Here, I explore some of the implications of the dollar reserve standard. What do I really mean by ‘dollar reserve standard’? I mean that a significant proportion of minor central banks own dollars and dollar-denominated assets. In short, the renminbi, the taiwan dollar, the korean won, etc. are all ‘good for’ dollars. Meaning; these currencies are liabilities of their respective central banks, that – in turn – own dollars (and dollar-denominated assets).

 

I seek to briefly answer the questions: what does this mean for the world? What does this mean for prices? How can a contrarian investor wield this understanding to his/her advantage?

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Here is the update of the Fed’s Balance Sheet (proportions) chart.

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The other day, I alluded to the analogy that central bankers are like naughty children; – they move the goal-posts after a shot at goal has already been taken. Here, I’ll explore the implications of this, and ask: could a period of ‘scarcity of money’ occur before debauched monetary policies have the platform to take hold?

 

When the Fed engages in monetary policy, it changes the stock of assets that back the volume of Federal Reserve notes in existence. I explain why this happens here. Every time they buy or sell something, the dollar in your pocket changes. It’s still called a dollar, but it’s no longer ‘good for’ what it used to be ‘good for’.

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I’ll discuss an interesting corollary of the fact that fiat currencies trade at discounts to par; namely, that any expansion in the balance sheet of (say) the Fed necessarily entails ‘dollar dilution’. That is, each dollar becomes ‘good for’ less stuff.

 

In case some people are thinking; ‘Duh! Money printing obviously dilutes the dollar!’, I should point out that there exists a large group of financial commentators that believe that QE is a (somewhat benign) asset swap. I have misgivings with this notion; my understanding of currencies flies in the face of this argument.

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In the old days, currencies were redeemable into gold or silver (usually). In order for currency issuers (e.g. central banks) to honor their agreements, they would have to own more than they owed. Occasionally, it would be revealed that currency issuers owned less than what they owed. In these cases, their currencies would fall to discounts to par.

 

It is my contention that irredeemable fiat currencies virtually always trade at discounts to par. The implications can seem paradoxical, hence they can be potentially profitable.

 

But, what do I really mean by ‘discount to par’?

 

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Gresham’s law is the (formerly popular) insight that states: ‘Bad money drives out good’. It occurred (and still occurs in a way) when governments compulsorily overvalued one component of the money supply with respect to the other(s). A sound understanding of this has brought fortunes to alert speculators in the past; it is my contention that it may bring fortunes to them in the future.

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