promised price. Therefore, an issuer of a gold backed currency needs to open its books to periodic and random independent audits.
But even independent audits are not completely sufficient. Complete confidence in a currency requires that the holder be able to take possession of the actual specie without incurring undue cost. For example, the gold might be held in a remote or possibly dangerous location, such as Moscow or Tehran. Worse yet, the currency issuer might refuse to redeem its currency for specie upon demand even though it had honored its promise not to issue fiduciary media.
For example, holders of rubles might not be allowed to take possession of the physical gold in Moscow, even though independent auditors had established that the ruble had not been debased by the Russian central bank. This risk could be mitigated by the currency issuer establishing gold redemption centers in many, convenient places around the world. These redemption centers would promise to surrender specie upon demand for any issuer willing to contract with it to do so and by the currency issuer moving sufficient specie there to reassure the market.
Sound Money Conveys No Special Privilege on the Issuer
Sound money (i.e., money that is backed one hundred percent by specie and for which provisions have been made for safe and dependable redemption) actually conveys no special privilege upon the issuer but, rather, an obligation. The “special privilege” that critics of the dollar have expressed refers to the Fed’s ability to debase its currency. Were it not allowed to do so, the Fed would become simply another market participant producing a good or service desired by the market. In a sound money environment, if the market discovered that the Fed had debased the dollar, demand to hold dollars would quickly erode.
The market’s demand to hold dollars would fall and its demand to hold other, sounder currencies would rise. Once found to be issuing fraudulent fiduciary media (i.e., media not backed 100 percent by specie), international demand to hold dollars might never return, because the Fed’s reputation for honesty had been destroyed.
I fear that the dollar’s reputation has been destroyed. It is no secret that base money in the US has risen tremendously, from $569 billion in March 2000 to $4,083 billion in September 2014. In that time the Fed’s inventory of gold has remained the same at 261.5 million ounces. This abuse of the market has opened the door for others. If any country could convince the market that its currency was sound, by following the principles outlined above, international demand to hold that currency would rise, supplanting the dollar as the world’s primary reserve currency. Furthermore, it would be doing all international market participants a favor. Remember, providing a sound currency conveys an obligation to the issuer to honor its promises; it does not convey a privilege to cheat the market by printing unbacked currency.
The benefits that accrue to issuers of sound money are all ancillary. For example, the British pound represented more than the fact that it was backed by specie redeemable upon demand. The convertible British pound was representative of a nation that honored the rule of law, fair dealing, honesty, and prudence. British law was exported to the world, as was its form of government, because the world recognized that these institutions were part and parcel of its financial and economic success. British bankers, lawyers, and businessmen gained in stature and real wealth because they upheld these values. The redeemable British pound was a daily verification of trust in everything British. In other words, Britain led by example, and the example was the British pound.
One More Thing
So far we have assumed that only central banks can issue money that would be accepted by international traders as a reserve currency. But there still is one risk to holders even of a fully redeemable, gold backed currency — the risk of sovereign suspension of gold redemption by all (or most) of the major central banks. This is exactly what happened at the start of World War I. Regardless of the reason for suspension of gold redemption, a central bank would be protected from court action by its national government. National governments hold the monopoly of coercive force within their sovereign area, so holders of the currency could be denied redemption there, although they might have access to partial redemption of gold held at remote locations. However, a private issuer of a redeemable gold backed currency would have no such protection and national governments would have little incentive to provide it. Courts in many countries could attach the assets of the currency issuer and even bring criminal charges of fraud against the principals, a risk that central bank bureaucrats need not face. Therefore, the ultimate reserve currency is one that is issued by private institutions, such as international banks.
The world needs honest money founded in law to which men everywhere can seek justice in the protection of their trade, property, and wealth. Honest, sound money is representative of an entire society’s dedication to the rule of law, fair dealing, prudence, and reliability. There is no secret to sound money, only dedication to providing its ready and convenient redemption. The perfect reserve currency is provided by private institutions who guarantee gold redemption through contracts with independent agents in many easily accessible and safe areas of the world. Failure of the issuer to redeem for specie would be prosecutable for breach of normal commercial and criminal law. The sooner the world adopts these principles the sooner will it recover from the headlong path to currency destruction to which it is headed today.
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.