Not Good as Gold
The case against global currency schemes, whether Chinese or American

by David Gordon
by David Gordon

Late last March, Treasury Secretary Timothy Geithner stunned world financial markets by stating that the U.S. is “quite open” to Chinese proposals to replace the dollar as the primary world reserve currency. In the Chinese proposal, a “super-sovereign reserve currency” would be run by the International Monetary Fund. Geithner’s remarks instantly caused the dollar to plunge against the Chinese RMB. The Treasury secretary had to retreat. He stated that he expected the dollar to remain the world’s dominant reserve currency for “a long period of time,” and even the Chinese officials claimed that their proposal was only intended for some indefinite future.

What was all the fuss about? To understand the controversy, one must first grasp a paradoxical fact. Suppose that you buy a cup of coffee at Starbucks. How does it happen that you get an actual good, a cup of coffee, for a piece of paper with some writing on it? We take this for granted, but isn’t it odd? After all, if I were to offer in payment a piece of paper with my name written on it, I would hardly meet with success. Why is government paper different?

Dollars, unlike the paper of my example, are backed by the United States government. But this does not resolve our problem. In the days of the gold standard, a dollar was indeed backed by a certain quantity of a real commodity. You could, if so minded, receive gold for your dollar. Now, though, there is nothing behind dollars. So why does presenting pieces of paper enable you to secure goods?

People accept these pieces of paper because they know, or at least have good reason to think, that everyone else will do so as well. The person who accepts your dollars in payment knows that he can use them to acquire goods and services that he wants. This system rests entirely on confidence: if people stopped believing that everyone would accept dollars, the entire system would collapse.

But it is not as though everything is right so long as people think that others will not reject dollars. Money, like all other goods, has a price, determined by supply and demand. An increase in the quantity of paper money reduces its value. If people think that the government is going to inflate the money supply, they value units of money less than before, and prices soar.

The matter is complicated, though not in essence changed, by the fact that most money today is not even paper. Rather, it is credit, issued by banks and other financial institutions. This credit does have something backing it up: it can be redeemed for dollars. But banks do not limit themselves to their deposits of dollars on hand; to the contrary, the amount of credit issued far exceeds what could be redeemed at one time. If people lose confidence in the system, a panic can rapidly ensue. After a collapse of credit, the dollar is in trouble as well.

Here Chinese complaints about the dollar as a reserve currency enter the scene. If I wanted to buy coffee at a Chinese Starbucks, I could not pay in dollars. I would first have to exchange my dollars for Chinese RMB. This presents no problem for a simple transaction, but matters are different for large-scale world markets in commodities like oil. Here it is obviously convenient for a country to have on hand not only its own money but other currencies as well.

A country will wish to hold money that other countries accept. Normally countries converge on one, or at most a few, monies as their main holding. If most countries want to hold large amounts of the same country’s money, that becomes the world’s dominant reserve currency.

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Copyright © 2009 The American Conservative

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