Detailed discussion on concept of Reserve Currencies

Reserve Currency : The Background

Every now and then there erupts a discussion on the topic of "Reserve Currency" and how some countries are getting an advantage and some are being shortchanged. The topic is rich and often suffused with enough nuances that one can attempt to write a complete book just scratching the surface. My attempt today would be to give some broad markers on how to think about the topic rationally without getting swayed by the current trend of currency values. There will be detailed discussion on why a particular currency becomes the reserve currency, what are the privileges and what are the responsibilities?of being a one. Then we have a look at what are the possible contenders and where they falter.

Thinking about Money?

We need to start right from the basics i.e. the definition of currency itself. What is money or currency anyways? Why it exists and what happens in a counterfactual reality where there is no currency or no money?

Human society is a complex phenomenon. It is a thinking, deceitful and politically motivated tribe where each of its 8 billion inhabitants has a mind and voice of its own. Some don't have a voice but that is a different discussion. Now as this mass of humanity needs to interact and engage to complete their life's purpose they have divided themselves in different artificial constructs like religion, class and nation states etc. These constructs provide a structure to the chaos and make the system work. Now humanity constantly produces and consumes, not everyone can consume what they produce neither they can produce everything on their own what they want to consume. This brings out the idea of trade, between people, between communities, between nation states. But trading as per the needs requires a lucky condition to get satisfied which is what economists call a "double coincidence of wants". I have bread, you have potato and both of us want to eat a sandwich, this is serendipity otherwise the matchmaking is difficult. Hence we need to exchange it to something more fungible, reliable and more transactionally efficient. Enter the concept of money, drum rolls please.

Money solves the problem of double coincidence. I can have money and use it later. The key is that the money which I hold should continue to have value, it should continue to be acceptable across the people with whom I want to trade, it should be difficult to counterfeit, the conversion and reconversion into consumable commodities should be hassle free. Now all these basic tenets about money will need to be revisited when we talk about the reserve currency.

For a considerable time in world history all these requirements were solved by gold, it was widely accepted and trusted, checking its purity was readily possible, it could have been drawn into different shapes i.e. coins, wires, jewelry etc. It retained its value, the supply was limited. It was however difficult to transport in large quantities and carried risks of getting stolen. Hence it required an elaborate system of safe keeping.

The changing world economy: Rise in trade and advent of paper money

Now gold has been present for 6 millenniums and has earned respect through the ages. The economic system built around it was perfected over centuries. However some 150-200 years back the world economy started changing and made a clear break from the past. The world earlier was a place with low mobility and constrained trade activity. Ships were slow, the shipping routes were treacherous making long voyages difficult. Sindabad was among few lucky sailors who survived scurvy and diarrhea and returned home with profits. But this was about to change, technological advancements partly due to colonial zeal and adventurism and partly due to European renaissance introduced some breakthrough technologies making world trade fast and possibly furious too. The whole world became one big trading ground, the products from one part arriving en masse to the other corners. This brought the era of growth to the world GDP, the time of autarkic economies was over, now people started producing primarily for trading and not for consuming.

This era of growth brought its own set of issues. If the transactions are to be settled in gold pieces then there were not enough gold pieces to go around. Then the innovation of a paper currency backed by gold was introduced. The paper currency was printed by the sovereign but with a promise that a certain quantity of gold will be paid to the bearer in case he wishes to redeem. This started the era of gold standard which was a variation on the earlier era. Paper money solved the problem of transaction inefficiency but brought a different set of problems. The most basic of the issue is of trust. Who will guarantee that the gold which the paper notes promised was actually there in the possession of the sovereign which was printing the paper notes. There is a universal truth about the fragility of human virtues, in absence of checks and punishment the virtues quickly evaporate. We humans are inherently amoral species and the institutions created by us are no different. Hence the paper printing soon descended into a full time exercise. The fa?ade of professionalism was created by transferring the authority to print to the central banks who were a strange cross species, govt backed but independent. The inherent dilemma in their conception was clear right from the beginning.

But unimpeded money printing served the purpose of supporting world trade well. The growth in trade and GDP if not supported with commensurate money supply runs the risk of deflation. If the same money stock is chasing the increased basket of goods and services, it runs the risk of price fall. The period from the last decades of 19th century till the end of the second world war was marked by an arrangement where paper currency and gold existed side by side. There were bouts of doubt about the system in case some central banks really abused the promise creating highly inflationary conditions. A case in point was post WW I Germany where the country was saddled with reparation loans put on as a war cost. As they were unable to fund the loans they printed the deustche marks with missionary zeal but ended up creating hyperinflation instead of getting salvation.

