Awesome question from Island Dweller, and one the Czar expects will generate a little bit of mail and, better still, commentary from other brooders within the Castle:

Most illustrious majesty,

Thanks to the Democrats, the yuan has gone up in value. But talk about it replacing the American dollar originates from, and is taken seriously only in, one place: China.

Have you heard anything about the alleged impending introduction of a gold-backed yuan by the PRC in the coming year? Allegedly this is to be done in a bid to make the yuan the currency of record in the world, vice the dollar. If this is to happen, what potential effect do you foresee on the value of the US dollar and the impact on interest rates and markets in the US from this action?

ID

Yes, indeed, the Czar is well aware of the plan, but reminds us that this has been discussed since 2005. For the benefit of our readers, what is the entire deal here?

The US Gold Standard

It is interesting that most Americans who cherish the gold standard know very little about it, and even die-hard economists squabble about what the gold standard meant for American currency at any particular point in our history. The Czar can say pretty much what he wants about it, and find three people to back it up and three people to say he is wrong. The odd truth is that people are going to object to this summary, but it is pretty accurate nevertheless.

When the United States set up the dollar, it did so much like shares of stock: the government had x amounts of gold and silver, and y amounts of dollar bills to print. The price was set at x divided by y. As we printed more dollars, the value of the dollar drops. As we acquire more wealth, the value of the dollar goes up.

Through its earliest years, the American dollar was backed more by silver than gold; this is because we had a lot more silver than we did gold. For example, Alexander Hamilton defined the dollar as 371.25 grains of pure silver out of 416 total grains of mixed metals. The price of silver was tied to the price of gold, so that with a little math you could work out the price of a dollar relative to gold prices. This was great: you could use the dollar to buy and sell goods in other countries using its gold value, and buy and sell good here in America using its silver value. There was about a 15.5:1 difference between the two, more or less, for forty years.

Then, in 1834, the United States set a 16:1 ratio for silver to gold, and as a result we had an operational gold standard in the United States. A debtor could pay off debts with gold coins rather than silver. However, this had an unexpected effect: by changing the value of the dollar, a debtor could save about 2% of his costs by switching from gold to silver, and pocketing the difference. As a result, silver became cheaper in the US and more expensive overseas. Silver began to vanish out of our currency, and by 1850 there were few silver coins in circulation. Every few years, the feds had to adjust and tweak these values to keep gold bearers happy and silver investors solvent.

In the Civil War, all this stopped. The American dollar became based on its promissory value. This means the dollar was not backed by gold or silver, only on the faith that the United States would honor it as legal currency; but no longer would you be able to freely convert your dollars into ounces of gold or silver. The US was no longer using either a gold or silver standard.

This worked well for the duration of the war, but by 1879, we were back on a gold standard, but not a silver standard. As a result, the price and availability of silver fluctuated like crazy. In 1900, we formalized a system by which gold would be the standard, but silver certificates, dollar bills, and silver dollars could be easily converted to gold.

In 1933, the United States realized it literally lacked enough gold to meet demand. To prevent the disastrous inflation experienced by Germany, but to prevent massive exporting of American gold to foreign investors, the Roosevelt administration ended the gold standard, nationalized all private ownership of gold, and revalued the dollar to devalue the price of gold by 40%. The net result was the government owned all the gold and issue about $3 billion in dollar bills without overtly creating rampant inflation.

Between 1934 and 1973, however, we had a fake gold standard. You could set the value of the dollar based on the price of gold overseas. But in 1944, the Bretton Woods international monetary agreement resulted in countries using the value of the American dollar to set their gold prices in their own currencies. This is extremely important. The point of this agreement is that a foreign country can buy and sell investments in US dollars as a form of protecting itself against its own financial crises. If a country’s own currency begins to tank, it can limit the damage by cashing in its investments made in US dollars.

Just to wrap this up, the Nixon administration experimented with setting the value of the dollar to various amounts of gold. Each adjustment seemed to create havoc in the markets until finally it was realized we had to just give up. In 1973, we elected to terminate the gold standard and by 1976, our currency was completely tied to consumer price indices, and not strictly gold.

We left a hell of a lot out, especially about silver, gold and silver certificates, devaluation, and price indexing. Please don’t write in unless you have a more succinct history.

The Reserve Currency

Okay, now that you know that the US never fully embraced the Gold Standard—sorry, Ron Paul—we need to turn our attentions elsewhere.

The US dollar is pretty much the number one reserve currency in the world. If you are another country, like say Australia, you buy dollars and lots of them. You also buy Euros and British pounds as well. After all, if some disaster befell the Australian dollar, your government would still have a lot of capital left thanks to your foreign investments. In other words, here is the Bretton Woods agreement we mentioned earlier.

