Gold as a Currency Backstop

From The FX Matrix (Harriman House, 2013)

Chapter 10 – Be Careful What You Wish For: Reserve Diversification and the Future of the Dollar
“We have gold because we cannot trust Governments.”
Herbert Hoover to President-elect Franklin Delano Roosevelt


The dollar is currently the single biggest reserve currency. Reserve currency status always creates policy difficulties for the issuer and for the rest of the world, chiefly because the issuer wishes to manage growth and inflation policies for its own self-interest and those policies can clash with the needs of the reserve-holders. It is inherently unfair for a single nation to have so much power over the financial fortunes of other nations, who perceive the reserve issuer is dictating their policies. Critics of the reserve currency regime in place today, including important institutions like the World Bank, call for a new regime.

More poppycock is written about the decline of the dollar and the need for a new gold standard and new reserve currencies than any other topic pertaining to foreign exchange. People unschooled in economic theory and economic history assert the principle that the dollar is on the road to perdition because the US abandoned the gold standard, first in 1933 and again in 1971. On no other FX-related subject do emotions run so high.

And yet the dollar remains the numeraire for some 75% of world trade and the dollar remains the top reserve currency among nations. What is at the heart of the persistence of the dollar as the premier reserve currency and on what basis might the euro replace it? The answers have to do with understanding the function of a reserve currency in the first place, which is intimately intertwined with concepts of sovereignty and of country risk. We live in a revolutionary time when these words are being redefined.

What is a reserve currency?

A reserve currency is the currency issued by a sovereign state that both public and private parties in other states use in commerce and finance as a numeraire. Throughout history, countries that trade with one another have found it most efficient to use a single currency.

On the whole, it was the merchants themselves who decided what currency they wanted to use. In the days of Byzantium, it was the gold-based bezant. From the end of the US Civil War to the 1930s, it was the UK pound. From the Bretton Woods agreement in 1944 to today, it has been the dollar. Gold coins of various issuers were, until the late 20th century, almost always acceptable in commerce once their weight was proved, and gold remains today a key component of official government reserves in every country.
Merchants seek the efficiency of a numeraire. Efficiency is the goal of governments in choosing a reserve currency, too – in the event of a sudden need for armaments or food, their reserve money must be accepted immediately by all suppliers.

You might think that the merchants could choose their own numeraire for trade and a government treasury could choose a different currency for reserves, but historically, it hasn’t worked that way. A possible reason is that states acquire reserves by buying the foreign money earned by their own merchants in return for the local currency they themselves issue. Sometimes this is compulsory – merchants are not allowed to hold foreign currency.
You don’t have to be a sovereign to issue a currency. Before the Federal Reserve was established in 1913, individual banks throughout the US issued their own banknotes. Today we have the strange phenomenon of a new creation named the bitcoin, a digital currency that actually works to enable real-world transactions without benefit of a known issuer or fixed value in other currencies.

Moreover, you can be a sovereign and not issue your own currency. Many countries have used the UK pound, pre-EMU French franc, or US dollar as their home currency, including India, Argentina and the countries of French West Africa. The Australian dollar as we know it today was created only in 1966 when the country gave up the Australian Pound, introduced in 1910 and fixed to the British pound. The introduction of the AUD came over 50 years after the Commonwealth of Australia was established in 1901 as an independent country. Australians would argue that their country is entirely its own sovereign, although no one doubts that if the Queen asked, Australia would send troops.

How to qualify for reserve currency status

To qualify as a numeraire and reserve currency, i.e., to be accepted by merchants, creditors and governments, a currency has to meet four criteria:

1 There has to be enough of it to go around, what we today call liquidity. You may think, for example, that the Swiss franc would make a dandy numeraire for world trade, but Swiss money supply is less than the equivalent of $1 trillion and global exports plus imports in 2010 were $28 trillion. There are not enough Swiss francs to go around.

2 Its purchasing power must be stable. Nobody wants to save up a currency that is likely to fall in value. Why might we suspect a currency will fall in value? In the absence of a gold backstop – and no currency in the world today is backstopped by gold – the main source of depreciation is inflation, which literally eats away purchasing power. Therefore, the central bank of the reserve currency issuer must command the confidence of the users that it will manage inflation.

3 The reserve currency must offer investment opportunities. Nobody wants to sit on cash in a suitcase or under the bed that is not earning interest. The institutions offering investment opportunities have to include a wide range of maturities – from overnight to 30 years, and variety – from low-risk to high-risk in a selection of forms.

4 The reserve currency issuer must promise not to expropriate currency held by foreigners, as in sovereign default, or otherwise render it unavailable for an indefinite period of time, as in the application of capital controls.

5 The issuer must be able to defend itself militarily against any enemy which might unravel the first four qualifications, especially the last one.

The US qualifies on all counts as a reserve currency issuer. It has size, liquidity, variety of yields and maturities, military superpower status, and equal treatment under the law guaranteeing no expropriation (except in war-time). The US has never defaulted as a sovereign. In fact, it has everything except people’s full, 100% faith in the anti-inflation resolve of the central bank. More to the point, no other country qualifies on all counts, except possibly the European Monetary Union and China, someday soon.

Predictions of the dollar’s fall

The World Bank predicts that by 2025, six of the emerging market countries, including China, India and Brazil, will account for over half of all global growth and they will stop accepting the dollar as the single reserve currency . It has said that the most likely global currency scenario in 2025 will be a multi-currency one centred around the dollar, the euro, and the renminbi. The World Bank refers to this multi-currency scenario as multipolarity. The Bank noted that the emerging markets as a group will grow by 4.7% per annum to 2025 while the advanced economies will grow by 2.3% p.a. on average, with international financial institutions needing to adapt fast to keep up.

The distress cries about the decline and fall of the dollar wax and wane over time. In fact, they are as cyclical as the world economy and a lot has been written on the subject down the years. If you perform a web search using the phrase “decline of the dollar” you get 18 million entries; Amazon has 53 pages of books on the subject, and that’s not counting the ones that have gone out of print and the acres of forest cut down to print Congressional hearings on the decline of the dollar. Setting aside the cranks and ideologues, many of the authors are clear thinkers with a coherent line of reasoning.

In the current cycle, a very large number of FX market observers believe that the accommodative monetary policy since the 2008-09 financial crisis must be inflationary, and the only way to surmount the now seemingly unsustainable US debt burden is inflation and devaluation. The logical conclusion for them is that loss of confidence in the dollar will lead to other currencies, first the euro and then the Chinese yuan, or a basket of emerging market currencies, taking over reserve currency status.

Unlikelihood of change

These distress cries, including the World Bank’s warning above, are overly dramatic because historically reserve currency status was never the possession of a single nation and reserve currencies – as we will see – are destined to have just the kinds of problems that the dollar and its issuer the US does.

In 1913, sterling accounted for less than half of official reserves, with the French franc accounting for a third and the German mark, a sixth. In the interwar period of the 1920s and 1930s, reserve currency status was shared by sterling, the franc and the dollar. “The conventional wisdom that one currency dominates reserve holdings worldwide thus derives mainly from the second half of the 20th century alone, when the greenback accounted for as much as 85 percent of global foreign exchange reserves.”

