As explained in the page about the
anatomy of the economy, the
monetary system to the economy is like the operating system to a
computer. Just as applications run on the computer's operating
system, economic institutions run on the economy's monetary system.
The monetary (or operating) system
that applied during the Bretton Woods era* used fixed exchange rates
and had
two sources of money:
Increased foreign reserves; and
increased bank
credit.
Money from increased foreign reserves generally represented an
increase in income (from exports) above spending (on imports).
When the money created from these savings
were eventually spent on imports, foreign reserves would
decline and this money would cease to exist. This form of
money is endowed money.
Note that spending on domestic
goods and services always equals the income from the sale of
domestic goods and services. (The spending of one person in
the nation is the income of another person in the nation.) If
national expenditure is to be greater than
national income, it must mean that spending on imports are greater than
income from exports.
Money from increased bank lending
(lending greater than loan repayments and other forms of saving such
as changes in bank capital) enables not only the borrower to spend more than
their income, but the nation. This money is unendowed money.
The growth in bank credit causes
spending to rise and increases imports above exports, depleting foreign reserves.
At that point, the money ceases to
exist. Also, it means that the endowed money created by the original
increase in foreign reserves has lost its asset backing. The
bank's asset backing (the borrower's debt) still remains.
We can consider that the remaining money has
been neutralized: that is, the excess spending caused by the bank
lending has now been exercised and
neutralized. The country now has additional money
(from the original growth in foreign reserves). The asset
backing of that money is now the debt to the bank.
As a general rule, countries in the
Bretton
Woods environment allow banks to increase lending provided that the lending does not deplete foreign reserves.
Excessive bank credit would deplete foreign reserves or raise foreign debt.
Operating system post Bretton Woods
The US government abandoned the
Bretton Woods Agreement because it was borrowing excessively from the
banking system (to finance the Vietnam War) and this was depleting
foreign reserves. Floating the exchange rate removed the
pressure from the Federal Reserve on President Nixon to raise taxes
to reduce the government's reliance on bank credit. The floating
exchange rate was a scheme to preserve US foreign reserves. It prevented the growth of bank credit from depleting
official foreign reserves. But it did not
prevent the underlying transfer of entitlements and obligations.
Also, the floating exchange rate system
prevented the accumulation of foreign reserves. All
international transactions were required to be traded on a foreign
exchange market and those wanting to buy foreign currency were
required to trade with those wanting to sell foreign currency to buy
domestic currency.
Hence, there was no opportunity to
create money from the growth of foreign reserves (i.e., from
national savings).
This meant that bank credit was the
only source of additional money.
As considered in paragraphs 5 and 6 above, money from bank credit causes spending to exceed
income. The only way a country can spend more than it earns is
to import more than it exports.
Yet the foreign exchange market
requires international receipts and payments to be equal.
The only way that the constraints
on the foreign exchange market and the monetary system (in paragraph
15) is reconciled is if the international capital inflows (debt and equity)
are greater than international capital outflows by the amount of the
growth in bank credit.
In other words, the net capital
inflow must equal the growth in bank credit. This is evident
for the USA, Australia and
New Zealand. It
was the case also for the Philippines
until the Central Bank of the Philippines became aware of this relationship and modified its monetary
system.
Implications
The implications of this are
extremely significant for the economy. While the Bretton Woods system
was in force, the process of neutralizing the money created by the
growth of bank credit was by reducing national savings in the form
of foreign debt. The net outcome was an economic environment in
which international trade was relatively balanced: the additional
imports being offset by foreign reserves generated from additional
exports.
In the post Bretton Woods economy,
it is not possible to neutralise the money created by the growth of bank
credit. Yet unendowed money continues to cause national
spending to be greater than national income. Therefore it produces an economic environment in which international
trade is unbalanced. The only way that the inherent excess
spending can be met is if there are additional imports and these are
paid for by increasing foreign debt.
This money cannot be said to be neutralized:
instead we can call it indebted money. This money not has not
only a domestic debt; it has a foreign debt. But if the
inherent excess demand in the unendowed money were not met by
foreign debt, the unendowed money would be likely to cause
hyper-inflation. So, it is better that unendowed money be
transformed into indebted money than being left as unendowed.
