History of the International Monetary System
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Evolution of the International Monetary System
The information in this section is based on Md.Azim Ferdous’ published work History of International Monetary System from the University of Dhaka, and Dr.Kenneth N. Matziorinis’ published work A Brief History of the International Monetary System from McGill University (Montreal, Canada) as well as other relevant articles and readings.
Over the past one-hundred years, some very important events have occurred that summarise and relate to the history of the international monetary system. These are: the Gold Standard, World War I and II and the collapse of the Gold Standard, the Bretton-Woods Era and lastly, the current system of Floating Exchange Rates and Targeted Inflation.
The Gold Standard, 1815-1914
Around 1815, England was a powerful European, and hence world, trading nation who was leading the globe into less mercantillistic and more open trade policy, political system and more secular beliefs which put them in a position where they were able and fit to impose their own order on the monetary system. A stable system was in need in the light of increasing world trade. This order was the Gold Standard. The Gold Standard is a policy of establishing gold as the medium of exchange, store of value and unit of account in a country. Each country tied the value of their currency to an ounce of gold, virtually creating a fixed exchange rate system. For example, £4.27=1oz gold=US$20.67. At the appropriate rate, currency could be exchanged for actual gold at commercial banks. The system had many advantages. At the time, renowned economist David Hume proposed that inflation was dependant on the money supply, which made the Gold Standard a favourable system as the supply of gold was relatively fixed (apart from newly mined gold), protecting the public from price shocks and hyper-inflation. Also, his specie flow mechanism theory, which, in short, proposed that in time imbalances in the trade account would equalize, favoured the Gold Standard as the fixed rate meant no country could inflate its way out of economic difficulties and would have to make real rather than monetary adjustments to achieve economic wellbeing. The fixed exchange rate also meant that foreign exchange markets to determine the value of currencies was unnecessary. The Gold Standard was seen to be quite successful as it provided good economic stability throughout the world and encouraged trade and globalisation like never before. However, when WWI occurred, the Gold Standard monetary system did have difficulties, which led to its collapse. This is explained further in the following section.
World War I, World War II and the Collapse of the Gold Standard
When World War I broke out in 1914, countries were in need of money in order to pay for the war effort. During the war, the economic strain on nations was high and surely, one by one, they abandoned their pledge to ensure convertibility of currency to gold. In other words, they printed money to pay for the war effort, resulting in extremely high inflation caused by the increased money supply. By the end of the war, economies were in turmoil and the general health of the financial system very unstable. Nations tried to return to the Gold Standard but failed miserably as global inflation and instability was too high along with the burden of the Great Depression. Nations implemented tariffs and protectionist policies because of the hard times which resulted in retaliatory barriers or “beggar thy neighbour” policies that ultimately led to World War II. This was the end of the Gold Standard; it could not operate in the critical environment the world was in.
The Bretton-Woods Era or the Gold Exchange Standard
As World War II came to an end it became clear that action needed to be taken, a new monetary system was in order, one that would replace the Gold Standard that had broken down in the Inter-War Period and effectively handle the Post-War Period. At Bretton Woods, New Hampshire, a meeting was held by the allied powers and two proposals made. The first was the British proposal by John M. Keynes which suggested having a real world bank called the International Clearing Union (ICU) that would issue and manage a proposed global currency called the ‘Bancor.’ The second was the American proposal which suggested that the U.S Dollar become the world reserve currency (as it was strong and stable) which would be based on gold (at $35 an ounce) and convertible to gold for central bank purposes. Other currencies would set the value of their currency against the U.S Dollar, virtually making the U.S Dollar a substitute for gold and therefore a reserve currency (international money). This proposal was simple and as the U.S were a super power at the time they left little room for negotiation. The era of the Gold Exchange Standard was born. The main weakness of the Gold Standard was that gold could not keep up with the increasing demand for it, leading to deflationary pressures. With the Gold Exchange Standard, the world supply of money could be expanded; as the U.S expanded its money supply, the deflationary pressures were eliminated. However, this system had a problem, it gave U.S segniorage status which at the time of the Vietnam War resulted in trust issues as they had a pledge to the rest of the world to be the governor of a stable reserve currency, yet they were printing large quantities of money to pay for the war effort, resulting in high inflation. Holders of U.S Dollars around the world became concerned with its future convertibility resulting in increased gold commodity trading. It breached the $35USD mark which resulted in holders of USD to essentially make a “run” on the Federal Reserve. In 1971, President Nixon severed the tie between the USD and gold and suggested that countries revalue their own currency, whose base values would be determined by the free market (the foreign exchange market). This was the end of gold standards and fixed exchange rates and marked the beginning of the managed floats and targeted inflation era.