The situation predicted by the World Bank further seems unlikely because we have no evidence that the European Monetary Union and/or China would chose to accept the high cost and responsibility of reserve currency status – including the obligation to serve as the lender of last resort to other central banks – even if others are clamouring for a dollar alternative.

Another issue is that reserve currencies are destined to persistent devaluation because global demand for the currency always outstrips the needs of the domestic economy. When the inevitable trade deficits are joined by fiscal deficits, devaluation accelerates. Most critiques of the US dollar fail to appreciate these points and the inability of any reform to overcome them – including elevating other currencies to reserve status, especially the euro and Chinese renmimbi.

Further still, a factor that most reserve currency critics do not address is the wide and deep spread of true capitalism in the two reserve currency nations of the past two centuries, the UK and the US. Capitalism is based on a legal system that allows leveraging property rights to create capital, which is more than mere money. The euro is supported by a like legal system but China is not, so far. Thus the dollar is likely to remain the top reserve currency, if not the only reserve currency, for the foreseeable future.

So, while commentators can agree on the diagnosis of an unjust system and may argue for the euro and renmimbi to become reserve currencies, the central banks of these currencies may be less keen because of the drawbacks associated with such a move – there is potentially a limit to the economic imbalances within the issuer country that reserve currency holders will accept. The US has flirted with this limit several times in the past (inflation) and is flirting with it again in the second decade of the 21st century (public overindebtedness). But people have been predicting the end of the dollar’s reign as the reserve currency for over 60 years. Despite a drop in the percentage allocated to dollars by sovereigns from over 75% to 61% of total reserves over the past two decades, the dollar still retains preferred status. Many in the FX world accept the dollar’s share will continue to drop – but we do not know where the capital will go or how fast.

In this chapter we will survey the unwelcome responsibilities and the criteria that must be met for reserve currency status, and reach the conclusion that the difficulties are so big and complex that regime change is unlikely over the next two decades. As a practical matter, for the US to lose its reserve currency status should be a very frightening prospect – for non-US investors. If you are a US citizen or policy-maker, losing reserve currency status would be wonderfully welcome, aside from the blow to national pride. On balance, for the dollar to lose reserve currency status belongs in the category of “be careful what you wish for.”

Reserve currencies are always doomed

Economists have known the dollar was doomed from the moment the Bretton Woods agreement was signed in 1944. This is because reserve currencies are the fall-guy for conditions outside anyone’s control, least of all the reserve currency issuer itself. It is the nature of the beast to fail in the end because the economic and financial consequences of taking the reserve currency role are heavy.

The inevitable decline and fall of the dollar is due to something called the Triffin Dilemma, also called the Triffin Paradox. Triffin was a Yale economics professor who identified that the reserve currency issuer has a duty to supply larger amounts of liquidity to the world market than optimum domestic policies would call for, thus running a current account deficit.

This was evident during the late 1950s and 1960s, when nations and investors complained about the shortage of dollars (the dollar gap). Further, when the US Treasury decided to stop issuing the 30-year bond at end-October 2001 – because it was paying down the federal debt and didn’t need to raise the funds – the investing world complained bitterly. In the end, suspension of the 30-year issuance was ended in February 2006 in part on rising deficits and an interest in diversifying liabilities, but also in acknowledgement of demand from pension funds and other large institutional investors, including reserve holders.
For foreigners, the paradox is that the issuer becomes ever more indebted to them even as the foreigners need to keep selling goods to the issuer and racking up surplus reserves. The solution for the foreign reserve holder, if it determines that the issuer has acquired an unsustainable amount of debt, is to contract its own economy. The reserve currency that was once the risk-free asset becomes ever riskier as both the reserve holder and the issuer face either severe economic contraction or default. For the issuer, the solution is to stop running trade deficits and to contract debt, thus limiting reserves, but then the world would become illiquid and risk a global contraction – exactly what happened in the Great Depression.

The dilemma for the rest of the world is accepting that the value of its reserves will almost certainly decline over time. The world has to trust and mistrust the reserve currency and its issuer at the same time. The dilemma for the issuer, in this case the US, is that policies optimum for the domestic economy tend to run counter to the best interests of reserve holders and other international investors.

Two policy issues rise to the top – all that liquidity risks inflation and all that debt creates doubt about the ability of any country to pay it back. Countries that cannot repay sovereign debt have an easy way out – devaluation. In Triffin’s day, exchange rates were fixed and devaluation was an occasional thing. But in today’s floating rate world, we still see a persistent tendency to devaluation of the reserve currency. See Figure 10.1, the dollar/mark from 1970 to 1999 and Figure 10.2, the euro from 1971 to the present. These charts are retrofitted (by eSignal) to the period before exchange rates were floated, with a linear regression line superimposed that clearly shows, despite pullbacks, the euro and its legacy predecessors were on a rising trajectory for over three decades.

Some observers and participants decry the dollar’s decline without grasping that decline is its essential nature as a reserve currency in an expanding world. Others find the dollar’s decline an agreeable comeuppance for an arrogant self-appointed world leader that sometimes behaves badly on the world stage. But to colour the Triffin Dilemma with emotion from either side of the spectrum is to miss the critical point: both the reserve issuer and the reserve holders are in the same insoluble fix.

It is the very nature of a reserve currency to fall in value, whether rates are fixed or floating, because it is the reserve currency that facilitates global growth. The only way for the reserve currency not to devalue is for every international participant to embrace rates of growth and global trade far reduced from today’s standards. In most countries with rising populations, this is not an acceptable choice. In a nutshell, the reserve currency issuer and reserve currency holders can have either a stable reserve currency or falling standards of living.

Somebody has to lead

The world needs a reserve currency for practical reasons, as described below, but the issuer of the reserve currency plays a far bigger role than just running the printing press – it is a leader in critical matters. It is vital that the world has a reserve currency of some kind; just look at what happens when leadership is lacking. Charles Kindelberger writes:
“The international economic system flourished, more or less, from 1870 to 1913 when Britain served as world economic leader. The public goods that it provided were a market for surplus or distress goods, a countercyclical source of capital, management of the gold standard that maintained a coherent set of exchange rates and coordinated macroeconomic policies, and the lender of last resort in crises. After 1913, Britain was unable to discharge these functions, and the United States was unwilling to do so. The great depression is largely ascribable to this gap.”

Let’s take two points from Kindelberger’s statement.

First, the great depression may have begun in the US with the stock market crash of 1929 and the wrong monetary and fiscal policy choices, as often charged, but it’s not clear that even the right policy choices in the US would have sufficed to end the crisis earlier in the absence of a properly functioning international financial system.

Second, the job of the reserve currency issuer is to lead the world economy in the sense that it provides a market for goods, is a source of capital, and acts as a lender of last resort. It is inherent in the job of reserve currency issuer that it accept imbalances in its own economy, especially a current account deficit, and that it lose control over its money supply. With vast amounts of reserve currency money in the hands of foreigners able to convert the money to gold (in the old days) or other currencies, in any amount at any time, the central bank of the reserve currency issuer cannot be said to control money supply in any meaningful way.

The chief risk of a shift from the dollar to other currencies as reserve currencies is exactly the same as the shift from the gold standard to the fiat-currency standard – an insufficiency of supply.

