The Network Effect – Can Gold replace the US Dollar?
Published on 5th September, 2024
In February of 2022, following the invasion of Ukraine, the United States declared unprecedented economic sanctions against Russia. Russian foreign exchange reserves were frozen, and Russian banks were cut off from the SWIFT payment system, effectively eliminating their ability to conduct international trade. This blatant weaponization of the US dollar shocked the world, and made it clear to the BRICS nations, that in order to protect themselves from such sanctions they must reduce their dependence on the dollar, and develop an alternative financial system. This, however, is easier said than done. In order for nations to adopt a new reserve currency, there must first be trust in the issuing body, and such trust is not easily gained. As we will demonstrate in this article, in order to rid themselves of the dollar, BRICS nations may have no choice but to revert to humanity’s most ancient money – GOLD.
The Dual Role of a Reserve Currency
A reserve currency serves two functions. In times of peace and prosperity, it is mostly used in order to conduct trade. International corporations will usually not accept local currencies, which are not considered to be trustworthy, have little to no use for them, and don’t have a large bond market in order to invest the proceeds. It is much easier for them to accept payment in a reserve currency such as the US dollar, which is considered stable and liquid, and can easily be invested in interest bearing bonds. In times of crisis, the reserve currency can also be used in order to stabilize the local currency, by selling the reserve currency into the market in exchange for the local currency, or God forbid in order to fund the purchase of arms and ammunition, in order to fight a war.
The Shifting Role of Gold in Modern Reserves
In the past, gold served both of these functions. It was a highly liquid commodity, which was accepted as payment all over the world. Under the classical gold standard, it was used in order to back local currencies, and constituted the bulk of foreign exchange reserves. Gold could have been counted upon to fund the government in times of need, and the amount of gold in a nation’s coffers was an indication of its economic strength and resilience. During the 20th century, the US dollar took over this role. Nowadays, many countries don’t have any gold reserves to speak of, and those that do hold it mainly due to historical reasons. Most economists have forgotten the importance of gold in mitigating tail risks. To use the words of Ben Bernanky when he was asked about it during a 2011 congressional hearing, central banks hold gold merely as a “tradition”. But this situation is changing rapidly, as more and more countries are coming to realize the advantages of gold as a reserve asset.
The Evolution of the US Dollar as a Global Reserve Currency
In order to understand the difficulty in replacing the US dollar, we must first explain how it came to be the global reserve currency. This did not happen overnight. It was a long process, which began during the 1920’s. After World War 1, European nations were struggling to reinstate the gold standard, which was suspended during the war. Instead of bullion, certain countries started accumulating gold-backed currencies as part of their foreign exchange reserves. This hybrid system was called the ‘gold exchange standard’. The American economy was largely unaffected by the conflict, and the gold backed dollar was considered to be stable and reliable. Indeed, by 1929 the share of the US dollar in aggregate foreign exchange reserves had surpassed that of the Pound Sterling.
The Bretton Woods Conference and the Birth of the Post-War Financial Order
A similar thing happened during World War 2. Again, the American manufacturing base remained unscathed, while the rest of the world lay in ruins. In July of 1944, after the allied forces invaded Normandy and it was becoming evident that they would win the war, a historic conference took place in Bretton Woods, New Hampshire. 730 delegates from all 44 allied nations convened in order to determine the international financial order after the war. The renowned economist John Maynard Keynes advocated for the formation of a global central bank, which would issue a new international currency called “the bancor”. However, the Americans insisted that the US dollar would be the foundation of this new system. The dollar would be backed by gold at a ratio of 40%, and the currencies of other nations would be backed by dollars. Although American citizens were forbidden at the time from holding gold bullion, foreign nations would be able to redeem their dollars at a fixed rate of 35 USD per ounce. This would grant some backing to their currencies as well.