The monetary system along with the political system was in a state of flux in the years leading up to second world war. The production systems, transport systems, communication channels were appearing in their modern avatar, cross border capital flows were happening, bond markets were getting established in major financial centers like London and New York where for once a Britisher or a New York gent can invest in bonds of a company getting established in Malaya or far east. The rules of transaction, execution and settlement were getting established. Financial intermediaries like banks were honing their skills in consummating these transactions. The underlying thread was trust which was getting created and making the money move through a complex network. Clients with money and service providers with bespoke solutions were embracing each other.

WW II and the changed world order

Then came World war II which changed the face of the world and configured it in a form which we recognize today. The war decimated the economies of most of the participants and forged new allies and foes. It created a bi polar world where at one end was America with its capitalism mantra and at the other hand stood its ideological nemesis the soviets. Both the factions divided by an iron curtain were in a constant state of heightened one-upmanship. One would do well to note that the ideological differences were existential in nature.

In such a charged atmosphere the American policy makers drafted a vision which deftly combined monetary policy with military objectives. All the allies were co-opted on the American bandwagon by helping them rebuild their economies, by providing them the market to sell their produce and providing them the safety umbrella of the US military under NATO alliance. The US private sector, its multinational corporations, its banks provided the structure to the Pax Americana by getting more and more entrenched in the local fabric of the alliance countries. Brettonwoods system ensured that the international currency of trade remained US Dollar. This was not a fluke or a stroke of luck, it was an acceptance of the financial system which the US had created. Any cross border transfer of either current or capital account requires seamless and trusted settlement which the US banks provided. The only other viable competitors were the European or British banks which were still nursing the losses from the war. They lacked the capital which was required to rebuilt their respective economies which was ultimately provided by the US in form of aid and equity. So in a modern sense, the US was the only full service provider at that time, Google, Amazon, MS, Netflix and Lockheed Martin all rolled into one.

The presence of the US military from the Korean peninsula to Japan, from Arabia to Hawaii was a major contributor in the increase in world trade because they ensured that the shipping lines were secured. This led to a proliferation of shipping traffic, the container boom started in the 1960s ensured that the cost of trade lowered to such an extent that it became profitable to ship grains from US to far east then it was to transport it on road to a different state in US.

Another thing which helped it was the promise of democratic ideals. Apart from the consumerism culture, democracy was one of the biggest exports which country did. It ensured that the allies it formed espoused the democratic ideals. It helped in keeping the flock together. On the other hand the communist grouping championed a completely different set of economic and political ideals. Central planning mixed with autocratic tendencies created some growth initially but failed ultimately to gauge the complexities of modern economy. It failed spectacularly in the 90s where the fall of berlin wall and the regime change in USSR crowned US as the sole power in the world. This was a resounding acknowledgement of the path the country had taken and causes it had championed. The strength of US Dollar in a way stems from this deep rooted appreciation of this system. Its cogs are the American private enterprises which keep the machine running.

Brettonwoods and free floating currencies

One thread which we need to revisit again was the break of the post Brettonwoods gold backed system. US in 1970s decided that the promise of changing the US Dollar to gold at a certain price was no longer tenable. This was the result of excessive printing of money, this ultimately thrusted the world into a pure fiat paradigm. It needs to be appreciated that in this set up there is no intrinsic value of the currency notes, there is no promise to change it to gold or some other precious metal. The only thing which makes this system run is trust, the trust that the in near or far future I will be able to buy real stuff from this piece of paper. So when in the foreign exchange markets the rates of different currencies fluctuate it is the underlying trust in their economies which is fluctuating, their growth prospects, their political systems, the sanity of their monetary policies are getting judged every second getting reflected in the price on the ticker.

So when it comes to reserve currency discussion it is better not to be flippant and have a more sanguine look of the history and the other requirements. Trust in a system takes time to get built, the fine tuning of the operational processes also takes time, the belief that those processes will work and will be fair is also a time consuming process. But nothing in this world is permanent and can't be taken for granted. Same is the case with the US Dollar, the fact that it provides the most liquid market to trade, most innovative hedging solutions and the most sorted out and convenient settlement ecosystem are important but not the cardinal aspects of it being the reserve currency. The cardinal aspect is the belief in the value of US Dollar and the fact that Federal Reserve wont abuse that privilege. This is where lot many assumptions come in. US Fed post GFC has seen that the panacea to every problem is money printing, this realization without the fear of any consequences is a dangerous one.

Competition to the?throne

Now lets see who are the competitors to the US dollar throne of reserve currency status.?

