How the dollar's collapse will lead to a new gold standard

The dollar is headed for collapse, says Justice Litle in The Daily Reckoning, And with no real paper alternative to take its place, the return to a gold standard seems inevitable. But which countries will lead the way?

On our way to a post-collapse, post-dollar world, Asia will likely transition from a de jure dollar standard to a de facto gold standard. This will happen in stages as the dollar crumbles; Asian countries and consumers will accumulate gold reserves surreptitiously at first, and may eventually formalize the transition through some sort of pan-Asian IMF-type arrangement.

Dollar collapse: therise of Asia

Asia has the 'second mover advantage' of being privy to all the Western World's mistakes. They are able to see where profligacy and runaway entitlement programs have led. Their top-down orientation will enable them to rein in expensive entitlement programs or, better yet, curtail young ones before they grow bigger. Not being as mentally and emotionally tied to the workings of empire and the capitalist welfare mentality, Asia will successfully cut the cord faster. In doing so, Asia will also rely on its citizens' natural propensity to trust precious metals and hoard them as a store of value in the first place.

Last but not least, Asia's relative lack of capital market structure - its underdeveloped backbone of lending networks - will make a de facto gold standard that much more attractive. By going straight to gold, Asians get the 'trust' that is already built into the metal...they can skip all the financial engineering, or get to working it in later.

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While Keynesians see the rise of gold as temporary - and will continue to assert their naysayer views as gold rises further - it will soon come to light that the 'world reserve currency' idea was the temporary thing, an anachronism of the industrial age.

The world reserve currency concept is tied to the notion of a single all- powerful superpower. That is a 20th-century idea that is going away. It is also tied to the idea of a single economic powerhouse striding atop the rest of the world. That idea is going away too.

Even if China becomes the new manufacturing Boss Hoss of the 21st century, it will not wield the same economic heft as America did in the 20th or Britain did in the 19th. There are too many competitors for that now. To the degree that China's power comes as a cheap manufacturing destination, it will always be one price cut away from noncompetitiveness with India or the rest of the Asian nations, and eventually the Middle East, South America, Africa, etc....economy of scale is simply no longer the powerhouse edge that it used to be. The agglomeration of industrial and political power seen in the 20th century will likely vanish into the pages of history. The concept of 'world reserve currency' may well vanish with it.

Whythere is no real alternative to the dollar

Gold is also a contender because the alternatives for replacing the dollar look so weak. The euro has its own set of long-term problems, in some ways more severe than those of the dollar. Over the next decade or two, Europe will be dealing with a declining population, a lack of defensive capability, social unrest due to immigration and cultural segregation and the fiscal cement shoes of an out-of-control welfare state. Nor is the yen ready for prime time, with Japan's economic behavior erratic and the Bank of Japan viewed as incompetent. China's yuan is not yet supported by a fully functional financial infrastructure and has too long been pegged to the dollar to suddenly go it alone.

Gold, on the other hand, steps up with a number of advantages. It is already regarded as a hard asset safe haven and a key barometer of financial anxiety. Its value is easily understood and appreciated by the masses. It can function without the need for a complex financial system to guide and regulate transactions.

Asia could well be the vanguard for a new gold standard because of internal dynamics. China is exemplary in this regard in that Chinese citizens regularly save as much as 40% of their personal income. This is in large part due to the lack of a safety net in China. There is no Social Security, no guaranteed medical care, no pension benefits and so on. Many of China's less-connected citizens seem as likely to bury their wealth in a shoebox as put it in a bank. This mindset strongly favors a physical, storable asset, like gold.

Einstein once said, 'Everything should be made as simple as possible, but not simpler.' That could well be a capitalist adage, with 'small' substituting for 'simple.' The less bureaucracy, the better; the more flexibility, the better. Both are attributes of being lean and small, not fat and huge.

