A Short Introduction to the International Monetary System “Dollar Standard”
The international monetary system dollar standard replaced the defunct Bretton Woods system in 1973. This system is characterized by structural flaws that are causing periods of economic growth and economic crises, in both isolated countries and as a group, as is the case of the crisis in the United States in 2007 that is negatively affecting several nations.
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Understanding these failures is necessary to find solutions to the socio-ecological problems that occur both locally (unemployment, social inequality, loss of biodiversity and ecosystems) and globally (human migration, climate change, international financial crisis).
The Failure of the “Dollar Standard”
Basically the main failure of the dollar standard is related to the composition of the assets of international reserves, which changed drastically after the end of the Bretton Woods agreement. From 1945 to 1973, the main reserve assets were, in descending order: gold, paper money convertible into gold and SDRs (Special Drawing Rights).
During this period, the dollar was the main currency used in international transactions and the fact that the dollar was backed by gold ($ 35 for one ounce of gold) limited credit expansion in a country, because, as Duncan says (2005) countries with current account deficits should, when its trading partners so require, send amounts of gold to foreign countries.
With the gold output of the financial system, agents authorized to extend credit (banks, for example) reduced the availability of credit in the country, causing periods of recession. On the other hand, the gold country receiver went through a period of credit expansion and, consequently, economic growth, and depending on the sectors that received the bank credit, economic bubbles
During this economic “hot period”, inflation was more advantageous for the importation of products, making the country incurred in trade deficit which led to the country’s gold output, thus reducing credit growth and leading to economic recession. Again, on the other hand, the gold country receiver, passed through the process described above.
This process, described in a very simplified way, prevented countries from incurring in deficits or surpluses that increased over time in their checking accounts.
The process of credit expansion in the pattern Dollar Standard
With the end of the Bretton Woods agreement, the composition of reserve assets changes considerably and the process of expansion of credit in the financial system increases in unprecedented numbers, causing periods of economic growth associated with the expansion of the economic bubbles that inevitably burst.
The main reserve assets become: (a) government debt securities; (B) debt securities issued by private companies; © derivatives; (D) shares of companies listed on stock exchanges, among other companies.
As you can notice, the reserve assets of almost every dollar standard are created by humans, unlike gold. Consequently, countries can finance their current account deficits by selling those assets, as central banks from other countries accept them.
This is the case of the United States that being the country issuing the main currency of the current international monetary system, starting in the 1980s has been financing all or part of its current account deficits (the largest in the world) with the sale of reserve asstes, as the US government federal securities, agency debt backed-up by the US government as Fannie Mae and shares of companies traded on stock exchanges (Figure 1)
The mirror pattern observed in Figure 1 is observed in other nations, both in countries that, as the United States, finance their current account deficits through their financial account, as well as countries with current account surpluses that need to recycle the incoming financial resources for this through the ‘ export ‘ of the same through their financial account, or purchasing reserve assets such is the case of China. We focus on the latter case to explain a key process to understand how this behavior in the balance of payments affects credit expansion and economic bubbles in a country.
How is it that economic bubbles are created
As Duncan (2012) explains when US resident companies pay for products imported from China, billions of dollars are transferred from the US to China. The central bank of the People’s Republic of China (BCRPC) in order to prevent the Yuan from losing its competitiveness and ensure that China continues to export to the US, buys dollars at a desired exchange rate. By doing this, two important processes occur that are detailed in Paiva Sobrino and Romeiro (2016a) and are briefly described below.
As it is known, during the international monetary system dollar standard, the FED creates dollars every time it buys something (FED 1982) and much in the same way other central banks create their own currency to buy financial assets of interest. When the central bank of China (BCRPC) buys the dollars that were sent by resident companies in the United States it is creating Yuans, which will be transferred to the banking system in China and destined for companies that export to the United States.
These Yuans as they enter the Chinese banking system, according to the level of indebtedness of the sectors of the Chinese economy, may or may not help banks to expand credit and depending on which sectors this credit spreads to can trigger both economic growth and economic bubbles. More details on how this process occurs can be found at Paiva Sobrino and Romeiro (2016a, b).
