The following is excerpted from a commentary originally posted at www.speculative-investor.com on 12th August 2012.
Last week we wrote: "The reserves held by a central bank have no influence on the associated currency's purchasing power and very little influence on its exchange rate. Today's currencies are not 'backed' by central bank reserves. The reserves are holdovers from a previous monetary system and are anachronistic under today's system." Here's what we meant.
A currency's purchasing power and value relative to other currencies are determined by supply and demand. These days, the supply of no major currency is limited in any way by the associated central bank's reserves. This means that currency reserves have no effect on the supply side of the equation. But what about demand? Would an increase or decrease in the FX reserves held by a central bank significantly alter the investment demand for the currency 'managed' by that central bank?
We don't see how. The real return that can be earned by making loans or investments denominated in a particular currency isn't affected by changes in the reserves held by the associated central bank. It could be argued that investors focused on safety might gravitate towards the currency of a country with substantial FX reserves, but the fact that investors flee to the US$ in times of trouble negates that argument. After all, the Fed has no currency reserves to speak of apart from 263M ounces of gold with a current market value of about $420B. This is less than 5% of the US True Money Supply.
With central banks having unlimited ability to inflate the money supply and exerting considerable control over interest rates, it is clear that central bank policy can strongly influence both currency supply and currency demand. Central bank policy is therefore an important determinant of a currency's purchasing power and exchange rate. And of particular relevance to the present topic, this policy is not constrained in any way by the quantity of FX reserves unless the central bank is attempting to maintain a fixed exchange rate. Furthermore, even in those rare cases where a central bank attempts to maintain a fixed exchange rate between its currency and another currency, the success of the policy relies more on the manipulation of money supply and interest rates than on FX reserves.
As we stated last week, currency reserves are a holdover from an earlier time and a previous monetary system. Moreover, in the earlier time that we are referring to the reserves constituted the actual money while the pieces of paper that often circulated within the economy were money substitutes. For example, when the US was on something close to a genuine gold standard during the last quarter of the 19th Century, pieces of paper known as dollars circulated within the economy. But the paper dollars weren't money. They were, instead, receipts for money (gold). There were a lot more receipts for gold than actual gold, but that's a separate issue.
Under the current monetary system the reserve concept has no meaning. Money doesn't need to be 'backed' by anything. Only money substitutes need to be backed -- by the actual money. The dollar (or euro or whatever) notes that you have in your wallet are not money substitutes, they are money and therefore do not require any backing in order to have value. Regardless of whether or not they have so-called 'backing' in the form of currency reserves, their value will be determined by changes in supply/demand as well as by the laws that force people to use them. As money they really only have two drawbacks: their supply can be arbitrarily increased by the government-banking partnership and they have no use outside of their role as money. Due to these drawbacks they would not be money in the absence of government coercion.
-- Posted Tuesday, 28 August 2012 | Digg This Article | Source: GoldSeek.com
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The irrelevance of currency reserves
