The Economy Thread Part II

Couple of weeks back we discussed briefly on some basic economic terms and the way the whole puzzle works out. Today we will discuss, the brief contours of the current monetary system (fiat money) and why it is what it is today. Before we get down to detail, there are couple (actually more) of terms that i would like to be clear about.

Fiat Money - is money that has its value because of government legislation. For e.g. Rupee as its value is because government has said (and guaranteed) that it is a legal tender for money.

Reserve Currency - is a currency that is held by various governments as part of their foreign exchange reserves and most commonly traded commodities (like gold, oil) are traded in it. Dollar for e.g. is a reserve currency. Oil/Gold are dollar denominated.

Fixed currency regime - where currency is pegged to a reserve currency and can trade within a parity. e.g Chinese Yuan

Managed Float regime - where currency is fluctuates daily but central banks intervene by selling & buying reserve currency. e.g. Indian Rupee

Free Float - where currency openly fluctuates in the foreign currency exchanges. e.g. Japanese Yen

The basis of current monetary system is a fiat money based and has a managed float currency (as is case with India) with the American dollar being the reserve currency. The world initially started with Gold Standard. In gold standard, the monetary unit was a fixed weight of gold. There were lot of variants of this standard, wherein either gold coins were circulated or where silver coins were circulated that had a fixed external value in terms of gold that is independent of the inherent silver value or where authorities have agreed to sell gold bullion on demand at a fixed price in exchange for the circulating currency. A full gold standard, exists when a monetary authority holds sufficient gold to convert all of the money it has issued into gold at the promised exchange rate. This is difficult to implement as the quantity of gold in the world is too small to sustain current worldwide economic activity at current gold prices.

These systems had some inherent problems, first being in bimetallism (a system establishes a fixed rate of exchange for the two metals) where if the market forces of supply and demand for either metal caused its bullion value to exceed its nominal currency value, it tends to disappear from circulation by hoarding or melting down. Besides in the beginning of 19th century due to the imperfections in the trade, silver which was being used to stuck coins began to get drained out of the industrialized world. Over those initial years variations in trade, deficits to fight wars and variations in supply of these metals caused governments to move back and forth between various types of gold standard and silver standard and sometimes entirely off the gold/silver standard. But it was the Great Depression of 1933 that put the final nail in the coffin of the standard. Due to gold backing, the central banks in those times were bound by how much money they could inject in the system by the gold reserves they had in their vault. This hampered their maneuverability to end the crisis. Besides the central had to defend the price of the dollar(by increasing interest rates), which caused deflation and led banks to redeem the gold backing causing further reduction in notes in circulation leading to more slowdown. By 1930's most of the world had abandoned gold standard and moved to fiat money. The basis the gold standard was convertibility.The international value of currency was determined by its fixed relationship to gold; gold was used to settle international accounts. The gold standard maintained fixed exchange rates that were seen as desirable because they reduced the risk of trading with other countries. Imbalances in international trade were theoretically rectified automatically by the gold standard. A country with a deficit would have depleted gold reserves and would thus have to reduce its money supply. The resulting fall in demand would reduce imports and the lowering of prices would boost exports; thus the deficit would be rectified. Any country experiencing inflation would lose gold and therefore would have a decrease in the amount of money available to spend. This decrease in the amount of money would act to reduce the inflationary pressure.

After the WWII, to empower trade between the devastated economies of the world, so that economies could recover it was decided that an international monetary standard would be established for free trade and exchange rate stability. This also ensured that devastated countries do not devalue arbitrarily just to rig exports and set of a chain of devaluation by competing nations. Since the only nation to emerge relatively stronger from WWII was US, it was decided that the value of the U.S. dollar would be fixed to $35 per ounce, and the value of the U.S. dollar was thus anchored to the value of gold. The US Government committed to convert dollars into gold at that price. Also decided in the Bretton Woods system was a system of fixed exchange rates. The rules further sought to encourage an open system by committing members to the convertibility of their respective currencies into other currencies and to free trade. This was also called as a peg currency regime. Nations were required to establish a parity of their national currencies in terms of the reserve currency and to maintain exchange rates by intervening in their foreign exchange markets. The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. The Bretton Woods regime also led to the establishment to World Bank & IMF. This regime led to huge transfers of gold to US, massive trade surpluses for US and an appreciated dollar. To reverse this dollar flow, US started the Marshall plan to distribute aid and grant to nations besides improving dollar liquidity.

By late 1950's the US balance of payment went negative, besides for $35 an ounce convertibility to work, the peg has to be maintained in the open gold market as well to avoid nations from buying gold from US and selling it in open market for profit. Rising US government spending in the 1960s, however, led to doubts about the ability of the US to maintain this convertibility, gold stocks dwindled as banks and international investors began to convert dollars to gold, and as a result the value of the dollar began to decline. Facing an emerging currency crisis and the imminent danger that the US would no longer be able to redeem dollars for gold, gold convertibility was finally terminated in 1971. The gold backing requirements for the US dollar were also repealed. This marked the end of the international gold standard and the fixed currency regime. Within five years, most of the nations moved to a floating currency regime.

One question that maybe in readers mind is since all currencies today are fiat money, what is stopping central bank from printing money and handing everyone 1000 Rupee notes. Yes it is true that there are no gold backing requirements that bars central bank from printing endless money, but increasing money supply will lead to inflation and hyperinflation.

The next part of this series would be on 2008 financial crisis.

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