Monetary system

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Monetary system
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Monetary system - is the set of institutions, laws and conventions through which a country (or a group of countries, or the world economy as a whole) creates money, defines its unit of account, decides what must be accepted in payment and manages the value of that money over time[1]. At the national level it answers questions like "what is a dollar?" and "who may issue it?". At the international level it answers a harder one: how do dozens of different currencies get exchanged, and who pays when the arrangement breaks?

Barry Eichengreen calls the international monetary system the glue that binds national economies together. Good glue goes unnoticed. Bad glue gets blamed for crises, and with some justice: the collapse of the interwar gold standard, the end of Bretton Woods in 1971 and the currency crises of the 1990s were all, at root, failures of monetary arrangements rather than of any single government's budget.

Elements of a monetary system

Whatever the regime, every monetary system has to settle a handful of practical matters:

  • Monetary unit - the name and the subdivision of the currency (pound and pence, dollar and cents). Historically the unit was defined as a weight of metal; today it's simply a unit of account with no physical anchor.
  • Legal tender - the forms of payment a creditor cannot refuse when settling a debt. Coins and bank notes issued by the official authority usually qualify; bank deposits, oddly enough, often don't in the strict legal sense, even though they make up most of the money in circulation.
  • Issuing authority - the body with the right to create base money. In most countries that's the central bank (in the United States the Federal Reserve System); in a currency board regime it's a board with very limited discretion; in a dollarized economy it's a foreign central bank.
  • Reserve and cover rules - what, if anything, must stand behind the issued money. Under the gold standard this meant a fixed ratio of gold to notes. Under fiat systems the "cover" is the balance sheet of the central bank and, ultimately, public trust.
  • Exchange rate arrangement - the rule tying the domestic unit to gold, to another currency, to a basket, or to nothing at all.
  • Rules of money emission and control - how the stock of money and credit is expanded or contracted, measured through monetary aggregates such as M0, M1 and M2.

Change one of these and the system changes. Abolish gold cover and you move from a commodity standard to fiduciary money; hand the issuing right to a supranational bank and you have a monetary union.

Types of monetary systems

Commodity money and metallic standards

The oldest form. Money is (or is directly convertible into) a physical good with its own value: grain, cattle, silver, gold. Coins were stamped pieces of metal whose value roughly equalled the metal they contained, and the state's job was mostly to certify weight and fineness. Debasement (quietly reducing the precious metal content) was the classic royal trick for financing wars, and the inflation that followed was the classic result.

Bimetallism

Under bimetallism both gold and silver are legal tender at a ratio fixed by law. The United States Coinage Act of 1792 set the ratio at 15:1; France, from 1803, used 15.5:1. The problem is easy to state. When the legal ratio differs from the market ratio, the metal that is overvalued at the mint drives the other out of circulation, a mechanism known as Gresham's law. Whenever world gold-silver prices drifted, one metal disappeared from use. The history of the gold-silver ratio is largely a history of such episodes, and the Latin Monetary Union of 1865 (France, Belgium, Italy, Switzerland) was in part an attempt to manage them jointly.

Gold standard

Under a classical gold standard the monetary unit is defined as a fixed weight of gold, the authorities stand ready to buy and sell gold at that price, and gold can move freely across borders. Britain was effectively on gold from the 18th century and formally from 1821; Germany switched in the early 1870s, and most industrial countries followed, with the United States confirming gold in law through the Gold Standard Act of 1900[2]. The period from roughly 1880 to 1914 is usually treated as the classical gold standard era.

The adjustment mechanism was described by David Hume as early as 1752. A country with a trade deficit loses gold, its money supply shrinks, prices fall, its goods become cheaper abroad, and exports recover. Neat on paper. In practice the adjustment ran through falling wages and output as much as through prices, which is why the system proved politically unbearable once mass electorates and trade unions appeared.

The interwar attempt to rebuild the gold standard (the "gold exchange standard" of the 1920s) collapsed during the Great Depression. In the United States the Gold Reserve Act of 1934 transferred all monetary gold to the Treasury, ended redemption of dollars in gold for residents and moved the price from $20.67 to $35 per ounce, cutting the gold value of the dollar to 59% of its former level[3].

Bretton Woods (1944–1971)

In July 1944 delegates from 44 nations met at Bretton Woods, New Hampshire, and designed a new international order. They created the International Monetary Fund and what became the World Bank Group[4]. Member currencies were fixed but adjustable against the US dollar, within a band of 1%, and the dollar alone was convertible into gold, for foreign official holders, at $35 an ounce. Keynes had pushed for a global clearing union with its own currency (the "bancor"); the American plan of Harry Dexter White largely won.

