In our previous article, New tricks required to bail out financial system, we mentioned about not ruling out the possibility of hyperinflation. In response, one of our loyal readers asked these questions:
How do you think the effect of hyperinflation in the US would impact on the global economy? Surely the world would need to adopt a new base currency? I know many suggest the Euro, as unstable as that actually is.
To go one step further, what do you think would happen if the Euro became the base currency? Given it’s problems(?) due to it spanning many countries, do you think that it would even last long? I suspect that as soon as the global base currency changed, it would be a very volatile time for everyone.
Yet another question: If the US currency was no longer the base currency, what effect do you think this would have on the US itself, when it would be trying to deal with it’s economic crisis?
These are good questions and we must admit we do not have all the answers. There are far too many Black Swans and tricky dynamics lurking around the extremely complex global financial-economic landscape. So, these are just our feelings, hunches and guesses. But we have some thoughts that may be useful to you to ponder on.
The US dollar is the world’s reserve currency, which places the US at a highly advantageous position. As we said before in Awash with cash?what to do with it?
The US, being in the enviable position of having its money as the world?s primary reserve currency, is not subjected (for now) to the same rules as the other countries?it can spend more than it earns simply by printing its own dollars to pay foreigners.
A hyper-inflationary US will occur in the context of highly and rapidly depreciated US dollar. That spells big trouble for nations with massive hoard of US dollar reserves. For example, China, which currently has $1.68 trillion US dollar reserves, is the first country that comes to our mind. Other countries include Japan, Russia, Middle East, and so on. As we said before in Why did the foreigners bail out cash-starved financial institutions?,
China?s trillions of US dollars reserve is a form of savings that will be used to acquire their future needs for resources to power their economy in the long term. Therefore, any threat to the long-term value of their savings will be a long-term threat to their economy.
Thus, if the US dollar collapse right now, China’s rapidly growing economy will immediately suffer a big bust. However, we guess that such a bust may just be a temporary setback in the larger scheme of things in the very long run (measured in terms of several decades)- we will explain more on that later in this article. For the Middle-Eastern countries, it is their oil dollars that let them live such a decadent and dependent lifestyle (note: we are generalising here). A collapsed US dollar will spell the end of such decadence even though as long as their oil tap remains running, they will probably live okay. But assuming that the Peak Oil theory is true, we wonder how much longer their oil tap can keep on flowing?
Since a collapsing US dollar means terrible unimaginable consequences, we expect countries like Europe, China, Middle East and Russia to be doing something quietly in the background. But it is not easy because if they do so in a hurry, there will be severe disruption in the financial markets, turning a US dollar rout into a self-fulfilling prophecy. What can these countries do? We see two major courses of actions:
- Slowly and quietly diversify away their US dollar reserves. Obviously, none of these countries will be doing so while talking about it with their megaphones- the US dollar will crash straight away if they act so foolishly. Also, they will probably not get rid of all their US dollars. What if the US dollar still remains the world’s reserve currency? They will still want to have some, just in case.
The next question is, what will they diversify into? Euro is a commonly nominated currency. But the Euro has its own problems. For one, it is a currency spanning many nations with diverse growth rates, culture and economic structure. If Australia’s two-speed economy (booming Western Australia and stagnating New South Wales) poses a tricky problem for monetary policy, imagine the difficulties faced by the European Central Bank (ECB). In addition, there are even some murmurings (and threats) about the political break-up of the European Union. Some even say that the Euro is not viable as a currency in the long run. So, saving all currency reserves as Euro is risky (these are Black Swan risks). Still, as usual, the diversifying nations may want to have some, just in case. Anyway, the Euro is still in an up-trend against the US dollar, which indicates that diversification towards it is under way. Will the Euro become the new reserve currency? Honestly, we do not know.
Could the Chinese RMB be the choice for diversification? If so, this implies that the Chinese RMB becomes the new reserve currency, supplanting the US dollar. This is possible, but we would not want to place out bets on it. Some investors like Jimmy Rogers are very much in favour of accumulating Chinese RMB though.
- Since there is so much to lose from a collapsing US dollar, we can be sure that central bankers around the world are collaborating together to avert a sudden loss of confidence in the US dollar. If possible, they may even want to engineer a rise.
Now, in this age of freely fluctuating currencies, the currency’s value is a relative concept. For example, a falling US dollar implies a rising Australian dollar. Therefore, one way to ‘maintain’ the value of the US dollar relative to the Australian dollar is to devalue the Australian dollar. Perhaps this is the route that central bankers will concertedly take to instil ‘confidence’ in the US dollar in order to create the illusion that the US dollar is still a reliable store of value? Well, they can try, but growing global inflation and skyrocketing gold price relative to all currencies will be tell-tale signs of such a dirty trick.
Anyway, a disorderly flight from the US dollar is a Black Swan event that will result in a mad scramble to find a reliable alternative. It will be a time of volatility and uncertainty. No prize for guessing that gold will be the primary beneficiary when that happens.
Now, what happens if one day, the US dollar no longer becomes the reserve currency? When that day arrives, future generations of Americans will live far much worse their fathers and grandfathers. Why?
The never-ending ballooning Current Account Deficit (CAD) of the US is a reflection of the nation’s spending beyond its means (see Understanding the Balance of Payments for what Current Account Deficit means). The only reason why they can get away with it for so long is because of their reserve currency. As we said before in How does the US export inflation?,
Through this convention [of the US dollar being the world’s reserve currency], the US can expropriate resources from foreign countries by buying their goods and services with its own printed money.
Once the US dollar loses this special status, the nation loses its power to expropriate resources from foreign countries. Since the US has been doing this for decades, their economy’s capacity to cater to the nation’s needs has largely being eroded. In the jargon of the Austrian School of economic thought, the US had been eroding its economy’s capital structure and engaging in capital consumption. An analogy for this situation would be this: Let’s say a king had been spoon-fed with a silver spoon since a child. He was reliant on this servants to take care of his everyday needs as well as to cater to his every whims and fancy. One day, a revolution broke out and the king was overthrown. All of a sudden the king was reduced to a commoner. It is unlikely that he can fend for himself because he does not have any essential life skills every commoner has to learn from young.
Now, remember we said before that in the event of a US dollar collapse, China’s boom will turn into a bust but that “bust may just be a temporary setback in the larger scheme of things in the very long run.” Over the past two decades, China had been busy building up the capital structure of its economy. It had been busy accumulating savings, skills, infrastructure and industrial capacity while the US had been running them down. Therefore, a Chinese bust will just be a setback. An American bust, on the other hand, is a different story- it will be longer lasting, deeper and more traumatic.
We remembered Warren Buffett saying that he believes Americans in 20 years time will live better. We do not share his optimism.