Floating Exchange Rates and Targeted Inflation
This current system is a slight variation of the previous. Instead of basing the reserve USD on gold and pegging currencies against the USD, the value of each currency is determined by the demand and supply for that currency in the foreign exchange market, the single largest market in the world. The exchange rates are therefore nominally flexible (apart from select cases) but are watched closely by central banks in order to make sure they do not cause instability in the economy. Central banks, usually independent institutions from governments, have methods that affect the exchange rate in order to keep domestic inflation in check (such as interest rates, reserve ratios, Open Market Operations, etc) hence managed system of floating exchange rates is a good description of the current monetary order. This system allows for each country to manage inflation as it sees fit (while under the looking glass of the IMF).
The monetary system has changed dramatically over the last century, having to adapt to the changing political and economic state of the world. With our ever growing global inter-connectedness there are talks of yet another change in the monetary system to one in which a single global currency rules. This idea will be explained in the last section of the report.
Gold Standard as a Currency in Our World Today
This section will explore the validity and benefit of a reintroduction of the Gold Standard in our world today based mostly on information from relevant readings Why we can't return to a gold standard—yet by Paul Nathan and What Would A return of The Gold Standard Mean? By Kira Brecht as well as various other sources.
Some reasons for having a Gold Standard would be the consistent, global price stability that the 19th century enjoyed for so long due to a fixed exchange rate as the supply of gold stays relatively fixed. It would also force nations to have sound fiscal policies as they would be unable to influence the money supply through interest rates, which most can agree can be seen as an advantage; to have fiscally responsible governments. It would also require a free movement of capital, goods and services amongst nations for it to properly operate, increasing international trade. “Modern finance has growing money. Money supply grows in reaction to the growth of the real economy,” says CPM Group’s Christian. “As an economy grows, more wealth is generated. Post-industrial growth for the last 160 years has averaged 2-3 percent and the gold supply hasn’t risen at the same pace,” (Brecht, 2012). A problem that arises with this system, however, is the imbalance between the growth and gold supply. If a Gold Standard was returned, then currency need be convertible to gold on demand. With the ever growing rate of the world economy, gold supply need increase at an appropriate rate to be able to back currencies, otherwise deflationary pressures would occur. Deutsch Bank analysts Daniel Brebner and Xiao Fu, along with others, suggest that a solution to this would be periodic re-evaluations of the gold itself in order to counter balance the low gold supply growth rate. This would keep inflationary pressures down.
The proposal of a gold standard is more academic than it is practical because to put it simply, it’s quite impractical. Before we could even think about receiving the benefits of a Gold Standard, many implementations around the globe would have to take place. Nations would need to balance their budget – which for important player U.S.A whom has currently around $16 trillion worth of national debt would take decades –, establish free trade zones and recapitalise banks to gold standard ratios. As Paul Nathan states in his book The New Gold Standard, “If a gold standard is to return, it will return on the wings of capitalism and not before.”
One World Bank, One World Currency
This final section of the report will discuss the advantages and disadvantages of having one world central bank, one single world currency and its implementation of monetary policy based mostly on information from joint Waikato University Presentation One World Bank, One World Currency by Facundo Ferreira, Sophie Frewin, and Yujie Zhou and One World, One Currency: Could it Work? By Eric Fontinelle among other various sources.
The idea of a world bank and currency has been proposed many times over by visionary economists, John M. Keynes, for example, was one of them. We can begin to understand the proposal of a central world bank in depth by observing how current central banks operate and then tweak and apply this model for a global setting.
