Will the Dollar be Replaced as the World's Reserve Currency?

Several weeks ago, the G-20 group of wealthy nations authorized the issuance of $250 billion dollars worth of an alternative currency called "Special Drawing Rights". Special Drawing Rights (SDR), are a currency issued by the International Monetary Fund, an inernational organization which provides aid to countries which are struggling financially.

Indeed, China's central bank recently proposed making SDRs the world's reserve currency.

Russia also backs making the SDR the world's reserve currency, and that Russia wants the SDR to be pegged to a basket of yuans, rubles and gold (currently, the SDR is pegged to four currencies: the dollar, yen, euro and sterling).

Before you dismiss this as beyond the realm of possibility, you should note that Nobel Prize-winning American economist Joseph Stiglitz believes that the authorization of $250 billion in SDRs is an important step on the way to creating a new global reserve currency, that the shift away from the dollar as reserve curency and towards a basket of currencies actually started a couple of years ago, and that SDRs could be phased in as the world's reserve currency within a year.

Interestingly, China has raised the possibility of an alternative peg for the SDR based upon commodities:

China's government has floated a variant of this idea, suggesting a currency based on 30 commodities along the lines of the "Bancor" proposed by John Maynard Keynes in 1944.

(Keynes was the most prominent economist of the first half of the 20th century, conventionally credited with ending the Great Depression.)

Indeed, the head of the China's central bank wrote recently:

Though the super-sovereign reserve currency has long since been proposed, yet no substantive progress has been achieved to date. Back in the 1940s, Keynes had already proposed to introduce an international currency unit named "Bancor", based on the value of 30 representative commodities. Unfortunately, the proposal was not accepted. The collapse of the Bretton Woods system, which was based on the White approach, indicates that the Keynesian approach may have been more farsighted. The IMF also created the SDR in 1969, when the defects of the Bretton Woods system initially emerged, to mitigate the inherent risks sovereign reserve currencies caused. Yet, the role of the SDR has not been put into full play due to limitations on its allocation and the scope of its uses. However, it serves as the light in the tunnel for the reform of the international monetary system.

Keynes proposed that the Bancor should be fixed to a basket of 30 commodities, including gold.

Keynes' arguments for a currency fixed on a basket of commodities was that it would stabilize the average prices of commodities, and with them the international medium of exchange and a store of value.

As China's central banker said, the goal would be to create a reserve currency “that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies”.

But Keynes proposed a lot more than simply pegging SDR's to a basket of currencies:

He proposed a global bank, which he called the International Clearing Union. The bank would issue its own currency - the bancor - which was exchangeable with national currencies at fixed rates of exchange. The bancor would become the unit of account between nations, which means it would be used to measure a country's trade deficit or trade surplus.

Every country would have an overdraft facility in its bancor account at the International Clearing Union, equivalent to half the average value of its trade over a five-year period. To make the system work, the members of the union would need a powerful incentive to clear their bancor accounts by the end of the year: to end up with neither a trade deficit nor a trade surplus. But what would the incentive be?

Keynes proposed that any country racking up a large trade deficit (equating to more than half of its bancor overdraft allowance) would be charged interest on its account. It would also be obliged to reduce the value of its currency and to prevent the export of capital. But - and this was the key to his system - he insisted that the nations with a trade surplus would be subject to similar pressures. Any country with a bancor credit balance that was more than half the size of its overdraft facility would be charged interest, at a rate of 10%. It would also be obliged to increase the value of its currency and to permit the export of capital. If, by the end of the year, its credit balance exceeded the total value of its permitted overdraft, the surplus would be confiscated. The nations with a surplus would have a powerful incentive to get rid of it. In doing so, they would automatically clear other nations' deficits.

As unlikely as it now seems, it is possible that - over the course of years or decades - the SDR or another currency based on a basket of other items could replace the dollars as the world's reserve currency.

Contrary View: The World Bank disagrees with China and Russia, and supports the continuation of the dollar as the world's reserve currency.