Miners do not produce new gold supplies at the same pace as world growth, and so investors substitute the reserve currency. That means the reserve currency issuer is vulnerable to any crisis of confidence in which holders want to exchange reserves for physical gold or some other currency.

This is the sense in which the Bretton Woods agreement that put the dollar at the centre of the financial system was flawed from the very beginning, and the US going off the gold standard in 1971 was inevitable. Before the dollar faced this problem, the UK faced it – and lost. In the interwar period 1918-1939, the UK was forced to go off the gold standard in September 1931, accompanied by a 30% devaluation of sterling (from $4.86 to $3.25 in three months). The US succumbed to the same influences in August 1971, the second year the US trade balance turned negative (for the first time since 1894), taking the dollar off the gold standard and floating the dollar two years later.

At the very centre of the Triffin Dilemma is that global money supply growth, both reflecting and enabling economic growth, is bigger and faster than the growth of gold supplies. In parallel, at the centre of the present-day dollar reserve currency debate is that the US is obligated to produce dollars at the rate of growth of the world, not its own rate of growth, or bearing in mind any other domestic consideration (like inflation). In the end, the leadership role of the reserve currency issuer includes an element of sacrifice for the greater good. Under the fiat money regime we have today, the reserve currency issuer courts inflation. Under the gold standard, the reserve currency country had to expend much effort to increase gold reserves – at the expense of producing all other public goods, like road and bridges. Being the reserve currency issuer may confer prestige, but it comes at a terrible cost.

The debate over gold vs. paper money

At the time of Bretton Woods, the gold coverage of the dollar was about 60%, meaning there was 60¢ of gold in reserve for every $1 of paper money. By the time the US went off the gold standard in August 1971, gold coverage had fallen to 22%. Under the gold standard, the only way the Federal Reserve could expand money supply would be to buy more gold. Abandoning the gold standard was a shock, but on the whole was a healthy development for the global economy, which expanded during the next decade at a far faster pace than before.

The change to the fiat currency basis was frightening to many. Switzerland had so big a capital inflow seeking a safe haven that it had to impose a capital surcharge on non-resident funds in June 1972. It was called a “negative interest rate,” which is not strictly accurate. It was really a form of capital controls, along with a 100% reserve requirement on foreign deposits. The first surcharge was 2% per quarter, raised to 3% and to 10% by February 1978.

What’s so frightening about paper or fiat currencies? Fiat means “let it be done” in Latin, referring to government appointing itself the sole standard-setter. As economic historians and gold buffs alike are wont to remind us, governments tend to create over-supplies of fiat currencies – the Chinese did it in the 11th century – and thus create inflation. As President Hoover told incoming President Roosevelt in 1933: “We have gold because we cannot trust Governments.”

It is literally not practical for the reserve currency issuer to build its own reserves, whether of gold or other currencies, to support use of its currency outside it own borders. The US would have to take an amount equal to about one year of GDP to buy gold and other currencies in order to backstop the number of dollars in use outside the US around the world today. Where would it get such a sum? If the US government diverted funds from domestic spending on defence and social programs in order to build gold and currency reserves, its economy would contract and the voters would protest. More importantly, what would be the point? The real reason to build reserves to backstop global money supply would be to inspire confidence among foreigners using the dollar, which is not a platform one can easily imagine any US politician adopting.

The amount of dollars outside the US is bigger than the amount inside the US. As early as 1985, according to the Bank for International Settlements, dollar deposits in the London Eurodollar market were a larger amount than domestic money supply in the US. Note that the Eurodollar market is outside the regulatory reach of the US government and its agencies, including the central bank.

By 1997, 90% of cross-border international loans were dollar-denominated. By December 2008, the Eurodollar market was $9.7 trillion, more than US M2 money supply at the time – $8.054 trillion – even if you subtract the banknote component in M1 that is incorporated in M2. (More US banknotes are held overseas than domestically.) To illustrate the reach of the dollar into foreign hands, consider during the 2008-09 financial crisis, the Federal Reserve lent to 14 central banks under dollar swap lines. According to the General Accounting Office’s audit of the Fed released in July 2011, of the $16 trillion lent on a short-term basis, the Fed lent over $3 trillion to private foreign banks such as Royal Bank of Scotland, Barclays, Deutsche Bank, BNP Paribas, and UBS and Credit Suisse.
Two consequences flow from the vast size of those balances outside the US economy.

First, they overwhelm any illusion that the Federal Reserve has true control over money supply and thus over inflation. This is because a dollar held overseas can, with the tapping of a few computer keys, become an onshore dollar. Eurodollars held offshore are not really permanently offshore. Money is fungible, meaning a dollar in the pocket of a Cairo street urchin is exactly the same as a dollar held by a Russian bank in London or a gambler in a Macao casino. Experiments (in Belgium and elsewhere) in separating a currency into those for commercial transactions (exports and imports) and those for financial transactions have always foundered on fungibility. The only way the reserve currency issuer can discriminate between domestic money and foreign-owned money is to impose capital controls.

This is the second consequence. In order to manage the money supply and prevent all those Eurodollars from returning to the US and causing inflation, the Federal Reserve would have to brand each dollar with a domestic or international brand, like cattle. To do so is not only very difficult as a practical matter, but runs contrary to the ruling philosophy of the day, which is “let markets be free.” As Russia, for example, starts using the euro as its secondary currency after the ruble, the supply of unwanted dollars goes up and value goes down. This outcome has absolutely nothing to do with the quality of Fed stewardship of the US economy and would occur even if every dollar on the planet were backstopped with gold and other currencies.

The subject of capital controls is a touchy one, to say the least. Developed countries started eliminating capital controls around 1958, ending with the last vestige in 1980 – the UK tax on ownership of dollars that resulted in the “premium dollar,” which cost UK residents 10% to 20% more in sterling terms than the market value of the dollar if they wanted to invest in the US.

Relaxation of US capital controls was proposed by President Nixon in 1970 and initiated after the 15 August 1971 Sunday night announcement of the US abandoning the gold standard. We tend to imagine that free capital markets were a feature of the post-war world, but Bretton Woods co-designer Keynes believed that capital controls were an essential feature of the fixed exchange rate regime and, historically, it was Washington that adopted the free-market model that quickly became ideological orthodoxy. Today no one would support the US imposing capital controls on the dollar, whether incoming or outgoing, because the world needs dollars. Dollars are the machine oil of the global economy.
Note that during the Asian crisis of 1997-98, the IMF and World Bank frowned on capital controls as a palliative, let alone a remedy, for capital flight. Malaysia alone imposed capital controls, forbidding foreigners to remove their funds for one year. The prime minister at the time made some unpleasant remarks about speculators but capital controls were effective. The IMF changed its tune and in 2010 offered that some capital controls in emerging markets (like Brazil) are appropriate.

The real lender of last resort

The issuer of the reserve currency has another responsibility, too – not only providing a larger money supply than it wants for its own economy but also promising to lend to other central banks in the event of financial distress. This is the lender of last resort function. Many central banks have agreements to lend to one another. China has established so-called swap lines with about twenty countries, including Australia and India. Japan has swap lines with South Korea, India and much of the rest of Asia. The word swap is somewhat misleading. In practice, Central Bank A lends dollars to Central Bank B and what it gets for the other side of the swap from Central Bank B is an IOU. Most central bank swap lines are for dollars. Obviously the biggest and most reliable of sources of dollars for emergency purposes is the issuer itself, the Federal Reserve.

