Dollars, Gold & the SDR

The UN suggests replacing unbacked US Dollars with notional SDRs. Why...?

WE READ WITH interest earlier this week a call from the United Nations Conference on Trade & Development for a new global reserve currency, writes Kris Sayce for Dan Denning's Australian Daily Reckoning.

Apparently the current set-up of having the US Dollar as a reserve currency isn't working very well. They're quick learners at the UN obviously!

"The Dollar-based reserve system is increasingly challenged," the UNCTD opines with slight understatement. If "increasingly challenged" were a euphemism for "dead" then we'd agree.

But what do they plan replacing the Dollar with? Special Drawing Rights, or SDRs. If you've got no idea what that means, it's simple.

An SDR is something made up by the boffins at the International Monetary Fund (IMF) to act as an "international reserve asset". The rationale for the creation of the SDR was that "the international supply of two key reserve assets – Gold and the US Dollar – proved inadequate for supporting the expansion of world trade and financial development that was taking place."

Look, I won't pretend to be a grade 'A' student of monetary theory, but to me the creation of the SDR is part of the reason the global economy is in this current mess. That gold was deemed to be inadequate for "supporting the expansion of world trade and financial development" tells you that's when the Western world begun its massive spending spree.

Back in 1969 with the creation of the SDR, we got a spending spree that couldn't be achieved just through stealing money from citizens through the tax system, but one which could only be kept going by the creation of more money. It was, you could argue, the beginning of the "Consume, don't produce" Western economic model.

The problem that SDRs "solved" was the ability to crank up the printing press. Of course that didn't happen straight away. There's always a transition with these things.

First, as it happens, and like the US Dollar, the SDR was backed by Gold. But if you're creating a new reserve that you want to be more flexible than gold – because you want to print more money and spend it. So backing it with gold isn't going to work.

Because backing a currency with gold helps to maintain the value of the paper currency. If you know that your $1 note is redeemable for a set quantity of gold then it will maintain value. Which means the banks can't – or shouldn't – create more paper money than the reserves they have in gold to back it up.

Simply put, Gold creates and requires discipline. Something that bankers and governments in the 1960s weren't happy with. The 'inflexibility' of gold made it harder to for governments to spend and made it harder for banks to lend.

Therefore the creation of the SDR was a stepping stone to abandoning the reserve status of gold. And sure enough, two years after the SDR was invented, US President Richard Nixon closed the gold window at the Federal Reserve and there was no longer any obligation for US Dollars to be exchanged for a fixed weight of gold.

Instead the US Dollar was backed by nothing, and so the SDR was backed by the US Dollar and other currencies which were also backed by nothing.

Yet it is this worthless SDR which is being touted as the new reserve currency. Why should it make any difference? It won't. An SDR is just a weighted basket of other currencies. Unless it is backed by something tangible, such as gold, then it will prove to be equally as worthless as the US Dollar it is replacing.

Perhaps bankers and governments will see the error of their ways and make a call for these new SDRs to be back by gold...?

Not a chance.

There are several reasons. One, as mentioned above, is that gold forces a government and its central bank to be disciplined. It cannot circulate more money without having a corresponding increase in its gold reserves.

If it were to do so then the paper money – or certificates – would not be fully backed by gold. This would cause the value of the paper to decrease – the greater supply of one thing relative to another devalues it.

If people got wind that the central bank was printing more money without increasing its reserve of gold, there would be an increased demand for physical gold. There would be a run on the banks.

The other problem gold has is an image problem. Take this comment from a recent article by Alan Kohler over at Business Spectator:

"But while there's no doubt the gold will continue to be underpinned by the demise of the dollar, it is not a currency. I can't go into JB Hi-Fi with a lump of it and buy a TV.

"Central banks around the world own about 26,000 tonnes of it, which represents 8.5% of total reserves, but it's not legal tender. It's just a commodity they got stuck with because it used to be a currency a long time ago and will never be again."

This represents the common attitude of the mainstream press to gold. They don't understand that it is a store of value. Kohler claims you can't go into JB Hi-Fi and buy a TV with a lump of gold. He's quite correct on that score. But it wasn't so long ago that is effectively what consumers did. Maybe not for TVs but for other items.

Under a gold standard where your Dollar (whether US or Aussie) was backed by Gold, consumers were exchanging a gold backed dollar for goods. It was an exchange of gold for goods, only that a paper note was used as a proxy.

What's so crazy about that? Nothing.

But if you look at Kohler's other comment about 26,000 tonnes of gold being only 8.5% of total reserves, it gives the game away for the real reason bankers and governments don't want a gold backed currency.

Limits on inflation.

It's no coincidence that since the early 1970s, global paper currencies have lost about 90% of their purchasing value. Virtually every currency you name is worth significantly less today than it was forty-odd years ago.

That's not because prices have risen, it's because currencies have become devalued. And as Kohler, perhaps unwittingly admits, central banks and governments have embarked on a massive money-printing exercise.

If paper money still had the backing of gold, then global economies would not have one-tenth of the current problems we are currently facing. The fact that the UN and other government organizations are proposing to replace one currency backed by nothing with another currency backed by nothing signals they are either ignorant or are intentionally pursuing policies guaranteed to deliver economic destruction.

And more importantly to you, to guarantee the continued devaluation of your money and wealth.

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Formerly editor of Strategic Investment with Lord William Rees-Mogg, Dan Denning is an independent investment analyst now based in Melbourne, from where he edits the Australian edition of The Daily Reckoning. He is also author of the best-selling The Bull Hunter (Wiley & Sons).

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