For several months, there have been news reports of announcements by bureaucrats in China and politicians in Russia about the need for a new reserve currency to replace the U.S. dollar. One suggestion: substitute the non-currency known as the SDR (special drawing rights) of the non-governmental, non-central bank IMF (International Monetary Fund).
No bureaucrat or politician recommends that his own nation’s currency replace the dollar. This is strange, on the face of it. The United States possesses a unique series of advantages as a result of its reserve currency status. These include the following:
The government can rely on the Federal Reserve System to create money out of nothing to buy U.S. Treasury debt, and then repay foreign central banks with this newly created counterfeit money.
Americans can buy imported oil in newly created dollars.
There is a huge market for its Treasury debt (at about 0% per annum), corporate debt, and even stocks, which foreigners and foreign central banks buy, thereby funding the nation’s gigantic trade deficit.
The world’s commodity futures markets are priced in dollars, making it more costly to trade in other currencies.
National governments possess the advantage of being able to pay off their domestic creditors with fiat money. Why wouldn’t they all love to do the same to foreign creditors? The United States has been doing this since about 1940. Why let the United States retain this monopoly of creditor-stiffing?
I can think of one obvious reason why no politician recommends his nation’s currency. The suggestion would be greeted with howls of derisive laughter. “Use the [ ]? Is he serious?” Then the critics would publish a laundry list of reasons why no one in his right mind would use that nation’s currency as its primary foreign currency holdings. The critics would be correct.
The U.S. dollar got its position fair and square: by staying out of World War II until the British government was clearly broke economically. Hitler then committed the second stupidest political decision of the 20th century: he declared war on the United States on December 11, 1941, which he was not obligated to under the Axis defensive pact, since Japan had attacked the U.S. (The stupidest decision was Hitler’s decision to attack the USSR in June of 1941.) This let the United States enter on the side of Britain, knowing that the U.S. would replace the British Empire as the dominant player in international affairs after the war. Roosevelt self-consciously scuttled the British Empire, and Truman completed this policy. (The best book on this is Otto Scott’s long-neglected masterpiece, The Other End of the Lifeboat, published a quarter century ago by Regnery.)
THEN THERE IS GOLD
There are no reports of any bureaucrat, politician, or central banker who recommends a return to gold as the world’s reserve currency. There is a reason for this. Gold served as the world’s reserve currency prior to World War I. It kept national governments and central banks in check. When they inflated, gold flowed out. Their monetary bases declined in response to the outflow of gold. This transferred control over domestic monetary policy to foreign central banks, gold speculators, and foreign currency users, such as commercial bankers and specialists in international trade.
This transferred sovereignty over money from the nation state to international speculators who put their own money at risk for forecasting incorrectly. They could make large profits by correctly forecasting a nation’s devaluation of its currency. When they believed a nation’s monetary policy was becoming inflationary, they would pull the plug. They would exchange currency for gold.
Central bankers hated this when it happened to them. But they put up with this system from the end of the Napoleonic wars in 1815 until the outbreak of World War I in the summer of 1914. Stable money reduced the risks of currency depreciations. World trade grew rapidly as a result. Prices were approximately the same in 1914 as they had been in 1815.
The price of this price stability was the reduction of control over currencies by politicians and central bankers. This was a political price that politicians always resented. It interfered with their ability to use newly created money to buy votes and weapons.
No central banker or national political leader is calling for a return to the gold coin standard, where citizens and foreigners can pressure governments to stop their legalized counterfeiting.
Nevertheless, it is possible for the central government of any large trading nation to establish its currency unit as the world’s primary reserve currency. The dollar’s position has not been based on gold since August 15, 1971. On that day, Nixon unilaterally took the United States off the gold-exchange standard. There would be no more gold sales to foreign governments and central banks at $35 per ounce.
I offer this strategy to any national political leader and his successors.
THE CRUCIAL PRESS RELEASE
Let us assume that the head of a central bank decides that his bank will become the next Federal Reserve System: the dominant central bank on earth. He issues an announcement.
Beginning tomorrow, this central bank of will no longer buy or sell the debt of our government or any other government. It will also not buy or sell any other form of debt or equity. We are freezing the bank’s currency operations.
To verify this, we have created a new Website that makes available all information relating to the bank’s asset holdings and daily operations.
The bank has shut down its currency-trading desks, domestic and foreign. The employees have been offered an opportunity to take an early retirement at full pay. Any of them who refuse the offer will no longer get a pay raise. They will be assigned the task of answering inquiries by staff members of the Parliament and the media.
The central bank will no longer attempt to influence interest rates, long or short. Since the bank will no longer buy or sell assets, it has no way to back up its official announcements on what the overnight inter-bank interest rate ought to be.
The central bank will no longer lend to commercial banks that offer collateral.
This policy is permanent. It will take five to ten years for us to prove this, but prove it we will.
