Spoiler Alert

This seems to be the weekend of currency collapse discussions.

Many of the comments and links have been well-thought cases for a cascading collapse of the US Dollar as global reserve, with arguments for its replacement with gold and/or silver.

One poster even suggested that digital ownership and transfer of bullion can overcome the perennial problem of weight, cost of transfer, and the concentration issue that arises from trade imbalances.

Let me throw my nominee into the ring, and explain why I think there won’t be the spectacular “break” so many are predicting, followed by a post-apocalyptic financial landscape.

Before I forget, the reason I call this a “spoiler alert” is that it floats one of the dozen or two ideas George Ure and I are kicking around in our upcoming book of economic and investment ideas for sentient adults who see that things aren’t going according to plan.

To put it in the proverbial 25 words or less, the US Dollar may be approaching its denouement as the single reserve currency for world trade.  I’ll suggest a potential replacement path that doesn’t take a detour through a Hieronymus Bosch painting.

You can argue (endlessly) about why the Dollar can’t take the stress, and you’ll no doubt stir up some hot partisan political rhetoric doing so.

I’m not interested.  For example, I don’t don’t think it matters one bit what politicians in the US say about acceptance of our currency by trading partners overseas or its use as a reserve by central banks.  In point of fact, there is nothing they can do about the choices of private companies or foreign countries when they decide how to be paid for their goods and services.

I’m more interested in how the system may evolve toward another paradigm.

I think there may well be a transition to currency baskets, as that is already in process among global trading partners in deals we are not a party to.  It’s only a matter of time until global oil trade, soft commodities and the world of Letter of Credit supported trade of all types shifts, in part, away from the dollar.

But to what?  The Euro is a mess.  The Yen is still feeling the doldrums of the Lost Decade (and counting), and the Asian Tiger economies are simply too volatile and small to support currencies that will work for any amount of time with global trade the size it is.

The intermediate answer is likely to be a basket of currencies.

But that still leaves the “fiat currency” issue, and nearly every central bank is creating liquidity like mad to counteract ever-slower economies burdened with cyclical slowdowns plus policy-driven austerity.  More than one person, company or country loading up its bulk carriers, tankers or container ships may feel that a portfolio of weak currencies is really no better than just one.

So why not gold?

Because the big issue that made the Great Depression go global was the fact that reserves were drained on one side of the Atlantic to meet obligations on the other side.  Unbalanced trade has no way to re-balance if the medium of exchange gets delivered until one party to the relationship looks into the vault and finds it empty.  At that moment, trade stops.

The US Dollar (so far) has had a means of balancing the books, by the mechanism of debt issuance.

I know that’s anathema to the “hard money” advocates, but I think they haven’t thought about what happens once all the chips are on one side of the table.  They think that as long as they have some of the new “chips,” they’ll be OK.  I beg to differ.  If a few billion people have nothing to lose, they will tend to do drastic things, things no one wants to see happen.

And before you say that prices will adjust and the chips won’t end up on one side of the table, think again.  If the domestic pressures are high enough, governments will ignore the peril to their reserves and keep buying the commodities their people require.  Think cooking oil, rice, crude oil or wheat.  If the choice is to fall out of power or keep the people fed, Prime Ministers and Presidents in any political system will keep on buying as long as they can.

Just look at history to see what I mean.  Even before America revved up its war machine for World War II, it was an overwhelmingly large opponent for the Empire of Japan.  Their military was already overextended in China and the rest of Asia.  Still, they felt they had no choice but to attack Pearl Harbor because America cut off their oil supply.

We would be kidding ourselves to imagine that any global financial system that always required payment vs. delivery wouldn’t engender just these kinds of problems in the future.

Why do you think the debt-based system has lasted this long?  Because nations have the ability to tax their citizens, extract resources, or earn exchange credits in some other way.  Until the debt got so large that it became clear some nations couldn’t pay, that worked.

So let’s not go to the simplistic solution of only trading C.O.D.  That almost certainly would lead to a drastic decline in global GDP, a decline so large that a big percentage of the people on the planet might not survive.

Let’s look at backing currencies with something of value because of its utility.  Let’s consider doing so with renewable wealth. I pick energy in all its forms, since we already know the physics formulae to convert KWH, BTUs, BOEs, etc into each other.