The system worked well in the 1950s and 1960s, but it carried a built-in contradiction, later named the Triffin dilemma. The world needed a growing supply of dollars as reserves. Those dollars came from American balance-of-payments deficits. And the more dollars piled up abroad, the less credible their convertibility into a fixed stock of US gold became. The London Gold Pool (1961–1968) and Federal Reserve swap lines bought time. Not enough. On 15 August 1971 President Nixon closed the gold window[5]. The Smithsonian Agreement of December 1971 raised the official gold price to $38, a further devaluation in February 1973 took it to $42, and by March 1973 the major currencies were floating.

Fiat money and floating rates

Since the 1970s nearly every currency in the world has been fiat money: it isn't convertible into anything, and its value rests on legal tender status, tax obligations payable in it, and the credibility of the central bank. The Second Amendment to the IMF Articles of Agreement (in force from 1978) legalised the new reality and left members free to choose their own exchange arrangements. Some float freely, some manage a float, some peg. Economists of the Austrian school have long criticised this regime as inherently inflationary; monetarists accepted fiat money but argued for strict rules on money growth.

Hard pegs: currency boards, dollarization and monetary unions

Between "float" and "gold" sit several arrangements that tie a currency's hands:

  • Currency board - domestic base money must be fully backed by a foreign anchor currency at a fixed rate, and the board can't lend to the government. Hong Kong has run its Linked Exchange Rate System since 17 October 1983, keeping the Hong Kong dollar within HK$7.75-7.85 per US dollar[6].
  • Dollarization - the country gives up its own currency and uses a foreign one (not necessarily the dollar). Panama has used the US dollar since the early 20th century; Ecuador dollarized in 2000, converting sucres at 25,000 per dollar; El Salvador followed in 2001[7].
  • Monetary union - several states share one currency and one central bank, as in the euro area. The theory behind it, Robert Mundell's optimum currency area, asks whether regions are similar enough, or labour mobile enough, to live with a single interest rate and no exchange rate between them[8]. The road to the euro, including the exchange rate mechanism of 1979, is covered under European monetary system.
Regime Anchor Exchange rate Who controls money supply Example
Bimetallism Gold and silver at legal ratio Fixed via metal content Mint rules, metal flows US 1792-1873, France 1803-1870s
Gold standard Gold Fixed (mint parity) Gold flows, central bank cover rules UK 1821-1914
Bretton Woods Dollar, dollar to gold Fixed but adjustable, ±1% National central banks within peg 1944/1958-1971
Free float None (fiat) Market-determined Domestic central bank United States, euro area vs. others
Currency board Anchor currency Fixed by law Mechanical: reserves in, money out Hong Kong since 1983
Dollarization Foreign currency None (no own currency) Foreign central bank Ecuador since 2000
Monetary union Common currency None internally Common central bank Euro area since 1999

Example: gold parity and a fixed peg

Two calculations show how the arithmetic of fixed regimes works.

Mint parity under the gold standard. Before 1914 the US Treasury valued gold at about $20.67 per fine troy ounce. The Bank of England bought standard gold (11/12 fine) at £3 17s 10½d per ounce, which works out to about £4.2477 per fine ounce. The exchange rate implied by the two gold prices:

\[ \text{Mint parity} = \frac{\$20.6718}{\pounds 4.2477} \approx \$4.8666 \text{ per } \pounds 1 \]

The textbook figure of roughly $4.866 to the pound comes straight from this division. The market rate could wander a little around it, but only between the "gold points". Suppose (hypothetically) that shipping, insuring and financing a gold transfer across the Atlantic cost 0.5% of its value. Then nobody would pay more than about 4.8666 × 1.005 ≈ $4.891 for a pound, because it would be cheaper to buy gold in New York and ship it to London; and nobody would accept less than about 4.8666 × 0.995 ≈ $4.842. A New York importer owing £100,000 knew in advance that the bill would cost between roughly $484,200 and $489,100. Exchange risk existed. It was tiny.

Band under a currency board. Take a hypothetical Hong Kong exporter with a US$100,000 invoice. Within the HK$7.75-7.85 band the proceeds will fall between HK$775,000 and HK$785,000. The full width of the band is HK$0.10, or about 1.3% of the central rate of 7.80. Compare that with a floating currency, where a 10% move against the dollar within a year is nothing unusual, and the attraction of a hard peg for small open economies is obvious.

Devaluation arithmetic. Going the other way, the 1934 change from $20.67 to $35 per ounce meant that the dollar was now worth 20.67 / 35 ≈ 0.591 of its former gold content (the 59% quoted above), while gold became about 69% more expensive in dollar terms. The Smithsonian step from $35 to $38 was an 8.6% rise in the gold price; the 1973 move to $42 was a further 10.5%.

Advantages of different monetary regimes

Gold and other commodity standards

  • Long-run price stability: over decades, price levels under gold tended to return to where they started.
  • Discipline on governments, which can't print money to cover deficits without breaking convertibility.
  • Predictable exchange rates among member countries, which encouraged trade and long-term capital flows.

Fixed but adjustable pegs (Bretton Woods)

  • Stable exchange rates combined with some room for national policy, thanks to capital controls.
  • An escape hatch: a "fundamental disequilibrium" allowed a parity change rather than years of deflation.
  • An international lender (the IMF) to bridge temporary balance-of-payments gaps.