Even so, the indebted money created by the growth bank credit
causes some inflation whereas the endowed money created from national
savings (the growth of foreign reserves) and neutralized money
reflect growth in income and do not have the same
inflationary effect. (See Money and
Inflation)
Inflation
occurs when the growth in the money supply exceeds the growth of the economy.
Under the Bretton Woods arrangements, monetary growth from rising
foreign reserves directly increased national income and the
money supply. Therefore, it raised both the numerator (money) and the
denominator (GDP). So inflation was low.
Unendowed money and indebted money (from bank credit)
raises the numerator (money) but they do not directly increase
the denominator in the same way as money from the growth of
foreign reserves. Thus these forms of money are more likely to cause inflation.
When there is inflation, the economy needs more
money to grow. The post Bretton Woods era began with a
recession called the "Oil Crisis". This recession was caused
by the inadequate growth of the money supply which was constrained
by the banking rules which were previously necessary to restrain the
growth of bank credit. Consequently, the financial system was
"deregulated" to allow banks to increase lending and provide more
money to stimulate the economy. In the post Bretton Woods
environment, the growth of bank credit results in the simultaneous growth of two
types of debt:
domestic debt, in the form
of bank debt; and
international debt.
Therefore, besides the
inflationary effect, there is a need for central banks to
regulate the growth of bank credit to minimise the international
imbalance.
Monetary growth under the
Bretton
Woods system had the capacity to generate rapid growth, full
employment and low inflation. Monetary growth under the post
Bretton Woods system does not have the same capacity.
Furthermore, as the economy continually
needs more money (bank debt) to grow, the quality of the debt declines over
time. This became blatantly clear when the US monetary system
collapsed in what was called the Global Financial Crisis.
While the Australian monetary
system has not collapsed in the same way, it is heading down the
same direction. As in the USA, Australia is now relying on the
poor to borrow, encouraging them through programs such as the first home buyers scheme.
Unless Australia changes its
monetary system, it will come to rely on banks lending to people who
cannot repay to facilitate economic growth. At that point,
the monetary system will collapse, as in the USA.
If Australia tries to maintain the
present monetary system and avoid lending to the poor, the
consequential lack of
economic growth is likely to cause many borrowers to default and
that would lead to the collapse of the monetary system.
Another implication is that the rate of
economic growth has declined in the post
Bretton Woods era.
Consequently, the growth in real wages have declined also.
While the world has experienced
globalization, trade is lower than
it otherwise would have been. This is because the real
exchange rates of countries like Australia and the US have
increased, making their products less competitive on the world
market, reducing their exports and also reducing their income, which
would otherwise have generated more imports. That is, both
exports and imports (trade) would have been greater within a Bretton
Woods environment than they have been in the post Bretton Woods
environment. (The increase in the real exchange rate can be
seen in the proportion of GDP spent on
imports.)
The post Bretton Woods system is
unsustainable in the long term. The US government has bailed
out the financial system following the Global Financial Crisis.
However, the economy continues to rely on the financial system to
expand the money supply. So far, this is not happening and
bank credit in the US is declining, contributing to a major US
recession. (Note that this is unchartered territory for the US
economy.)
If the US government attempts
to borrow to stimulate its economy, it may be able prolong its life
before its eventual demise.
It seems foolish that the US
government discarded a stable monetary system in order to improve
the re-election prospects of President Richard Nixon. This
short sightedness has meant that the US economy has collapsed and
now stands on the brink of disaster.
Solutions, such as the optimum
exchange rate system would enable countries to neutralize their
indebted money. They create foreign reserves in the banking
system that can be used to repay private sector debt (both bank and
non-bank). When this is done, the foreign debt is eliminated
in much the same way as imports neutralize unendowed money.
A country converting its
indebted money to neutralized money would experience rapid growth,
high employment levels and low inflation. The rapid growth
comes from exporting more than is imported and raising GDP.
This leads to high employment. However, as production or
supply is greater than spending or demand, the country does not
experience inflationary pressure.