May 21, 2021

The Rise & Fall of Petrodollar & the Rise of Cryptocurrency

By Dr Baba J Adamu

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The US Congress acted on Hamilton's recommendations, with the Coinage Act of 1792 that established the dollar (symbol: $; code: USD) as the basic unit of account for the United States. The word dollar is derived from the Low Saxon cognate of the High German Thaler. They created a decimal currency by creating the dime, nickel, and penny coins, as well as the dollar, half a dollar, and quarter-dollar coins, all of which are still minted in 2021. Several forms of paper money were introduced by Congress over the years, the latest of which is the Federal Reserve Note that was authorized by the Federal Reserve Act of 1913. The U.S. dollar as a currency is sometimes referred to as the greenback by the financial press in other countries, such as Australia, New Zealand, South Africa, and India, due to the banknotes' historically predominantly green colour.

 

In wartime, banks can have their monetary reserves stolen, either captured by the enemy or appropriated by their own country. In 1944, Allied nations sought to create an international monetary order that sustained the global economy and prevented the economic malaise that followed the First World War because World War II has devastated European and Asian economies while leaving the United States' economy relatively unharmed. As European governments exhausted their gold reserves and borrowed to pay the United States for war material, the United States accumulated large gold reserves. This combination gave the United States significant political and economic power following the war.

 

Consequently, during WWII, banks in England and France shipped their gold to the US for safekeeping. After the war, the allies tried to create some stability. In a small New Hampshire town called Bretton Woods, they hammered out an agreement that made the US dollar a worldwide standard. The gold standard is a system in which a country's government allows its currency to be freely converted into fixed amounts of gold.  “The dollar was pegged to the price of gold, and foreign currency was pegged to the dollar,” “The US dollar was crowned as the world’s reserve currency. It was a stable source of stored value, a medium of exchange a country’s currency might not have.” The arrangement, which came to be known as the Bretton Woods Agreement, codified this economic dominance of the dollar and established that the central banks would maintain fixed exchange rates between their currencies and the dollar. In turn, the United States would redeem U.S. dollars for gold on demand. Countries had some degree of control over the currencies in situations where their currency values became too weak or too strong relative to the dollar. They could buy or sell their currency to regulate the money supply.

 

The Bretton Woods agreement laid the foundations for an international monetary order that created rules and expectations for the international economic system. It created the International Monetary Fund (IMF), the predecessor of the World Bank, and an international monetary system based on fixed exchange rates. It valued the dollar at $35 per ounce of gold and the remaining signatories pegged their respective currency relative to the dollar, leading some economists to argue that Bretton Woods "dethroned" gold as the default asset. While Bretton Woods institutionalized the dollar's importance following the war, Europe and Asia faced dollar shortages. The international community needed dollars to finance imports from the United States to rebuild what was lost in the war. In 1948 US Congress passed the European Recovery Program - generally known as the Marshall Plan – giving dollars to European countries to purchase imports needed to rebuild their economies. The plan helped European countries by providing them dollars to purchase the imports needed to produce exports, eventually allowing the countries to export enough of their goods to obtain the dollars necessary to sustain their economies without reliance on any Marshall-like plan. At the same time, Joseph Dodge worked with Japanese officials and Congress to pass the Dodge Plan in 1949, which worked similarly to the Marshall Plan in Europe, but for Japan rather than Europe. But nothing lasts forever, though. The Marshall and Dodge plans' successes have brought new challenges to the U.S. dollar. In 1959, dollars in circulation around the world exceeded U.S. gold reserves, which became vulnerable to the equivalent of a bank run.