If the US is basically unhappy about having lost control of its money supply due to the development of the offshore dollar market, why would it make matters worse by lending more to that very market? The answer is that it’s a moral obligation arising from its role as the issuer of the reserve currency. The US does not always fulfil this leadership role gracefully. As President Nixon’s treasury secretary John Connally famously said, “The dollar may be our currency but it’s your problem.”

Foreign dollar holders are acutely conscious of the US’ forced leadership role and sometimes prod the giant with a stick. In recent years, for example, China has complained that the lengthy period of ultra-low interest rates in the US is encouraging inflation down the road, not to mention depriving China of interest revenue. But were the US to have raised interest rates during the worst recession since the 1930s solely to favour China, US growth would suffer and US citizens would have a legitimate grievance. In fact, Chinese citizens may have had a legitimate grievance, too, since US unemployment would have been higher under rising US rates and thus consumer spending on Chinese imports reduced.

The bigger grievance would have been felt in Europe. The US provides liquidity to non-US parties in copious amounts in time of financial crisis – as noted above, over $3 trillion in the 2008-09 financial crisis to private banks alone. Many non-domestic parties using the dollar have a mismatch between dollar-denominated assets and liabilities, and in a liquidity crunch their own central bank cannot act as a lender of last resort without the help of the Fed. The Fed acts as a reserve currency issuer should act – as a lender of last resort to other central banks.

The Fed has to perform this role only occasionally, when markets become stressed and overseas banks decline to lend dollars to one another on even a short-term basis such as overnight. As an example, say a bank in Germany was funding its dollar loans by borrowing from other banks in the London market, but a crisis such as the 9/11 attacks on the World Trader Center in New York caused the other London banks to decline to do business. The German bank would seek funds from its central bank, the ECB. The ECB, in turn, may need to get dollars from the Fed.

After 9/11, the Fed’s swap lines with the European Central bank (ECB) and Bank of England were reactivated, having fallen into disuse, but used for only three days. In late 2007, the swap lines were re-authorised to help cope with the subprime crisis, with $20 billion named as available to the ECB and $5 billion to the Swiss National Bank. The Fed opened the lines up again on 18 September 2008, when Lehman failed, for $180 billion available to the central banks of the EMU, England, Canada, Switzerland and Japan. At the time, the Fed said there was “no upper limit on collateral,” meaning it stood ready to lend essentially any amount.

Amounts actually used by these central banks can be hard to come by; the Fed shows them as “other assets.” A New York Federal Reserve paper from April 2010 says in the second phase of the swap expansion, from 18 September 2008 to 12 October 2008, “the Fed boosted the available amount by nearly a factor of 10, to $620 billion from $67 billion.” In the third phase of the FX swap line program, from 18 October 2008 to 1 February 2010, the Fed removed the caps from the swap lines with the ECB, BOE, SNB and BOJ. On 21 December 2010, the FOMC extended the lines again to 1 August 2011, and then on 29 June 2011 they were extended to 1 August 2012. Finally, on 30 November 2011, the FOMC and the five other major central banks announced coordinated action to “provide liquidity support to the global financial system.” As part of these measures, the FOMC extended the swap lines with these central banks until February 2013.

What does the Fed get in return? A claim on local currency deposits at the foreign central banks. It’s not hard to argue that these are of no benefit to the US at all, but don’t lose sight of the alternative that failing foreign banks are of no use, either.

The gold standard is a non-starter

Critics say that if we still pegged currencies to gold, we would not need the Fed to act as lender of last resort to the rest of the world. But only about 166,000 tons of gold have been mined throughout all history, according to the World Gold Council, and of that, governments hold roughly 29,000 tons. All the gold in the world is therefore worth about $7.5 trillion (at $1500 per Troy ounce). US money supply alone is $8.4 trillion (July 2011) and there is an equal or larger amount outside the US. We could not return to the gold standard without a severe contraction in every single economy in the world.

This is the central problem of using gold as a backstop for a reserve currency – there is simply not enough of the stuff. The second problem is worse – we still need a numeraire in the form of a reserve currency in which to price transactions and settle debts. Gold is an asset, to be sure, but it is not a financial asset and it is not money. Gold fails to pass all three tests in the definition of money. Money must be more than a store of value and unit of account – it must also have transactional capability.

Moreover, a reserve currency pegged to gold would have its purchasing power determined by international market forces responding to factors outside the issuer’s control, including plain old supply and demand. The issuing country central bank would lack control over internal price stability, employment and market stability. This is the context in which Keynes issued one of his most quoted phrases: “When stability of the internal price level and stability of the external exchanges are incompatible, the former is generally preferable.” Keynes went on, “There is no escape from a ‘managed’ currency, whether we wish it or not. In truth, the gold standard is already a barbaric relic.”

Note that Keynes did not say gold itself is a barbaric relic, but rather that the gold standard is a barbaric relic. Keynes was warning that a system dependent on something as undersupplied and subject to market fickleness as gold was inherently unstable.
Emotions run so high on the subject of the gold standard that we tend to forget what actually happened to cause the US to go off the gold standard in the first place and to float (including devaluation) two years later.

Exorbitant privilege

First, following complaints of a dollar shortage in the 1950s and early 1960s, in 1965 French president de Gaulle launched an attack on the US’ “exorbitant privilege” of being the reserve currency issuer (which provided a built-in buyer of its debt and thus lower financing costs for its government). France announced it would convert $300 million of dollars into gold. Spain followed with $60 million. The 1964 trade deficit was about $3 billion and by mid-1965, US gold reserves had fallen to a 26-year low of $15.1 billion (at $35/oz).
It is thought that de Gaulle was playing the gold card to get US agreement to the French proposal for a new international reserve unit of account named the CRU (collective reserve unit). The unit would be gold-backed and of the member countries issuing the CRU, those with the most gold would have biggest voting rights. By 1967, de Gaulle withdrew France from the US-led Gold Pool – now named the Group of Ten – set up in 1961 to provide emergency intervention funds (and managed by the Bank of England, whose pound shared reserve currency status with the dollar). The purpose of the Gold Pool was to share the costs among central banks of maintaining the price of gold at $35 an ounce rather than depleting US gold reserves. The willingness of a member, France, to act for its own individual good rather than the collective good led directly to the collapse of Bretton Woods when the dollar had to be taken off the gold standard in August 1971.

de Gaulle’s timing was acute, forcing a crisis at a time of cyclical downswing. The year 1967 was a bad one for the two reserve currency countries. The US was building a fiscal deficit for an unfunded war in Vietnam, and the UK economy was weakening. Capital outflows from sterling to dollars to gold accelerated, with a record 80 tons of gold sold in London in one five-day period (and the pound was devalued later that year, by 14%, in November, the first devaluation since 1949). By the end of 1967, US gold reserves had fallen to $12 billion.

