Bacq 2 Bretton Woods

I hope if you are reading this, you understand that we didn’t invent money, we discovered it, and that gold is money, or more correctly, currency.  We should really reserve “money” to describe the idea alone, and “currency” for what we use to trade.

We have all lived in a time when things other than gold are used as money, i.e. our fiat currencies.  When I was born and through my childhood, gold was still very much in use, and that “gold is money” was common knowledge.  All the paper money bore the words “Pay to the bearer on demand” which meant that the bill represented a claim against a certain weight of pure gold.

We were operating then under a form of gold standard, the Bretton Woods standard that established the US dollar as the “reserve currency” of the world, to be used to settle international trade.  It was a very bad idea, and a very bad example of a “gold standard”, but first the history.

By August 1971 it had become clear that the number of dollars created by the US exceeded the amount of gold they had to back it up.  Countries that questioned the Bretton Woods gold standard sent the dollars they had accumulated in global trade back to the ‘States, who were obligated to send back gold in return.

It only lasted until ’71, and the last country to get their gold was France.  Since then, the US dollar has “floated”.  Sunk is more like it, but we’ll stick to the vernacular.  The question to be answered is “why did Bretton Woods fail”?

The answer lies in incentives.  Incentives for human beings are like forces in physical systems.  If the forces are balanced in some way, the system won’t move and it will be stable.  If things get out of balance, in complex natural systems there are feedback paths that react and push back, again keeping things relatively stable despite exogenous influences like weather.

In human beings, incentives act slowly to push our decision-making in certain directions, and feedback may or may not occur, depending on what rules we choose to use and enforce.  Let’s ask what were the rules and incentives at work under Bretton Woods?

Well first off, foreign countries were required to settle their current accounts in US dollars.  So if a country were a net exporter, they had to accept US dollars as payment to the extent exports exceeded imports to/from other countries.  The system created an incentive for foreign central banks to accumulate US dollars, so during times of trade deficit, they had sufficient reserve currency to buy goods without having to depreciate their own currency by selling it on the open market to get US dollars with which to trade.  Essentially, what Bretton Woods was was an “uber-money” arrangement, similar to the argument set forth here.  Instead of every country having to maintain a reserve of the currencies of all its trading partners, it could just keep US dollars.

The US’ situation was quite different.  The fact that other countries needed their currency meant that they had to create it, and ship it abroad.  Instead of just giving it away, they instead ran a trade deficit with the rest of the world for forty years.  A chart of the US trade deficit is rather revealing on this issue.  Note that serious chronic US trade deficits begin just after US dollar gold convertibility ends, chart below:

Before 1971, US trade was pretty flat, exports roughly balancing imports.  This is normal.  Until 1971 the US had an incentive not to print and export too many dollars, as they might come back and demand real gold.  After 1971, the dis-incentive against printing was gone, and the US printed away, supporting both its widening trade deficit and growing federal budget deficits.

There were two possible ways that Bretton Woods might have continued post-1971.  First, foreign countries could have stood firm, and demanded gold for their USD, and failing that, cease trading with the US.  But there were strong short-term disincentives to doing that.  Their local economy would certainly suffer under the trade shock, and because the US could kick anyone’s ass, other countries basically had to accept whatever terms were offered in 1971.  It would have taken concerted action by large global trading blocks to do anything other than follow along with whatever the US said.  It didn’t happen.

The other way would be that the US could have simply continued to honour the gold-convertibility.  Why didn’t they?  Again, strong disincentives existed, or perhaps better said, there were strong incentives for abandoning convertibility, and effectively renegging on the deal they had all signed at Bretton Woods.  The US got to keep *all* the gold they owed to foreigners for US dollars abroad, a not inconsiderable act of global thieving, with no possible punishment or recourse for the victims.  The US could afterwards print money and fund government deficits, and lots of military and other spending with it.  Lots of wealth could be siphoned off the middle classes through inflation, the least-visible form of taxation.  The uber-rich making these global financial decisions, of course, could still keep their wealth in gold and other hard assets.  Without wanting to go too tin-foily on you, let’s just say that there were sufficient incentives to abandoning gold convertibility, few disincentives, it happened, and here we are in fiat-land.

Is it possible that a different structure for currency and banking could have been found, one that would have allowed gold-convertibility to continue?  The answer is “yes”, and we find the answer, as always, in nature.