How we got here
It's amazing what a few weeks can do. Before the crisis spiraled out of control into the trillions, you never could have seen a commentary like this one in the mainstream media. The following article is from the Financial Post:
Gold is hovering again around $900, commodity prices are on the rise, and the U. S. dollar is back to its downward trend of the last few years. This isn't a surprise.
The $700-billion bail-out plan is mum about the dollar -- a big mistake (reflected in the immediate currency/gold price movements), since the Fed's mismanagement of the dollar as a reserve currency contributed to the present mess. The signals were all there for the Fed to see. Yet academic fads blinded it. How did we get here? More important: how to get out? Take a deep breath.
Abruptly, in 1971, the world moved from fixed to floating exchange rates without in-depth debate. Under a fixed exchange rate anchored in gold, 5% interest in London or 5% in NY reflects the same returns. Money, whether the dollar or the pound, anchors pricing. Coca Cola knows that in pricing its beverages and selling them around the world, or in issuing U. S. dollar denominated debt, it faces no exchange rate risk. The company is neither inadvertently drawn in the exchange rate business nor does it need to hedge and pay fees to avoid being in that business.
This is not the case with floating exchange rates. Every global business -no matter what it sells or buys and how it finances itself -- is in the currency business. Unless companies buy complex derivatives to insure that they stay in their own lines of business, currency fluctuations cause volatility in their costs and revenues. Financing companies becomes more expensive, resulting in a contraction of the non-financial sector and a large expansion of the financial one compared to a world adhering to anchored fixed exchange rates. The fact that national aggregates count the financial sector's expansion as increased well-being just shows how meaningless such measures are. The expansion measures the cost of adapting to bad monetary policy, which could have been avoided.
It has been a mistake to say that floating means "laissez-faire" for currencies. The main role of money is to be a trusted anchor for pricing. People's holding of cash as a "store of value" has always been insignificant. As to a medium of exchange: it fulfills this function properly only when people trust its stability. When the dollar plunges in terms of other currencies by 40% to 60% within few years, and when street vendors in emerging countries refuse dollar bills or accept it at deep discounts, as now happens, it becomes less of a medium of exchange. True, the dollar remains the reserve currency of choice because other countries mismanage their currency too. But relying on the mistakes of strangers is not a good policy. People want to understand that a promise to be paid 5% on U. S. Treasury represents 5% in their own currency too-- rather than, suddenly, minus 10%. When this happens, everyone speaks the same standard monetary language. When this is not the case, then it is gobbledygook to discuss what's "real" and what's not; what's floating and what not; and what clauses one must add to contracts to be reasonably protected.
Standards require agreements between parties, backed by institutions to enforce them. The standards may be arbitrary, as the "metre," "foot," "kilogram" or "pound" are. But as long as people know that their meaning does not change, it does not really matter which one anchors the various measurements. This is obvious, yet in monetary affairs this fundamental role of money seems to be forgotten.
Crises have been mothers of innovations in monetary affairs. This also means that crises have been mothers of forgetfulness too. But whereas in business if the innovation does not sell, management eventually closes the operation down, government-backed innovations, harmful as they may be, can last for decades and centuries.
The crises that have led to the present unsettled state of affairs, in which we lack a standard, followed a sequence of monetary mismanagement since the 1920s. In 1925, while serving as chancellor of the exchequer under prime minister Stanley Baldwin, Winston Churchill made the mistake of restoring the depreciated English pound (depreciated when the U. K. suspended the gold standard during WWI) to its pre-war gold value. This blunder increased the value of the pound, raising the price of everything denominated in its terms (relative to other countries' prices). Every contractual agreement -- including employment ones -- would have had to have been adjusted downward quickly to prevent recession. That did not happen. Economists misinterpreted the sequence of events and attributed the rising unemployment to rigid wages and prices, rather than the government's mistake to re-anchor the pound to gold at the wrong rate. In 1931, Britain abandoned the gold standard.
Britain's decision was likely helped by a sequence of events in Austria a few years before. The Austrian events bears similarities to what is happening now both in the U. S. and in Europe, and thus worth summarizing.
