Oct 042014


The Bretton Woods Conference was held in 1944. Its aims were to rewrite the monetary rules of the international economy to prevent devastating trade wars as well as protectionist and speculative currency manipulations and to provide more flexibility for government intervention during downturns in the business cycle.

Monetarily, what came out of Bretton Woods was a dollars for gold system. The dollars for gold system was very beneficial for the US because it placed the dollar in a unique, privileged position in relation to gold and the world economy. But deficit spending during the Vietnam War undermined the dollar and there was a run on US gold reserves which forced Nixon to bring the dollars for gold system to a sudden, dramatic end in August of 1971. Bretton Woods was officially over. It had lasted just shy of 30 years.

The dollars for gold system was then replaced by an ingenious dollars for oil system which put the US dollar in an even more privileged position. In both cases, the dollar acted as a sort of privileged middleman in monetary exchanges. In both cases, the US traded its military assets to secure this privilege, but much more so in the latter case.

What follows are some details of that story.

A modified gold standard for the sake of the workers

“One of the most innovative aspects of the Anglo-American deal [at Bretton Woods] was the fact that it prioritised the need for full employment and social insurance policies at the national level over thoroughgoing international economic integration. To this extent … it represented a dramatic departure from older assumptions about the way the world’s financial system should function. Under the gold standard, which had facilitated a period of financial and commercial globalisation in the late 19th and early 20th centuries, governments had possessed few means of responding to an economic downturn beyond cutting spending and raising interest rates in the hope that prices and wages would drop so low that the economy would right itself. Populations simply had to ride out periods of deflation and mass unemployment, as the state couldn’t do much to help them: pursuing expansionary fiscal or monetary measures (what states tend to do today) would jeopardise the convertibility of the state’s currency into gold. For these reasons, the gold standard was well suited to a 19th-century world in which there were few organised workers’ parties and labour unions, but not so well suited to a messy world of mass democracy. The Keynesian revolution in economic governance gave the state a set of powerful new tools for responding to domestic economic distress – but they wouldn’t work as long as the gold standard called the shots.” http://www.lrb.co.uk/v35/n22/jamie-martin/were-we-bullied

This is a fact of life on the gold standard: there will be periods of deflation and mass unemployment. Those who advocate a return to the gold standard do not deny this, though they tend to gloss over it. This occasional deflationary downturn, they say, is a necessary market correction. They refer to this as the “necessary pain”, likening such periods to an addict’s recovery from the disease of the malinvestment that comes with prosperous boom times and easy credit. The deflation is therefore just “the bitter taste of medicine”, a required pill that must be suffered until health returns.

To the unemployed, to the businessmen and women who lose everything in these periods – not because they were foolish, but because their bank failed – not because the bank was foolish, but because something else went sour somewhere – to those innocent individuals who lose everything during these deflationary periods, the gold advocates say to them, “Life’s a bitch. Suck it up.”

As Alvin Hansen described life under this kind of arrangement, ‘If it gave us good times, we were thankful. If it gave us bad times, we accepted this as an inevitable concomitant of a system of free enterprise.’

Well, the world eventually got tired of all that. A couple of world wars and one Great Depression will tend to do that sort of thing to a world. So, despite the claims of the gold bugs that this was the best of all possible worlds, the world decided to try something new. There were new economic doctors on the scene and they prescribed monetary intervention during periods of economic sickness.

“What was needed, and what both Keynes and White wanted to establish, was a system of fixed but adjustable exchange rates, which would allow states to make domestic policy without worrying too much about how it would affect their international economic position. Along with capital controls, this system would work to stabilise currencies, as the gold standard had done, but in a way that gave states more breathing space to pursue the interventionist and welfarist techniques of national economic management that had recently come into vogue across the Atlantic world. The compromise that Keynes and White reached was based on this fundamental insight, and reflected what had become a new (if fleeting) consensus: that the state owed its citizens basic economic security.”

