The events of the last few weeks should have spelt the death-knell for the US dollar. This is not only because of the acknowledged recessionary impact of the bursting of the housing/credit bubble on the US economy, but even more so on account of the 'no-debtor-left-behind' bailout orchestrated by Messrs Hank & Bank.

But the markets have reacted in just the opposite way. The dollar has gained between 5 and 25 per cent against most major currencies and even more against the market currencies of gold and silver while all the major equity markets around the world have seen a severe tumbling. Why should this be the case?

The reasons are many - liquidation of overseas assets by troubled financial institutions, unwinding of leveraged trade positions, a flight to liquidity (what is mistakenly identified as a flight to 'quality') and lack of covering due to the overwhelming short position against the dollar before the crisis erupted.

While it's difficult to predict as to when the turnaround would happen, it's certain that when that happens, the dollar is staring at an unprecedented collapse. The massive deficit programmes promised by both the presidential candidates, McCain as well as Obama, would certainly ensure a 'change' that both the candidates have promised. However, the change is not going to be for the better as far as US citizens are concerned, but it's going to be in the monetary system that the world has adopted since 1973 (what is referred to as the fluctuating fiat currency standard with the US dollar as the world's reserve currency). With world leaders, including British prime minister Gordon Brown, calling for a Bretton Woods II, it's clear that the dollar's supremacy is ending.

Most experts have predictably drawn all the wrong conclusions from the unwinding credit bubble. Former Fed.Chairman Greenspan (he blames it on under-regulation of the derivatives sector), the present Fed chairman Bernanke (has now suggested that central banks should research on how to avoid asset bubbles) and IMF director Strauss Kahn (he blames it on supervisory failure) have suggested solutions to the recent crisis that display an ignorance of the causative factors. None of them had an inkling of the problem till it surfaced, and quite understandably are now reacting like 'headless chicken.'

The problems of excess liquidity and monetary interference in free markets through central banking cannot be solved by even more liquidity and even greater interference. What we need is market-based regulation and a move away from the printing presses-based creation of capital that has resulted in these massive bubbles. Capital, by definition, has to come from savings and as long as Central banks insist on replacing lack of savings by creating capital out of thin air, the outcomes would continue to be the boom-bust cycles that we have witnessed for almost the last 100 years.

What should the RBI do under the current scenario? Firstly, our monetary policy continues to be extraordinarily lax (refer the piece The Reddy Years at the RBI - Running away from Greatness, IE Oct 2008), with excessive growth in money supply and a negative savings rate. While tightening of the policy would be politically impossible with the elections around the corner, the Governor should at the very least desist from a further loosening of strings.

On a more fundamental note, it's time that the RBI realises the impotence of the very concept of central banking to ensure economic stability. More than 5000 years of history has repeatedly shown that the only end result, and we stress the word 'only,’ of a fiat currency system is hyper-inflation. The system seemingly works for a while, but always collapses in the long run. The only monetary system that works in the long run is a fixed hard-asset system ie. the gold standard.

However, it's quite unlikely that we return to the gold standard. After all, it is the fiat currency system that has allowed governments all over the world to appropriate capital (or what is euphemistically referred to as redistribution of capital) from the citizens to themselves through the mechanism of inflation. So all that the RBI can do for now is to try to operate within the framework of sound monetary principles.