But wait!  What about Peak Oil?  Sure.  But there’s coal, natural gas (fracked), nukes, hydro, solar, wind, tidal power, geothermal, and maybe some day deep ocean methane or oil-producing algae.  In one sense, all but nuclear power is just solar power with up to a hundred million years of delay.

The good news?  The sun will keep sending us new energy for another few billion years.  As we get better at catching it, storing it and using it in all its forms, we’ll be able to grow our usable supply of energy over time, and grow our economy.  Maybe we’ll even keep up with population growth.

My favorite part of this plan?  If you need to take payment from your counterparty, it will be very useful to you, something you can’t say about their fiat currency, or their $5,000 an ounce gold.  Basically, unlike Rooster’s well-argued currency idea that requires non-economic value to work, this actually bases itself on a set of deliverables that can be used by the recipient to do more than trade onward for something else.

By the way, one of the issues that may be raised is the idea that the currency would vary too much.  Too much for what?  Even if it varied as much as a barrel of oil (which careens around far more than capital-cost-derived kilowatt hours, for example), the variability is not too much more than currencies themselves.  And for those who prefer gold — fuggedaboutit.  600% in one decade?  So maybe the convertibility sets a floor value.  Interestingly, that may work out well, since currencies tend to fall when an economy is weaker, which is also when the price of energy components tend to fall.

I should make it clear that I believe the participants in the market will decide what to trust in their money and trading, and I believe that no politician can dictate those terms, especially for others.  On the other hand, it might make sense for countries to take actions that make their currency more attractive.

I don’t kid myself that this (alone) would stabilize the world economy, or that there wouldn’t be the normal variance caused by supply and demand during business cycles.   I’m just saying that countries who agree to back their currencies with energy units might find themselves enjoying the benefits (acceptance of debt at lower interest rates, for example) that comes from being a reserve currency.

I’m not saying we’ll get rid of currencies, or bank accounts, or central banks.  I’m saying those work for what we need them for — daily commerce with minimal friction.  We need the divisibility, ease of transport, and fungibility that currency gives us.

But if we get to a place where the world needs backing for currencies, given the fiscal imbalances in the US, Europe and Japan, I think converting currencies into BTUs might be the way to go, since even when the cupboard is bare, petrochemical extraction, solar collection, hydro power, etc. can replenish that cupboard.  That might even satisfy the “audit the Fed” crowd, assuming they’ll believe that Bonneville Dam will still generate electricity tomorrow and the next day.  Layer in some debt to handle cold winters or cyclical downturns, and you might have a system that could survive the next couple of centuries.

By then, there will be new problems, but they will be somebody else’s to solve.


13 Responses to Spoiler Alert

  1. Raymond May says:

    can a currency really be backed by a consumable? it would be like burning money

    second because energy was money this would lead to a huge oversupply, leading to too much energy, and then deflation – no

    • harold young says:

      How about food as a world wide currency? We have the best potential production than any country. That would solve the unemployment problem; i.e. put every one to work in the flelds, make your own garden and get rich.

      • hhill51 says:

        I know you’re just kidding around with me, but you have put your finger on the reality that a country such as ours can and does create wealth all the time. That’s why our dollar didn’t immediately go to zero after we went off the gold standard.
        You’re missing the point if you think I’m saying we should “replace” our currency. Modern economies need currencies to operate. How would you get change from your Krugerand when you buy a pack of gum, after all? Or your bag of coal or potatoes. We’re far beyond the need to barter goods for goods for every transaction, and only going Beyond Thunderdome, or back to medieval times (or post war Vienna, as in the Third Man) would currency actually be replaced.
        By the way, anyone who has so romanticized private markets that they think a black market would be better than using an agreed currency had better stay out of the Casbah, or they’ll be bringing home carpets that cost at least twice what they would pay at the local strip mall. Black markets are naturally homes for fraud and inordinate profiteering. That’s why they call them “black”.

  2. hhill51 says:

    Why not? Gold is consumable, though its value for plating contacts or caps on molars might only be a few hundred dollars an ounce.
    A currency that is “backed” by something other than a promise only needs to have that backing valued by the user of the currency. That’s the primary assertion by the precious metal fans — that there is inherent value in those metals.
    How frequently do holders of currency demand payment from the issuers? FWIW, we do have nearly a billion barrels of oil in the SPR, and we do own the TVA, the BPA (Bonneville Power Administration) and all the offshore reserves we lease out to oil companies. We also own a substantial fraction of the world’s supply of enriched uranium. I’m just saying that if the government’s promise is not good enough to keep the Dollar in its place as the world’s reserve, this is an option for “backing” it.
    I actually prefer the fact that our dams and nukes generate power (real wealth) 24/7 to the idea that we would set ourselves up for a run on the bank if we switched back to gold. My reason is simple — if there ever is a serious demand for conversion, a gold-backed currency can make a major trading partner to the world potentially unable to pay, which stops the world economy dead in its tracks.
    That “cure” would be worse than the inflation disease it was designed to treat.

