Friday, April 24, 2009

No Way The US Dollar Is Replaced As The World's Reserve Currency

In recent days, Canada and Sweden have joined most of the other G10 central banks by indicating that they too might have to engage in quantitative easing, now that their interest rates have been reduced to 25 and 50 basis points respectively. The European Central Bank is wrestling with ways to extend its own form of quantitative easing, and an announcement is likely at its next meeting on May 7.

While some observers have focused on the potential debasement of the U.S. dollar by the aggressive monetary and fiscal policies of both the Bush and Obama administrations, many investors are worried about the viability of the whole universe of paper money.

As Gillian Tett, the journalist at the Financial Times, put it in a column earlier this month, there has been a four-decade-long experiment with fiat currencies not backed by gold or silver. The present crisis is so profound that increasingly it appears to have shaken confidence in the experiment. At the same time, the crisis appears to have widened the range of possibilities.

The Special Drawing Rights that the Chinese and others have suggested to eventually replace the dollar do not get beyond paper money. The SDR is a basket of fiat currencies. It is not and cannot be a serious alternative to the U.S. dollar.

Consider that 44% of an SDR is the dollar. The IMF's figures show that roughly two-thirds of the world's reserves are in dollars. If countries' reserves were allocated according to the SDR, the dollar's share of reserves would fall by about a third. While the euro would pick up some slack, the big winners would be the yen and sterling, whose shares of the SDR are 11% apiece, which is two to three times larger than their reserve allocation.

If there has been a shift in reserve allocation in recent years, it is not away from the dollar, as so many wrongly claim. It has been away from the yen and toward sterling. And even this shift has been marginal at best. Reserve managers generally want, in order of importance, security, liquidity and yield. Japanese bonds are often seen as deficient in both liquidity and yield.

Can gold return to its role as the anchor for currencies? The advocates of gold are a passionate and vocal minority that appears to be second in terms of intensity only to Ayn Rand devotees. Of course there is a large overlap among these groups, as Alan Greenspan's 1966 essay "Gold and Economic Freedom" illustrates.

Top Gold Holders (in metric tonnes)

US 8,133.5
Germany 3,412.6
IMF 3,217.3
France 2,508.8
Italy 2,451.8
China 1,054.0
Switzerland 1,040.0
Japan 765.2
Netherlands 621.4
ECB 533.0

Source: World Gold Council

To appreciate why gold is ill-suited today to once again back paper money, we need to consider why the gold standard was ended in the first place. Simply put, the gold standard provided an economic barrier to the political agenda. That political agenda called for rapid growth to resist the spread of communism. It called for "guns and butter" in the U.S., with the Great Society and the war in Vietnam. The European political agenda including the expansion of the welfare state -- from cradle to grave.

Jettisoning gold not only allowed for the pursuit of the political agenda, it helped create the conditions for the rapid and dramatic expansion of trade, capital flows and globalization. What is all too often lost amid the despair and cynicism that the crisis has wrought is the amazing success of that regime. Since 1980, for example, the world economy has grown by 145%. Taking into account the (roughly 1.6% per annum) increase in the world's population, per capita income has risen by almost 40%.

How that wealth is distributed is an important issue that is beyond the scope of this discussion. Yet it is interesting to note that longevity, a measure that subsumes numerous other metrics, has risen sharply in both developing and developed countries, and the gap in longevity between the two has narrowed.

The same problem would exist with a new gold standard that existed with the old. There is simply an insufficient amount of gold. Or to say the same thing, the price of gold that would be necessary to put the international monetary regime back on a gold standard is so astronomical as to make such a plan unworkable.

There are different ways to go conceptualizing the magnitude of the challenge. As the table above indicates, the U.S. has more gold that Germany, France and Switzerland together. Given that foreign investors own about $2.5 trillion more of U.S. assets than Americans own of foreign assets, what price of gold is necessary for the U.S. to no longer be a debtor? Answer: more than $8,500 an ounce.

Another approach, suggested by a Swiss investment bank, is to relate the price of gold needed to cover some measure of money supply. By its reckoning, the U.S. would need gold to be worth about $6,000 an ounce to reintroduce a gold standard. However, it may not be sufficient to simply have the U.S. adopt a gold standard. For the three largest economies (measured at purchasing power parity) -- the U.S., China and Japan -- to back their money with gold, they would require a price closer to $9,000 an ounce.

The price of gold is just above $900 an ounce. It peaked in March 2008 near $1,032. It has averaged $638 over the past five years and $473 over the past 10 years. For the yellow metal to reach the kind of levels that would be necessary to make a gold standard mathematically feasible now would require a protracted period of deflation, and that would not be politically acceptable.

There is no realistic alternative to the dollar. Not SDRs. Not gold. Not the euro. Not the yuan. That might not be deducible from macroeconomic first principles. But it is proven by what central banks are actually doing.

This does not mean that there is no role for gold in individual portfolios, though often people seem to confuse a paper claim on gold for the actual bullion. Also, the touts for bullion often do not include the costs of storage and insurance for gold, which has gone decades without appreciating and, of course, generates no income stream.

Central banks that have accumulated large holdings of foreign currencies, such as those in Asia and the Middle East, tend to have relatively little gold. European central banks, which could not get enough gold during the late 1960s and early 1970s, have turned into sellers in recent years. Paradoxically, as they sold off their gold in an orderly way, the price of gold trended higher. Yet many seem to believe that it is a given that the dollar will fall if these same or other central banks sell dollars. Huh?

China revealed on April 24 that it has dramatically increased its gold holdings since 2003. In 2001, China said it had about 500 tonnes of gold. By 2003, it had risen to a little over 600 tonnes. Now it says it has 1,054 tonnes of gold, more than a 75% increase. Still, this means that gold accounts for only about 1.6% of China's reserves.

China is the world's largest producer of gold, but it also refines scrap gold. As part of the standard arguments, gold advocates assert that all the gold that has ever been mined is still here. That is true up to a point, and it is at that point that the issue gets interesting. China is exploiting the fact that a ton of computers and cell phones has several times more gold than a ton of gold ore.

Central banks in Asia and the Middle East may buy more gold going forward, and European sales seem set to slow (though the IMF sales will reportedly go ahead), but it will be barely noticeably in terms of the international monetary regime and the role of the dollar.

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