The World Monetary System … another look.

During my commentary on the credit crunch, I had a brief look at the World monetary system which has been at the root of the current crisis. The cornerstone of the Bretton Woods agreement, convertibility of the USA Dollar into gold, was abandoned in 1971 and “free floating” currencies have ruled the roost. The early part of the experiment was accompanied by Governments, through their Central Banks, maintaining a semblance of control of money supply within their economies.

The 1990’s heralded a change as it appeared that the bogeyman “inflation” could be kept under control with inflation targeting and interest rates. Inflation was almost exclusively defined as consumer price inflation, measured by statistics. Statistics, often manipulated and massaged, to serve the needs of Governments … the lower the rate the easier to bargain with labour … the higher the real rate the easier to grow tax revenues without apparently increasing taxes. Naturally a higher real rate than “official” rate would also make the economy appear to be growing while actually stagnant or contracting.

This era can be looked on as the grand partnership between business and government. For business it meant that you could probably get away with price increases around 5% annually while keeping wage increases down to 3 or 4%, without improving efficiency or output, profits would rise. To the trading sector, as opposed to manufacturing, the percentage mark up would result in an increased profit per unit of sale, while margins theoretically remained the same.

These policies led to distortions within economies, particularly the English speaking countries around the world, where imbalances started building up. Housing price inflation.
Oh! What a wonderful thing, people start thinking they are wealthier as the “value” of their house has grown and, as a result, are more willing to take on debt and increase their consumption. Lo we have created a boom! Easy peasy! Alas one day someone said; “look mummy, the Emperor has no clothes!” and the illusion burst.
To illustrate what I am saying: There were approximately 25 million homes in the UK in 1997 at an average price of £66000 representing a “value” of £1.6 trillion. There are approximately the same number today maybe a couple hundred thousand more at an average price of £107000 representing a value of £2.7 trillion. Does this mean that the wealth of the UK grew by £1.1 trillion during Gordon Brown’s tenure (as he tried to persuade you it had)? No it was only an illusion.
How do I know that a market is in an inflationary phase? Fairly simply, it is when popular wisdom starts responding to a question about the value of something with an answer like whatever someone will pay for it. It is that stage when price increases are attributed to supply and demand. What is generally overlooked is that in a perfect market (functioning properly) price should equal cost of production after allowing for a normal profit.

But, I will leave inflation for another topic and return to the monetary system, as I believe, the root causes of the current crisis is the actual monetary system rather than the excesses of bankers.

Traditionally, and by this I mean particularly pre 1971, and possibly until the 1990’s. Central Banks maintained reserves, gold and foreign currencies, in relation to the quantity of money in circulation within a country and the level of foreign trade done by the country. It was this that gave us a basis for confidence in our currency. Provided these ratios were maintained there would never be a sudden collapse in the value of a currency. As Globalisation became more of a reality, capital flows around the World started distorting Balance of Payment figures making the picture a lot fuzzier, and therefore placing a greater obligation on governments to manage their economies prudently.

Banks were now taking foreign deposits, in the case of the UK this amounts to around 85% of deposits being held by banks, increasing the risk profile of the banking sector and allowing for distortions within economies. Where there is no strong Central Bank intervention to limit the monetising of foreign capital flows (banks using foreign deposits to fund local lending) it becomes a case of an accident waiting to happen.
In the UK the Bank of England had been absolved of that responsibility which was handed over to the FSA. The Bank of England was no longer building its reserves to keep a relationship with the quantity of money in circulation and level of foreign trade (into which we now need to add the potential outflows from foreign deposits). Similarly the USA moved from being the banker of the world in 1970 to being the borrower from the world … even the poor third world countries are lending the USA far greater amounts of money than the so called aid being poured in!

The last 15 years or so have seen only 3 Central Banks consistently increasing their reserves. These are Japan, China and the Euro Zone. To a lesser degree some of the emerging countries as well, although their economies have not yet reached the point where this is significant.

For a world monetary system to work properly this should be the case throughout the world.
We either need a single world currency or a system of increasing reserves to which all Central Banks subscribe. To be effective this must be beyond political interference. We need a basis where we can have confidence firstly in our own currency but generally in any currency.