On the other hand, the dollars acquired by the BCRPC are invested in the United States through the purchase of securities of the federal government, agency debt by the US government, shares traded on stock exchanges, REPOs (sales and repurchase agreements), among others. Each time the BCRPC, or any other central bank, buys a financial asset in another country it is acquiring reserve assets and this is computed with a negative sign in the balance of payments (Figure 2).
Those dollars come into the banking system of the United States and depending on the level of indebtedness of the sectors that make up the US economy may help banks expand credit for activities that contribute to economic growth as well as for those seeking speculation of assets be it in the furniture or real-estate market, triggering economic bubbles that inevitably burst.
The process of credit expansion and its relationship with economic growth and economic bubbles is analyzed through a multilevel analytical framework described in Paiva Sobrino and Romeiro (2016b).
The process described is valid for other nations, whether they have current checking account deficits, as well as those presenting surpluses, such as Japan.
The Dollar Standard changes the rules of the game
Thus, the dollar standard led to a period of transnational transfer of financial resources unprecedented in the history of mankind. Several factors have contributed to this phenomenon, the main ones are the following:
Adoption of the primary dealers system in 1960 in the USA, currently adopted by most countries. This system comprises financial institutions known as primary dealers that play an important role in the process of creating money with governments and central banks. This system allowed the primary dealers to have access to one of the most liquid financial assets (government debt securities of a country) forming the global market of government securities and private debt that becomes highly connected since 1979 with the implementation of Society for Worldwide Interbank Financial Telecommunication (SWIFT) system. The problems associated with this system are described in Paiva Sobrinho and Romeiro (2016th).
High interconnectivity of financial institutions through SWIFT banking, which allows the international flow of financial resources in amounts and speeds never before witnessed in the history of mankind. SWIFT also serves as a means of coercion against countries by suspending the system (Bloomberg, 2012, 2014).
Removal of restrictions to control capital inflow, which was completed in 1990, establishing the globalization of financial markets.
Globalization of products and services made with cheap labor, mainly from Asian countries, which led to a significant reduction in production costs.
Sustained use by US and European banks, from the 1980s, of the practice of securitization as a means to get the cash to finance long-term loans granted to customers.
Deregulation of the derivatives market in 2000.
These factors allowed the formation of a complex system of financial flows, goods and services between countries around the world generating both positive and negative consequences for humanity. The problem is that the negative impacts on the social environment are outperforming the positive consequences
The Dollar Standard, Crisis and Money
There are other details related to the international monetary system, dollar standard, which are described in Paiva Sobrinho and Romeiro (2016th, b) and will be presented in future posts.
Among these details, one that I find very important is related to the process of money and credit creation by financial institutions. This process is unknown even by many politicians and economists (Paiva Sobrinho, 2015) and deserves to be understood in order to create solutions to the socio-ecological problems affecting humanity in this geological era: the Anthropocene.
I hope this brief post may contribute to begin to understand the dynamics and functioning of the current international monetary system, dollar standard. I hope soon to present a post that shows how this dynamic pattern of the dollar contributed to the outbreak of the current economic crisis being experienced in my country, Brazil.
Duncan, R. 2005. The dollar crisis. Causes, consequences, cures. John Wiley & Sons.
Duncan, R. 2012. The New Depression: the breakdown of the paper money economy. John Wiley & Sons Singapore.
FED. 1982. Putting it simply. Federal Reserve of Boston.
Paiva Sobrinho, R. 2015. Creación de dinero y sus consecuencias para la sociedad.
Paiva Sobrinho, R.; Romeiro, A.R. 2016a. Understanding the dollar standard in order to improve ecological macroeconomic theory. (Sometido para publicación)
Paiva Sobrinho, R.; Romeiro, A.R. 2016b. An analytical framework to assess economies in the dollar standard. (Sometido para publicación)