A reserve currency for the 21st century...

The 15th of August 1971 passed by as a largely normal summers day in the northern hemisphere. The main news focus within the British media was on the controversial British horse rider Harvey Smith. He had been stripped of his British Show Jumping title and £2,000 winnings for allegedly making a two-fingered "up yours" gesture in the direction of the judges after winning the British Show Jumping Derby. A big deal it seemed, breaking with the expected decorum of the British summertime.

A more significant break from decorum that the general public, the media and most financial observers were largely oblivious to also took place on August 15, 1971. The implications of that event, however, have had an enormous impact on global financial conditions ever since. On that date, US President Richard Nixon “closed the gold window”. In essence, Nixon had given his own two-fingered salute - in his case to the Bretton Woods Agreement established in 1944, which made the US dollar the world’s reserve currency and allowed other countries to convert their US-dollar holdings into gold. Those who may have glanced at the announcement buried within the pages of their daily newspaper were unlikely to have understood the implications for their financial future. In simple and realistic terms, the US government had defaulted - they could no longer sustain the established link between the convertible price for gold and their currency, so they defaulted on the agreement.

Under the Bretton Woods agreement, there was some control over the world's money supply since other currencies were convertible into US dollars, and the dollar itself was convertible into gold. With the demise of Bretton Woods, the entire world found itself on a monetary system backed by nothing more than the faith and credit of individual governments for the first time in history – what is termed a pure "fiat" system. This meant there were no longer any restraints on the amount of money that individual governments could create at will. As a direct consequence, a flood of paper money was unleashed globally, a trend that has increased exponentially over recent years.

Without the fiscal restraints that are part and parcel of a gold-backed currency, politicians worldwide were able to promise social programs and expand government bureaucracies that could be delivered through borrowing money created by the central banks rather than through direct taxation. They could embark on military campaigns and other "extravagances" with borrowed dollars that future generations would have to repay. And borrow they did, particularly in the US. In 1971 the total US federal debt stood at $436 billion. Today, that number exceeds $11 trillion. The increases in the 2009 annual deficit will, in nominal terms, be many multiples of the entire US debt in 1971. Worse still, when calculated in accordance with Generally Accepted Accounting Principles (GAAP), and taking unfunded Social Security and Medicare obligations into account, the total federal debt is actually in excess of $50 trillion. Taken on that controversial basis the US deficit is running at around 400% of GDP, which makes Ireland's government spending look positively thrifty.

It's pretty clear from US and other G20 country's plans to address the current economic crisis that increasing the size of their debts is not an obvious concern for policy makers. Much of the discussion in the media, is about whether the debts that are being increased will be affordable for future generations. Perhaps as the Chinese are starting to mutter about the need for a new reserve currency, the real concern may be that the US doesn't actually care about degrading their currency to the point of effective default - their current needs are even more pressing than that. As John Paul Getty once said: "If you owe the bank $100, that's your problem. If you owe the bank $100mm, that's the bank's problem." Given the size of the foreign debts of not only the US, but many other countries, the lenders/ savers like China may ultimately be the ones with the problem. This situation is not dissimilar to the unfortunate pensioners of the world, who tried to prepare thriftily for their retirements, only to see their funds dramatically eroded by excessive risk taking by those who were managing their monies.

Terry Smith of the London interdealer broker Tulletts commented recently: "Two thirds of the world's assets are denominated in a fiat currency issued by a country whose authorities are taking policy actions which seem inevitably to lead to its debasement - it seems the Chinese have now concluded that this is not acceptable. The logical conclusion of where we will end up eventually is with some type of gold standard," he explains, arguing that future inflation will almost inevitably cause a future collapse in government bonds.

The growing discussion about a return to a gold standard is understandable, but at this stage not really viable or logical. UBS, the investment bank, has calculated that the US reserves of gold are so small, relative to its monetary base, that the gold price would need to rise more than sixfold to above $6,000 per ounce for a "standard" to be re-implemented. Furthermore to implement the standard in Japan, China and the US, the price would be more than $9,000. The truth is that none of these governments would want to follow this route - replacing the fiscal shackles of 40 years ago is beyond unpalatable.

Gillian Tett in the FT points out, however, the fact that this debate is occurring at all shows just how much "cognitive dissonance and utter uncertainty continues to stalk the markets". In the interest of continuing this cognitive dissonance - a few thoughts: What about alternatives to a dollar reserve, or to the gold standard? As I've discussed on a previous blog, there is no real reason for either of these being "the standard" as they only retain value if everybody believes they are good stores of value - faith which should be disappearing in the case of the dollar. In the case of gold - it was only a credible store of value because of a historical trend, not because of any long term practical value.

What about a standard based off something that we will all need for all time, the three most obvious things being food, air and water. Drinking water or wheat, for example, or even at some later stage something like carbon emission credits, might suffice? All of these retain a long term value that stretches far deeper than gold or the US dollar - they are literally crucial to human existence - so could not be so easily degraded by policy action in the same way. Moreover, as expectations of future shortages of water, food and breathable air are major global concerns, perhaps these are compelling reasons to make one of them a real centerpiece of our economies as their preservation and production would be all the more important.

A wild and outlandish suggestion perhaps, but nothing seems beyond the pale given where we have put ourselves.