Fiat money with floating rates

  • Monetary policy can respond to domestic recessions and shocks.
  • The exchange rate absorbs external shocks, so adjustment doesn't have to come through mass unemployment.
  • The money supply isn't held hostage to gold mining or discoveries of new deposits.

Hard pegs, dollarization and monetary unions

  • Imported credibility, often decisive after episodes of galloping inflation.
  • Lower transaction costs and the disappearance of currency risk with the anchor country or within the union.
  • Typically lower interest rates, because the risk premium for devaluation shrinks or vanishes.

Limitations of different monetary regimes

Gold and other commodity standards

  • The money supply depends on gold output, which has nothing to do with the needs of the economy. Gold shortages in the 1870s-1890s brought prolonged deflation.
  • Adjustment to deficits through falling prices and wages is slow and painful.
  • Vulnerability to runs: if people doubt convertibility, everybody wants gold at once.

Fixed but adjustable pegs

  • The Triffin dilemma: the reserve currency country can't supply liquidity and keep its currency credible at the same time.
  • Pegs invite speculative attacks once markets smell a devaluation, a pattern repeated in 1967 (sterling), 1992 (the European exchange rate mechanism) and 1997 (East Asia). See currency crisis.
  • Countries can't simultaneously have a fixed rate, free capital movement and independent monetary policy (the "impossible trinity").

Fiat money with floating rates

  • Nothing physical limits money creation; discipline depends on institutions. High inflation in the 1970s and hyperinflations in weaker states show what happens when they fail.
  • Exchange rate volatility raises uncertainty for exporters and borrowers in foreign currency, and short-term speculative capital can push rates far from fundamentals.
  • Depreciation can feed imported inflation, especially in small open economies.

Hard pegs, dollarization and monetary unions

  • No independent interest rate and no exchange rate to cushion a country-specific shock; Argentina's currency board-type convertibility regime ended in crisis in 2001-2002.
  • A dollarized economy loses seigniorage (the profit from issuing its own money) and its central bank can't act as lender of last resort in the usual way[7].
  • Exit is extremely costly, which is the point, but also the danger.

The international monetary system today

The present arrangement is sometimes jokingly called a "non-system". There's no common anchor. The US dollar dominates official foreign exchange reserves, trade invoicing and cross-border lending, with the euro a distant second, and the IMF's role shifted after 1973 from policing parities to surveillance, crisis lending and technical advice. Central banks cooperate through the Bank for International Settlements and, in emergencies, through swap lines like those first set up in the 1960s[5]. Historians such as Bordo and Eichengreen stress that each regime was a response to the failures of the previous one: Bretton Woods to interwar chaos, floating to the Triffin dilemma, monetary union in Europe to the instability of floating among closely linked open economies[9]. Which suggests the current setup won't be the last.

Several debates remain live. Should central banks target inflation alone? Could digital central bank money or private cryptocurrencies change the role of commercial banks in money creation? Would a larger role for IMF Special Drawing Rights reduce dependence on a single national currency? Nobody has an agreed answer yet.

Related approaches

  • Monetary policy frameworks - inflation targeting, money growth rules and exchange rate targeting are ways of running a fiat system, not monetary systems in themselves.
  • Redenomination - changing the monetary unit (for example, removing zeros after high inflation) without changing the regime.
  • Floating vs. fixed exchange rate debate - the most practical question a small country faces when choosing its monetary system.

References

Footnotes

  1. ↑ Eichengreen B., Globalizing Capital: A History of the International Monetary System, Princeton University Press, 2019, Introduction
  2. ↑ Bordo M.D., Schwartz A.J. (eds.), A Retrospective on the Classical Gold Standard, 1821-1931, University of Chicago Press, 1984
  3. ↑ Richardson G., Komai A., Gou M., Gold Reserve Act of 1934, Federal Reserve History, 2013
  4. ↑ Ghizoni S.K., Creation of the Bretton Woods System, Federal Reserve History, 2013
  5. ↑ Ghizoni S.K., Nixon Ends Convertibility of U.S. Dollars to Gold and Announces Wage/Price Controls, Federal Reserve History, 2013
  6. ↑ Hong Kong Monetary Authority, Linked Exchange Rate System, HKMA website
  7. ↑ Berg A., Borensztein E., The Pros and Cons of Full Dollarization, IMF Working Paper 00/50, 2000
  8. ↑ Mundell R.A., A Theory of Optimum Currency Areas, The American Economic Review, 1961, pp. 657-665
  9. ↑ Bordo M.D., Eichengreen B. (eds.), A Retrospective on the Bretton Woods System, University of Chicago Press, 1993
Monetary system — recommended articles
Money — Fiduciary money — Gold-silver ratio — Fixed exchange rate — Monetary union — European monetary system — International Monetary Fund — Currency crisis
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