The world wanted to be able to intervene in times of trouble, and prevent the worst horrors of economic seizure which can arise from the loss of liquidity in periods a fear and panic. And the world increasingly wanted a means of government intervention that could address unemployment.

When it came to economics, domestic policy was the focus of nations in the 19th and early 20th centuries. In the later half of the 20th century, however, the world would increasingly turn its attention to international economic policy. World leaders learned from previous disasters that “there is no domestic solution for international problems” (need citation) – a reference to the sorts of protectionist trade policies and currency manipulations that the nations had embarked on to tragic consequences in the previous century.

One of those lessons, which came from the Treaty of Versailles after WWI, was that a functional world economic system was essential in order to prevent the outbreak of more domestic chaos and war. Many believe that the failure to address this question of international economic concerns at the Treaty of Versailles is what ultimately led to WWII as the economic punishments laid on Germany put it in an impossible position.

Moreover, many economists believed that the failed attempt to revive the gold standard after WWI proved that the world needed a new monetary system. What was proposed was a modified gold standard with a fixed exchange rate that everyone agreed with. They argued that the old gold standard did not allow governments and monetary authorities the flexibility to intervene to revive economic activity but this new gold standard would be flexible enough to allow for such necessary interventions.

This sort of intervention was a new idea, a new prescription from the new monetary doctors, a break from classic economic thought. As such, there were many critics – and there still are. (See Keynes vs. Hayek for more) Nevertheless, only time could tell who was right and who was wrong. The second half of the twentieth century would see this idea play itself out.

We are still in the midst of this experiment.

Ultimately, the arrangement at Bretton Woods failed, at least technically. The agreements that were made were broken and the nations who were party to the agreement abandoned it. The final official blow came when Nixon was forced to completely sever the connection of the US dollar to gold as debts exploded in the US.

How the gold standard finally died

As mentioned, the Bretton Woods arrangement of 1944 ultimately established the US dollar as the medium of international trade between countries. The dollar was the only currency available widely enough across the world to play this role. Although the English wanted to establish a new reserve currency to be controlled at the IMF the US prevailed in their efforts to establish the dollar as the world’s medium of exchange.

The dollar became the only currency pegged to gold, convertible at $35 per ounce. This made it a convenient currency for countries to hold and use for trade. Countries could adjust their exchange rate to the dollar as they saw fit to address local concerns regarding growth or inflation and so on.

At issue was how to stabilize volatile exchange rates and protectionist currency manipulations and prevent harmful short-term speculative investments that affected capital flows. These are the sorts of problems that were widely believed to have destabilized the international monetary system in the period between WWI and WWII.

The IMF (International Monetary Fund) was established at this time as a sort of buffer to smooth out trade imbalances and to provide loans to struggling member nations when needed. The intent was to prevent national bankruptcies and sovereign defaults. The World Bank and World Trade Organization were also created at this time. They survived the fall of Bretton Woods.

Trade imbalances occur when a country imports more than it exports, or vice versa.

Balance of payments imbalances can arise when … well, there are many definitions, and disagreements as to what degree such imbalances matter. Thinking on such topics tends to change. But in this transitional period from the gold standard to the new monetary economics, countries paid a lot of attention to this.

One thing is for certain, the US at this time ran very large export surpluses. This meant that US dollars were flowing into the US to pay for the goods flowing out of the US. This created a dollar shortage overseas (known as a dollar gap). Countries needed US dollars to pay for the goods America was exporting.

It turned out these imbalances were what the IMF was designed to deal with, but in reality they were more than the IMF could handle.

The US responded in the 1950s with a series of grants which injected US dollars overseas. The most famous was the Marshall Plan. The US also established multinational financial institutions designed to direct the flow of US dollars overseas. In each case, the intent was for this money to be used to build up the decimated economies of Europe after WWII, which would in turn create new markets for US exports.

