Yesterday I explained why a gold-backed currency cannot replace the fiat dollar without fatally disrupting global Capitalism and the political Status Quo everywhere from China to Europe: Why the U.S. Dollar "Works" and Why a Gold-Backed Currency Doesn't (September 7, 2011).

Today we look at why the fiat dollar is the one essential currency, and as a result, why it will rise in value in the Eurozone crisis ahead. I know this is heresy and sacrilege to those who believe the dollar is doomed, and soon, but if you're not yet locked into one quasi-religious faith or another just yet, then please follow along as I trace out the dynamics of trade and currency valuation.

To understand the essential role of the dollar and how its value is derived via trade flows, let's start with a simplified model of global trade.

Country A manufactures surplus goods and generates surplus services. Since its domestic demand is structurally constrained (for example, a mere 35% of China's GDP is domestic demand), the only way Country A can keep its citizens employed and politically pliable is to sell its surplus in other countries.

This is the basic mercantilist export model of growth pursued by Germany, Japan, South Korea, China et al.: growth and value are created by generating surplus goods and services, and exporting those to other nations.

In sum: Country A has stuff it has to sell to other countries to keep its economy from spiraling into depression. It can demand whatever it wants: gold, moon dust, etc., but it is not in the driver's seat: it has no alternative to dumping its surplus in whatever markets will take it. Managing its exports boils down to getting the best deal possible, but saying "no" is not an option.

There is little demand for Country A's currency, as what it is trading isn't currency, it's stuff: it trades its surplus production (stuff) for somebody else's currency.

Country B has a something called "the world's reserve currency" which is a fancy name for paper money that is universally recognized as a placeholder of value that can be traded everywhere from Burma (pristine $100 bills preferred) to Bolivia (cocaine-laced $100 bills OK) and accepted without question (even counterfeit bills are OK as long as they're the high-quality North Korean counterfeits). Let's call Country B's currency the doru.

Country B has exports, but its demand for imports far exceeds the value of its exports. For all imports over and above the value of its exports, it exchanges its paper money for the imported real goods and services.

Country C has no reserve currency and no gold-backed currency. It has paper money which it can print in unlimited quantities. Country C has exports, but its demand for imports far exceeds the value of its exports. For all imports over and above the value of its exports, it exchanges its paper money for the imported real goods and services.

Country C has a tricky problem. Since its paper money has no intrinsic value, the only value it can possibly have is scarcity value: the supply must be strictly limited so that exporting nations will accept County C's currency (let's call them quatloos) in exchange for tangible goods like oil and iPads.

In effect, Country C is asking exporters to accept a premium on the intrinsically worthless paper, a premium "earned" by scarcity: if there are relatively few quatloos floating around the world, then quatloos may well retain some scarcity value, even though their value based on other factors is basically zero.

The best way for Country C to finance its import trade is to exchange its intrinsically worthless quatloos for "the world's reserve currency," the doru, which is accepted everywhere.

Some would argue that Country C should buy gold with its quatloos, and that would certainly be an excellent trade: worthless paper for gold. But in terms of trade, shipping gold about is hazardous and costly: every nation engaged in trade needs an electronically traded currency that can be transferred, loaned, borrowed and so on, all in the blink of an eye.

Gold is a reliable store of value but it is a cumbersome means of exchange, especially globally.

Furthermore, gold's value in currency or other goods has a history of fluctuating wildly. Those managing quatloos could easily get burned, as the trade they're really managing is quatloos to gold to the reserve currency which can actually be traded globally for goods and services.

Any such commodity-based transactional chain is rife with risk from geopolitics and speculation. From the managers of the quatloo's perspective, the easiest way to lower risk is to cut out the middle step of buying and selling gold, and just buy the reserve currency (the doru) directly.

All this works until Country C succumbs to the temptation to print money to the point it is in surplus rather than scarcity. And what a temptation it is, to "increase our wealth" magically by printing quatloos.

But exporters, forced by circumstance to constantly assess the tradable value of all currencies they trade goods for, will quickly detect that the scarcity value of the quatloo--it's only real value--has rapidly declined.

The cost of imports priced in quatloos in Country C shoots up as quatloos lose scarcity value, and the residents of Country C find they can no longer afford to buy imports. The sales of imports collapses down to match Country C's exports.

These are the key dynamics of trade and currency valuation. Now let's consider Country B, owner of "the world's reserve currency," the doru.

Superficially, it might seem that the only value in dorus is also their scarcity value, and since Country B prints/creates large quantities of dorus every year, many observers make the understandable mistake of claiming the value of the doru should be zero, since it is has little to no scarcity value.

