Beyond the dollar
By Martin Hutchinson

People's Bank of China governor Zhou Xiaochuan said last week that the Special Drawing Rights (SDR) of the International Monetary Fund (IMF) should replace the dollar as the world's main currency. The political reasons for his proposal are clear, its merits rather less so. Could the world economy work better with a global central bank, whether in the form of the IMF or some other body, and with a global currency as its main reserve unit?

There is certainly a good argument for the world ditching the dollar. It's estimated that the US budget deficit for the current fiscal year that runs through September will be 12% of gross domestic product (GDP). Broad money supply, whether measured by M2 or the St Louis Fed's MZM, has risen at annual rate of 17% in the six months through March 16, before the start this week of the Fed's potentially hyper-inflationary purchase of US$300 billion of Treasury bonds over the next six months.

There is thus no reason to believe that the dollar represents a sound store of value, the principal function of a reserve currency. While liquidity in US dollar debt instruments is enormous and ever increasing as their supply skyrockets, there must be a danger of disruptions in the Treasury bond market similar to that caused by the "failed auction" last week in the UK gilts market, potentially causing price discontinuities and liquidity outages. In criticizing US economic management, therefore, Zhou is on solid ground, reflecting many of the criticisms this column has made of US monetary policy since 1995 and fiscal policy since 2002.

Other major world currencies don't look any more solid than the dollar. The pound is equally affected by the financial services disaster, and the UK has a budget deficit that is as large as the United States in terms of GDP, has been much worse managed over the last several years, and has an economy with very little raison d'etre outside the shrunken financial services sector. The yen has been strong recently, but that strength has caused a collapse in Japanese exports, down in February by almost half from the previous year. Domestically, the Japanese economy had been quite well run until September 2008, but Prime Minister Taro Aso represents a reversion to the worst tendencies of the 1990s, with four wasteful public spending "stimulus" plans announced, a budget deficit as large as that of the United States, and a government debt three times larger.

Only the euro represents a haven of stability, particularly if the German and French reluctance to indulge in excessive public spending spreads to the remainder of the currency's members. While the Mediterranean group of countries have structural weaknesses, their membership in the euro will force discipline on them, and so the chances are that the euro bloc will hold together. If it does, the euro will provide a satisfactory store of value, since the European Central Bank's policy has been far less inflationary than that of the United States and its members' budget deficits are much smaller. The danger is that of the unit's relative novelty; in a deep and prolonged recession, it is possible that Italian, Greek and Irish profligacy will overwhelm German and French good management, either debauching the unit or splitting it apart.

Zhou no doubt regards China's monetary management as a model of solidity. That is nonsense. For one thing, in spite of its $2 trillion in reserves and massive balance of payments surpluses, China has still not allowed its ordinary residents to invest abroad on a free basis. Doubtless that policy results from a desire to maintain the apparatus of a police state rather than from balance of payments paranoia. Still, it is highly immoral, blocking one of the most fundamental and important economic freedoms and protections against arbitrary government. No currency that is subject to an exchange control regime has any claim to be included in the international monetary system, the essence of which is the free movement of capital.

There are also, incidentally, remaining questions about the Chinese banking system. The $911 billion of bad loans in the system estimated by Ernst & Young in the boom year of 2006 will certainly not have diminished and may well have increased further in the current downturn, which appears to be more severe than the Chinese authorities are admitting.

Nevertheless, whether or not his own currency is in a fit state to travel, with $2 trillion of international reserves Zhou has a perfectly reasonable desire that the value of those reserves should not disappear in an orgy of inflationary monetary policy and "Yes, We Can" deficit spending. US authorities may object to this desire, since a withdrawal of any significant portion of China's reserves would irretrievably doom the Treasury bond market, but their right to object is vitiated by their responsibility for the spendthrift policies that led to the dollar's vulnerability.

As the proprietor of a non-convertible currency, Zhou doubtless has only a limited grasp of the purpose of a reserve currency. This is threefold. First, it must provide immediate liquidity for the world's pools of international reserves. Second, it should provide a store of value, preventing those reserves from being artificially devalued. Third, it should as far as possible be "politician-proof", gaining its value through some automatic mechanism that is not dependant on the whims of central bankers and politicians. As the current unpleasantness has demonstrated, central bankers and politicians are only too likely to panic in crises and engage in value-destroying currency debasement.

The gold standard, in place with a few interludes for more than 200 years from its establishment by Isaac Newton as Master of the Mint in London in 1717 until its final collapse in 1931, fulfilled all three purposes admirably. Since gold could be melted down and re-minted in the form of any of the world's currencies, it was admirably liquid. It provided a superb store of value, although that value fluctuated by as much as 20% to 25% with periods of new gold discoveries (California and Victoria for a decade from 1849-51, South Africa and the Klondike in the 1890s) when prices rose, and periods of economic expansion faster than the rate of gold discovery (1870-93) when prices declined. Most important, it was automatic and independent of political and central banker control. Under it, bubbles were throttled fairly early by shortages of specie and downturns were ended by natural means rather than by dissolute floods of money creation.

