Currency Looniness and Reserve Currency Madness; What Should the Global Reserve Currency Be?

Given the clearly dire consequences associated with Greece being in a currency union with no control over its own currency, one might think such results would put an immediate halt to new currency unions and momentum of countries instituting new currency pegs as well.

Yet, about a week ago, the Globe and Mail commented Canadian envoy to Iceland sparks loonie controversy.

For 150 years, the rest of the world has shown scant interest in the Canadian dollar – the poor cousin to the coveted U.S. greenback.

But now tiny Iceland, still reeling from the aftershocks of the devastating collapse of its banks in 2008, is looking longingly to the loonie as the salvation from wild economic gyrations and suffocating capital controls.


Officially, the Icelandic government is targeting membership in the 27-member euro zone. But support among Icelanders is slipping.

In a recent Gallup poll, seven out of 10 Icelanders said they would happily dump their volatile and fragile krona for another currency. Their favoured alternative is the Canadian dollar, easily outscoring the U.S. dollar, the euro and the Norwegian krone.

Iceland is in a bind. The country imposed strict currency controls after its spectacular banking collapse in 2008. A major downside of those controls is that foreign investors can’t repatriate their profits, making Iceland an unattractive place to do business.

Those capital controls are slated to start coming off next year. And many experts fear a return to the wild swings of the past – in inflation, lending rates and the currency itself. Iceland is the smallest country in the world still clinging to its own currency and monetary policy. The krona soared nearly 90 per cent between 2001 and 2007, only to crash 92 per cent after the financial crisis in 2008.

Iceland's Problem

Why is it the problem (and unintended consequences) that you don't have, always look better than the problems you do have? The fact of the matter is Iceland is recovering from its crisis quite nicely.

Hopefully Iceland learned something from its recent crash and burn. Moreover, given Iceland's willingness to do the right thing (default), hopefully the foolish investors who drove up the value of the krona learned something as well.

Argentina's Ruinous Currency Peg

Entering a currency peg with no control over monetary policy, interest rates, or currency demand as Iceland is considering, has a history of spectacular blowups.

Argentina is a classic case although it made numerous flaws in its attempts to maintain a peg to the US dollar between 1991 and 2002. The peg blew up spectacularly as described in the Wikipedia article regarding the Argentine Currency Board.

Inquiring minds should also consider Confiscatory Deflation: The Case of Argentina by Joseph Salerno on the Mises website.

Existing Currency Pegs

Nonetheless, there are many existing currency pegs that for now seem to be working. Please consider the following chart from Wikipedia on Currency Pegs.



Legend: dark blue - EUR users; dark green - USD users; light blue - EUR pegs; light green - USD pegs (including cascaded like Macao->HK->USD); orange - AUD users; brown - NZD users; lila - ZAR users; yellow - INR users and pegs; red - GBP users and pegs; light pink - XDR/other currency basket pegs; dark pink - two-country usage/peg, multiple cases (CHF in Liechtenstein, ILS in PNA, Singapore/Brunei)

Reserve Currency Madness

Regardless of what Iceland does or does not do, Iceland is essentially irrelevant to the global economy. Nonetheless, every time we see a story like this, someone manages to blow it up way out of proportion to reality.

For example, please consider snips by ZeroHedge from Iceland Wants To Adopt The Dollar... No, Not That One, The Other One

According to the Globe and Mail tiny Iceland, "is looking longingly to the loonie as the salvation from wild economic gyrations and suffocating capital controls...And for the first time, the Canadian government says it’s open to discussing idea.

It is a huge slap in the face of those statists (and the United States of course) who keep repeating no matter the facts that the USD will never lose its reserve status. Here's a hint: it can and it will.

Bogus Threats to US Reserve Currency Status

Not to belittle Iceland (as I wish them well and  also commend them for telling the IMF and EU to shove it) but the United States does not care what Iceland does, at least it shouldn't because Iceland is statistically meaningless in terms of global trade.

The irony is the US would gladly give up reserve currency status. Please consider Bogus Threats to US Reserve Currency Status: No Country Really Wants It!

In spite of all the hype regarding the Yuan as a reserve currency I have stated many times recently that discussion of the Yuan as a reserve currency is nothing but ridiculous hype.

My reasons are:

• The Yuan does not float, and there is no indication China is prepared to allow the Yuan to float any time soon
• China is a command economy
• In China, property rights and civil rights are questionable
• Chinese banks are insolvent because of malinvestments in infrastructure and an enormous property bubble

Michael Pettis at China Financial Markets has a similar list of reasons, phrased slightly differently. Pettis does add one key item I overlooked: "Very deep and open domestic bond markets"

From a recent email post Pettis writes ....