By March 1968, the Gold Pool had sent almost 1000 tons of gold to the weighing room floor at the Bank of England, with the US Air Force delivering emergency supplies of gold from Ft. Knox. On 15 March 1968, the US asked for a two-week closing of the London gold market. In April, the Group of 10 met in Stockholm, and thus was born the Special Drawing Right (SDR). SDRs were called ‘paper gold’ but note that they were never called money. Before going on to consider SDRs, fix it in your mind that a return to the gold standard, even if it were realistic, would open the door to a single country wreaking havoc with other countries’ economies and financial systems, as France did. This cannot be an improvement in the present international financial system.

The SDR is a non-starter, too

Russia, China, various Gulf States and even the United Nations have clamoured for years for a non-dollar reserve currency choice and have put forward expanding the use of IMF special drawing rights (SDR) as a dollar alternative.

SDRs were created by the IMF “to supplement member countries’ official reserves.” Shares of SDRs, seen as an international reserve asset, were assigned to each IMF member country, with each member allocated both an asset (SDR holdings) as well as a liability (SDR allocation). When a country has a net asset position in SDRs, it earns interest, and when it holds fewer SDRs, it pays interest. Initially, one SDR unit was defined as an equivalent to 0.888671 grams of fine gold. Later it was changed to a base of a basket of four currencies, the euro, the dollar, sterling and yen. The IMF website says “SDRs can be exchanged for freely usable currencies.”

The basket is reviewed every five years by the IMF Executive Board. In November 2010, the IMF conducted its latest review and decided that effective 1 January 2011, the SDR valuation basket would be composed of the following weights: 41.9% US dollar (versus 44% at the 2005 review), 37.4% euro (compared to 34% in 2005), 11.3% pound sterling (compared to 11% in 2005) and 9.4% Japanese yen (versus 11.0% in 2005).
“The criterion used to select the currencies in the SDR basket remains unchanged from the 2000 and 2005 reviews: the currencies included in the SDR are the four currencies issued by Fund members or by monetary unions that include Fund members, whose exports of goods and services during the five-year period ending 12 months before the effective date of the revision had the largest value, and which have been determined by the Fund to be freely usable currencies in accordance with Article XXX (f) of the Fund’s Articles of Agreement. The weights assigned to these currencies continue to be based on the value of the exports of goods and services by the member (or by members included in a monetary union) issuing the currency and the amount of reserves denominated in the respective currencies that are held by other members of the IMF.”

In its current form, however, the heightened use of SDRs are a hard sell to world central banks and the IMF knows this. In February 2011 the IMF Executive Board said “an enhanced role for the SDR could potentially contribute to the long-term stability of the IMS (International Monetary System), provided appropriate safeguards are put in place and political commitment and private sector interest are mobilised.”

At the same time however, the Board said, “Directors observed that, despite its theoretical benefits, an enhanced role for the SDR faces significant technical and political challenges, which call for realism in assessing its role in practice.”

In other words, even the IMF acknowledges that the benefits of the SDR are theoretical. China and others propose SDRs as the new reserve currency, but SDRs are not money. They may be a useful unit of account but they do not perform the other functions of real money – to execute transactions and serve as a store of value. Individuals and corporations cannot use SDRs – only governments. In terms of replacing the UK and the US as sovereign issuers of the reserve currency, the IMF may be an improvement in the sense that it has no voters to tax or to woo and no wars to fight and to fund. But it is politically unrealistic to think that sovereigns will be able to sell the idea of yet another fiat currency to be controlled by foreigners to voters already uneasy about their own fiat currency. It is also unrealistic to think that the IMF will act without the same self-interest as individual countries; some members will always be more equal than others.
In February 2011, ECB Vice President Vítor Constâncio offered his opinion on dollar alternatives: “I do not see a major reform of the international monetary system on the horizon, as there is no real substitute for the US Dollar in medium term. The special drawing right (SDR) is not a promising option, and the insufficiently deep and liquid financial markets of emerging market economies will limit the role that their currencies can play in the foreseeable future.”

Other reserve currencies

We find it interesting that the latest World Bank report on multi-polarity does not propose the SDR as a reserve currency to replace the dollar. It predicts the euro and renminbi will join the dollar as reserve currencies, and we already have reports that some sovereigns are adding euro to reserves, notably China and Russia.

However, before we get carried away we have to remember that the Chinese currency is not fully convertible and the market for money market instruments is not free of government rate-setting and heavy regulation, and thus the renminbi does not yet qualify for reserve currency status. Even more important is how the Triffin Dilemma would affect the euro zone and China, which would by definition lose control over their money supply, not to mention having their public finances gone over with a fine-tooth comb, just like the US today. As the European peripheral sovereign debt crisis unwinds, we are learning more than we wanted to know about public finances in certain European countries – but we have yet to see China’s books.

Ever since the euro’s inception in January 1999, it was seen as the first viable alternative to the greenback. Its money market, while not as large and deep as the US bond market, is tried and true. The euro was also seen in some circles as a quasi-Deutsche Mark, making for an easy transition as well. The economic boon of having one common euro zone currency also made investors, including the world’s central banks, eager to hold euro in their portfolio. It’s not going too far to say the financial world became besotted with the idea of the euro zone and its currency, the euro. The bloom, of course, came off the rose for the euro in December 2009, when Greece announced that it had lied about its budget deficit for the year. In the months that followed, peripheral country spreads began to widen markedly and the euro was shunned.

The euro zone peripheral debt crisis taught investors a valuable lesson – the euro is still a nascent currency. While they might buy euro going forward as the crisis ebbed and flowed, these investors would keep an eye out for other non-dollar and non-euro alternatives.

Let us also gently suggest that while Germany, with its fiscal rectitude and rock-hard abhorrence of inflation, could no doubt easily become the replacement for the US as the reserve currency issuer, it does not have its own currency. It shares the euro with at least three countries that were in need of bailouts (Greece, Ireland and Portugal) and one that is likely to default in the end despite a second bailout (Greece). At the time of the second bailout, Greece was paying over 30% to attract investors for two-year notes. Does this look like a reserve currency replacement?

If Germany were to leave the euro zone and reissue the Deutsche Mark, it would face the same complaints of DM shortages that the dollar faced in the 1960s. The Bundesbank would be leery of increasing money supply because of its inflationary effect. World growth would slow down to a crawl. Gresham’s Law would come into effect – bad money would drive out good money. In other words, we would be back to the dollar as the sole reserve currency.

So, with all due respect to the World Bank and the IMF, and to critics who long for an impossible return to the gold standard, we are stuck with the dollar, and yes, it is likely to continue a long-term secular downtrend unless and until the US reverses from a severe deficit condition to surpluses, whereupon there will be a dollar shortage and the cycle begins anew.

The changing shape of how currency reserves are held

We often see headlines suggesting that the share of the dollar as a percentage of reserves is declining. Since not all world central banks report the breakdown of their reserve holdings, it is hard to know if the dollar share is actually changing. The International Monetary Fund Currency Composition of Official Foreign Exchange Foreign Exchange Reserves (COFER) data from December 2011 put total FX holdings at $10.197 trillion in the fourth quarter. Of this total, allocated reserves stood at $5.646 trillion. Thirty-four advanced countries and 108 emerging and developing counties report to COFER. Unfortunately, China is not one of these countries. Therefore, economists assume that China allocates its $3.2 trillion in currency reserves in roughly the same percentages as other world central banks.

