Professor Elam

Weekend April 12, 2015

Money Games

The nations should consult and agree on international monetary changes which affect each other. They should outlaw practices which are agreed to be harmful to world prosperity, and they should assist each other to overcome short-term exchange difficulties.

Agreement leading to formation of the International Monetary Fund

Bretton Woods, New Hampshire, USA, July, 1944

Those lofty principles would not become reality until 1958 when all European currencies became convertible. This  allowed the US Dollar to become the world’s’ reserve currency. But the winds of change are beginning to blow, harder and harder, a new World Oder is emerging.

The agreement took the entire month of July, 1944 t hammer out. But the basics agreed on included

• Creation of the International Monetary Fund and the Bank for Reconstruction and Development both of which ar now part of the World Bank.
• Fixed exchange rates for currencies of different countries
• Currencies were convertible, one to another, to facilitate trade
• Members could adjust currency values up to  10%

The idea was to encourage open markets and increased world trade to raise standards of living. Keep that thought in mind.

The US Dollar as  the world reserve currency meant that all international transactions, say the payments  for oil, would be settled in dollars. The US Dollar would be stable as it could be converted into gold. This conversion guarantee was intended to keep the US from inflating its currency. The US could not spend any more than it had gold backing the currency, thus the world was tied to the largest economy, and the Dollar was backed by literally, the gold in Fort Knox.

The profligate spending of the US on both the Viet Nam war and various social program of the 1960s did begin to inflate the dollar. The US could produce all the dollars it wanted by merely printing them. The rest of the world however had to put up real money to obtain dollars. Thus the US was free to inflate its currency, which it did. Other nations led by France’s de Gaulle, began exchanging dollars for gold. Soon the dollars in circulation exceeded the gold available to back the currency.

On April 13, 1971, President Nixon

• Suspended the convertibility of the Dollar into gold
• Froze wages   and prices in the US
• And imposed a 10% import surcharge on goods brought to the US

With no requirement to back the currency with hard money, gold which cannot be printed from trees,  the official inflation race was on. This eventually led to the stock-flation  with the Dow rising from below 1,00 in 1982 to its present 18,000 lofty level.

But now the center of world commerce has moved East. There have been far more Initial Public Offerings originating on the Hong Kong Exchange than in New York. Indeed, the real reason for the Gulf War was Saddam Hussein’s avowed desire to replace the US Dollar with another currency.

Europe’s attempt at its own currency, the Euro, has fallen apart without the combined political discipline of one governing body. Greece is hastily making debt payments as it literally runs out of money to do so.

It is no surprise then to learn that China created the Asian Infrastructure Investment Bank  AIIB on  October 24, 2014. Already almost all Asian countries and most major countries outside Asia had joined the AIIB, except US, Japan (which dominated the ADB) and Canada.  Despite US objections, South Korea an d Australia have joined. Hong Kong followed as well. China organized the bank to provide what it sees as the necessary funds to pour $8 trillion into the region by 2020. Clearly this is a competitor to the World Bank.

How long until the AIIB begins using currencies other than the Dollar to facilitate its lending?  The one thing that supports the dollar is world demand to settle world debt payments. If however, as Saddam Hussein envisioned, the world begins using say the Chinese Yuan for international settlement the demand for Dollars will dwindle. This would leave the US with trillions  of debt in foreign hands but without the ability to print dollars at will to pay on the notes.

This past week investors literally bought some European bonds at negative interest rates. Surely we are at or near the low in rates. Once interest rates begin to rise, along with the strength of the AIIB, the US may find itself, shall we say, internationally constrained to spend and spend.