1 kg. gold bars are seen on a production line in Ahlatci Metal Refinery in the central Anatolian city of Corum, Turkey, May 11, 2017 Reuters / Umit Bektas

Deutsche Bank's Jim Reid contends that the fiat currency system "is inherently unstable and prone to high inflation."

China's rapid economic emergence in the 1970s, and an explosion in the global working-age population, has allowed inflation to be controlled externally, but that period is coming to an end.

What could replace fiat currency is yet to be determined.

LONDON - Deutsche Bank isn't known for its gold bugs, but that hasn't stopped its strategist Jim Reid from writing a paper that discusses "the start of the end of fiat money."

Reid's basic contention is this: The dominance of the fiat currency system since Richard Nixon decoupled gold from the dollar in 1971 "is inherently unstable and prone to high inflation," and an offsetting disinflationary shock that kept it afloat since 1980 is now slowly reversing.

If that's the case, Reid says the fiat currency system - a term which describes any currency whose value is backed by the government that issued it, rather than by a commodity like gold or silver - could be "seriously tested" over the next decade.

Disinflationary forces

The basis of Reid's argument is that China's rapid economic emergence in the 1970s, and an explosion in the global working-age population, has allowed inflation to be controlled externally, because a boost in labour supply during a period of globalisation naturally supressed wages.

Externally-controlled inflation means policy-makers and central banks can respond with familiar tools: More leverage, loose policy, and extensive money-printing.

"It's not usually this easy as inflation would have normally increased with such stimulus and credit creation," says Reid. In fact, "it could be argued that this external disinflation shock has perhaps 'saved' fiat currencies."

An end to the demographic super-cycle

If this theory is correct, Reid says, then "any reversals in this demographic super cycle could spell problems for the fiat currency system."

Under that scenario, inflation would pick up externally as the working-age population stopped rising and labour pricing power returned, as demand rose and supply shortened.

Reid continues:

"Central banks and governments which have 'dined out' on the 35 year secular, structural decline in inflation are not able to prevent it rising as raising interest rates to suitable levels would risk serious economic contraction given the huge debt burden economies face.

As such they are forced to prioritise low interest rates and nominal growth over inflation control which could herald in the beginning of the end of the global fiat currency system that begun with the abandonment of Bretton Woods back in 1971."

After fiat currency

Eventually, Reid says, "it's possible that inflation becomes more and more uncontrollable and the era of fiat currencies looks vulnerable as people lose faith in paper money."

One such alternative is cryptocurrency, which uses blockchain, a much-hyped online ledger system whose primary benefit lies in the difficulty of tampering with data recorded within it.

"Although the current speculative interest in cryptocurrencies is more to do with blockchain technology than a loss of faith in paper money, at some point there will likely be some median of exchange that becomes more universal and a competitor of paper money," Reid says.

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