Brief History of Money

History was never among my favorite subjects in school. Yet, as I have come to realize over the years, history has an uncanny ability to repeat itself and past experience holds important lessons for the future.

The current macroeconomic environment bears strong resemblance (albeit not as acute) to what existed in the German Weimar Republic between 1921-24. During this period Germany experienced a period of extreme inflation caused by the unchecked printing of currency. This ultimately resulted in the death of the local currency (the Papiermark) and the rise of Hitler. Adam Fergusson’s book “When Money Dies” chronicled this tumultuous period and concluded that what really broke Germany was the adoption of soft political options over sound economic policy. We are yet again in the midst of a similar battle between politics and economics – one that has already claimed 9 European governments (France, Greece, Ireland, Italy, Netherlands, Portugal, Spain, Slovakia, Slovenia). Sadly, little has changed in a 100 years and politics once again has the upper hand.

In order to understand why this is the case, it is important to first understand the origin of the modern financial system and recognize that it did not evolve out of sound economic theory but through a history of chance events. As a result it is just as susceptible to a collapse as were the previous monetary regimes.
                    

Emergence of the Dollar as the International Reserve Currency

In the aftermath of the Second World War, Bretton Woods was the location of a landmark international conference held in July 1944 to discuss post-war reconstruction of Europe and establishment of a new global monetary order. The United States offered to back the Dollar through its vast stockpile of Gold in order to promote its acceptance as the new international reserve. This coupled with the overwhelming political and economic strength of the US (which had benefitted from the war as both the arms supplier and bread basket to Europe) resulted in the acceptance of the US proposal and the Dollar emerged as the dominant international reserve currency.

This system worked well while the US maintained large trade surpluses. However due to costs associated with the Vietnam war and increased domestic spend, the US started running a deficit by the early 1970s. It funded this deficit by simply printing more Dollars prompting the belligerent Charles De Gaulle of France to denounce ‘Ze Imbeciles’ in Washington for exporting inflation and debasing the Dollar. De Gaulle and other European nations however did more than grumble about this and started swapping Dollars for as much Gold as they could get their hands on. They could do this because at that point all they had to do was show up at the US Fed to swap Dollars for Gold. A run on US gold reserves ultimately resulted, prompting Nixon to unilaterally close the Fed Gold Window in August 1971. The Dollar thus became a Fiat currency backed by a promise to pay back nothing.

Clearly at this point everyone should have started moving away from the Dollar. However, in one of the greatest economic coups in history the US signed the JECOR agreement with Saudi Arabia in 1974. Under this agreement the US promised to modernise Saudi Arabia and to support the House of Saud (the ruling family of Saudi Arabia) both economically and politically. In return, Saudi Arabia through its considerable weight in the OPEC ensured that it sold oil only in Dollars. Since Oil comprised the bulk of imports for most countries, they were forced to suck up and accept the fiat Dollar as fait accompli. The dominance of the Dollar was thus complete and continues till date.

America’s Exorbitant Privilege

Having an international reserve currency is core to the political and economic might of the US. While all countries need to earn Dollars, the US just needs some paper and ink, making the Dollar its chief (and highly profitable) export. The end of the gold peg removed any last hurdles in printing unlimited currency. The US government has therefore been able to finance its expenses (eg military spends) using simple financial sorcery. But this isn’t all - in addition to a blank cheque the Dollar is also a potent political tool as was demonstrated this March when SWIFT (the dominant international mechanism for inter-bank money transfer) payments to Iran were shut down under pressure from the US.  

The Big Printing Press

Over the years, the Dollar’s ‘Exorbitant Privilege’ has been used to fund extravagant expenditures and satisfy domestic constituencies in the US. This deficit spending is financed by borrowing money (through the issuance of Treasury Securities) from other countries or from the Fed. It is this latter component that is financed by printing money (politely referred to as Quantitative Easing or QE). These borrowings comprise the total US National debt which today stands at a little over $15 trillion. Include off balance sheet liabilities (such as pensions) and this exceeds $55 trillion, increasing at over $1 trillion a year. To put this into perspective, the GDP of the United States in 2011 was $15 trillion and Total Federal Revenues were $2.3 trillion.

Of the total US federal government expenditure, mandatory entitlements (Social Security, Medicare, Retirement programs etc) comprise a massive 87% of total revenues. Such has also been the case in Europe and as the merry-go-round of governments there shows, it is difficult to take away such benefits from a public used to government largesse. There is therefore little chance of curtailing this deficit spending let alone pay any of the accumulated debt back.  This rising debt isn’t being supported by a rising tax base for not only is unemployment increasing in the US, but with baby boomers going out of the workforce demographics are deteriorating rapidly as well. The only way out then is to print more money to fill this hole of interest payments, debt payback and pension liabilities. This was again demonstrated last night when Ben Bernanke promised to buy $40bn dollars of bonds every month.

It is therefore a given that QE will be extended indefinitely, further debasing the Dollar. Also likely is a protracted period of low dollar interest rates for any increase will increase the cost of servicing US federal debt (already at $250bn a year at the prevailing low interest rates) and blow an even bigger hole in the budget. While the post above largely covers the US dollar, the same can equally be said of other major currencies such as the Euro. The US dollar's reserve status however permits QE at a much larger scale than is possible with other currencies.

The next post covers what this means for individual savings and the overall monetary structure.