The IMF COFER data showed that the dollar’s share of allocated reserves rose to 62.2% in Q4 2011 from 61.8 % in Q4 2010, while, amidst ongoing euro zone peripheral woes, the euro’s share slipped to 25% from 26% at the end of 2010. The other noticeable increase was in the percentage share of claims in other currencies (not the dollar, the euro, sterling, yen or Swiss franc) which rose fractionally to 5.3% in Q4 2011 from 4.4% at the end of 2010.

Compare these percentages to COFER data from Q4 1999, just after the euro came into being. Total foreign exchange reserves were a mere $1.782 trillion, with $1.38 trillion reserves allocated. The dollar’s share of reserves at the time was 71% , the euro’s share was 17.9%, with claims in other currencies at 1.6%.

While the 10% decline in the dollar’s share of reserve holdings over a ten-year-plus period could be viewed as disturbing, the dollar’s share of reserve holdings has held fairly steady in recent years. Even in Q1 2009, when the S&P 500 was bottoming at a 12-year low of 666.92, the dollar’s share of reserve holdings was 65.2%. The share later edged down in subsequent quarters as safe-haven buying of US Treasuries diminished and investors again sought out riskier assets.

Recent analysts have begun to single out the rising share of claims in other currencies, which account for a mere $289 billion of the total of the nearly $10.2 trillion total. While the total is small, the percentage change over time is impressive. Emerging and developing economies have seen their share rise from 2.1% in the first quarter of 2009 to 5.1% in Q4 2011, which has begun to meet the accountants’ criterion of material (5%).

China holds the ace

Analysts assume that world central banks are buying other developed country currencies such as Aussie and Canadian dollars and Korean won in an attempt to diversify their assets. What is China buying? A mere 1% shift in the country’s currency allocation would mean about $30 billion hitting the currency market. While that is still a drop in the bucket of the $4 trillion daily turnover, the FX effect could be cataclysmic if China acted in such a way as to create an announcement effect.

In 2010, China announced that it had increased its Japanese government bond holdings and had begun to buy Korean bonds. Throughout the European debt crisis, China has offered a steady helping hand, buying Portuguese and Greek debt along with non-peripheral euro zone debt from time to time and the triple-A-rated bond issues of the European Financial Stability Fund. Without China’s intervention in European debt markets during the crisis, the euro would probably have fallen much further than it did. If the crisis passes without further turmoil, then China will have some attractive yields on its books, such as 7% in Portuguese 10-year bonds. Such high-yielding debt will offset what is likely to be other losses on China’s and other central banks’ books, as longer-dated low-yielding instruments, purchased during the US sub-prime mortgage crisis, begin to show losses as global yields rise.

Chinese foreign currency reserves stood at $2.85 trillion at the end of 2010, compared to $2.4 trillion at the end of 2009, and rose to $3.2 trillion as of end-December 2011. Some of the increase may be due to increased profits on China’s fixed income investments, but the lion’s share was seen as stemming from People’s Bank of China’s intervention efforts to thwart speculative yuan demand from investors. Of the $782 billion reserve increase seen from December 2009 to December 2011, only a small portion appears to have gravitated to the US. Appears is the appropriate word, in that China, along with other Asian and Middle East central banks, employ banks in London or the Caribbean to purchase US instruments.

Looking to gauge foreign inflows, analysts gravitate to the monthly US Treasury International Capital Systems data, called the TICS report, as well as the only recently offered, more detailed yearly TICS report. The yearly TIC report, while backward looking, offers a clearer picture of US inflows and outflows. As an example, final TICS data for 2011 showed that from June 2010 to June 2011 China increased its US asset holdings by $116 billion to $1.727 trillion, with the country’s total stock holdings rising by $32 billion to $159 billion and total debt holdings by $84 billion to $1.568 trillion over the course of the year. The bulk (83%) of China’s debt holdings were in US long-term Treasury instruments. During this same June 2010 to June 2011 period, China’s FX reserves rose by $743.2 billion.
While China’s total holdings remained sizable, the Treasury Department noted that on the year, “Japan, the United Kingdom, the Cayman Islands, Luxembourg, and Canada all increased their holdings by larger amounts, i.e. $192 billion or 14% growth for Japan, $184 billion or 23% growth for the United Kingdom, $146 billion or 20% growth for the Cayman Islands, $195 billion or 31% growth for Luxembourg, and $135 billion or 32% growth for Canada.” While Chinese holdings of US assets increased modestly over the year, analysts red-flagged other countries’ purchases of US instruments as further proof of underlying safe-haven buying and or expectation of US outperformance.

The composition of China’s foreign exchange reserves is a closely-guarded secret, but using IMF’s COFER report, analysts estimate that about two-thirds of the country’s reserves are likely denominated in dollars, with the euro accounting for 26%, sterling 5%, and the yen 3%.

So, if China was not buying directly from the US Treasury in the June 2010 to June 2011 period, we must assume that purchases were likely done via other centres. As mentioned above, the TICS report showed a sizeable $192 billion increase in UK holdings of US assets during this period, as well as a large $146 billion increase in Cayman Island purchases. Middle East and Asian accounts often use London banks or offshore banks to buy US assets. By doing so covertly, there is less embarrassment if there is an eventual loss on the position. And Asian banks especially do not want to report losses on their reserve holdings. In late August/early September 2010, there were reports that the PBOC may have lost as much as $430 billion on the US Treasury holdings, with select board members to be held personally responsible for the losses.

While these reports were later refuted, the understanding that losses are not acceptable remained. By investing reserve assets covertly by using UK and other centres, the PBOC can maintain its anonymity.

In a May 2012 report, the Treasury Department outlined “three pitfalls of the TICS data that can cause misleading interpretations of cross-border flows,” with a few examples:

The TICS data are recorded according to country of the first cross-border counterparty, not the country of the ultimate buyer or actual seller or issuer of the security. So if a German resident buys a US Treasury through a London broker, TICS records this as a sale to the UK, rather than Germany.

The TICS “measured transactions” don’t fully account for deals made on behalf of official foreign investors. If the Chinese government buys US agencies via an intermediary in Hong Kong, TICS will count that as a purchase of US agency bonds by a Hong Kong account.

TICS does not record “important cross-border flows in securities that do not pass through standard broker-dealer channels” and does not “collect data on cross border acquisitions of stocks through merger-related stock swaps or re-incorporations because these transaction are considered direct investment transactions, for which data are collected by the BEA.”

Military power and reserve currency status

Whenever the US engages in a military adventure, such as repelling the Iraqi invasion of Kuwait and the invasion of Iraq itself, the dollar rises. This is not because FX traders are particularly blood-thirsty, but because the US action reminds them of the US’ hard power.
It is a historical fact that the reserve issuer has always been the dominant military power of the day, possibly starting with Babylonia but certainly from the time of the Spanish King Charles V in the 16th century, followed by the United Kingdom in the 18th and 19th centuries, to 1931. In the end, Spain squandered its gold and power, and the UK chose industrial revolution and colonial conquest over preserving and building sovereign wealth in the form of gold. But at the time, Spain and then Britain literally ruled the seas.

