Late last March, Treasury Secretary Timothy Geithner stunned world financial markets by stating that the U.S. is “quite open” to Chinese proposals to replace the dollar as the primary world reserve currency. In the Chinese proposal, a “super-sovereign reserve currency” would be run by the International Monetary Fund. Geithner’s remarks instantly caused the dollar to plunge against the Chinese RMB. The Treasury secretary had to retreat. He stated that he expected the dollar to remain the world’s dominant reserve currency for “a long period of time,” and even the Chinese officials claimed that their proposal was only intended for some indefinite future.
What was all the fuss about? To understand the controversy, one must first grasp a paradoxical fact. Suppose that you buy a cup of coffee at Starbucks. How does it happen that you get an actual good, a cup of coffee, for a piece of paper with some writing on it? We take this for granted, but isn’t it odd? After all, if I were to offer in payment a piece of paper with my name written on it, I would hardly meet with success. Why is government paper different?
Dollars, unlike the paper of my example, are backed by the United States government. But this does not resolve our problem. In the days of the gold standard, a dollar was indeed backed by a certain quantity of a real commodity. You could, if so minded, receive gold for your dollar. Now, though, there is nothing behind dollars. So why does presenting pieces of paper enable you to secure goods?
People accept these pieces of paper because they know, or at least have good reason to think, that everyone else will do so as well. The person who accepts your dollars in payment knows that he can use them to acquire goods and services that he wants. This system rests entirely on confidence: if people stopped believing that everyone would accept dollars, the entire system would collapse.
But it is not as though everything is right so long as people think that others will not reject dollars. Money, like all other goods, has a price, determined by supply and demand. An increase in the quantity of paper money reduces its value. If people think that the government is going to inflate the money supply, they value units of money less than before, and prices soar.
The matter is complicated, though not in essence changed, by the fact that most money today is not even paper. Rather, it is credit, issued by banks and other financial institutions. This credit does have something backing it up: it can be redeemed for dollars. But banks do not limit themselves to their deposits of dollars on hand; to the contrary, the amount of credit issued far exceeds what could be redeemed at one time. If people lose confidence in the system, a panic can rapidly ensue. After a collapse of credit, the dollar is in trouble as well.
Here Chinese complaints about the dollar as a reserve currency enter the scene. If I wanted to buy coffee at a Chinese Starbucks, I could not pay in dollars. I would first have to exchange my dollars for Chinese RMB. This presents no problem for a simple transaction, but matters are different for large-scale world markets in commodities like oil. Here it is obviously convenient for a country to have on hand not only its own money but other currencies as well.
A country will wish to hold money that other countries accept. Normally countries converge on one, or at most a few, monies as their main holding. If most countries want to hold large amounts of the same country’s money, that becomes the world’s dominant reserve currency.
The Chinese claim that because of reckless American financial policy, the world has lost confidence in the dollar. It would thus be better to shift to a world money, which all countries would accept. Are they right? Should we accede to the Chinese suggestions? Or should we try to hang on to our position?
When the world operates with paper money, there seem to be advantages if our dollar is the world’s reserve currency. Ordinarily, a country’s central bank faces sharp limits to a policy of monetary expansion. If a country expands its currency, other countries will not want to hold its reserves of that money. Its currency is devalued against less expansionist monetary systems.
Matters differ with a country whose currency is dominant. Because other countries find it convenient to hold this currency, they are reluctant to rid themselves of it, despite inflation. The dominant country thus has much leeway to conduct an expansionary policy. As economist Jeffrey Herbener has noted, “Without the fetter of gold reserves and redemption commitments of dollars for gold binding it, the Fed has no objective constraint in determining the rate of dollar inflation.”
The alleged advantages do not stop here. America can run up a huge balance of payments deficit. This situation differs from a mere trade deficit, in which we buy more goods and services than we sell. In a balance of payments deficit for a particular country, all American items for sale, including financial assets, are less than what we want to purchase from that country. In this circumstance, our currency will lose value, but because the other country still wants to hold American dollars in reserve, we can continue to have such deficits much longer than any other country could.
These advantages come at a price. If another country wants to expand its monetary reach, the pressures of the system inhibit it from doing so. But it may defy these pressures and expand anyway. In that case, there may be disastrous consequences for us. As Herbener explains,
A rogue nation will be tempted to defend its currency, and stave off devaluation, by spending its dollar reserves. Any significant disgorging of dollars would threaten to ignite price inflation in America if the dollars were repatriated. Significant domestic price inflation would, at best, bring a repeat of the 1970s, and, at worst, a hyperinflation.
The chances of collapse increase drastically if countries lose confidence in the dollar. Then the process to which Herbener has called attention would be greatly intensified, as all other countries endeavored to spend their dollars.
What should we do? One answer would be to weigh the advantages of remaining the world’s reserve currency against the dangers. Are the benefits of being able to inflate more than other countries and running up huge balance of payment deficits worth the chance that foreign pressures might ruin our monetary system?
Surely, though, this is the wrong approach. Far from being an advantage, the ability to expand the money supply more than other countries is a grave liability. What happens when we expand the money supply? As Austrian school economists, notably Ludwig von Mises, Friedrich Hayek, and Murray N. Rothbard, have explained, an expansion of bank credit will drive the money rate of interest below the “natural” rate, largely determined by people’s preference for present over future goods. When business people see that money is available at low interest, they will expand production. But the money rate of interest rises after the expansion ceases, because people’s actual preferences for present goods over future goods have not decreased. The businesses that expanded based on these lower rates now must liquidate their enterprises. This liquidation is what constitutes a recession or depression. Our present financial crisis is a prime example.
Unless we want continued depressions, we should reject the supposed benefits of retaining dollars as the world’s reserve currency. But the solution does not rest in adoption of the Chinese proposal of a world monetary system. If inflation by one country is bad, how would shifting to a system that allows global inflation improve matters? If, under a new arrangement, the IMF embarked on inflation, nothing could stop it. The result might be a depression of unparalled magnitude.
We seem caught in a quandary. The present system has little to be said for it, but the replacement would only worsen matters. Fortunately, a solution lies at hand: take money out of the control of the state.
The idea is no mere theoretical velleity dreamed up by free-market extremists. Under the classical gold standard, money was a commodity: its supply was not determined by government fiat but was a quantity of physical material, and that worked very well in the 19th century. A return to this system would be no simple matter, but this salutary reform could be accomplished.
Rothbard’s proposal, explained in The Mystery of Banking, would define the gold content of the dollar so that the government’s gold reserves would equal the sum of Federal Reserve notes and demand deposits. That done, all gold reserves would be distributed to the banks, enabling them to cover their existing obligations. Banks, now solvent, would no longer be allowed to issue money in excess of deposits on hand. They could issue bank notes to supply the public’s demand for paper money, but these notes would be backed by gold: fractional reserve banking would no longer exist. No purpose would then remain for the Federal Reserve System.
Rothbard’s idea must confront an important objection. Once we converted to the gold standard, the money supply could then expand only through new gold mining. But does not a growing economy require constantly increasing money? Without such inflation, we face the menace of deflation. Ben Bernanke becomes almost apoplectic when the word is mentioned. But what is so bad about lower prices? So long as prices are flexible, a growing economy does not require more money: any quantity would be adequate. Decreasing prices and economic growth often go together.
Ron Paul has been the foremost champion in American political life of the gold standard. We would be well advised to turn a deaf ear to Geithner and Bernanke and embrace Paul’s sound common sense.
David Gordon is a senior fellow of the Ludwig von Mises Institute and editor of The Mises Review.
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