In the course of understanding the global economic system, one must begin with an understanding of the nature of money and how it became the dominant force it is today. Griffiths and Wall (1997) documented four functions that any commodity must fulfill in order to function as money; the four functions are[1]:
- It must act as a unit of account.
- It must act as a standard of deferred payments.
- It must act as a store of value.
- It must act as a medium of exchange.
The earliest transactions were made with a simple exchange of goods of equal value that is known as barter trade. This was a physical constraint and as commerce increased, man began to use other items of intrinsic value such as shells, precious metals as a medium of exchange. Later, metal coins became the primary medium of exchange and it was the first attempt to standardise the unit of exchange. Eventually, it was found that it is more convenient to use paper money as a medium and keep the precious metals in vaults. In essence, paper money is a bill that was the equivalent of a receipt showing that the bearer was good for the money because it represents a certain amount of precious metal. But that was in the old days. In truth, the paper bills we hold today are nothing more that expensive pieces of paper that have no intrinsic value. What give value to paper money today are the shared expectations of two transacting parties, if that expectation breaks down, we are back to good old barter trading. The event I am building up to is the abolishment of the Gold Standard in 1971 by the Nixon administration.
In 1944, the Bretton Woods institutions – the International Monetary Fund (IMF) and International Bank for Reconstruction and Development (IBRD) or the World Bank was created. The fixed exchange rate era started when countries agreed to create a new global financial system where the participating nations pegged their currencies to the greenback at a fixed rate. In return, the US government guaranteed to exchange US dollars on demand for gold at USD35 per ounce. Therefore, holding the US dollar was as good as holding gold in your hands. Not surprisingly, many countries chose to hold their foreign exchange reserves in US dollars than in gold. All was well for more than twenty years, until it became clear that the US was unable to fulfil its role because they were simply printing more dollars than they can back by gold in order to finance their military and economic expansion. Now that was the crunch, if everyone holding US dollars was to go to the US government to redeem their gold, and there is more dollars than gold, what would the excess money be? Exactly! Nothing more than worthless pieces of paper! From then on, money became totally delinked from anything of real value, except that we all have the shared expectation that the opposite party would accept them in good faith for exchanges in goods and services. Therefore, this is the picture, much of the function of the modern capitalistic world is based on wealth creation, and wealth is based on monies, and monies is now based on shared expectations…it seems that we are treading on very thin ice here.
Historically, ‘great’ currencies were associated with ‘great’ nations. In the 19th century, the sterling pound was the dominant currency. The pound had a long history of stability with Britain’s monetary policy tied to gold. The biggest contributing factor was the fact that the Imperial British Empire stretched forty percent of the world. After the First World War, the American ‘greenback’ grew in dominance just as Britain’s power began to diminish which partially lead to the decline of the pound. After World War II, the sheer size of the American financial market (which was not devastated during the WWII) and the stability of the US dollar formed the foundation for the dollar’s dominant role as the leading currency. This was, as mentioned before, the Bretton Woods institution era where the fixed exchange rate regime was in place and gold price is fixed at US$35 per ounce. The fixed exchange rate regime was highly successful for over twenty years where there was strong non-inflationary growth, low unemployment and stable financial markets. However, finally the system broke down partially due to the financing of the Vietnam War by the US government. Therefore, in 1971, the US dollar left the gold standard and subsequently other currencies left the US dollar. The breakdown of the Bretton Woods system had one major impact; it took the leadership of the monetary system away from government or sovereign states and gave it to the free world market. Since then, the international monetary system had increasingly become highly unstable and volatile.
Gold has occupied a less important role in the international monetary system since the abolishment of the Gold Standard. The price of gold in the post Bretton Woods system were allowed to fluctuate just as exchanges rates of major currencies. In general, the movement of gold prices serves as a barometer of confidence in the international monetary order; the higher the confidence, the lower the gold prices-and vice versa (Walters and Blake, 1992). For example, in the period of 1978-1980, value of gold increased dramatically[2] during periods of uncertainty about the stability of international currencies. In the period between 1983 and 1985, gold prices fell[3], as there was a general confidence in US dollars as the primary currency of the international monetary system. The volume of gold has remained virtually steady throughout the period between 1971 to 1989, but the value of gold, as dictated by its market price, had risen more than 700%[4]! As a barometer, it speaks volumes about the general confidence level of the international monetary system in the post Bretton Woods era.
I am not proposing a return to the gold standard; in fact, it is a bad idea. We must remember that gold, for all its value because of its scarcity, is nothing more than useless lumps of metal. The demand and supply of gold has nothing to do with the needs of the global economy. Moreover, a return to a gold standard would have all the disadvantages of a rigid fixed exchange rates. The point I am hoping to emphasise is that while a free-floating exchange rate system has its advantages, it creates risks and uncertainties for the international traders and investors. It also sets a stage for monetary managers free to be irresponsible.
With the emergence of the digital currency (e.g. Bitcoin), it will undoubtedly change the international monetary scene. However, there are some key questions; will it stabilise or destabilise the already highly volatile international monetary system? If digital currency becomes generally accepted (let’s use this term loosely) into the mainstream, will a digital currency like Bitcoin become a major contender to replace, say…the US dollar as the global dominant currency? Whether the answer is yes or no, there are many crucial questions. Will national sovereignty of the countries be undermined? What will the far-reaching economic and political consequences on countries still using traditional currencies? Is digital currencies evolutionary or revolutionary?
These are questions that only time can answer. But if history has taught us anything about money, it all boils down to one simple word – Trust.
Bibliography:
Griffiths, A. and Wall, S., 1997, Applied Economics, 7th ed., Longman, London.
Walters, R. S. and Blake, D. H., 1992, The Politics of Global Economic Relations, 4th ed., Prentice Hall, New Jersey.
[1] For full explanations of the four functions of money, see Griffiths and Wall (1997, pp. 437)
[2] Source: International Monetary Fund, International Financial Statistics, June 1989.
[3] Source: International Monetary Fund, International Financial Statistics, June 1989.
[4] Source: International Monetary Fund, International Financial Statistics, June 1989.
Armchair Economist 