    • Wayne says:

      Interesting idea. What should be back our debts and/or currencies with? Say I’m a blacksmith and want to get some bread. I go to the baker and negotiate a “fair deal” where in exchange for bread today, I agree to provide the baker with some service later. In this case, my “credit” is my services as a blacksmith. Of course, someone else’s credit would have a different form of exchange, but in all cases the credit is some kind of debt. So why do we need physical dollars bills? Today I use my credit/debit/bank card for almost everything. Do I have dollars in the bank, or just some kind of “credit?” To me, it does not matter how it’s backed as long as I can pay my bills with it. Why not just pay me in US credits. Uncle Sam could then tax me in the same currency. And we could carry out international trade based on some kind of conversion formula. Pretty much as we have things now, but the difference would be that no one currency would be the de facto standard. So stop printing dollars or minting coins? Why not, we seem to be headed in that direction. Now all we need to do is agree on how many credits each country has and how these are actually created. (It would eliminate the possibility of a run on a bank as well as tame speculation on things like gold.)


  3. RoberB says:

    You cannot settle in nukes, hydro, solar, wind, tidal power, geothermal, so these energy units have no value as currency backing outside their almost immediate location. Only oil and nat gas could be used in settlement, and only immediate inventory would be available for settlement, hardly enough. This does not even take into consideration the requirement of the ‘globodollar’ to be used for all the transactions of the world. To take ‘probable and inferred reserves’ as backing for the ‘globodollar’ invites inflation of another kind, and anyway, possible future availability does not satify the need for immediate settlement.
    A currency basket is just another version of the Euro, which everyone other than Nobel-winning economists knew would fail. The only surprise is that it lasted as long as it did – 12 years and counting down quickly.
    Here’s another tip: immediately you try to fix the price of anything, value is distorted.
    But the solution is alluded to in the story: each country with their own currency, managed (or mismanaged) by themselves, with settlement as agreed between themselves and other states. If gold or some other tradeable commodity, such as oil or natural gas must be used as an intermediate method of exchange in lieu of their fiat money because nobody will accept it, then let them negotiate that. And let such states learn to discipline themselves in the practical arts of money creation, production, consumption and the value of holding something in reserve that people actually would be willing to accept other than paper. The Swiss could offer lessons.
    Even today, despite the dollar’s difficulties, having the choice between Venezuelan bolivars or the US dollar deposited to your bank account is an easy one. Unless of course the bolivar was convertible into gold.

    • hhill51 says:

      I thought I said that trades should settle in currency. If I didn’t say that clearly enough the first time, I’ll say it again now.
      If, in the unlikely event that a holder of US Dollars in this imaginary future is presenting their demand to the Treasury, it will be up to that holder to figure out how to take delivery. They could take title to some government-owned KWH’s, and have an aluminum smelter pay them in some other medium of exchange for their electricity. It they happen to be France, they can take some fuel rods for their nukes. Fortunately, there is physics to tell us what the BTU equivalents are for each form of energy, so at least that part can’t and wouldn’t be set by political negotiations.
      I am NOT, repeat NOT suggesting that money will or should disappear. It’s too useful for ordinary commerce to use ANY of these other things in its place.

      • RoberB says:

        No need to say it again, because I acknowledged and agreed with what you said in the article!…when I say:
        “But the solution is alluded to in the story: each country with their own currency, managed (or mismanaged) by themselves, with settlement as agreed between themselves and other states.”
        Unfortunately you cannot ship containers of electricity or generic KWH for settlement and shipping fuel rods wouldn’t do it…even if the US would even agree to let these things go (strategic material), fuel rods are a custom item for each installation and are not a fungible commodity. In addition they need extraordinary procedures to ship and secure them. At some time or other it must be possible to settle and only oil or liquified natural gas or its equivalent can be used to settle if the unit of settlement is BTU/equiv KWH.
        To issue credits for generic energy without settlement is the equivalent of issuing credits for electronic money in a zero fractional reserve system. And if it’s based on stated ‘reserves and resources’ the possibilities for fraud are without limit – sort of like Greece times infinity.
        I also suppose the only way to administer the program would be to have a World Central Energy Bank, a kind of UN for energy, and it doesn’t take too much imagination to predict the outcome of that – taking as an example the Oil For Food scandal, what would happen with all the wealth of he world?