Chinese Yuan

The current favorite is the Chinese Yuan, commentators often get over awed by the recent growth of Chinese economy and its pace of reserve accumulation. But think of the Chinese Yuan from the different tenets which we discussed above. How open is the Chinese financial system, is their free flow of capital allowed in and out of China, what is the trust level in its policies and institutions. The second aspect of it would be the military might, how entrenched is the Chinese geo political machine on the global routes, can they protect the shipping routes on their own.

Ultimately even with the countries where they run a balanced current account will those countries accept settlement in Yuan. Yuan is a controlled currency with a peg to US Dollar, will this be a comforting factor for their counterparties. These are difficult questions to answer and require a less binary approach. May be in future the world system will evolve in a bipolar fashion with one sphere totally aligned with China, may be in this sphere the Chinese currency will become the reserve unit. But the recent crackdown by the Chinese authorities on the tech giants and the doubt about its real estate bubble inspire little confidence. As we previously noted that the little bird called trust is notoriously difficult to raise and grow. Every act howsoever small or big adds to your trust account. Human societies are complex and unreasonable at times, the centralized approach of erstwhile communist mindset often gloss over these complexities. Such set ups look calm from outside but in absence of pressure valve mechanisms are prone to spectacular failures. A Chinese reserve currency ambition has to overcome this apprehension. I can't tie my future with you if I am not sure what's going on with you.

Euro

Second alternative is Euro, Euro scores well on the institutional trust front but is too rickety an edifice to be considered viable for too long a time. First of all it is not a nation but a grouping which have come together to bolster growth. The monetary policy sits in Brussels with ECB whereas the fiscal policies sit with each individual governments. This sometimes gives rise to perverse incentives. The profligate nations can take advantage of low rates and issue unsustainable debts, these debts are housed by European banks in good times and when the times go bad, they have to be saved for the sake of common good. The common grouping is not a military power too. The fall out of WW II ensured that the militarization of certain countries stopped by clubbing them together under NATO umbrella. In case this umbrella goes away the whole edifice might become shaky. One of the most underappreciated fact of the world today and about many export powerhouses was that they were saved from investing too much into their defense. This outsourcing to US obviously was a hit on the national pride but worked extremely well for the industry and job creation. Germany and Japan are the stellar examples. So once that protection is out, how the currency might behave is difficult to predict. Reserve currency dreams hence is a chimera to be honest.

Crypto Cousins

Third alternative is a newly discovered love called cryptocurrencies. The utopian dream of crypto evangelists is to save the world from the clutches of central bankers who are continuously printing paper money and hence bringing inflation in its wake. Crypto currencies in a small form have started getting used for transaction purpose, some establishments have started accepting them but that remains a tiny part of the euphoria. The bet which is being made here is that the technology is so wonderful that it is a force of nature. Here I have some doubts. The philosophy underlying the bitcoins that is blockchain certainly elicits trust. It is a mechanism where the centralized gatekeeper is done away with and each and every transaction is verified by each party in the chain. Without going into specifics of how this will be done in case every gets on to the bandwagon, one big issue is whether the energy required to keep the system afloat can be provided. Unless there is a neat technological scalable solution to this, one needs to be skeptical about the utopian claims. The second and the more important issue with crypto currencies is the backlash by the existing power structures. Why the sovereign will yield its seat of power to crypto even if there is a demand for such a product is difficult to answer. Already a slew of CBDCs or central bank digital currencies are in work. In that case the current system stays just that the system becomes more digital. I am not sure about the structure of such currencies but maybe an intermediary wallet becomes unnecessary. But these details are more gimmicky and less central to the question of reserve currency status.

Return of Gold

Finally, some people opine that as the central banks continue to prime up the printing presses something more tangible in value will make a comeback. What better than our good old neighborhood gold. Gold is trusted as a store of value but for the transaction purpose it becomes difficult. Any derivative in the form of a note which can be traded digitally and is backed by the physical gold has the same issue as that of the gold backed currencies of old. The system works well till a time and when the abuse becomes public, it collapses. Hence the gold use has a limit in an inherently complex world economy as it exists today. Even if the gold value is recalibrated to a new equilibrium to account for all the money printing it won't be able to work as a currency. Maybe someone can take a bet on it as an investment asset.

Conclusion

Hence one can conclude that the US Dollar has earned the prime place through years and it is not going out in a hurry. But nothing is permanent in life. As the German philosopher Hegel famously said that each thesis gives rise to its own anti-thesis and in due course the two swap places, giving rise to a new synthesis. There are forces working to dislodge the dollar thesis currently but their time hasn't come yet. Maybe in the future a new hybrid synthesis will emerge. The above discussion was an extremely simplistic take on a complex issue, the idea was to see the current system from a more structural perspective. Future like past is difficult to predict but a Hegelian tussle is always going on.