 

The New Deal

The New Deal was a series of programs, public work projects, financial reforms, and regulations enacted by President Franklin D. Roosevelt in the United States between 1933 and 1939. Major federal programs and agencies included the Civilian Conservation Corps (CCC), the Civil Works Administration (CWA), the Farm Security Administration (FSA), the National Industrial Recovery Act of 1933 (NIRA) and the Social Security Administration (SSA). They provided support for farmers, the unemployed, youths and the elderly. The New Deal included new constraints and safeguards on the banking industry and efforts to re-inflate the economy after prices had fallen sharply. Its programs included both laws passed by Congress as well as presidential executive orders during the first term of the presidency of Franklin D. Roosevelt. The programs focused on what historians refer to as the "3 R's": relief for the unemployed and poor, recovery of the economy back to normal levels, and reform of the financial system to prevent a repeat depression. The New Deal also produced a political realignment, making the Democratic Party the majority (as well as the party that held the White House for seven out of the nine presidential terms from 1933 to 1969) with its base in liberal ideas, the South, big city machines and the newly empowered labour unions, and various ethnic groups. The Republicans were split, with conservatives opposing the entire New Deal as hostile to business and economic growth and liberals in support. The realignment crystallized into the New Deal coalition that dominated presidential elections into the 1960s while the opposing conservative coalition largely controlled Congress in domestic affairs from 1937 to 1964.

 

The New Deal coupled with the mounting inflation, debt from the Vietnam War and other factors loosened the Bretton Woods agreement. Eventually, the United States chose to devalue the dollar. During the early 1960s American officials largely prevented the conversion of dollars to gold with a series of "gentlemanly" agreements and other policies – which included the London Gold Pool - but these actions were not sustainable and American officials became increasingly concerned; the danger of a run on U.S. gold reserves was too high. With Nixon's election in 1968 and faced with this mounting debt and extravagant domestic spending habits, and a persistent balance of payments deficit, the Nixon administration finally issued Executive Order 11615 in August 1971, ending the direct convertibility of dollars to gold, essentially creating what was referred to as the “Nixon Shock,” the world saw the end of the golden era and a free fall of the U.S. dollar amidst soaring inflation. Nixon added, "We must protect the position of the American dollar as a pillar of monetary stability around the world ... I am determined that the American dollar must never again be a hostage in the hands of the international speculators." This became known as the Nixon Shock and marked the dollar's transition from the gold standard to a fiat currency, making the dollar floating, with no gold backing.

 

Who started the petrodollar?

The petrodollar was started by the United States in an agreement with Saudi Arabia in the 1970s with the intent of standardizing oil sales and purchases in U.S. dollars.

 

Understanding Riyal and Saudi Arabia's Economy

In 1932, the Kingdom of Saudi Arabia, as a country, was formed by combining the Kingdom of Hejaz and the Sultanate of Nejd. After its creation, Saudi Arabia utilized a bimetallic monetary system based on British gold sovereigns and silver Riyals. In 1952, the monetary system was reformed to use a single currency. This currency, the Saudi Riyal (SAR), was backed by Saudi gold guineas equivalent to the British gold sovereign until 1959 when a system based on fiat money issued by the Saudi Arabian Monetary Agency was created, which is the Saudi Central Bank.

 

The Riyal briefly rose to a 20-year high in 2007 when the U.S. Federal Reserve slashed interest rates in the wake of the Great Recession and the Saudi Central Bank chose not to follow for fear of hyperinflation. However, after a few months, the Riyal returned to its pegged rate of 3.75 SAR. Because the Riyal is pegged to the U.S. dollar, its only correlation is to the "greenback."

 

Saudi Arabia's economy is driven largely by its oil and gas industry. It produces almost 12 million barrels of oil per day and nearly 12% of world output. The country ranked as the largest oil producer in the decade from 2003 to 2012, after which it fell to second place due to surging oil production in the United States. Saudi Arabia remains the world's largest petroleum exporter. With proven oil reserves of about 337 billion barrels and relatively low production costs, Saudi Arabia should maintain its position as a top-three oil producer ((alphabetically) Russia, Saudi Arabia, and the United States) for the foreseeable future. The country's oil and gas industry is controlled by Saudi Aramco, which is controlled by Saudi Arabia's Ministry of Petroleum and Mineral Resources and the Supreme Council for Petroleum and Minerals. Saudi Aramco is mostly state-owned but had an initial public offering (IPO) of 1.5% of the company in Dec. 2019. Meanwhile, although international oil companies do not participate in oil production in Saudi Arabia, several partners with Saudi Aramco in joint-venture refineries and petrochemical plants in the country, partners include Exxon Mobil, Royal Dutch Shell PLC, Sumitomo Chemical Co., and Total S.A.