We will fund existing internal operations from the interest received on present holdings.
It is our intention to replace the United States dollar as the world’s reserve currency. To prove that we are serious, we have removed all of our gold from the Federal Reserve Bank of New York and had it shipped to our national vault. This will confirm the rumors to this effect that began six weeks ago.
All that is necessary to establish a currency as the world’s reserve currency is a central bank that is immune to domestic politics and which follows the press release to the letter on a permanent basis.
The same result could be achieved even more rapidly by a joint press release by the head of the central bank and the Prime Minister.
The news of this press release would have leaked out for weeks. This would merely confirm the rumors.
THE ECONOMIC FALLOUT
Initially, most investors would not believe the press release. They would assume that the central bank will buckle, i.e., knuckle under to government pressure.
The nation would soon be in a recession. Interest rates would climb. There would be no counter-cyclical policy. Commercial banks would go bankrupt. These would include the largest banks.
The economy would contract. Labor unions would call strikes. Production would fall. Unemployment would rise. The bad investments that had been made in terms of the assumption of monetary expansion would produce losses.
As banks went under, there would be monetary contraction. Solvent banks would face a domino effect, since they keep deposits in other, insolvent banks.
There would be no bailouts. The national equivalents of Bank of America, Citigroup, and J. P. Morgan would close their doors. There would be a money panic. There would be a run on the bad banks.
The economy would be in a serious recession and maybe depression within six months.
When it became clear that none of this forced the central bank to go back to its old ways, money would begin to flow into the solvent banks. These banks would gain the reputation of being survivors.
The pain of recession has been too great for any political regime or any central bank to resist since 1933. This is why we live in an age of price inflation. Resistance to market-adjusted prices is universal, especially among economists, whether Keynesian, Chicago, or supply-side. They all preach salvation by inflation.
The U.S. dollar would begin to fall against the reformed currency. There would be ups and downs, because no one would really believe that any central bank and its government would stick to such a scheme.
The reformed currency would move toward a new status: “paper gold.” That is what the original IMF SDR’s were called in the early 1970’s. This was dismissed by one hard-money writer as the equivalent of glass diamonds. So SDR’s have proven to be.
The national government would be forced on domestic saving and international demand to sell its debt. On the one hand, investors would expect the new plan to be abandoned as soon as the government runs out of low-interest buyers. But if the bank stuck to its guns, investors would change their view. On the other hand, foreign central bankers might decide to buy the debt of the reformed currency nation. The nations’ export sectors would want to sell more goods abroad. By creating new money domestically, the foreign central bank would lower the value of its currency, making its exports even more attractive. This would lead to a beggar-thy-neighbor competition among rival central banks. That would make reformed currency look even better.
It would become apparent over time that the reformed currency’s value is due to supply and demand for an asset with a fixed supply. This might take two years. It might take five years. But, year by year, word would get out: this currency is the equivalent of gold. Investors will not have their wealth undermined by the central bank’s policy of monetary expansion.
Private investors seek a profit. An appreciating currency lures in private capital.
Currency futures markets would begin to adopt the new currency.
If the oil-exporting nations began to sell in the reformed currency as well as the U.S. dollar, the world’s marketers would see an advantage. “Buy the reformed currency and wait for its appreciation to lower the price of oil.” Those holding dollars would suffer comparative losses.
Central banks are not profit-seeking. The directors do not own the banks, nor do they represent profit-seeking investors. They are not under pressure to buy high-yielding assets.
At some point, however, central banks would move out of depreciating dollars into the reformed currency. Why? Because of political pressure. Word would get out that the dollar is a loser’s game. Central bankers do not want to be identified as losers.
THE COST OF REFORM
The reason why the BRIC nations — Brazil, Russia India, and China — do not want to see their currencies replace the dollar is because central bankers and politicians are Keynesians. They believe in salvation by inflation. The few Chicago School economists in the staffs are convinced that the central bank can and should inflate to forestall a recession. That was Milton Friedman’s main legacy to the modern world as far as the modern world’s leaders are concerned. He blamed the Federal Reserve System for not inflating, 1930—33.
This is why we see no candidates to replace the U.S. dollar. Any of the BRIC nations could establish policies that would elevate its currency to number-one status. But the price is too high. It is as high as adopting the gold coin standard. It would mean the end of monetary intervention.
The modern world believes in salvation by inflation. So has every civilization except one: the Byzantines, who had a stable gold currency for a thousand years after 325 A.D.
The cost of reform is too high for central bankers and politicians. That cost is the restoration of monetary freedom. None of them is willing to pay that price.
The IMF’s non-currency cannot replace the dollar in the world’s currency markets. So, every currency is counterfeit. The investor has to decide which fiat currency will be best over his lifetime. They are all bad choices.
July 11, 2009
Copyright © 2009 Gary North