But the value of "the world's reserve currency" is not simply a matter of scarcity, as it is for other lesser fiat (paper) currencies. One factor is the nature of scarcity is different for the doru and the quatloo: the quatloo has only one use in terms of global trade: the imports and exports of Country C.

Since Country C's GDP is a thin sliver of global GDP, then demand for quatloos is limited to importers and tourists.

Compare that to "the world's reserve currency," which is in constant demand as a means of exchange in the entire $60 trillion global economy.

"The world's reserve currency" (in our example, the doru) has another unique feature: everybody eventually needs to exchange quatloos and all other currencies for doru, because that is the only universally accepted means of global exchange. Sure, Country C and its cronies can set up an exchange which only accepts gold and quatloos, but as soon as they need wheat, electronics, and everything else the cronies don't manufacture or harvest, then they will need to exchange the gold or quatloos for "the world's reserve currency."

As a result, the demand for doru ("the world's reserve currency") is stupendous and constant. Since currency is a commodity, albeit one with unique features, its ultimate value as a means of exchange is set by supply and demand. In other words, scarcity is not the only source of value: demand is the key driver of value of any commodity, good or service.

Let's say that Country B's economy is about 25% of global GDP. (In other words, like the U.S.) Let's further assume that Country B prints/creates about 10% of its GDP every year in paper doru.

Now if Country C printed 10% of its GDP every year in newly issued quatloos, the supply of quatloos would quickly overwhelm demand for quatloos, and the value of quatloos globally would crash.

Country B doesn't have that problem, because printing 10% of its GDP is a mere 2.5% of global GDP. Globally, the value of currencies exchanged daily exceeds 10% of Country B's GDP and more or less matches the total value of doru in global trade.

In other words, the demand for exchangable, tradable currency--"the world's reserve currency"-- far exceeds the supply of doru. Printing doru, even in quantity, is like adding a glass of water to a bathtub: the supply increase is not even close to the daily demand.

How did Country B get the "the world's reserve currency" instead of Country C? Most importantly, there has to be enough of the currency to grease the tremendous flows of goods, services, loans and hedges globally: the tiny quantity of quatloos is completely inadequate to the task.

Second, the "the world's reserve currency" must be relatively immune to increases in supply, i.e. money printing. For example, if global GDP is $60 trillion, and daily foreign-exchange trading is $2 trillion, then exactly how much impact can printing $1 trillion of "the world's reserve currency" generate? The answer globally is very little.

The third factor is one which few commentators recognize, sometimes called "the hidden export:" global security. All financial transactions involve trust, some more than others. In terms of currency, the primary trust being offered and accepted is that the mechanics of the currency are transparent and thus so are the risks.

The secondary trust is that the value of the currency will remain stable over the short term, which is long enough for the vast majority of trading.

A third trust is in the stability of the issuing nation. Once again, transparency is key: if that nation's problems are well-known and transparent, then the risks of that currency can be easily and accurately assessed. If its institutions are robust and its trade flows gigantic, then people recognize it's a safer bet to hold dorus than quatloos.

The key mechanism for creating surplus value in advanced Capitalism is trade, and the key mechanism for enabling that trade is a "reserve currency" of sufficient quantity and stability. The Chinese renminbi is a proxy for the U.S. dollar, the euro is unraveling, and the yen is not expansive enough to fund global trade and currency flows.

Envy is a key human trait, and the envy of all those who don't hold/print "the world's reserve currency" is understandable. But you can't create "the world's reserve currency" like some other paper money, as paper money only has two sources of value: demand and trust.

As Jesse of the always-valuable Jesse's Cafe Americain recently wrote (and I paraphrase), people often offer reasons why certain things that have happened could not happen. Conversely, they also often offer reasons why things that can't happen should happen.

At some point the trade imbalance of $600 billion a year between the mercantilist nations and the U.S. will go away, as will the notion that printing paper money is creating wealth, and debts that are unpayable will magically be paid instead of being liquidated or repudiated. The point here is that the Status Quo of all the major trading nations is committed to conserving the present system of fraying imbalances, as their own wealth and power flow from this shaky, unsustainable structure.


Podcast/Interview alerts:

My friend Richard Metzger of the highly popular Dangerous Minds site invited me down to his studio in L.A. for a high-definition (and hopefully illuminating) discussion on THE END OF WORK: AN INTERVIEW WITH CHARLES HUGH SMITH (video). Thanks, Richard! As always, it was great fun and I learned a lot.

Zack Miller of tradestreaming.com was kind enough to interview me recently: check it out if you're interested in investing in troubled times, like now, f'rinstance: Investing In Troubled Times – With Charles Hugh Smith. Thank you, Zack, for the chance to ramble on about my favorite topics.

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