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With the Dollar Index testing its lower bounds to start the week, the same two messages we’ve heard for a while now are echoing again:
The U.S. dollar is in trouble.
There is no alternative to the dollar for the global economic system.
Both of these statements are true, but the second assumption could change rapidly. Network effects, Chinese innovation, and U.S. hubris all put the present order at risk.
Network effects increase the value of a product or service as more people use it. The most famous example: a fax machine. The first fax machine had zero value until the second one came on line, but each additional fax machine made all the previous machines more valuable.
Markets are networks of commodity exchange, and so currencies experience network effects as well. The dollar is benefitting from these effects right now: declining dollar values increase demand for dollar reserves as export-oriented economies scramble to counteract the relative appreciation of their currencies. If they don’t act, their export prices will rise abroad, blunting demand for their products.
Any other currency seeking to gain a similar advantage faces the same problem faced by every network effect play: how do you deliver initial value to early adopters? China’s yuan has the potential to supplant the dollar if it can crack this code, and there is reason to think it might.
First -- and most remote -- is the possibility that China could begin backing the yuan with gold. The Global Times, a publicly-owned Chinese newspaper, floated the idea of a gold standard revival in an editorial last year, and at least one Chinese economist has proposed a mechanism by which it could be done.
But the People’s Bank of China (PBOC) is already preparing a far more significant effect with its advanced efforts to deploy a national digital currency. Called the “digital currency electronic payment” system, or DC/EP, the platform takes a page from cryptocurrencies while replacing the decentralized ledger with a centralized accounting system at the PBOC.
The DC/EP will eliminate huge swaths of rent-seeking in the financial system. Unbanked “cash-and-carry” consumers can avoid predatory fees, for example. For a country where 80% of consumers use mobile payment options, this is a huge opportunity
But the real benefits will come in international trade, as a digital-first currency will eliminate significant costs and delays for large transactions. Exchanges between digital wallets eliminate the need for separate clearing and settlement processes -- the current system whereby financial institutions do the paperwork first and then send the money. The DC/EP will drain middleman costs out of the system and deliver faster payment for exports, investments, and aid.
All things being equal, more parties are more likely to want to trade in this currency than any other. That’s how network effects are born.
China’s Belt and Road Initiative provides both an opportunity and an impetus for the effects to take hold. Investment across the 138 countries is slowed by lack of a common currency, and many of the participants have the least capacity to pay fees. Solving this problem with the DC/EP would mean a multi-trillion dollar reserve shift in rapidly developing economies, raising global pressure to settle more trade transactions in yuan, right as it is getting cheaper and easier to do so.
Just last week China announced a major new expansion of the DC/EP pilot project, covering Beijing, Hong Kong, Macau, and much of the wealthiest parts of the country. Meanwhile, U.S. economic leaders have blown off the need for a digital currency. They comfort themselves with the “no alternative” narrative and hesitate to put their buddies -- the fee collectors of the financial system -- at risk.
But successful network effects create a positive feedback loop where every additional user adds value to all the earlier assets, thus increasing their demand and bringing on more value-adding users. Rapid, exponential change can result: Uber and Lyft launched in 2011 and 2012, and in less than 7 years they had wrecked the economic basis for the entire taxi industry, for example.
If recent times have taught us anything, it should be skepticism towards confident predictions of things staying the same. There may be no immediate alternative to the dollar, but innovators aren’t letting that stop them from building one.
Disclaimer
Our only investment advice: Don’t watch the DNC.
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Photo Credit: Xinhua.