Tuesday, March 29, 2022

Cancel the Funeral for the US Dollar: The "Patient" Just Leaped Out of the Coffin

Sealing the USD's coffin requires conjuring up a replacement reserve currency, and that turns out to be a lot more challenging than many understand.

You know the scene in movies where the body-bag is being zipped up or the coffin lid slid into place when the recently deceased startles everyone by suddenly sitting upright? That's an analogy for the funeral currently being planned for the US dollar--a funeral that has been cancelled.

OK, I get it: there are plenty of reasons why so many expect the dollar to die: it's a fiat currency, for goodness sakes, and those always die sooner than expected; US debt is soaring like an Elon Musk rocket; its purchasing power is in freefall; America's unipolar moment is history in a multi-polar world, and let's face it, it's simply not as pretty as other currencies.

Die, dollar, die!

But sealing the USD's coffin requires conjuring up a replacement reserve currency, and that turns out to be a lot more challenging than many understand.

The "death of the dollar" narrative ignores several critical requirements for a reserve currency:

a)  Scale: a reserve currency, fiat or otherwise, must have sufficient units in circulation for commerce, credit expansion and debt service and to hold as reserves. Proposed replacements lack the scale to replace the USD.

b)  Free float: The reserve currency must be allowed to float freely on the global FX markets so participants know the price is being discovered by the market rather than imposed by the issuing nation's leaders.

c)  Backed by interest-bearing bonds that float freely: The reserve currency must be backed by interest-bearing bonds that are priced by the global marketplace, i.e. the value is transparently discovered by markets.

Historically, no fiat currency backed by free-floating interest-bearing bonds has hyper-inflated. Note that "money" can be "printed" or it can be created by the issuance of a new asset, i.e. a sovereign bond paying interest to the owner. The combination of a transparent market discovering price and offering liquidity and the interest paid doesn't lend itself to hyper-inflation because the dynamics of markets act as governors on "money" creation and bond issuance. If the yield is too low for the risk, buyers disappear and the market for new issuance crashes.

Yes, central banks can monetize sovereign debt but central planning is no replacement for the market.

d) Liquid: Both the currency and the bonds must be extremely liquid so a significant percentage of the currency and bonds outstanding can be bought and sold daily. Holders of the bonds and currency must be confident that they can sell in size at any time.

e) Unpegged: All currencies pegged to the USD are essentially proxies of the USD. No currency can be a reserve currency unless it is unpegged and its value discovered transparently by the market, not by a peg managed by central planners.

f)  Convertibility: Many expect gold-backed currencies to rule the world. There is a critical difference between an abstract (and therefore meaningless) claim "backed by gold" and "convertibility to gold" Convertibility means the paper currency can be converted to gold by sovereign holders. When the US dollar was "backed by gold" in the 1960s, this meant France could submit US dollars and receive gold in exchange for the USD. The dollars were convertible into gold.

True "backed by gold" means the currency would have to be convertible to gold on demand. Anything less means the currency isn't actually backed by gold, it's only backed by shuck and jive involving the word "gold."

Let's imagine a currency that is convertible to gold. Let's call it the yuan, oops, I mean the quatloo. So why would anyone hold quatloos when they could convert the paper currency into the real deal, gold? Which would you trust more, the issued paper or the gold itself? Which would you rather hold in a crisis? With the currency, there's a very iffy dependency chain connecting the gold to the currency. With the gold, there's no dependency chain: you have the gold, period.

(Note to self: no wonder I've been called a gold bug for 15 years...)

The quatloo's gold reserves would quickly be depleted in a true convertibility of currency "backed by gold." This is precisely what happened to the US gold hoard in the late 1960s: the gold was being shipped overseas at a rate that would have reduced the nation's gold holdings to zero had the convertibility not been closed.

g) The sum of the parts: The value of a fiat currency is based on more than its sovereign debt and bond yield. The currency's value reflects the entirety of the issuing entity's wealth, economic social and political stability, productivity and financial reliability, with that reliability being set by the entity's reliance on transparent, liquid markets to discover price and value.

h) Markets are transparent, central planning is not: Centrally planned economies are simply not trustworthy financially because they are inherently opaque and are prone to central-planning directives that change the rules and valuations without warning or recourse. The processes of central-planning directives are opaque and therefore unpredictable and not to be counted on.

The requirements of a replacement for the USD are high and no other currency is close to meeting these requirements: vast scale, free float, backed by interest bearing bonds whose price is discovered by markets, extremely liquid markets for the the currency and bonds, the processes that affect valuation are transparent to all holders, and the currency is issued by a transparent system reliant on markets discovering the price of the currency, bonds and risk.

I know, I know, the dollar will die--but not just yet.

The Empire Will Strike Back: Dollar Supremacy Is the Fed's Imperial Mandate (August 18, 2020)




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