However, the United States failed to keep its promises, and during the 1960s it issued too many dollars, in order to fund a variety of social programs and the Vietnam war. Inflation started to creep in, and the dollar was losing value. The efforts to keep the price of gold pegged at $35 an ounce failed, and the amount of gold held at Fort Knox started to fall. In August of 1971, president Richard Nixon suspended the convertibility of dollars into gold, in what is now known as “the Nixon Shock”. Fearful that the US may lose the rest of its reserves, he reneged on the Bretton Woods agreement, and severed the last connection between the Dollar and gold. As a result, the US dollar became a pure fiat currency, which is backed by nothing more than trust. In an attempt to shore up the dollar, The Nixon administration negotiated in 1974 an agreement with Saudi Arabia, according to which the Saudis will only trade oil in exchange for dollars, and in return the US will supply them with arms and vouch for their safety. This agreement gave birth to the “petro-dollar”, and cemented the dollar’s position as the dominant currency for international trade. Although its effects took some years to be felt, it greatly contributed to the dollar’s strength. This is how the US dollar managed to achieve what no other currency in history was able to do. On one hand it was a fiat currency, unbacked by any tangible commodity.
On the other, it maintained its popularity, generating constant demand. Indeed, it could never have attained this position without first being backed by gold. But once it reached “escape velocity”, it no longer needed gold.Just like Google has a monopoly over the search engine market, and just like Bitcoin is the leading crypto-currency, the Dollar enjoys a form of “Network Effect”. Since dollars are needed in order to conduct international trade, governments are forced to hold large dollar reserves, and since they hold large dollar reserves, it is convenient to use them for international trade. These two facts reinforce each other. This is also why the United States has such a well-established and liquid bond market – once you have those dollars, you may as well invest them in an interest bearing instrument. Any country which tries to abandon the dollar in favor of another reserve currency soon realizes that it has hardly anyone else to trade with, and that there is no reliable way to invest those funds. In order to change this reality, multiple economies would need to switch their reserve currencies all at once, and such coordination is very difficult to accomplish.
Another factor which stabilizes the dollar and helps it maintain its position, is the fact that many corporations around the world have dollar-denominated debt. This debt is issued by non-U.S. banks, who have no authority to issue new dollars, and yet the financial system treats this debt no differently than debt which is issued by U.S. banks, which are part of the Federal Reserve system. In financial jargon, these are known as “Eurodollars”, not because they have anything to do with the Euro currency, but because originally they were mainly issued by European banks. This market is largely unregulated, and its size is estimated to be a staggering 65 trillion dollars. In order to stay in business, these corporations need to constantly service this debt. This creates a strong demand for dollars all across the world. As a matter of fact, some analysts argue that this demand is enough to offset any deficit that the US government may incur. This also means that corporations cannot walk away from the dollar until they have settled this debt.
The Dollar’s Dominance and Resilience in Global Finance
Last but not least, there is another advantage for countries who remain within the dollar sphere, and are in good standing with the US government. In case of a financial crisis, they may expect the Federal Reserves to bail them out through the mechanism of currency swap lines. This transfusion of dollars has already been used on several occasions in order to address liquidity events and prevent their contagion to the rest of the financial system. Every country which chooses to de-dollarize puts itself in danger of a dollar crunch, which cannot be resolved.
Today, about half of global trade is denominated in US dollars, although the United States accounts for only 10% of global trade. The US dollar is also involved in almost 90% of foreign exchange transactions and 85% of transactions in spot, forward and swap markets. The US dollar is the most traded currency in the world, with an average volume of 2.9 trillion dollars per day. As of 2022, central banks across the globe held about 59% of their reserves in US dollars. These reserves are either held as cash, or in the form of US treasuries. In light of this dominance, we may wonder – is the US dollar impervious to economic downturns? Since 2009, the Federal Reserve has enacted controversial policies of zero percent interest rate and QE. The national debt ballooned from 11 trillion to 35 trillion dollars. Arguably, these policies have led to the outbreak of inflation. But apparently, they have not hurt the position of the dollar at all, and the hiking campaign which the Federal Reserve has been leading since 2022 has only made it stronger.
This is at least the prevailing narrative among economists nowadays. In reality, the US dollar has remained strong only compared to other fiat currencies, and not compared to goods and services. According to the CPI, since the inception of the federal Reserve in 1913, the dollar has lost no less than 97% of its purchasing power. Most of this decline occurred after 1933, when gold coins no longer circulated in the US, and no meaningful deflation was able to take place. Gold, on the other hand, preserved its value during the same time period, and according to the CPI even gained purchasing power. Adjusted for inflation, the price of an ounce of gold in 1913 is equivalent to 662 present day dollars, whereas the current price of gold is about 2,500 USD. As a matter of fact, in terms of gold, many items which we consume on a daily basis, such as food or fuel, have maintained their prices, or even gone down in price. The rising cost of living is not lost on the American public, which is showing increasing discontent.