In an ideal world, we would satisfy Zhou's requirements by a simple return to the gold standard at a parity, of perhaps $1,000 per ounce, that was high enough not to be excessively deflationary. There would doubtless be a few years of disruption, as there were in 1815-19 when Britain was forced into deflation to return to the gold standard at its pre-1797 parity. However, in the long term, the world's monetary system would settle down on the basis of the major currencies being linked to gold. Central banks and politicians would be deprived of much though not all of their power over money creation. Damaging bubbles such as those of 1995-2007 would be cut short by a drain of gold from the banking system, forcing higher interest rates before prices of stocks, housing and commodities got too far out of line.

In the world we live in, that option is not politically available. In any case, with global population growth running at around 1% annually, it is doubtful whether gold can be discovered fast enough to prevent an excessively deflationary price regime under a gold standard. Contrary to the absurdly overblown view of Federal Reserve chairman Ben Bernanke, deflation of 1% to 2% per annum is harmless, even beneficial, but in extreme cases such as that of 1930-33, when US prices fell 25% in terms of gold dollars, it stifles productive investment because holding cash becomes highly profitable in real terms.

Gold mine production in 2008 of 2,407 tonnes, higher than in recent years because of high gold prices, was only 1.4% of the gold stock of 170,000 tons. If velocity were constant, that would not be sufficient to accommodate 1% population growth and desired global economic growth of 3% without an unpleasant average annual deflation of 2.6%. (In the 19th century, gold mine output was higher in terms of the existing gold stock while population increase averaged only about 0.5% annually. The faster population growth and relatively slower gold stock increase after 1900 made the 1920s' gold standard unpleasantly deflationary.) Thus a global return to the gold standard is at present impossible, though it would certainly be feasible and possibly attractive for an individual country.

Zhou's proposal for increasing SDR issuance passes none of the above tests for a reserve currency. Before 1971, the SDR was linked nominally to gold, but it is currently a basket made up of 63 US cents, 41 euro cents and smaller amounts of yen and sterling. The total of SDR quotas is currently SDR 21.4 billion; a proposal has been outstanding since 1997 (effectively blocked by the United States), which would increase that total to SDR 64.2 billion (about US$100 billion.) Smaller than the money supply of Malaysia, that is a laughably inadequate amount of money to provide adequate liquidity for the world's reserves.

Zhou would propose - with the breathless endorsement of senior IMF officials - that new SDRs be created to raise the SDR money supply to an adequate value comparable to the broad US money supply of $9.6 trillion. Needless to say, this would be extraordinarily inflationary.

Spurred by the grossly over-expansionary US monetary policy, and later by similar follies elsewhere, international reserves more than quadrupled in the decade from 1998, rising at an average annual rate of over 16%. Since September, most monetary authorities have pursued even laxer monetary policies, so an epidemic of high global inflation is inevitable once the recession bottoms out. A large expansion of SDRs would greatly worsen that problem, preventing the SDRs themselves or any other currency from representing an adequate store of value, for international reserves or any other purpose.

However, the most serious reason why the SDR should not be used as a reserve currency is its control by the unaccountable bureaucrats of the IMF. Far from being immune to political control, SDRs would be managed by international bureaucrats subject to no outside control by electorates or the market. Such bureaucrats would be at least as prone to damaging panic as domestic monetary authorities. Even more dangerous, they would be free to manage the world's money by whatever cockamamie left-wing economic theories they chose, and to siphon off resources from the world's money supply to every corrupt Third World Marxist regime they wanted to support.

Allowing the SDR to become the world's reserve currency, even on a non-exclusive basis, would place global monetary policy entirely on a non-market basis, without individual countries having any recourse but to purge their international reserves of SDR assets and refuse to accept SDRs in payment - which would defeat the point of the exercise. It is a proposal worthy of the impoverished and genocidal China of Mao Zedong, not the hopeful market-oriented China of today.

If China is really worried about the value of its reserves and wishes to provide a long-term benefit to the world economy and its own citizens' wealth, it has an alternative to the SDR, which would weaken rather than strengthen the trans-national bureaucrat class. The IMF, typically enough, forbids its members from linking their currencies to gold. Governor Zhou should break that prohibition and put the yuan on the gold standard. With $2 trillion in reserves and a structural balance of payments surplus, China can well afford it.

Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found at

(Republished with permission from Copyright 2005-2009 David W Tice & Associates.