Can there be an alternative reserve currency?

June 24th, 2008

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Today, we will answer another of our readers’ question from our earlier article, What is a crack-up boom?,


So in a crack-up boom, will this be different to the times of Germany? There are so many fiat currencies out there, whats to stop Australia for instance adopting the Euro? (I bet there are many reasons). What about if people get sick of $USD, and start trading in Chinese Yuan instead? Or Reals? Is that possible? Due to our global trade system, that was not as highly developed in the time of Germany?s troubles, would that not alter the possible outcome when the crack-up ?conditions are met??

Sergey Stadnik

It the new hyperinflation hits the world, starting with US. What?s going to become such an anchor: gold, oil, Chinese Yuan?

For those who are new to this publication, the context of these two questions lies in the US dollar being the world’s reserve currency. Please note that as always the case, we are not making any predictions about the future. Instead, we are exploring the possibilities with a view to understand what are the economic signs to watch out for.

First, how will today’s crack up boom different “to the times of Germany” in the 1920s? Well, if a crack up boom is confined to only one currency, then it is only that currency’s country that get affected. For example, Zimbabwe is ravaged by hyperinflation today. There is no major economic effect on the rest of the world because of it. But the US dollar is a different- it is the world’s reserve currency. An inflating reserve currency will have an effect on to the rest of the world- see How does the US export inflation?. As we can all read from the mainstream media, inflation has become a global phenomenon, with the sky-rocketing oil prices blamed on the ‘weak’ US dollar (see Can ?weak US dollar? be partially blamed for rising oil prices?).

Now, let us suppose that the US will fall into a crack-up boom (i.e. hyperinflation). As we said before in What if the US fall into hyperinflation? (and we encourage you to read this article for the context), when that happens,

… 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.

Will the Euro become the reserve currency? Or the Chinese yuan? There are a few problems with that:

Firstly, all these currencies are fiat money (in fact, all currencies today are fiat money). As we said before in What should be your fundamental reason for accumulating gold?, money is fiat if it

… enjoys legal tender status through the authority of the government instead of through the choice of the free market. This means that fiat money is not backed by anything physically tangible?it derives its value from an elusive intangible called ?confidence.? Simply put, fiat money is backed by nothing!

For this reason, we can liken choosing a reserve currency to a beauty contest that chooses the least ugly woman as the winner- all choices are bad choice and we have to choose the least bad choice.

Secondly, each of these currencies have their own unique problems.

Thirdly, if an alternative reserve currency is to emerge, it will involve unhealthy economic conflict and competition among the nations (similar to the years prior to the Second World War). A good way to illustrate this instability is to use the reality TV show, Big Brother, as an analogy. In that show, all house mates vie, plot, back-stab and struggle among each other in order to win the one and only top prize. In the same way, the country having the world’s reserve currency will be in a very commanding position. We can be sure that if China vies for this position, there will surely be opposition.

All these problems leave only one candidate to function as the world’s reserve currency- gold. The world used gold under the classical gold standard (there is a brief history of money in Why should you invest in gold?) and it arguably worked very well until the interruption of the First World War. But it will require the global economic situation to deteriorate to the point of extreme pain for the idea of reverting to the gold standard to be entertained. So, don’t hold your breath on that. But if it does happen (who knows?), we can imagine it happening the way we described in What is the future of silver?.

Lastly, can oil function as money? As we said before in Properties of good money, oil does not fulfil the necessary properties to function as money.

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