 

In 2016, there were talks of a potential devaluation of the Riyal. As oil prices plunged, Saudi Arabia was receiving fewer receipts from its oil exports. Because oil is denominated in U.S. Dollars, devaluation would see them receive more Riyal for each barrel sold. However, despite the oil crisis, SAMA refrained from shifting the peg, and ultimately oil prices rebounded off their lows to alleviate some of the pricing pressure. Saudi Arabia is a member of the Gulf Cooperation Council, and in 2010 there were talks of a single currency for the Gulf region. This has yet to come to fruition, although the topic has come up periodically in the region since.

 

The Rise of Petrodollar

Petrodollars are U.S. dollars paid to an oil-exporting country for the sale of the commodity. Put simply, the system is an exchange of oil for U.S. dollars between countries that buy oil and those that produce it. The was the result of the oil crisis in the mid-1970s when prices spiked to record levels. It helped increase the stability of oil prices denominated in U.S. dollars. The term regained notoriety in the early part of the 2000s when oil prices rose once again. Although, initially referred primarily to money that Middle Eastern countries and members of the Organization of the Petroleum Exporting Countries (OPEC) received, the definition has broadened to include other countries in recent years. After the collapse of the Bretton Woods gold standard, the United States struck a deal with Saudi Arabia to standardize oil prices in dollar terms. Through this deal, the petrodollar system was born, along with a shift away from pegged exchanged rates and gold-backed currencies to non-backed, floating rate regimes. The petrodollar system elevated the U.S. dollar once again to the world's reserve currency and, through this status; the United States enjoys persistent trade deficits and is a global economic hegemony. The petrodollar system also provides U.S. financial markets with a source of liquidity and foreign capital inflows through petrodollar "recycling."

 

How It Happened

Through bilateral agreements with Saudi Arabia beginning in 1974, the U.S. managed to influence members of the Organization of the Petroleum Exporting Countries (OPEC) to standardize the sale of oil in dollars. In return for invoicing oil in dollar denominations, Saudi Arabia and other Arab states secured U.S. influence in the Israeli-Palestinian conflict along with U.S. military assistance during an increasingly worrisome political climate, which saw the Soviet invasion of Afghanistan, the fall of the Iranian Shah, and the Iran-Iraq War. Out of this mutually beneficial agreement, the system was born, which cement the US-Saudi relationship and the U.S.-Saudi Arabian Joint Commission on Economic Cooperation till today.

 

Benefits of the System

Since the most sought-after commodity in the world, oil, is priced in U.S. dollars, the helped elevated the greenback as the world's dominant currency. With its high status, the U.S. dollar enjoys what some have asserted to be the privilege of perpetually financing its current account deficit by issuing dollar-denominated assets at very low rates of interest as well as becoming a global economic hegemony. Petrodollars are oil revenues denominated in U.S. dollars. They are the primary source of revenue for many oil-exporting members of OPEC including Nigeria, as well as other oil exporters in the Middle East, Norway, and Russia. Because petrodollars are denominated in U.S. dollars, or greenbacks, their true purchasing power relies on both the core rate of U.S. inflation and the value of the U.S. dollar. This means petrodollars will be affected by economic factors the same way the U.S. dollar is affected. So if the value of the dollar falls, does the value of petrodollars, and thus the government's revenue.

 

Petrodollar Recycling

Petrodollar recycling is the international spending or investment of a country's revenues from petroleum exports. It generally refers to the phenomenon of major petroleum-exporting nations, mainly the OPEC members plus Russia and Norway, earning more money from the export of crude oil than they could efficiently invest in their own economies. The system also creates surpluses of U.S. dollar reserves for oil-producing countries, which need to be "recycled." These surplus dollars are spent on domestic consumption, lent abroad to meet the balance of payments of developing nations, or invested in U.S. dollar-denominated assets. This last point is the most beneficial for the U.S. dollar because it makes their way back to the United States. These recycled dollars are used to purchase U.S. securities (such as Treasury bills), which creates liquidity in the financial markets, keeps interest rates low, and promotes non-inflationary growth. Moreover, the OPEC states can avoid currency risks of conversion and invest in secure U.S investments. The recycling system was also used to invest surplus dollars into sovereign wealth funds, the profits of which were used to invest in activities not related to oil, reducing the nation's dependence on oil. $711 Billion is the global net oil export revenue from OPEC members in 2018, according to the U.S. Energy Information Association.

