Outside the Box
Wednesday, 18 November 2009
Since the end of World War II, there has been one truth about the way the world works. From the most remote South Pacific island to the highest mountains, in the deepest jungle, on the streets of every city on the planet, everyone knew the value of an American $100 bill.
At the end of the war, 44 nations sat down and created the Bretton Woods Agreements, which established a framework of rules, institutions and procedures to regulate the international monetary system.
The most important part of the agreements was that these countries would maintain the exchange rate of their respective currencies within a narrow band, based in part of the value of gold and the ability for the international monetary fund to provide trade financing.
Bretton Woods was an attempt to bring order to the chaos after World War I, as nations devalued their currencies in relation to gold. American President Roosevelt added to the destruction of “real money” when the US revalued the dollar to gold several times prior to World War II.
Bretton Woods was supposed to solve the problems of currencies not having any real value that is not being convertible to gold or silver. The problem of the Bretton agreements was that there was no way to stop governments from just printing as much paper currency as they wanted regardless of the amount of gold these governments held. Theoretically, the value of gold was pegged at $35 per ounce, and the dollar was the only currency that was still convertible to gold. The dollar became the world’s reserve currency. That is, countries preferred holding a portion of their national wealth in dollars knowing that it could be converted to gold and that the US government maintained a fixed value of gold to the dollar.
By the end of the 1960s, the US government could no longer support the $35 to one ounce of gold peg. There were simply too many dollars in circulation to pay off in gold if all dollars were suddenly converted. The US government, through the 1960s, had simply printed too many dollars, primarily to pay for its domestic programs.
In 1971 the US government closed the “gold window” and dollars were no longer convertible to gold. The world’s currencies were allowed to “float,” exchange rates were now being set by market forces and government controls rather than against the hard assets of gold. Gold went to $40 an ounce and by 1972, gold traded at $70.
While no longer convertible to gold, the dollar still retained its status as the reserve currency of choice. This is primarily due to the fact that the US government has always shown some restraints against too much money printing and because the US was always the largest, strongest and most resilient economy. The dollar has traditionally held the highest and most consistent purchasing power of any currency.
During the year, we have heard many times about a general call for another instrument to replace the dollar as the foremost reserve currency. Several nations have moved to settling their trade obligations using their own currencies rather than the dollar, as in the case of China and Russia.
In truth, the world economy can operate more easily and efficiently with a single, universally accepted reserve currency like the dollar. It is burdensome to have to settle trade obligations with several different countries in several different currencies as China might have to do with the US (dollars), Russia (rubles), Japan (yen) and Europe (euros). And each of China’s trading partners might have to source yuan to pay back their trade obligations. Using only the dollar makes more sense.
But 2009 has brought a fundamental change in the way the US does business. The Obama administration has embarked on the most massive deficit-spending program possible with a current government debt equal to all the US government debt of the last 200 years combined. The October 2009 monthly budget deficit was equal to the entire budget deficit of 2008.
There is no way that the US government can pay for all of its expenditures, except by printing more dollar bills.
With each new dollar that is printed, without a corresponding increase in real national wealth, the purchasing power of all dollars is reduced. And the only value that currencies of the late 20th and 21st century have is the amount of goods and services that they can purchase.
A reduction of purchasing power translates in to price inflation. As prices increase, confidence in the currency as a medium of exchange goes down, creating more price inflation.
There is no single currency that can replace the dollar as the world’s reserve currency. That is why there have been calls for the new reserve currency being created from a basket of currencies.
The US dollar is the world’s reserve currency. Most nations hold much of their cash wealth in dollars. However, there is and will continue to be a shift toward this super reserve currency. It is inevitable.
The new currency must adequately reflect world trade patterns. Therefore, it will be a mix of yuan, yen, euro, dollar, perhaps the new South American real and, of course, a portion of gold.
With a mix, the stability of the purchasing power of the currency will be greater than with the dollar. Further, one nation’s overprinting of its money will not have as great a negative impact as now.
This will take a year or more to happen but it will occur. And honestly, world trade will be better for it. Countries like the Philippines will be less inclined to focus on trade with the US to get dollars. Further, it would allow the Philippines to more easily and quickly diversify its currency holdings.
Saturday, 21 November 2009