Since WWII, it is the United States that rules the seas. British economist R. G. Hawtrey, in Economic Aspect of Sovereignty, published in 1929 and again in 1952, stated that “Power is economic productivity capable of being applied as force, and is represented primarily by output of movable goods and the capacity to move them.” In other words, the top military power is defined by the ability of an economy to maintain military goods, to increase them very, very quickly and to deliver them where potentially needed. This is why we expect the US Navy to move closer to conflicts, whether the Sea of Japan, the Mediterranean or the Strait of Hormuz. In practice, it may not be literally the Navy showing the flag – it can be aircraft or drones or boots on the ground.

Whether we like US military supremacy or not is a judgment call involving non-economic values, but we must acknowledge that the US has it and nobody else does – at least, not yet, and not since the only other challenger to US military superiority, the Soviet Union, dissolved in 1991. Many analysts suspect that China intends to become the next world superpower. Data from the Stockholm International Peace Research Institute shows US military spending in 2010 at $698 billion in 2010 or 4.8% of GDP. From 2001 to 2010, US military spending increased by 81.3%, with China number two, with estimated military spending of $119 billion in 2010 or 2.1% of GDP. In China, military spending increased 189% from 2001 to 2010.

In the third, fourth and fifth slots are the UK, France and Russia, spending respectively $59.6 billion, $59.3 billion and $58.7 billion, or 2.7%, 2.3% and 4% (estimate) of GDP. UK military spending increased by 21.9% from 2001 to 2012, while France’s spending increased 3.3% and Russia’s increased 82.4%.

We literally do not know whether US military power is a necessary condition for its reserve currency status. Just because historically the reserve currency issuer was also the top military power does not mean that the two roles necessarily must go hand in hand. Much of the analysis of US military primacy as it pertains to the dollar’s primacy as a reserve currency is crackpot stuff that can safely be brushed off.

We have no reason to suppose that the necessary conditions for dollar primacy – a very large economy; free, deep and liquid markets; the rule of law (including property rights); political stability, and national security – would change much if China, say, were to surpass the US as a military power, short of invasion and occupation. China has none of those other necessary conditions. If the world were to decide suddenly that the Chinese renminbi would henceforth become the reserve currency, we can imagine that some of the conditions would be created, such as deep and liquid markets, but the remaining conditions depend upon political choices (such as the rule of law, property rights, and financial market prices set by markets and not bureaucratic whim).

Hard vs. soft power

Political scientists speak of the hard power of the reserve currency issuer, which takes the form of being able to run current account deficits and pay lower interest rates on government bond issues, as contrasted with soft power, which takes the form of influence. Some influence is, in fact, pretty hard, as in the application of dollar diplomacy – supporting foreign regimes for the commercial benefit of US companies in places like Latin America, for instance, or to squash ideological opponents. After the end of the Cold War, the ideological motivation was less in play. The American sphere of influence has shifted from the military threat embedded in the Monroe Doctrine (1823) – foreigners, stay out of the Americas – to more economic, cultural and political types of influence. At the far end of the spectrum, but not trivial, is application of US soft power preventing the loud and often rude complaints about US policy decisions that somehow never make it into the communiqués of G8 summits.

One of the costs of being the reserve currency issuer is the loss of prestige and credibility under adverse conditions (like the US twin deficits in trade and public finance). Then, as Cornell University Professor of Government Kirshner writes, the long leash becomes a choke collar.

Although the political and international monetary context is distinct, the experience of Sterling illustrates these phenomena. In the 19th and early 20th centuries, the pound served as the international currency of choice, with London as world’s financial hub. During World War II, Britain was able to quite explicitly cash in on its key currency status, employing the sterling area to its advantage, financing billions in military expenditures in ways that would not have been possible without the mechanisms that were already in place as a result of the pound’s long-standing global role.

The war forced Britain to scrape the bottom of the financial barrel, and the ability to essentially borrow at will in the sterling area and route the pounds back through London was an important element of the war effort. But after the war, the sterling balances became a vexing problem, complicating the management of Britain’s relative economic decline and exacerbating its chronic financial crises in the 1960s. With sterling invariably on the ropes in international financial markets the demand for a clean bill of macroeconomic health placed British budgets – and British military spending and overseas commitments – under constant pressure as a result. It can be argued that the challenges associated with the loss of ‘top currency’ status were at the heart of Britain’s postwar economic distress. Kirshner notes, for example, that “after the war, with sterling in decline, the vulnerability of the pound left Britain exposed and forced it to abandon its military adventure over Suez in 1956.”

The comparison of the UK and US as reserve currency issuers has its limitations, of course. For one thing, the world is far more integrated (flat) today. Currency rates were fixed at the time of Suez. But the hard fact remains that if a country does not have a war chest and cannot raise one quickly at an acceptable cost, its military ambitions are severely constrained.

The current loss of US prestige and power is due not only to the dollar’s decline, but also to acknowledgement that political choices are yet to be made about the massive US debt, at nearly $15 trillion in mid-2011 and reaching 100% of GDP by 2012. Because of various financial crises, including the US subprime crisis and the peripheral euro zone debt crisis, the US has been able to avoid paying the piper in the form of higher interest rates. Safe-haven inflows into dollar assets, including risk-free US government notes and bonds, keep rates not only low, but yielding a negative real return after inflation. This is precisely the exorbitant privilege that de Gaulle complained about 50 years ago – without at the same time acknowledging the cost of being the reserve currency issuer in the form of permanent current account deficits, the need to offer liquidity to all comers, and the responsibility of sane world leadership.

At some point, it is reasonable to assume that those crying wolf will be right and an actual wolf will appear, taking the form of a risk premium for US debt. In the viral way of market thinking, the premium can appear and grow huge before policy-makers can come together to take action. Politicians and voters have to make the choice between raising taxes and cutting spending, including defence spending. If defence spending is, indeed, cut, by how much does the US lose hard influence – the ability to send the Navy in the direction of any conflict where the US perceives it has a stake – and soft influence? No one knows. A gradual loss of power is more palatable and less shameful than a sudden one, but a sudden loss of power could easily come about in the form of China taking a military action contrary to US wishes and the US declining to engage in a showdown.

Such an event would mark only a step, if a shocking one, on the road to the dollar losing reserve currency status. As noted at the beginning of this chapter, the primary function of a reserve currency issuer is to provide liquidity to the rest of the world and to act as a banker of last resort to all the other central banks. China does not get reserve currency status for the renminbi by winning a military showdown with the US if it does not also meet this condition. It is fine for China to make the renminbi a transaction medium for regional commercial transactions and other liberalisations, but it is not until China establishes swap lines with the other central banks and they are depended upon in a real, live crisis, that China will actually get reserve currency status, whatever its military capabilities.

Evaluating China’s prospects as a reserve currency issuer

We should probably assume that any rival for top reserve currency status needs to match the criteria that were used in selecting the dollar as the primary reserve currency at Bretton Woods in 1944. These are chiefly economic and political criteria, including not only the ability to lead but also the willingness. Ability resides in the size of the economy and the capabilities of the country’s institutions, especially the central bank. Willingness to lead is a political matter. The reserve currency issuer has to be willing to lend emergency funds to others who insult and demean it, for the greater good of greasing the world’s financial machinery.