 

However, countries like China, which holds vast quantities of U.S. debt, have voiced their concerns in the past about the possible dilutive effects to their asset holdings should the dollar depreciate. Nevertheless, the privileges associated with being able to run persistent current account deficits come at a price. As the reserve currency, the United States is obligated to run these deficits to fulfill reserve requirements in an ever-expanding global economy. If the United States were to stop running these deficits, the resulting shortage of liquidity could pull the world into an economic slump. In 1960, Yale economist Robert Triffin described the problem to Congress: either the dollar was not freely available and other countries could not afford to import American goods, or the dollar was freely available but confidence that the dollar could be converted to gold would disappear. However, if the persistent deficits continue indefinitely, eventually, foreign countries will begin to doubt the value of the dollar, and the greenback may lose its role as the reserve currency. This is known as the Triffin Dilemma, named after Robert Triffin, the economist who wrote of the impending doom of the Bretton Woods system in his 1960 book, Gold and the Dollar Crisis: The Future of Convertibility. He pointed out that the years of pumping dollars into the world economy through post-war programs, such as the Marshall Plan, was making it increasingly difficult to stick to the gold standard. The country had to achieve this by instilling international confidence through a current account surplus while also having a current account deficit by providing immediate access to gold.

 

The Triffin Dilemma

The Triffin dilemma or Triffin paradox is the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies. This dilemma was identified in the 1960s by Belgian-American economist Robert Triffin, who pointed out that the country whose currency, being the global reserve currency, foreign nations wish to hold, must be willing to supply the world with an extra supply of its currency to fulfill world demand for these foreign exchange reserves, thus leading to a trade deficit.

The use of a national currency, such as the U.S. dollar, as a global reserve currency leads to tension between its national and global monetary policy. This is reflected in fundamental imbalances in the balance of payments, specifically the current account, as some goals require an outflow of dollars from the United States, while others require an overall inflow. Specifically, the Triffin dilemma is usually cited to articulate the problems with the role of the U.S. dollar as the reserve currency under the Bretton Woods system. John Maynard Keynes had anticipated this difficulty and had advocated the use of a global reserve currency called 'Bancor'. Currently, the IMF's SDRs are the closest thing to the proposed Bancor but they have not been adopted widely enough to replace the dollar as the global reserve currency.

 

In the wake of the financial crisis of 2007–2008, the governor of the People's Bank of China explicitly named the reserve currency status of the US dollar as a contributing factor to global savings and investment imbalances that led to the crisis. As such, the Triffin Dilemma is related to the Global Savings Glut hypothesis because the dollar's reserve currency role exacerbates the U.S. current account deficit due to heightened demand for dollars

 

How the Triffin Dilemma affects Currencies

By "agreeing" to have its currency used as a reserve currency, a country pins its hands behind its back. To keep the global economy chugging along, it may have to inject large amounts of currency into circulation, driving up inflation at home. The more popular the reserve currency is relative to other currencies, the higher its exchange rate and the less competitive domestic exporting industries become. This causes a trade deficit for the currency-issuing country but makes the world happy (foreign official dollar reserves (FRODOR) are an indicator relating international liquidity to the effect of foreign central banks on U.S. monetary policy). If the reserve currency country instead decides to focus on domestic monetary policy by not issuing more currency, then the world becomes unhappy.

 

Becoming a reserve currency presents countries with a paradox. They want the "interest-free" loan generated by selling currency to foreign governments, and they need to be able to raise capital quickly because of the high demand for reserve currency-denominated bonds. At the same time, they want to be able to use capital and monetary policy to ensure that domestic industries are competitive in the world market and to make sure that the domestic economy is healthy and not running large trade deficits. Unfortunately, both of these ideas, cheap sources of capital and positive trade balances, usually can't happen all at the same time. Issuing a reserve currency means that monetary policy is no longer a domestic-only issue, it's international. Governments have to balance the desire to keep unemployment low and economic growth steady with their responsibility to make monetary decisions that will benefit other countries. The reserve currency status is, thus, a threat to national sovereignty.