In my mind there is only one way such confidence can be built, is for central banks to be growing their reserves at a rate equivalent to the expansion of the economy and its commitments to foreign countries. In my commentary I proposed such a scheme, which I would now like to expand.

I suggested that if all money flows between countries were channelled through the Bank of International Settlements and a proportion (5%) of that money were kept by the BIS in exchange for a certificate issued to the Central Bank of the recipient country we would actually be forcing countries to increase their reserves.
You would say “oh that’s a tax”.
No, it is not!
The mechanics are as follows;
Country A transfers to country B $1million
BIS intercepts the transfer and withholds $50000 and issues the Central Bank of country B with a certificate of deposit for the $50000.
The Central Bank of country B in turn credits the ultimate recipient with the full $1 million. Thereby increasing the actual amount of currency in issue in country B by the $50,000.
The transaction in the books of the Central Bank of country would look as follows;
Foreign Deposits $50000
Currency in circulation $50000

While this may be “printing money”, it is actually strengthening the position of the Central Bank at the same time, as the foreign reserves would be growing at the same rate at which money is being printed which will continually improve the ratio of foreign assets to liabilities.

If we look at this further, we see that the BIS would become a “super central bank” slowly building up reserves based on the level of International Trade. This would replace the IMF as the source for emergency funding to countries.
It could also become the source of developmental aid to the third world. Both the IMF and the World Bank with their prescriptive conditions have lost most of their credibility in the third world, and as we have seen in the current crisis have not had the funding strength to address the world needs.
We need a body that can finance infra-structural development in the third world, as the poorer nations must have a route to joining the more developed nations, in the club of “haves”.

For the current crisis to subside, we need to give the world a basis for confidence in currencies. It is doubtful that we can ever give them a basis for confidence in politicians, and at the moment that is all that is on offer. Politicians will never address the real issues, they will only try and paper over the cracks.

The Bretton Woods agreement which relied on $ convertibility into gold at a fixed price of gold was ultimately flawed, as the supply of gold, at a fixed price, would dwindle to the point that there was insufficient gold available to satisfy the growing need for additional currency as world trade grew. The Nixon era of free floating currencies turned banking and international business into a casino, aggravated by the failure of the UK and USA to properly regulate their banking sectors.

While casino economies might have appeared to be doing well, while the dice were rolling for them, every gambler knows that a run in your favour will turn sooner or later and if you are not putting aside a good proportion of your winnings, you will not weather the storm when it turns.

What does my proposal really mean?

  • Central Banks will be increasing their reserves at a rate that will sustain foreign trade and limit the risk of exchange rate fluctuation.
  • Governments would be obliged to manage their economies so that their international trade was kept in a reasonable semblance of balance, in other words, without an ever widening trade balance.
  • There will be a fund available to support countries during short term crises with far greater strength than the IMF.
  • There will be a fund that could be used for infrastructural development of the third world, provided we can find a way of making such projects free of political interference.

Will this solve the Credit Crunch crisis?

Over the long term it should change the whole economic cycle, with far less risk of boom and bust. However, we will never be able to stop politicians interfering in their own economies. The nature of politics will always result in politicians trying to create a “feel good” environment within their countries. A contented person is unlikely to throw out a government and politicians will always try create a contented electorate regardless of future consequences.

Yes, it will give people from around the world a basis for confidence in currencies, which should result in money flowing across borders but, no it wont correct the imbalances that have built up within individual economies, those are things that need to be addressed by the countries concerned.

Surely the immediate world economy crisis is our priority?

Yes, but that crisis cannot be solved by simply printing money. We need an environment where trade between nations can grow and flourish. We need an environment where businesses around the world can make decisions that will be valid in the long term. We need a future in which we can be confident. Only the most naive will believe that, that, can be achieved without addressing the root cause of the current crisis, which is the world monetary system.

We know that the monetary system has failed, so any solutions that fail to address the basic problem with the monetary system are themselves doomed to failure, or at best will only provide temporary relief.

The original Bretton Woods agreement placed an obligation on countries to manage their economies, so that they had a stable exchange rate. The revised agreement following 1971 was a lot less clear about this obligation. As stated earlier only three of the trading blocks have consistently been improving their foreign reserve position. The most interesting of course is the Euro Zone where countries have voluntarily accepted an obligation to manage their own economies.

Leave a Reply