The Central World Bank
The current role of a central bank is to oversee a country’s financial wellbeing and monetary system. They focus mainly on price stability through the manipulation of national money supply via injections and withdrawals of money into the circular flow of income, they register and monitor commercial banks as well as hold their reserves, they issue currency and detect discrepancies and they also act as a bank to the government and hold foreign currency reserves. A world central bank could take on much the same role but on a larger scale. That is, it could conduct monetary policy for the globe via the one single currency, it could monitor governments or central banks of all nations according to their agenda and direction, it wouldn’t necessarily need foreign exchange reserves as their would only be one currency in question and lastly it would be the issuer of this single currency possibly via the existing central banks around the globe. How would this system be implemented?
Conditions of Such a System
A quick analysis of the European Union and its establishment will help us better understand how a union system could be imposed. Before the European Union was established, many conditions had to be met by member countries, particularly surrounding each country’s economic wellbeing and monetary stability. For example, government debt, interest rates and exchange rates had to be within a certain range that was based on the economic powerhouses of the union to ensure that all members were at a healthy level stability wise and would not breakdown the system when they joined. The world central bank would have to impose many similar conditions and requirements that the world has to reach before being able to implement a system that will remain sound. Once this has been done the issuing of a world single currency could occur.
The single currency would bring many advantages and disadvantages with it, we explore these in the following sections:
A single currency would result in price transparency, meaning consumers and businesses alike will be able to conveniently compare prices across all and any part of the world simply by looking at the absolute values without having to convert prices. Transaction Costs would be reduced in all forms of international trade as the cost of exchange would no longer be present. Implications for consumers would be lower prices and ease of travel across countries. Lower interest rates may occur as banks will not have to account for exchange rate risk. This could mean better investment opportunities and lower cost of borrowing. With a single currency the lack of exchange rate fluctuations means there will be no currency risk when making any kind of negotiation/contract or business deal as well as projections into the future so decisions regarding the future will be much more secure in terms of currency. An example of this is international debt, its cost would be the same in the future as the present. Rather than businesses having to set up separate accounting systems, banks, etc. for transactions in foreign currencies, a single currency would make it simple to operate from a single central accounting office and use a single bank. With one central bank prices would be able to be kept under control on a global scale. The world would have a much more stable price mechanism with minimal fluctuations like with the gold standard. Another advantage is that nations will be unable to manually manipulate or fix exchange rates in order to be more competitive (China sets their rate low to promote exports for example)so competition based on efficiency will be encouraged. Lastly, since all countries are sharing the same currency they are in a sense more connected and interdependent which may foster relationships and cooperation on issues other than monetary.
All of these advantages represent a form of monetary integration between countries which will encourage and make international trade much easier.
Having a single currency would not come without its disadvantages. It has long been told that “The control of money and credit strikes at the very heart of national sovereignty,” (A.W. Clausen, President of The Word Bank). A single world currency means that there would be no national monetary policy, as all adjustments would be made by the World Bank, which raises the issue of sovereignty over a nation’s economy. Public and political sovereignty over the opinion of direction of monetary policy in their country would cease to exist. The other main disadvantage of a single world currency which is tied to the monetary policy aspect of it is the difference in strength of nations’ economies. Nations with opposing economic situations such as one enduring a strong movement of activity posing the risk of inflation and being helped through money supply manipulation may put at huge risk smaller economies and send them into recession and vice versa. Also unstable economies such as many of the African and South American nations may drag down the rest of the world due to the monetary tie. Other nations would have to help them just to keep the world economy at bay much like the EU crisis due to Greek’s instability.
The single world bank and single currency union pose many useful advantages such as price transparency and stability and reduced transaction costs. However, the loss of sovereignty and differences in economic situations of nations are too great a compromise which societies around the world are not yet prepared to come to terms with. With our increased technology and connectivity in every aspect of business and personal life, the globalisation movement seems to be quite unstoppable and moving in a direction of complete global union. However, that time will be many years into the future and much development of economies and deeper more important issues need to be resolved before beginning to think of implementing such a system. To end on a personal note, I believe that in time the world will achieve not only a monetary union but a complete social and cultural integration (even though there is beauty in diversity) where one language, one culture, possibly one belief system will be the case and hopefully the dependency on each other will lead to a more peaceful, harmonious world.
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