Citizens can be easily coerced into using the government’s currency. Usually it is enough to demand that taxes be paid in that currency. Today, most governments make it illegal to use a foreign currency within their borders.
People in other countries are beyond such simple mechanisms of control. For an international currency, there must be reasons to use the currency voluntarily.
The best currency is the one that is most stable in value. Historically, the premier international currencies, whether the US dollar after World War II, the Dutch guilder in the seventeenth century, or the Athenian owl in the fourth century BC, were those reliably pegged to gold. Gold has been the superlative monetary standard for thousands of years.
Even after the US dollar left the gold standard in 1971, it remained the most stable currency in the world, which allowed it to maintain its prominence up to the present day. There was no better alternative.
During the 19th century, the US was considered an emerging market. The premier international currency was the British pound.
In 1914, the British pound had been pegged to gold (with brief lapses) for 233 years. However, the beginning of World War I tossed all the European powers into turmoil, including Britain. The pound’s link with gold was broken. People in Europe looked for a reliable store of their financial assets. They observed that the United States was untroubled by war and had by then a long history of gold-linked currencies and protection of property rights.
In the 1930s, all European governments devalued their currencies again. The United States did as well, in 1933, but the dollar remained pegged to gold afterwards while most European currencies (and the yen) floated. World War II cemented the transfer of financial prominence to the US To put it quite simply: the US Treasury bond – denominated in gold-linked dollars – was the most reliable store of value in the world.
Financial theorists divide the world of investments into two asset classes: the risk-free asset, and all other risky assets. With currencies mismanaged constantly by central banks, nothing today even approaches the ideal of a “risk-free asset.” In marketing-speak, a vast demand goes unsatisfied.
How could China establish an international currency? I predict it will happen when a person anywhere in the world is able to say: The Chinese government bond is the most reliable store of value in the world – the closest approximation to the “risk-free asset.”
Obviously, we are not there yet. How could the Chinese government promote this process?
The Chinese yuan would have to be reliably stable in value. In the past, this has always meant a gold standard. Fiat floating currencies managed by bureaucrats are never very reliable, and have a nasty tendency of disappearing altogether. In the past, the international currency was always the one that remained pegged to gold, while the alternatives sank into chaos and devaluation.
Chinese authorities may claim that their floating currency managers are better than the US or European floating currency managers, but nobody would believe them.
The yuan would have to be a reliably independent alternative to the dollar, euro or yen. Since 1950, the yuan has had one form or another of a dollar peg. It is completely pointless to use yuan instead of dollars, if the yuan is pegged (tightly or loosely) to the dollar. The desire for stable exchange rates is entirely reasonable. However, the Chinese government has not established any record of being able to manage an independent currency.
Simply having a floating currency is not enough. Both the euro and yen float, but they are not really independent of the dollar. Monetary policies at all three central banks are eerily similar. The Bank of Japan, in particular, seems to be subject to political pressure from the United States. If the dollar were to fall in value considerably, it is likely that the euro and yen would also be guided lower to avoid disadvantages to trade. They would all decline together, if not quite at the same speed.
To put it a slightly different way: Even though people are getting nervous about the reliability of the US Treasury bond, neither the German government bond nor the Japanese government bond are clearly better.
If China adopted a gold standard policy, this would establish true independence from the dollar. However, if the dollar fell in value considerably, then the yuan/dollar foreign exchange rates could change dramatically. Instead of about 7:1 today, perhaps it could go to 1:1 in the future. This would be due to a dollar fall, not a rise in the yuan.
Many countries could not tolerate such a situation. Switzerland tried, in the early 1970s, but the trade consequences were too great. It would be quite unpleasant for China as well. However, China already has significant trade advantages, so even large forex moves like this could be withstood.
The Gulf States – and Russia to some degree – have an even larger advantage in this regard. They have no real competition for their primary export, crude oil.
A credible military remains, unfortunately, an important component of political independence, and consequently currency independence. The US is not likely to hand over its mantle of world leadership without complaint. While hostilities are unlikely, certain political pressures by the US can be imposed upon governments who, in schoolyard terms, seem like they can be pushed around. Japanese leaders remember the military exercises the US Navy conducted in Tokyo Bay in 1989, a rather blatant reminder of the Black Ships of 1853. Russia is well aware of political incursions in the former Soviet republics, and even Germany still hosts enormous US military bases.
China is establishing itself as a military power. An alliance with Russia, and acquiescence among the other Asian states, would help establish real political independence.
There remains a little problem of exactly how to manage a gold standard system. This is not very difficult, but the Chinese monetary authorities apparently have not yet mastered the basic concepts involved. Fortunately, there is now a handbook on these subjects – Gold: the Once and Future Money (2007), which is available in a Chinese edition.
The US dollar is, quite frankly, not a very good currency. It would not be difficult to develop a better alternative – a currency pegged to gold. Once the Chinese authorities had demonstrated that they can manage such a system, people everywhere would flock to yuan-denominated assets. Lenders would demand that their loans be denominated in reliable, gold-linked yuan. Shangahi would become the financial capital of the world.
for The Daily Reckoning
Nathan Lewis was formerly the chief international economist of a leading economic forecasting firm. He now works for an asset management company based in New York. Lewis has written for the Financial Times, the Wall Street Journal Asia, the Japan Times, Pravda, and authored Gold: The Once and Future Money.
The Chinese are promoting a currency comprised of many countries including gold. What is this article supposed to be about?
that very tired, old and re-tred concept of a “market basket of currencies”. currencies by their very definition are NOT money. long ago I learned the characteristics of real money. Store of Value and Fungibility were only two on that list. I learned this in High School, from an ecominics teacher who had been a Korean Police Action Fighter Pilot. others can research the rest. whatever.
Shouldn’t the title of this article instead be “How To Establish an International Currency”?
Government run stable currency? Balderdash. For a genuinely stable international currency based on gold, look to a private and independent company to store gold and issue certificates on it. It is entirely possible for a company to be profitable on the basis of absolute, unshakeable integrity. Look at Bureau Veritas in the shipping world. Their only stock in trade is their integrity. How such a gold company would operate and charge is beyond my modest ability to specify, but it would work. And work damned well.
Nathan, you forget one very important point: what does China has to gain by displacing the US$? So far China holds an enormous amount of US$ denominated bonds. If a gold-based yuan – or a new Chinese gold-based currency – were to become the new world trade currency, the US$ would devalue precipitously, to the advantage of the US, who will pay its debt in devalued dollars, but to the disastrous disadvantage of China – as well and Japan and other major holders of US$. Hence, I repeat my question: what does China has to gain from taking over the world currency?
My question: What does China have to gain holding a doomed fiat currency?
How long can the $ be trusted when the aim is to deflate US debt. China and others can see that the writing is on the wall, at some point holders of the $ will head for the exit. One more thing if China takes over the world currency they can create cash and buy whatever. They might even keep it going for as long as the USA did, at least they might think they could.
I am reading and enjoying Nathan Lewis’ book Gold our once and future money. But it is very unfortunate that it ends in 2007, and since then a lot has happened, and it would have been great had he posted a blog updating his analysis regularly to cover the unfolding recession. His article above claims that China could allow the RMB to go to 1:1 against the USD. That would mean NO EXPORTS AT ALL. Do we take Nathan Lewis’ theory as showing that a Gold Standard could only work if everyone was on one? In recent years, the dollar has fallen a lot against gold, and any currency pegged to gold would have forced a huge crisis on its home economy.
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