 

The fall of the Petrodollar System

A falling dollar hurt oil-exporting countries because contracts were priced in U.S. dollars. Their oil revenue dropped along with the dollar.  The cost of imports, denominated in other currencies, increased. With the decline in the purchasing power of the greenback, some nations started to debate the benefits of the petrodollar system. Countries like Iran, Russia, and India have considered shifting the base value of their exports in their currency rather than the U.S. dollar. Recently also there have been concerns of a shift away from US dollars to other currencies. Venezuela said in 2018 that it would begin selling its oil in the Chinese yuan, European euro, and other currencies. Then, in 2019, Saudi Arabia threatened to abandon petrodollars if the U.S. moved forward with a bill, called NOPEC that would allow the U.S. Justice Department to pursue antitrust action against OPEC for manipulating oil prices. The No Oil Producing and Exporting Cartels Act (NOPEC) was designed to remove the state immunity shield and to allow the international oil cartel, OPEC, and its national oil companies to be sued under U.S. antitrust law for anti-competitive attempts to limit the world's supply of petroleum and the consequent impact on oil prices. In short, the changing landscape of the global energy market could result in a de-facto end to the U.S.-Saudi petrodollar agreement.

 

Meanwhile, the U.S. is becoming a major exporter of energy for the first time since the 1960s. Fracking changed that equation and led to a new boom in oil and gas production in the U.S. Total U.S. crude oil production roughly tripled in the decade spanning from 2010 to 2020. Over the same period, the amount of total U.S. oil consumption provided by imports fell substantially. Fracking uses horizontal drilling to access shale deposits previously unavailable through conventional drilling methods. After drilling into the earth, a high-pressure water mixture - called fracking fluid - is applied to the rock to release the gas and petroleum inside. From both a bottom-up and a top - down approach, there is significant evidence that shale oil could be profitable at a price level of $60 per barrel but at $120 per barrel, fracking is a very profitable business. At lower prices, companies are forced to weigh the cost of expensive fracking compared to less expensive extraction methods. While falling oil and gas prices leave producers scrambling to cut costs, fracking can survive below $50 per barrel due to new exploration and production methods. Already, some higher cost wells have already been shut down and the most expensive oil produced in the United States today comes from older wells known as “stripper wells. This, along with a strong domestic energy sector that focuses on exports, could help a smooth transition away from the petrodollar as energy exports replace the capital inflows from Saudi purchases of U.S. assets and uphold global demand for the U.S. dollar. An added advantage for the United States is that it will ensure domestic energy security, which was the main reason for the petrodollar agreement in the first place. Nevertheless, while it will not happen overnight, a drying up of recycled petrodollars could drain some liquidity from American capital markets, which will increase the borrowing costs (due to higher interest rates) for governments, companies, and consumers as sources of money become scarce.

 

If the petrodollar collapses there would be significant economic fallout as this would mean the dollar's value as the world's reserve currency may not hold, impacting the dollar balances of a variety of nations. However, if the petrodollar was phased out gradually and replaced with another currency, such as the yuan, markets may remain stable but the dollar would lose significant power. Many countries favour the de-dollarization.

 

Another Reserve Currency

What would happen if another currency, such as China's yuan, were to become the world's reserve currency of choice? The dollar would likely depreciate relative to other currencies, which could boost exports and lower the trade deficit. The bigger issue, however, would be an increase in borrowing costs as demand for a constant flow of dollars tapered off, which could have a severe impact on the ability of the U.S. to repay its debt or fund domestic programs. China, on the other hand, will have to quickly modernize its financial system, long lamented for protecting its export-led industries, through currency manipulation. Demand for yuan convertibility means that China's central bank would have to relax regulations relating to yuan-denominated bonds.

