The governor of China’s central bank this week remarked that there was a need for an alternative to the US dollar as the main reserve currency held by central banks. When the US Treasury Secretary Tim Geithner was misquoted as supporting this idea the US dollar took a brief tumble, though later Geithner stated that he had been misquoted and his comments taken out of context.

The fact that most central banks hold the majority of their reserves in the form of US dollars might provide support to the idea that the US currency is a safe haven in times of trouble. The recent drop in the Australian dollar has been caused partly by the fact that our currency tends to move up and down with rises and falls in commodity prices, but the US dollar has also risen because of the perception that the US dollar is a safe haven. This view is not too different to the view that prevailed from the mid 1990s to the early part of this decade, that the US government supported a “strong dollar.” The strong dollar view was popular in financial markets, and helped underpin a rising value for the US dollar.

But like the strong dollar idea, the safe haven view of the US currency is misguided. The reality is that no currency is entirely safe. Trust in a currency depends on holders of currency trusting that not too many notes will be issued. Today there is nothing to stop central banks from issuing too much currency other than the damage that this would do to their reputation. Some central banks, including the RBA, jealously protect this reputation, but others do not.

Under the classical gold standard period that prevailed from the 19^th century until the Depression, currency notes did have intrinsic value, and perhaps could be relied on to be a safe haven. In some countries notes were issued by central banks, but in many countries private banks could issue notes, as long as they held gold to back the note issue. Under this system the value of a currency note depended on the amount of gold that backed each unit of currency.

After World War II it was decided to modify the gold standard system so that countries would hold US dollars as reserves. In principle these US dollar reserves were supposed to be exchangeable for gold, though in practice this was discouraged. This system worked quite well as long as the US government and Federal Reserve limited US note issue so as to maintain the value of the US currency. But the financing of the Vietnam War strained this system, and led to excessive US note issue and inflation. By 1971 it was clear that the US dollar was not going to be able to maintained at the then price of US$35 per ounce. After some demands for gold from the German central bank the Nixon administration suspended convertibility of US dollars for gold in August 1971.

Since 1971 there has been nothing “backing” the issue of notes in most countries. Maintaining the value of notes requires that countries do not issue too much money. It is ironic that the US has been regarded as a safe haven when it seems that there are many obvious parallels to the early 1970s when it comes to current management of the US economy. The government is currently running huge budget deficits, and the US Federal Reserve last week announced that it would be purchasing some US Treasury bonds that are being issued to fund this spending. This is equivalent to printing money, and while the amount of additional money supplied in this way is currently a small fraction of total currency outstanding, it seems likely that further printing of money will occur.

Will the US dollar tumble as a result of excessive issuance of money? I doubt it. But faith in the US dollar as a “safe haven” relies on the US Treasury and Federal Reserve being more conservative than other central banks as far as inflation and money growth goes. On this front the evidence is clearly that the US should not be relied on as a safe haven – not now, and not in the past either.