A paradox of the dollars for gold system thus becomes apparent: as the world’s economies grow, more and more of the reserve currency is demanded, which means the country supplying this currency must run a constant trade deficit (or balance of payments deficit?) where currency flows out of the country in order to fuel this growth. Eventually, this trade deficit would erode confidence in the currency because as more and more of it is created, the less valuable it becomes. (see Triffin Paradox: http://en.wikipedia.org/wiki/Triffin_dilemma#Implication_in_2008_meltdown)

And this is exactly what happened.

The US trade surplus reversed. The dollar gap of the 1940s and 1950s turned into a dollar glut in the 1960s. Foreign countries were no longer experiencing a shortage of dollars, but were awash in dollars that the US was “exporting.” Meanwhile, real Japanese exports were catching up to the US manufacturing levels and the Vietnam War (and the Great Society programs?) were creating large budget deficits in the US. Instead of paying for these costs by raising taxes, the US went deeply into debt as it continued to print more money.

This in effect caused a run on US gold.

By the late 1960s foreign countries concerned with US debt levels were converting their (increasingly devalued) dollars for gold causing US gold reserves to become depleted. Devalued dollars were flowing back into the US while valuable gold was flowing out.

The US responded by offering military protection to those countries who would hold their US dollars at a loss. In effect, the US was using its military assets to protect its gold (if you don’t trade in your dollars for gold, we will offer military protection), but also to protect the capitalist world’s economic system. It was a trade they would use again and again. The new world order of Bretton Woods was designed to run on US dollars and if needed the US military would make sure it did so.

But to some extent foreign countries were only willing to take a loss holding dollars in exchange for favorable US military policy as long as they supported US military policy, and Vietnam was changing that.

Meanwhile, the IMF was trying to create a special kind of currency that could potentially replace the dollar as mediator in transactions between banks and the IMF. The IMF was positioning itself to replace the US as the world’s central banker. (This tension within the IMF between the US dollar interests and the other members is something to watch going forward as the so-called “currency wars” develop.)

By 1970 US gold reserves had been cut in half as countries demanded fulfillment of America’s “promise to pay”. Tens of billions of dollars worth of gold drained out of the US reserves. It seemed as if the world had lost faith in the ability of the US to cut its budget and trade deficits. For the first time in the 20th century, a country (the US) was running a balance of payments deficit and a trade deficit at the same time.

By August, 1971 the US decided that it had no choice: without informing the international community beforehand, President Nixon closed the gold window. On Monday morning, before the markets opened, Nixon made television announcement that the US would no longer allow dollars to be converted to gold.

It became known as the “Nixon Shock.” Suddenly foreign countries all over the world were holding dollars that they could no longer convert to gold. And just like that, the Bretton Woods system of dollars for gold was officially over. It had lasted just under 30 years.

Bretton Woods was over and the gold standard was gone.

A most ingenious idea

In response to this waning demand for the dollar, America found an ingenious way to create a new artificial demand for the dollar. The US made a deal with Saudi Arabia, and then later with other oil producing nations, who agreed to denominate their oil in dollars. This meant that they would only sell oil for dollars. Anyone who wanted oil had to first convert their currency to dollars to get it. In return for this privileged position as middleman between the Middle Eastern oil and the rest of the world, the US would provide military weapons and military protection to these oil producing nations. Some say, protection from the likes of Israel.

Instead of dollars for gold, now the US was in the business of dollars for oil, which also meant flooding the Middle East with arms. So the US was able to export its inflation (expanding money supply) to other countries by trading on it’s military assets, just as it had done once before in Europe. Except this time, it was on a much, much larger scale.

The dollars for oil system (known as petro dollars) sheds important light on US foreign policy. “The defense of Saudi Arabia is vital to the defense of the United States” – FDR

Indeed, the US provides much much more in aid to these other nations in the Middle East than it does to Israel (citation needed), an act which speaks for itself with regard to real US interests in the Middle East.