The dollar is, thanks to that agreement, the world’s primary reserve currency. Basically, no matter how screwed up your country is, you can always depend on the dollar. The euro is basically a doomed currency since it supports marginally okay governments like Germany and charlie foxtrots like Greece. The volatility is too high. The British pound is great, but we saw in the collapse of the Asian markets in 1997 that there aren’t enough pounds sterling to go around. The yen? No chance. The Canadian dollar? Nope: not enough of them.

So the dollar is really the best choice for doing business. There are a lot of them, people like it, and there exists enough resources to know the exchange rate between a dollar and anything else. You can be Chile and pay a huge debt to Thailand using American dollars. You can be Lesotho and purchase a huge investment from Uzbekistan using American dollars. Good luck doing that any other way…except using gold, of course: but if you export your gold, your home currency is devalued and your economy takes a hit.

The Yuan As Replacement

Okay, so now there is concern about the yuan being a replacement.

Is Poland considering it? Cambodia? Colombia? Sri Lanka. perhaps? Maybe Pakistan? No? The Ivory Coast? Indonesia? Algeria? Singapore? Russia? South Africa? Japan? The Philippines, maybe? How about Panama? Kuwait? Kenya? Israel?

The fact is that only one country is considering the yuan as the new world’s reserve currency: China.

Presently, the Chinese 元 (yuán) is curious unit of currency. Because China is becoming a massive economic power—although it is nowhere close to the United States, being about half as productive as we are—it wants to do a lot more business around the world than it is already doing.

The problem for China is that nobody else wants to touch its toilet paper currency. You want to do business with China? You do it in US dollars.

You do this because the yuan is a piece of paper whose value is set by the Communist Party. You have no reliable index to know whether or not the Chinese are ripping you off when you do business with them. The yuan is worth precisely what some nameless agency in Beijing says it is, and nothing more. Most foreign investors are aware that China has two values for the yuan: a worthless one, used by the Chinese themselves, and a seemingly valuable one that is limited to doing business with gullible foreign investors. Yes, the implication is that the Chinese have been cooking their books for years—just as we saw American debtors doing by converting silver and gold back and forth in the 1800s—using the difference in exchange rates to skim off the debt.

China is terribly sensitive about this, of course. She insists her yuan is worth about 6 to the US dollar, which is up 3% since 2012. But so what? Until you fix its price to something convertible, no one wants to do business in yuan.

As a result, China is now considering using a gold standard. Of course, as we see in our own country’s history with the gold standard, this is not always desirable. A gold standard can cause as many problems as it solves—hence, the world’s other countries elected to use the American freaking dollar as the reserve currency.

China can dicker around with a gold standard if she wants. Best of luck. But the world is not about to undo a century of great work by flipping the dollar to the yuan. Know why?

It would be disastrous to the value of foreign investments. By the way, as we all know, China holds a shitload of American investments in US dollars. China is not about to see those get devalued despite Xinhua’s editorial on why the dollar is done. Something like 62% of the world’s reserves are in US dollars. The rest is made up of euros, yens, pounds sterling, and Swiss francs. No, not even a sliver are yuan. In fact, only Australia and Japan trade in yuan, and they do so in limited, restricted ways.

Also, as long as the Chinese are nominally communist, there will be no faith in the yuan’s value. One of the reasons people trust the dollar is that America makes all information about its value completely public and heavily up to the free market. Nobody trusts a commie in a bad suit deciding what the yuan is worth to you, today.

All oil is sold in petrodollars, not petroyuan. Although the petrodollar is a construct of economics, the reality is that US dollars are still the default currency of oil transactions for many, many major economies. The yuan is only now cracking into that market; it has decades before it will be taken seriously.

Reality Check

Yes, the yuan will likely become a major economic consideration, and it can become a world currency like the euro, pound, yen, and franc. But it will take a very long time, and a lot of major changes in China, before it will be taken as seriously as even the Swiss franc.

A Chinese gold standard could help the yuan; history says the result may be more problematic. But here’s the thing: if the yuan ever sticks to a gold standard, the odds are ridiculously high that this gold standard will be indexed to the American dollar before it is translated to yuan.

The American dollar has more to fear from quantitative easing than it does from the yuan.

The Czar of Muscovy

Божію Поспѣшествующею Милостію Мы, Дима Грозный Императоръ и Самодержецъ Всероссiйскiй, цѣсарь Московскiй. The Czar was born in the steppes of Russia in 1267, and was cheated out of total control of all Russia upon the death of Boris Mikhailovich, who replaced Alexander Yaroslav Nevsky in 1263. However, in 1283, our Czar was passed over due to a clerical error and the rule of all Russia went to his second cousin Daniil (Даниил Александрович), whom Czar still resents. As a half-hearted apology, the Czar was awarded control over Muscovy, inconveniently located 5,000 miles away just outside Chicago. He now spends his time seething about this and writing about other stuff that bothers him.