What to Expect When the Reign of the U.S. Dollar Comes to an End

Lloyd Blankfein has got it all wrong again.

Speaking last week, the Chief Executive of Goldman Sachs (NYSE: GS) claimed that if the "fiscal cliff" of tax increases and spending cuts go into effect on January 1, the U.S. dollar would lose its reserve currency status.

As the Vampire Squid's representatives often do, Blankfein actually has it backwards.

Contrary to what Blankfein thinks, a legitimate movement to deal with the fiscal cliff would cut the federal deficit in half, make the country more or less solvent and strengthen the dollar.

However, the problem is that the fiscal cliff involves pain. And since politicians like to delay pain as long as possible, the chances are good the fiscal cliff will be postponed again.

Instead, the country will likely continue to run trillion-dollar deficits in the hopes that Ben Bernanke can finance them through even more quantitative easing. It's the only play in the Keynesian playbook.

Unfortunately, that is the policy most likely to crash the dollar -- and it's headed our way.

So what will the world look like when the dollar has crashed, and international investors and traders have lost all of their confidence in the greenback?

The truth is if that happens it won't be like anything we've seen within living memory.

To understand why, you need to understand how the world managed to get by before the U.S. dollar became the world's reserve currency.

Before the Rise of the Dollar

Ever since the Bretton Woods agreement in 1945, the U.S. dollar has been the world's reserve currency. So far, that role has been relatively unquestioned.

But prior to that, beginning in 1914, the world had relied on two reserve currencies. One was a declining British sterling. The other was a rising U.S. dollar.

Oddly enough, the sterling was the stronger of the two in the 1930s, after Britain went off the gold standard in the 1920s. That's largely because while the U.S. suffered through the Great Depression, Britain managed to enjoy something of an economic renaissance.

Before 1914 though, the British gold pound was the world's main reserve currency for over 100 years--ever since the Napoleonic Wars.

Just as with the dollar today, when it came to true international transactions and investments, there was no real alternative to sterling at the time.

However, that wasn't always the case, either. History is full of examples where there was no one true reserve currency like the dollar or the gold pound.

Before 1800, the pound was important, but scarce - the main British gold coin of the time was the guinea, worth 1.05 pounds.

In the American colonies, however, British gold coinage hardly circulated at all, because gold was scarce. Instead Spanish silver coins -- "pieces of eight," or 8 Spanish reals -- were the main coinage for trade, investment and, of course, piracy.

When Long John Silver's parrot squawked "Pieces of eight," the intelligent bird was simply expressing a preference for the medium in which it wanted its pirate treasure to be paid!

Around the same time, after a 1751 re-coinage, the thaler issued by the Austrian empress Maria Theresa become the common currency for the German-speaking world.

Strangely, this common currency continued after Maria Theresa's death in 1780, spreading to Africa and the Middle East. The British government, in particular went on coining Maria Theresa thalers, basically counterfeit (though made of real silver) until as late as 1962, continuing to date them 1780.

In fact, when my father made his first trip to Saudi Arabia in 1963 he brought one back. He said they were still using them in a big way there. Of course, since the Saudis still used the Moslem calendar, many of them were probably unaware that it was, alas, no longer 1780 for the rest of us!

The point is that if the dollar becomes no longer credible, other currencies will have to do the job-like they have throughout history.

The problem is that there is no obvious single alternative to the U.S. dollar today.

The euro is a mess, the sterling has the same problems as the dollar, Japan has a humongous debt problem, and China's currency isn't freely traded and is endangered by a huge black hole in its banking system.

Living in a World Without a Strong U.S. Dollar

In a world without the dollar, it's likely that smaller currencies would have to be used.

Doubtless some of these would be "specialist currencies," tailored to the needs of different users.

For instance, asset-only savers would want a currency that is a truly reliable store of value, with rock-solid monetary policies like the U.S. in the days of Fed chairman Paul Volcker.

Meanwhile, traders would be partial to a currency that is as close as possible to a median between the various economic blocs, so that neither buyers nor sellers are disadvantaged.

Debtors undoubtedly would want a currency with sloppy Bernanke-ite monetary policies and very low interest rates. When they find it, they will combine with the hard-sell operators on Wall Street to stuff it into unsuspecting investors' portfolios, especially investors like insurance companies and pension funds, which try to match assets and liabilities.

Of course, like clockwork every now and then confidence in a particular currency would collapse.

You see, none of these currencies would be backed by a hard asset, like pieces of eight or the Maria Theresa thaler. They are paper money.

That's why we are likely to re-learn some painful eighteenth century lessons...

Eventually, over the wailing protests of the world's economists and central bankers, we may move to an eighteenth century solution - a gold standard.

That's the only thing that could truly be used to replace the greenback as the world's reserve currency.

It's why the soaring price of gold is not an anomaly.

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