But more to the point the world’s demand for dollars absolutely skyrocketed in response to this arrangement. Any country that did not possess a surplus of US dollars could not buy oil. At least, not from much of the Persian Gulf region. Some oil producing nations (Iran, Syria, Venezuela, and North Korea) did not sign on to the dollars for oil program. Many of these nations, interestingly, are known in the US as the “Axis of Evil”.

Countries who needed a supply of dollars could go into the costly currency exchange markets – or they could run an export surplus to the United States. All they had to do was get their prices low enough to attract US dollars. This is exactly what East Asia (Japan) did in the 1980’s. It needed lots of oil, so it sold Hondas cheap to the US.

This is why the US runs a permanent trade deficit while other countries do the opposite. The world needs dollars because the world needs oil. In order to supply the world with those dollars, requires a trade imbalance.

Another part of the deal with Persian Gulf countries is that they agreed that any excess profits made from oil production would be held in US securities in US banks. This has the benefit of keeping interest rates low. Interest rates on bonds and securities work inversely with the price of bonds and securities. An increase demand for US securities raises the price of US securities while lowering the interest rate paid on those securities.

Bonds and securities can be thought of as promissory notes on a loan. Loans that come with interest payments. Promissory notes that can be sold. The purchaser of a promissory note receives the interest payments from the borrower. The price of the promissory note and the rate of interest the note pays the owner move in opposite directions. The higher the interest rate, the lower the price of the note.

The borrower in this scenario is the issuer of the promissory note. In the case of US securities, the borrower is the US government. The purchaser of the security (Saudi Arabia, for example) is making a loan to the US government.

Persian Gulf countries who are part of this system agree to loan the excess dollars they receive from world oil demand back to the US in what Henry Kissinger called “petrodollar recycling”.

So the US was able to create an artificial demand for US dollars by attaching dollars to oil, then it was able to guarantee that an excess of those dollars return in the form of low interest rate loans. Not only does this create an artificial demand for US dollars but an artificial demand for US debt – all backed by military promises and arms deals.

An important thing to notice in these observations is the effect that these US dollar policies have on everything from Wall Street to Main Street to foreign military policy.

On this last point of interest, we should note that if the dollars for oil system ever broke down like the dollars for gold system did – well, the United States can simply never let that happen, right?

Time Magazine ran a story in 2000 that Sadaam Hussein announced its plan to dump the dollars for oil system in favor of euros.

“Iraq says that from now on, it wants payments for its oil in euros, despite the fact that the battered European currency unit, which used to be worth quite a bit more than $1, has dropped to about 82[cents]. Iraq says it will no longer accept dollars for oil because it does not want to deal ‘in the currency of the enemy.'”

Sadaam dumped the dollar in 2002. We went to war with Iraq in 2003. Is it possible that the United States went to war with Iraq to protect its dollars for oil program? It would certainly make a lot of sense. It would fit in line with US policy to use the military to defend the dollar, our truly “vital” interest.

Meanwhile, the US is the unique position among most countries that it can buy oil with money it prints.

And print money it did. As noted, this dollars for oil arrangement causes demand for US dollars to increase exponentially (need citation). And as more and more money is printed, assets prices (stocks, housing) naturally rise – along with consumer prices. This inflation has caused the dollar to lose a lot of purchasing power since 1970.

For example, you would need roughly $3000 by the year 2000 to get the same purchasing power as $500 in 1960. “http://www.measuringworth.com/ppowerus/”

Of course, if wages and incomes rise accordingly, this offsets the rise in prices. As long as it is as easy to get $3000 in the year 2000 as it was to get $500 in the year 1960, there is no problem. But this isn’t what happened.

Those individuals in possession of enough assets are shielded from this consumer level price inflation as the rise in asset prices has more than offset the rise in consumer prices. But the working class depend on rising wages, not assets, to compensate for rising consumer prices. Our current trouble is that while asset prices and GDP continued to climb with the ever increasing supply of US dollars, wages stopped rising in the 1970’s. While GDP has risen as the economy has grown, real wages have not.