But other factors are in play, too. Should we also assume that the successor to the US as reserve currency issuer needs to have a capitalist economy? And does it have to be a capitalist economy modelled on the US? History suggests that capitalism is likely the most enduring form of economic organisation and thus offers the best chance of institutional survival. Hernando de Soto postulates that:

“Capital is the force that raises the productivity of labor and creates the wealth of nations. It is the lifeblood of the capitalist system, the foundation of progress, and the one thing that the poor countries of the world cannot seem to produce for themselves, no matter how eagerly their people engage in all the other activities that characterise a capitalist economy.”

This is because in poor countries, title to resources is defective – people live in houses to which they do not have title and thus cannot mortgage in order to raise funds. Their businesses are unincorporated and have unmeasured assets and liabilities, and investors cannot find them. Assets are not documented and therefore cannot be leveraged or traded. De Soto calls them “dead capital”.

“In the West, by contrast, every parcel of land, every building, every piece of equipment, or store of inventories is represented in a property document that is the visible sign of a vast hidden process that connects all these assets to the rest of the economy. Thanks to this representational process, assets can lead an invisible, parallel life alongside their material existence. They can be used as collateral for credit. The single most important source of funds for new businesses in the United States is a mortgage on the entrepreneur’s house. These assets can also provide a link to the owner’s credit history, an accountable address for the collection of debts and taxes, the basis for the creation of reliable and universal public utilities, and a foundation for the creation of securities (like mortgage-backed bonds) that can then be rediscounted and sold in secondary markets. By this process the West injects life into assets and makes them generate capital.

“Third World and former communist nations do not have this representational process. As a result, most of them are undercapitalised, in the same way that a firm is undercapitalised when it issues fewer securities than its income and assets would justify. The enterprises of the poor are very much like corporations that cannot issue shares or bonds to obtain new investment and finance. Without representations, their assets are dead capital.

“The poor inhabitants of these nations – five-sixths of humanity – do have things, but they lack the process to represent their property and create capital. They have houses but not titles; crops but not deeds; businesses but not statutes of incorporation. It is the unavailability of these essential representations that explains why people who have adapted every other Western invention, from the paper clip to the nuclear reactor, have not been able to produce sufficient capital to make their domestic capitalism work.”

Capital is not money. Any country can print money – look at Zimbabwe. Capital is created from property and through an institutional process that includes rules, information sharing and measurement and depends fully on a legal property system – in other words, the rule of law that confers legal rights on property owners. Further, “By transforming people with property interests into accountable individuals, formal property created individuals from masses. People no longer needed to rely on neighbourhood relationships or make local arrangements to protect their rights to assets. Freed from primitive economic activities and burdensome parochial constraints, the could explore how to generate surplus value from their own assets.”

De Soto has put his finger on an important difference between the two reserve currency issuers of the 19th and 20th centuries and the putative issuer-in-waiting of the 21st century, China. Formal property rights protect ownership and the security of transactions in the west. Citizens and institutions respect property titles and honour contracts. Once a party asserts title to property, he loses anonymity and can be punished by failure to respect others’ property titles and to honour contracts.

But in China, title to property is often unclear, especially title to land, all of which belongs to the state. Conditions are changing and changing rapidly, but farmers do not have clear title to the land they till, nor to the crops they produce – the state can and does appropriate land and crops at will. We all know the disdain of the Chinese for intellectual property rights, from Hollywood movies to Microsoft operating systems, and the conflation of any criticism with illegal state dissent. Factory owners who produce dangerous products like tainted milk or toxic toys may either escape punishment or be hanged – the rules are unclear. The laws banning pollution that got so much publicity ahead of the 2008 Beijing Olympics were motivated by national pride and not based on the protection of individuals’ property rights or a concept of a social contract promoting public welfare; as of 2010, over 250 cities had no sewage disposal system whatever and discharged raw sewage into rivers.

The concept of human rights draws its heritage from the concept of property rights, and is either absent or only nascent in China, which has no right of free speech or assembly. The US is the destination of millions of immigrants from every corner of the globe every year, many of whom become citizens. Immigrants flock to China from lesser economies in the region but not to the same extent and not from the West. China began formulating an immigration policy only in 2010.

The Chinese economy is growing at rates triple and quadruple the rate of growth in the US and West, and surpassed Japan to become the second largest economy in 2010. It is likely to surpass the US by 2027, according to research by Goldman Sachs. But foreign direct investment into China in 2010 was about $105.7 billion, less than the flows to Germany ($46 billion) and the UK ($71 billion) combined. Into the US, foreign direct investment was $228 billion. To be fair, foreign direct investment ($1.24 trillion in 2010) is growing faster to emerging market and “transition” economies, at the expense of development country flows. Inflows to all of Asia rose 24% in 2010 and to China, the single largest recipient, by 11%.

Capitalism is still evolving in China and does not yet exhibit De Soto’s “representational process.” By this standard, China is not qualified to become the issuer of the world’s reserve currency.

What’s next

Former IMF chief economist Michael Mussa created a formula which measures the willingness of foreigners to hold the dollar as a reserve in the form of a trade-off between economic growth and inflation. Specifically, the ratio of net foreign liabilities to GDP will be stable when the current account deficit as a share of GDP is equal to the rate of growth of nominal income.

This is not really a brain-twister. When the current account deficit rises faster than economic growth, we correctly assume a rise in imported inflation and expect a dollar devaluation that will reduce the desirability of holding dollars as reserves. Assuming the Federal Reserve acts properly to suppress inflation, higher interest rates depress consumption, but may also depress output, which may work counter to improving the current account deficit. The trick is to get more of a drop in consumption than in output.

As Eichengreen states, “Higher interest rates that depress output may then also destabilise the financial system; after all, the combination of higher interest rates and a collapsing exchange rate, occurring against the backdrop of chronic fiscal and external imbalances, is the classic recipe for a financial crisis. None of these scenarios have happy endings for the reserve currency role of the dollar.”

In other words, a US recession is a good thing for the dollar as a reserve currency when external and fiscal imbalances are extreme.

The IMF seems to be right that the euro and renminbi will become co-owners of reserve currency status – there is nothing to say the world needs to have only one reserve currency, as Barry Eichengreen points out. The region around China can use the renminbi and Europe can use the euro. Coexistence is not all that complicated and consists chiefly of building vast accounting systems.

But in a crisis, the central bank of last resort is the central bank of the reserve currency issuer. We see no evidence that the ECB or PBOC are gearing up for this function. For one thing, they would have to disclose the lender-of-last-resort function to their voters. It can safely be argued that US citizens do not have a clue that their central bank is performing this function – and they would not approve if they did know.

For these reasons, it’s logical to deduce that the dollar will remain the primary reserve currency – unless the US shoots itself in the foot and persists in fiscal mismanagement. US indebtedness has reached the point of unsustainability, according to the ratings agencies. The downtrending dollar may be inevitable on the Triffin Dilemma, but it’s accelerated by self-inflicted overspending. Adoption of serious structural deficit reduction measures would slow down the pace of dollar devaluation and probably involve a rally of some not insignificant magnitude, since investors are all to aware of the drawbacks and shortcomings of the reserve currency rivals, not least the reluctance of their central banks to step up to the plate for all comers.