As Peter Drucker observed shortly before his death, the savviest way for future companies to go is probably to outsource all functions that do not lead to a position in senior management. The big players of the current age are getting small as fast as they can.

Even traditional behemoths like the oil majors are becoming less like behemoths and more like raw capital allocators. When BP announces plans to invest $8 billion in alternative energy, it is acting more like a hedge fund trading on its industry knowledge than a lumbering giant exploiting its size. Similarly, Wal-Mart is essentially an information network, utilizing its knowledge and its clout to bring tens of thousands of suppliers together in a profitable collaboration.

The edge is in getting smaller and leaner, outsourcing nonessential tasks and jettisoning excess baggage entirely. This will apply to governments as much as companies in the long run; rather than enjoying captive capital, governments will have to go out and win it. In the new post-collapse environment, the number of competitive jurisdictions will thus multiply as large governments lose their capital accumulation edge to smaller ones.

Successful governments in this hyper-competitive environment will be customer service providers rather than shakedown operations; they will have to provide more value for money as capital flows become all the more mobile and hard to pin down. This shift will naturally favour sound money.

Howthe gold standardwould work

Sound money naysayers argue that a gold standard cannot work in today's modern global economy. They declare the gold straitjacket too fiscally restrictive. They warn that there is not enough gold in the world to properly grease the wheels of commerce. But the naysayers wrongly assume that a gold-based system cannot contain leverage.

Leverage is like nitroglycerin - dangerous in the hands of idiots, but highly useful to the skilled. The whole reason fiat currencies came about is because 20th- century governments realized the power of leverage as applied to existing assets. Giving politicians free rein to leverage the moon via fiat currency was stupid, but the baby need not be thrown out with the bathwater.

Leverage can be a good thing if applied in the correct fashion; when an entrepreneur borrows a small sum and turns it into a much larger sum by using it wisely, he has made beneficial use of leverage, and added value to society at the same time.

The use of leverage itself is not a bad thing except when abused. An example of a model system for preventing abuse of leverage is the modern-day futures industry.

Through rigorous self-regulation and mandatory self- insurance against financial accidents, the futures industry has shown how leverage can be applied sensibly, with a focus on two key elements: transparency and mutual responsibility.

Governments cannot be trusted to apply leverage responsibly, but private entities could - under the watchful eye of investors and deposit holders, who would have a personal interest in maintaining vigilance and bear direct financial responsibility for any failure. Remove the moral hazard of a federally subsidized blank cheque to cover losses and you immediately reintroduce private-party vigilance.

The same logic applies to banks and bank panics.

Historic bank panics of the past were largely fueled by two things: 1) a lack of fiscal transparency, making it hard for investors and depositors to be aware of unsafe habits and practices, and 2) the moral hazard of guaranteed government bailout, allowing banks to go wild knowing Uncle Sam would step in if things went bad.

A sound money system policed by private creditors - without the moral hazard of government influence - could make use of leverage responsibly and well, without undue political pressures. A transparent rate of exchange could be maintained at all times, giving depositors assurance that their electronic balance could always be exchanged for physical metal. Total leverage levels of the institution could be posted and observed by all, allowing the market to police itself in real time. And the institution could voluntarily maintain membership in a mutual-responsibility insurance system, similar to the futures industry clearing system that provides a pool of assets for emergency situations.

These types of advances could only be implemented through a combination of investor savvy and advanced technology, both of which are developing here and now.

For moreon the possible return of the gold standard, see How high would gold rise under a newgold standard?If you would like to know more about investing in gold, go to the Goldhomepage for a full list of articles.

ByJusticeLitlefor The Daily Reckoning

The editor of Outstanding Investments has worked with soybean farmers, cattle ranchers, energy consultants, currency traders, scrap metal dealers and everyone in between, including multiple hedge funds. Mr Litle also acted as head trader for a private equity partnership, and contributed to Trend Following

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, a popular trading book by Mike Covel (FT/Prentice Hall, 2004).