 

The Prospects of the Yuan becoming the World's New Reserve Currency

China has long been the world's second-largest economy, with the largest foreign exchange reserves and the second-largest share in world trade. However, its position in the global economy has long been recognized, but this recognition has not been accompanied by the international monetary significance of the yuan. Despite China's economic significance, the political importance and the voting power in the International Monetary Fund (IMF) cannot be compared to that of the U.S. because the U.S. has over 17% of the votes, whereas China has 3.8 %. Owing to that, the U.S., together with its allies, gets to block decisions and tailor global economic policy. Striving to establish the world's reserve currency, China has been leading comprehensive economic and trade policies while strengthening the yuan convertibility. As a result, effective October 1, 2016, the yuan has become a reserve currency in the basket of special drawing rights along with the dollar, the euro, the yen, and the British pound. China has been supporting the IMF reform while establishing new institutions aimed at redefining the current international policy under the strong influence of the U.S. There have been several analyses on the channels of Chinese authorities' actions and the prospect of recomposing the international monetary system and reducing the global U.S. influence, to identify whether it is likely that the Chinese currency will obtain the status of the world currency.

 

China has been strengthening its economic and political position in international institutions for years, not only by being integrated into existing institutions under the current rules of the game but also by creating new institutions and changing the actors of the global economic scene according to its needs. The internationalization of the yuan is part of this process. China hopes the yuan will weaken the dollar's impact and take its fair share as one of the world's dominant reserves.  The share of the Chinese yuan in the world’s foreign currency reserves is about 1%, and it has come a long way in a short time. The yuan has made impressive progress in international finance. Entering the IMF currency basket is a symbolic but significant step because it has placed the yuan in the upper echelon of foreign currencies.  It is unlikely that the yuan will succeed in replacing the dollar, especially from the perspective of the poorly developed financial market and the capital account closed. The Communist Party is not an institution of trust outside of China, and the fear of losing their invested funds by a single decision of the Communist Party of China will surely keep the investors away from large-scale investments in China's financial market. Nevertheless, securities from China are still attractive in terms of higher yield, so a certain level of interest in them will exist. Unlike China, the U.S. is called a haven and is considered a lender of last resort, which means that financial assets denominated in dollars, especially the U.S. Treasury bonds, are most reliable. To be considered safe, assets must be the first choice of panicked investors, and must also have a high level of liquidity. For a country’s currency to be considered a haven, such a country must have trustful institutions.

 

Analyzed a bit further and beyond the current moment but on the wave of current realities, China is trying to strengthen its position in the world as much as possible, although 20% of its exports go to the U.S., a market that is introducing taxes on its products, which may lead to a slowdown of China's economic growth. The growth may also be affected by the "fewer workers, more pensioners" trend, and it is therefore likely that the consumption in China will stagnate or decline. In 2013, China reported 13.7% of the population aged 60 and older (MPRA, 2013). According to the UN, a society in which 10% or more of the population is 60 and older is considered an ageing society, and a burden on social security systems is typical for such societies. In a situation with volatile consumption and exports, and hence economic growth, pressure for institutional reforms piles up and, therefore, the ability of China to internationalize the yuan becomes questionable because investors' trust in currency requires trustful institutions. It is unlikely that the yuan will replace the dollar as the global reserve currency because there are many limitations on its more extensive usage and further internationalization. However, the yuan will likely come to and remain at the level of other currencies from the basket of special drawing rights, and hence at the upper echelon of the world currencies

 

New International Monetary System

There is another possibility for reducing the pressures countries face trying to maintain reserve currency status: a new international monetary system, an idea floated for several decades as a potential solution. One possibility is the special drawing right, a type of reserve asset maintained by a global institution, such as the International Monetary Fund (IMF). While this is not a currency, it does represent a claim by other countries on foreign exchange assets. A more radical idea would be to create a global currency, a concept pushed by John Maynard Keynes, with a value-based either on gold or the mechanizations of a global central bank. This is probably the more complex solution available and does present problems relating to sovereignty, stability, and administration. After all, how can you hold an organization accountable that is voluntary?

 

The Bottom Line

In the short term, the prospect of a reserve currency replacing the dollar is slim to none. Despite the economic and political problems facing the United States, its "safe-haven" status is hard to beat, especially in light of the plight of the euro. It is hard to parse out what exactly would happen if the dollar were to be overtaken by another currency, and it is equally difficult to predict what budgetary and austerity measures in Europe and the United States will do to the global economy in the coming years.

