monetary

To sum up this three-part Money Politics serial of articles I would like to exhibit a brief historic development of global monetary system. Unlike the first two parts of this serial, this part is not focused on “country case” political phenomenon (or issue), but it is focused on structural topic which is relevant for almost every citizen on the Earth. First of all, let us explain what the global monetary system is consisted of. According to Mark Carney and his article The evolution of the international monetary system, global monetary system underpinned with three “pillars”: exchange rate arrangements, capital flows and collection of institutions, rules of the game and conventions. Global system task is to maintain stability in exchange rates and prices, to enable suitable adjustments to external shocks or structural changes and to promote economic growth and prosperity.

Exchange rate systems

In this article the main focus will be on the first of three “pillars”- exchange rate arrangements. Exchange rate system is basically a set of rules which determine the size of intervals in which some national currency can appreciate or depreciate in the foreign market exchange. There are two basic systems of exchange rates:  fixed exchange rate system and floating exchange rate system. In fixed system, governments can allow only minor changes in national currencies’ exchange rates. In this system the role of government is the most important one because it establishes a fixed price for a national currency according to external standard (e.g. gold) or in terms of another national currency. The fixed price of currency is maintained by selling and purchasing currencies in the foreign exchange market. In order to make these kind of transactions possible, government holds a stock of other national currencies in foreign reserve system. In floating system, interval of changes in exchange rates are practically limitless in the foreign exchange market. In this system government cannot engage itself in market interventions in order to influence appreciation/depreciation of its national currency. Value of currencies is determined by actors on market (enterprises, individuals, financial institutions) as they buy/sell currencies in the foreign exchange market. If demand for specific currency rises, that currency appreciates. If demand for specific currency falls, that currency depreciates.

The Gold Standard

Here we will start the brief historical review of two dominant global monetary systems from the end of the 19th century to the second half of the 20th century. The first “station” is the classical gold standard (1870-1914). This system was decentralized and market based and with very little institutional support. There was a joint commitment to maintain the gold price of national currencies (of major economies). In other words, there was a fixed rate of exchange between national currencies notes and gold (e.g. $20,67 per ounce of gold). This fixed system presupposed exchange rate stability and stimulated growth of international trade. Domestic prices were determined by cross-border gold flows: prices rose as the gold flows rose, and prices fell when gold flows flowed out.  Governments were supposed to obey “rules of the game”, instead of “counter price changes using monetary policy instruments. If a country had an external deficit, it would lose gold, and it had to raise discount interest rate (rate at which central banks are loaning money to commercial ones) in order to restrict domestic credits and investments. In this way, deflationary pressure (caused by gold outflow) would be reinforced. The Gold Standard system did not survive World War I.

Bretton Woods system

Bretton Woods system is a post-war (WWII) international monetary system. It was established in 1944 and was backed with the creation of two new international institutions: the IMF (International Monetary Fund) and the World Bank. According to Andre Astrow (Chatham House Report) this new system was capable to deal with and also prevent “beggar-your-neighbor” policies. Complementary to USA’s political power in post-WWII period, its currency, the US dollar, consolidated itself as a world’s pre-eminent currency. Other countries agreed to system of fixed but adjustable exchange rates in which their national currencies were tied directly to the US dollar which was tied to gold ($35 per ounce). This direct tie between US dollar and gold enabled dollar to become primary international reserve currency. The Bretton Woods system allowed countries with economic difficulties to devalue their national currency against US dollar to get back on the track in order to establish “fundamental equilibrium” in the balance of payments. Also, countries had access to IMF’s short-term funds to avoid deflation (problem during the Gold Standard). This system, as you may guess, also “vanished”. Starting point of the Bretton Woods’s collapse was the fact that volume of US dollars (as a foreign-exchange reserve) exceeded the amount of gold in the Federal Reserve, therefore credibility of a fixed price of gold was undermined (on demand for all who were holding US dollars). In 1971, President R. Nixon suspended the gold convertibility of the US dollar, and the Bretton Woods came to an end.

Post- Bretton Woods era

Collapse of the Bretton Woods system called for reforms regarding international monetary systems. One of the most interesting reform proposal was to develop neutral reserve asset – SDRs (Special Drawing Rights). SDRs, according to IMF’s factsheet is an international reserve asset, created by the IMF in 1969 to supplement it member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchange for freely usable. Four key international currencies are: US dollar, Japanese yen, British pound and the Euro. Most important fact for our discussion is that SDRs, as the primary international reserve asset, is its independence from gold (in 1978 this enhancing role of the SDRs was built into Second Amendment to the IMF Articles of Agreement). The post-Bretton Woods system (which we live in) functions reasonably well, but not without issues and demanding challenges.

Conclusion

As a conclusion I would like to raise the question about potential future role of gold in international monetary system. Will gold ever come back to its glory days? According to Michael Maloney and his Hidden Secrets of Money series of lectures and documentary movies, we should take the gold’s role in the future seriously. According to his findings, each international monetary system “collapses” (is being replaced by another) in interval of thirty to forty years. Our time exceed this interval (because the Bretton Woods collapsed in 1971 and today is 2015 – so that is 44 years), but Maloney is warning that US dollar, as the most fiat currency (according to Investopedia: Currency that a government has declared to be legal tender, but is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of.) in the world is starting to show weakness – as he puts it – nails in the dollar coffin signs have started to appear. We cannot make exact prediction about “next” international monetary system or the role of gold in it, but we should definitely be aware of the fact that we live in fiat currency system where money can be created (printed) without “cover” or “backbone” and this can lead to serious economic problems. That is why, to understand the whole fiat currency concept, we need to bear in mind difference between money and currency. In order to do that, let us remind you about that from the first part of this Money Politics serial of articles: as M. Maloney puts it: currency is a medium of exchange and a unit of account which is portable, durable, divisible and fungible (interchangeable). Money also has all these features, but the crucial thing is that money is store of value and currency is not (or does not have to be). This means that paper bills and coins we have in our wallet are currencies (printed and minted). Mentioned store of value concept is connected to currencies’ dependence on, or interrelation with precious metals (gold and silver). In a way, this distinction is challenging us to think about role of the gold in future monetary concepts.

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