Is it time for the US to disengage the world from the dollar?

Last week on Thursday, the Financial Times published an OpEd piece America Must Give Up The Dollar I wrote arguing that Washington should take the lead in getting the world to abandon the dollar as the dominant reserve currency.　

My basic argument was that every twenty to thirty years – whenever, it seems, that the American current account deficits surge – we hear dire warnings in the US and abroad about the end of the dollar’s dominance as the world’s reserve currency.　 Needless to say in the last few years these warnings have intensified to an almost feverish pitch.　

But I think these predictions about the end of dollar dominance are likely to be as wrong now as they have been in the past.　 Reserve currency status is a global public good that comes with a cost, and people often forget that the cost is much higher than most countries are willing to accept....

No One Really Wants Reserve Currency Status

I am quite sure that Pettis has this correct. After all, if reserve currency status was such a gift, why doesn't China take the steps that would make it possible. Why doesn't Europe?

The fact is, for all their bitching, nearly every country on the planet does not want to relinquish their "export growth model". Every week there is some trumped-up report by someone about how China is trading more in the Yuan with Russia and Southeast Asia countries. In the grand scheme of things such trade in Yuan nearly meaningless, not representative of a significant adjustment.

Mathematically, the fact remains, the US runs a huge trade deficit, and countries accumulate US assets, most frequently US Treasuries.

The Fed is fighting back by attempting to force the US dollar lower. Mathematically every currency cannot be weak relative to each other. Central bank actions to achieve the impossible are behind the rise in commodities, especially silver and gold.

Unstable Mess

The irony in this mess is those cheering the demise of the US and the US dollar look at baby-step moves countries like China make in that direction as if that would hurt the US.

The reality is the US would be better off (and so would the world), were the US to lose reserve currency status. Nonetheless, don't expect it any time soon. China is not ready and Europe is in the midst of a sovereign debt crisis that will not go away for years. ....

Who Doesn't Want Reserve Currency Status?

• Bernanke would love for the US to lose reserve currency status. He wants a weaker US dollar and his actions prove it.
  
• Congress is threatening to label China a currency manipulator, seeking to force China to revalue the RMB higher. By its actions, Congress would gladly see the US lose reserve currency status.
• President Obama and Mitt Romney both want a weaker US dollar.
• Brazil does not want a rising currency (see Brazil Declares New Currency War on US and Europe; Japan Losing Balance of Trade Battle)
• Switzerland does not want a rising currency and pegged to the Euro to prevent it
• Japan clearly does not want a rising Yen
• Europe wants to increase exports to grow its way out of its mess. A rising Euro would hinder that idea.
• China does not want a rising Yuan

The Big Picture

1. The US will be better off, not worse, were the US to actually lose reserve currency status.
2. The Fed, Congress, Obama, and Presidential hopefuls do not want the US dollar to have reserve currency status.
3. No other country wants reserve currency status
4. The US has the largest economy and the only bond markets outside of Europe deep enough to support being the world's reserve currency
5. The US is stuck with reserve currency status as a result of Bretton Woods II, and president Nixon halting gold convertibility.

ZeroHedge missis the big picture. That said, I very much agree with ZeroHedge on one point: The US will indeed at some point lose reserve currency status, possibly as a result of a massive global currency crisis involving the US dollar, Japanese Yen, Chinese Renmimbi, and the Euro.

Such a day of reckoning is indeed coming, and from my perspective the sooner the better. In the meantime, just keep in mind that trade agreements between Canada and Iceland, and China and Timbuktu (or whoever), are not worth the massive amount of hype given to them by most writers.

What Should the Reserve Currency Be?

Fiat money, fractional reserve lending, inane fiscal polices, and central banks all acted together to create the global financial crisis. None of them can be any part of a lasting solution.

Thus, as for what should replace the US dollar as the world's reserve currency, let me suggest real money, gold.

Gold would also cure these trade imbalances in a flash. For a discussion, please consider Hugo Salinas Price and Michael Pettis on the Trade Imbalance Dilemma; Gold's Honest Discipline Revisited.

Who Doesn't Want Gold as the Reserve Currency?

1. Governments who want to print money to fund warmongering without raising taxes
2. Bankers who benefit from inflation because they are always bailed out by central banks when they get into trouble
3. The wealthy because they have first access to money and get to bid up the price of assets before the greater fools rush in.

The housing bubble is the classic example of point number three. By the time money was available to anyone who could breathe, home prices were so high that an outright crash was inevitable.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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