Another crack in the dollar’s armor is the fact that Saudi Arabia is currently stepping back from the petro-dollar agreement. Although no formal declaration has been made, it appears that Saudi Arabia is now open to the selling of oil in exchange for other currencies such as the Euro or the RMB. This is no doubt connected with the deterioration of US-Saudi relations, due to a strategic divergence over the issue of Iran, and also due to personal friction between the Biden administration and crown prince Mohammed bin Salman. Although Saudi security is provided by the west, its livelihood comes primarily from the east. For instance, 50% of Saudi exports in 2021 went to China, Japan, India and South Korea. Its announcement earlier this year that it will be joining the BRICS organization is a clear signal that it is pivoting away from the west.
As the international oil trade becomes less centered around the dollar, its position as the global reserve currency is weakened. But none of the factors which undermine the US dollar is enough to bring to its downfall. In order to supplant the dollar one must present an adequate replacement, and apparently none of the existing national currencies is up to the task. The Euro, for instance, is the currency of some of largest and most powerful economies in the world, and already has a 20% share of global foreign currency reserves. But many economists argue that it is a flawed currency, because it represents only a monetary union, and not a fiscal one. As long as countries within the Eurozone have independent fiscal policies, the Euro will remain problematic, like we’ve seen during the European debt crisis of 2009. The RMB is equally unsuitable to replace the US dollar. Although China’s economy is second only to that of the US, and although it is a manufacturing powerhouse, the RMB currently represents only 2% of global foreign currency reserves. The reason for that is that it is not a free floating currency. Since 2004, the PBoC has been gradually promoting the internationalization of the RMB, but it still has ways to go. At any rate, all national currencies nowadays are fiat currencies, just like the US dollar. Therefore, in an inflationary environment, they have no real advantage over the dollar.
Enters gold. For decades, the yellow metal has been maligned in the financial press as a “barbrous relic”, or as a “pet rock”. Asset managers have repeatedly pointed out that it has no yield, overlooking the fact that the dividend yield of the S&P500 itself has fallen, and for the better part of this century has been less than 2%12. In recent years, the stock market has outperformed it handedly, but on a long enough time scale, such as 20 years, it had an annualised return of over 8%, which is comparable with the return of both US and EM stocks, and far exceeds that of US treasuries. In times of crisis it tends to outperform the stock market, and in most cases the bond market as well. But here’s the thing – gold is not supposed to compete with the stock market or the bond market. Physical gold is a risk free asset, which can never go bankrupt and can never default. It has been money for thousands of years, and under the correct set of circumstances it has the potential to become money yet again. Therefore, it should only be compared with our national currencies, and on that category it is a clear winner.
Every fiat currency loses value over time, and the US dollar is no different. In times in which this process is slow, people don’t give it much thought. They invest their savings in the capital markets and hope to earn a return which compensates them for inflation, and then some. But in times of high inflation, the preservation of our purchasing power becomes a priority. History shows that in such an environment gold performs best. Suddenly there is a renewed interest in the yellow metal, and it begins to outperform. Year to date, for instance, the price of gold is up 20%, and this is probably just the beginning. We are seeing record breaking demand for gold from central banks across the world, which is putting pressure on the price to rise. In addition, there is strong investment demand in countries such as China and India. Is this enough to make gold a viable alternative to the dollar?
Not quite. The main disadvantage of gold is that it is difficult to transport, and involves storage and insurance fees. It is not as convenient as the dollar and other digital assets when it comes to international trade. But BRICS nations may yet change this situation, with the launch of projects such at “The Unit”, a gold-backed trade currency which utilizes blockchain technology. Using such a currency, there is no need to physically transport gold for each and every transaction. A network of national clearing houses will track the amount of gold which is entering and leaving each member state, and the deficits and surpluses will be settled periodically in physical gold. These clearing houses can also cut down on storage and insurance fees, thanks to economy of scale. Using smart contracts, such a currency can also support the establishment of a bond market, which will allow surpluses to be invested and provide a yield.
For the first time ever, the US dollar will have a worthy contender. An international currency which is both convenient, and naturally immune to inflation. A currency which comes with a built-in network effect, because it is constructed by a group of nations, which is interested in its success. If a project of this kind takes off, and manages to acquire a decent share of global trade, it has the potential to give the dollar a run for its money.
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