 

The Rise of Cryptocurrency like Bitcoin

There is no doubt that cryptocurrency is a game-changer. But in the near term, it will not replace the US dollar. In the long term, anything is possible. Bitcoin is the digital currency that utilizes cryptocurrency and it is controlled by the decentralized authority which is not like the government-issued currencies whereas the Cryptocurrency refers to the technology that acts as a medium for facilitating the conduct of the different financial transactions which are safe and secure.

 

This idea is intriguing on several levels. In terms of retaining value through thick and thin, the ultimate reserve currency cannot be printed (and thus devalued) with abandon by a government. Gold and silver have served as the ultimate reserve currency, as precious metals can be traded for commodities and services, provide collateral for debt and serve as reliable stores of value. While many observers believe gold is still the only reliable reserve currency (or if you prefer, the only reliable backing for government-issued paper money), it’s a worthy thought experiment to ask if a digital currency could also act as a reserve currency.

 

Since there is no real-world commodity backing the digital currency, its value must be based on scarcity and its ubiquity as money. The two ideas are self-reinforcing: there must be demand for digital money to create scarcity, and the source of demand is the digital currency’s acceptance as money that can be used to buy commodities, goods, services and (the ultimate test) gold. It follows that the first step in a non-state-issued digital currency becoming a reserve currency is that it isn’t created in quantities that dwarf demand. If the digital currency is issued with abandon, it cannot be scarce enough to gain any value. “If I own one quatloo (our hypothetical digital currency) and a trillion new quatloos are issued tomorrow, the value of my one quatloo will decline to near-zero”.

 

The second step is its widespread acceptance globally as money, i.e. a store of value and something which can be traded for goods and services. There is a bit of a built-in conflict in these two requirements. To be useful in the $60 trillion global economies, the quatloo must be issued in size: there must be enough of it around to grease transactions large and small in all sorts of markets. Using the U.S. dollar as a guide (since the USD is the primary reserve currency), we can estimate that a minimum of $1 trillion in quatloos would be needed to become a practical global currency. To act as a reserve currency, another trillion or two would be needed, as nations would hold these quatloos as reserves. (Nations hold an estimated $7 trillion in USD reserves, about $3 trillion and $1 trillion or so in yen, pounds and other currencies.) But issuing quatloos in these quantities would remove any scarcity value. Thus the issuer of the quatloo would have to carefully issue more quatloos only when demand justified the need for more monetary “grease” for the global economy.

 

As a transactional form of currency, bitcoin's limitations are inherent. As a reserve asset, bitcoin's possibilities are limitless. One Satoshi could equal $1, $10, $100... It is infinitely scalable. It is also likely ungovernable, adhering only to the will of the people. If governments attempt to reign in bitcoin with regulation, a new layer could emerge with users bypassing the exchange intermediaries (such as Coinbase) with their wallets running on their local hardware connected directly to the network. This was the way it was done in the beginning. If governments target the free will of the individual, this too could backfire. It might only drive fear that they are attempting to salvage their authority from the onslaught of technology, driving bitcoin's legitimacy.

 

We are living in one of the most bizarre moments in history, driven by the accelerating pace of technology, an exponential curve. Tech investors often go by the idiom "if you're not early you're late." Perhaps the euphoria and excitement regarding the tech bubble, that humanity would be reshaped by the transformative impact of networks and computers, was not wrong, just early. Though there are certain "meme stocks" that are in a phase of speculative euphoria today, perhaps this time it is very different in a general sense, and things like bitcoin will indeed be transformative in the long run. There are nations in the world that would like to see the end of the US dollar's dominance, as it would shift the balance of power in their favour. Some central bankers would like to see digital currencies, giving them incredible new tools to track, monitor, and implement monetary policy directly. But perhaps a new Bretton Woods agreement has already happened, and it was a group of cryptographers and software developers creating bitcoin... “Giving the power of the central banks to the masses”. If the government can click a few keys at the Federal Reserve and create money, why can't the people?

 
 
 

 

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