  4. Steven Schwarz says:

    This is a lovely utopian proposal. The energy bank. However, just like any other standard it creates an interest group. Just as some countries are long gold (or credit facilities) and others are not, some countries are awash in BTU’s and some are BTU poor. This would call for a realignment of political and economic power that I don’t think would be willingly accepted by, say, Japan.

    That said, the basket idea is very good, and is going to happen, and it may well be a good thing to put gold and BTU’s in the basket.

    • hhill51 says:

      Hey, Steven…
      Reasonable thoughts, to be sure. I guess I didn’t make it clear that I was only talking about how we might deal with eventual repudiation of the US Dollar as reserve currency and currency of choice for international trade. Other countries will have to decide how to manage their own issues, but if international counterparties start demanding collateral for taking the sovereign risk of currencies, this is one idea that I hadn’t seen elsewhere that addresses some of the issues of limited supply like we have with gold.
      Japan has a strong yen, and that’s in spite of a debt-to-GDP ratio that Rogoff and others would say implies immediate doom, not to mention their aging population, lack of immigration and dearth of native energy sources. In other words, the yen is strong because of how the world perceives Japan’s willingness and ability to pay, just like any credit analysis.
      By the way, some years ago it occurred to me that holding a country’s currency is like holding equity, while their bonds are more like convertible debt. Sort of a claim on assets and future earnings after all senior claims are settled.
      Just another way to look at currencies.

  5. Jeremy Abrams says:

    In order to settle a debt backed by energy, or more accurately in order to foreclose on one, the creditor would need to take possession of a coal mine, oil field, nuclear plant, or wind farm in its trading partner’s territory.

    Wouldn’t that be problematic?

    • hhill51 says:

      I don’t think so….. Consider that the Strategic Petroleum Reserve has $100 billion worth of oil in it right now, and it was drawn upon after Katrina and Ike, and all the companies that took delivery were able to go through a fair equivalence calculation and replacement. Power companies trade massive amounts of different forms of energy with each other every day, as do banks that have energy trading desks. I guess you could say that was one good thing from having the Enron crew — they pretty much established a trading market between and among energy users, producers and speculators.
      Daily shipments of electricity from Grand Coulee Dam get delivered thousands of miles away and are worth billions over the course of a year. LNG carriers have what, $100 to $200 million worth of gas in one shipload?
      People seem to forget that it was a demand for delivery (from France, allegedly) that moved Nixon to end the gold standard in 1971…. Perhaps an offshore oil and gas lease could be payment, so that counterparty would be able to run a drilling/pumping platform…
      No matter, anyway. The whole point of reserves is NOT to have regular everyday transactions call on the reserve. That, I think is the silliest part of the objections I see — people are acting like I’m suggesting replacing currencies with the reserves. Hardly. Taking the currency conversion option is a last resort. Perhaps the conversion ratio would be set well below the current market level of those BTU’s, so it truly would not make economic sense unless the counterparty was concerned about getting paid at all.
      If people insist that it must always be set by markets, then I have this challenge for those advocating gold-backed US currency:
      Who will calculate the reserve requirement as the value of the dollar and the number of dollars in circulation or represented by debt fluctuates? How will they present and enforce the margin call for more gold? What happens if counterparties take a big chunk of gold as settlement? Do we just live with less currency in circulation? What if that means Social Security checks can’t be paid? Where do you draw the line, or is there a line?

  6. Interesting, but I’m not sure you are saying anything new. The value of any currency, including gold coin, is the value of what you can buy with it. Dollars have value because you can buy land, food, military equipment, etc. An old friend used to track the price of bread in various countries and found that over time exchange rates tracked pretty closely.

    I like your point about the game ending when all the chips are on one side of the board. When I was a kid we played Monopoly. The game ended when one player had all the money, but we wanted the game to continue. so.. we either issued more money to the losers or we confiscated some of the property of the winner or we wiped out the debts of the losers (unmortgaged their property for free). Hmmm…. very much like the solutions we see in today’s economy.

    Enjoying your blog very much!!!

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