Real wages as a percentage of GDP:

Wages adjusted for inflation (so-called real wages) have been declining for over 40 years in the United States. In 1950 a high school graduate could find a job working in a factory and support a family of 4 or 5 on that one income. Once wages stopped rising, women went to work and families increasingly needed to use credit cards to maintain living standards.

The upshot of this analysis is that the “economy” is growing during this time (assets prices are rising, GDP is growing) but non-asset owning wage workers are not benefiting from it.

So why are wages not growing with the economy?

Is it because the “real economy” is not really growing? Remember, in order to supply the world with dollars (which causes assets priced in dollars to rise), the US needs to run trade deficits, meaning no more manufacturing and so on. Is it possible that this has created a situation where the rise in GDP is no longer attached to a rise in US productivity?

In short, yes. GDP growth detached itself from real wages precisely in the 1970’s. http://en.wikipedia.org/wiki/Real_wage

Are we in the midst of a currency war?

There has been increasing talk of a currency war in the past few years, which, if true, could have some very large consequences for the US – especially if the US dollar loses. So, are we in fact in the midst of a currency war?

Since 2007 a series of bestselling books have been sold in China titled “Currency Wars”. The same is true in the US. So this is a somewhat popular idea in both China and the US to some level, but is it true?

In 2010, the Brazillian Finance Minister made headlines by claiming that an international currency war had broken out. Many financial sector writers were in agreement but others – especially in the administration – say the claim was exaggerated and that things had fizzled by 2011.

However, after the crisis of 2008, there have been repeated calls by leaders in several countries to begin a discussion about a “Bretton Woods II”.

Perhaps most notably, the People’s Bank of China Governor Zhou Xiaochuan said in 2010 that whereas US monetary policy “may be optimal for the U.S. alone . . . it is not necessarily optimal for the world. There is a conflict between the U.S. dollar’s domestic role and its international settlement role.”

If Britain had won out in the original Bretton Woods agreement, the US dollar would not have been the world’s exchange currency. Keynes wanted to create something he called the “bancor” which the IMF would control. This currency would only be exchanged between banks and the IMF as a means of exchange and debt relief and so on. The IMF did eventually create such a thing, called the “SDR” but it represents a small fraction of the reserves there at present.

But more and more nations are speaking out in support of this idea.

Zhou Xiaochuan, the governor of China’s central bank, said the global economy would be better off with a “supersovereign” reserve currency, in place of one issued by a specific nation — in other words, the dollar. “The frequency and increasing intensity of financial crises,” Zhou said, “suggests the costs of such a system to the world may have exceeded its benefits.” Zhou recommended turning Special Drawing Rights (SDRs), the unit of account used by the International Monetary Fund (IMF), into the premier international currency. Then a U.N. panel of economists led by Joseph Stiglitz, the Nobel laureate, concluded that a reformed financial system with a new No. 1 international currency would help bring greater strength and equity to the global economy. Stiglitz told reporters there was a “growing consensus that there are problems with the dollar reserve system,” which he described as “relatively volatile, deflationary [and] unstable.” http://content.time.com/time/business/article/0,8599,1889588,00.html

In fact, Zhou even cited the Triffin dilemma as a proximate cause of the 2008 crises. For reference, see page 6 of this IMF document: https://www.imf.org/external/pubs/ft/spn/2009/spn0926.pdf

These sorts of discussions continue and examples are easy to find if you search for them. The fact is, there is increasing talk of creating alternatives to the US dollar as the world’s reserve currency and increasing desire around the world to free itself from what it sees as US financial hegemony that is no longer in the best interest of the world economic system. Whether this is a plausible threat to the dollar is questionable. Some say these nations are in fact trapped in the dollar:
Prasad, E.S.: The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance. (eBook and Hardcover)

But for how long?

Whatever the answer to this question might be, understanding the history of the US dollar is helpful in understanding many of the nuances of US domestic and international policies in the world today.

 Posted by at 12:27 pm

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