Credit Anstalt, Austria's largest deposit bank, saw its financial situation worsen after 1929. By 1931, its capital was wiped out. Instead of allowing it to default, the government injected funds -- giving rise to rumors that the losses were far greater than disclosed and that all banks were on shaky grounds. The withdrawals by both domestic and foreign depositors and capital flight continued. The central bank asked foreign banks not to withdraw deposits but it did not fulfill its role as lender of last resort. As the domestic drain went on, the government injected funds and also adopted exchange controls -- while pro-forma adhering to the gold parity of the Austrian schilling. Of course, you cannot sustain such parity when the trust in the country's financial institutions is gone and the government adopts exchange controls. The pricing in schillings loses meaning. However, instead of drawing the lesson that governments' misguided interventions and misunderstanding of monetary affairs were the culprit, the lesson derived was that having a pricing standard was the problem. A similar sequence of events took place in the U. S. in the 1930s.
Jump forward a few decades.
From 1944 until the early 1970s, Bretton Woods shaped the postwar monetary system: Participating countries agreed on the formation of the International Monetary Fund (IMF) and they agreed to let their currencies fluctuate 1% to gold values or the (pro-forma) gold-anchored U. S. dollar. Since central banks did not adhere to the monetary discipline that such agreement requires, the new Smithsonian agreement in 1971 allowed for more than 1% fluctuations for currencies. By 1972, European countries formed the European Joint Float, agreeing on an even larger band of fluctuations in their currency rates. Countries continuing to print money with abandon led to the collapse of these agreements too in 1973. Governments could now choose to peg their currencies, to kind-of-peg their currencies (allowing for a range of fluctuations) or to allow them to float freely. For the pricing reasons explained above, these policies did not bring the desired results, and monetary discipline was not adhered to.
In fact, the 1987 stock market crash was caused by these misguided exchange rate policies. There was no significant bad news, no declining corporate earnings, and no sudden interest rates jumps. What happened was that politicians at the G5 meetings decided that they could change trade numbers by lowering the value of the dollar significantly. There have been no debates on the consequences of politicizing the value of reserve currencies and further distancing monetary policy from any notion of sustaining a standard. The possibility that financial markets could--and would--expand greatly and rapidly with a vast range of derivatives to accommodate such a floating world was not anticipated.
Stumbling from one crisis into another, Europe gradually went back to one currency, and is now in the midst of experimenting with something unprecedented again. Although Europe looks superficially to have a fixed exchange rate, it doesn't. For the very first time in history, a paper money neither is anchored in gold nor backstopped by a government. The Euro is only promised to be anchored in a nebulous politically negotiated statistical construct -- a European CPI, which is no standard for anything. People have no idea what the number means, whether or not the
European Central Bank will adhere to its mandate of keeping it stable-- whatever this number is -- and what European governments can do if the ECB does not carry out its mandate.
Because the dollar is backed by the U. S. government, the public's displeasure with its management can be readily expressed. Nevertheless, since the inception of the Federal Reserve in 1913, the U. S. dollar lost roughly 95% of its value in terms of domestic purchasing power. During the last few years the dollar fluctuated wildly relative to other currencies, in the plus/minus 50% range, and whatever were the Fed's declared policies, they did not succeed either in devaluations or in preventing inflation from rising.
Legally, the devaluation of the dollar is not called a "default." But that's what it is.
It is not surprising that financial crises have been on the rise. They always are when governments abandon one monetary system and bet on others, often based on half-baked ideas, or no ideas at all -- this is what today's floating exchange rate system and our lack of commitment to any standard implies.
To avoid such crises, people must know what their money is and what it will be worth. With no agreement on a standard, and without trust that there are institutions to enforce it, the world and the U. S. in particular are crises prone, as the expansion of credit based on the mismanaged reserve currencies can easily happen. It is time to get back to basics, to get rid of the jargon, and to see the monetary system for what it is.
-Reuven Brenner holds the Repap Chair at McGill's Desautels Faculty of Management. The article draws on his Force of Finance (2002) and A World of Chance (Cambridge UP, 2008).