Only Gold Can Replace the Greenback as the World’s Reserve Currency

Initially published at Seeking Alpha on January 25, 2008.

At the World Economic Forum in Davos this week, George Soros warned that the subprime crisis would bring about the end of the US dollar as the world’s default reserve currency. In recent years, as emerging economies posted growth rates approaching 10%, and as the US economy’s share of global GDP declined, it made sense for other countries’ central banks to park their reserves partly in dollars, partly in other currencies.

There are however two problems with forecasting a final demise of the US dollar.

First, central banks around the world already hold hundreds of billions in instruments denominated in US dollars. A concerted move to shun the greenback would lead to significant paper losses on current holdings, greatly damping the benefits of switching to another currency.

Second, applying Winston Churchill’s aphorism on democracy, the US dollar may be the worst reserve currency, except for all those others. And here is why.

The Euro is currently riding high thanks to strength and optimism in the European economy. Although there is currently a differential in interest rates earned by holding Euros vs. holding dollars, this gap, in theory, should not be sufficient to warrant a massive move from dollar to Euro. Except for the most nimble of traders, future expectations of growth and inflation would arbitrage away any gains achieved in the near term. In addition, fantasies of European decoupling from the US economy’s turmoils have been quashed in recent weeks as can be seen by the contagion now reaching the old continent’s financial institutions.

The Yen is another option but the Japanese economy, like Europe’s, has been supported by rising demand from emerging markets. Should the US economy weaken, demand for industrial goods from Japan and Europe will also slacken. Furthermore, Japan’s management of its economy since 1990 has done nothing to commend its currency to nervous central bankers.

Meanwhile back in the United States, the Federal Reserve’s frantic interest rate cutting is pushing the dollar down while fueling inflation.

Looking at all these factors together, what are central bankers to do with their reserves? Selling current dollar holdings in a massive fashion is like shooting yourself in the foot. The Euro and Yen reside in economies that are too dependent on US growth to be considered safe havens. The only clear option therefore is to place a significant portion of new reserves in gold.

Since its lows of 2001, the Euro has nearly doubled vs. the dollar, but gold has more than tripled. And there will likely be more upside. The price of gold in real terms remains significantly below its last high recorded in the early 1980s, and would need to double to match that level again. While the amount of gold available in the world has risen since 1980, its rate of growth has been dwarfed by an enormous creation of capital in the past 25 years, capital which may now look for a safe haven away from the world’s wobbly currencies.