Roll out the bunting. Tomorrow is the 40th anniversary of the modern global economy.
That’s right: come Monday morning we will have managed to survive four decades of fiat money – though, given the chaos in markets in recent weeks, it is anyone’s guess how much longer it will last.
On 15 August 1971, with the US public finances straitened by the cost of the war in Vietnam, Richard Nixon finally cut the link between the US dollar and gold. Until then, the US Treasury was duty bound to exchange an ounce of gold with central banks willing to pay them $35.
Suddenly, for the first time in history, the level of the world’s currencies depended not on the value of gold or some other tangible commodity but on the amount of trust investors had in that currency. Central banks were allowed to set monetary policy based on their instincts rather than on the need to keep their currency in line with gold.
It was one of those seminal moments whose significance has only gradually become apparent, obscured as it was at the time by Vietnam and then Watergate. But the more one examines economic history, the more obvious it is that this was one of the most important policy decisions in modern history.
Were it not for that decision, it is quite feasible that we would not have suffered the financial crisis of the past four years; or indeed the crisis after crisis that have beset the world’s markets. We might not have just faced the most volatile few weeks in markets since 2008.
Far from it. But understanding the problems with the imperfect international monetary system we inherited from Nixon can help enlighten us on so many of the fundamental problems the world economy is facing: Why, for instance, does the West borrow so much and the East save excessively? Why do we seem to be fighting a losing battle with inflation? Why is protectionism on the rise again?
Let’s start with first principles: for as long as anyone can remember, politicians have sought to spend more than they can afford. Since the invention of money they have discovered ever more ingenious ways to do so.
The initial method involved debasing the currency. Henry VIII earned his nickname “Old Coppernose” because he added so much copper to what were supposed to be silver coins that eventually it would show through on the nose of his portrait.
These bouts of debasement typically end in disaster, as faith is lost in the currency, inflation shoots through the roof and the economy collapses, after which politicians introduce a new, more credible system.
After trust evaporated in gold and silver coinage, we had the gold standard and then the Bretton Woods system and now, today, fiat money – but the routine is painfully familiar. The main difference with fiat money is that whereas under the gold standard it was all too obvious when politicians were spending beyond their means (they would simply run out of gold reserves), these days it is slightly more difficult to tell quite how close the system is to breakage.
Nonetheless, as we look back at the chaos of the past few weeks, it is quite clear that our current version is on its last legs. This, in essence, was the point Sir Mervyn King tried to make again and again in the Inflation Report press conference last week: 2008 was only one stage in a far bigger crisis of confidence in the way we have structured the world economy.
Over the past 40 years, in the absence of a coherent international monetary system and under the veil of floating currencies, countries which would otherwise have been penalised for doing so were allowed to borrow enormous amounts (eg. The US and UK, or Greece). Other countries (eg. China or Germany) indulged them by lending enormous amounts. In the meantime, investors convinced themselves that the apparent economic growth fuelled by this debt was genuine rather than an artificial product of a binge.
The 2008 crisis represented the first recognition that those increases in asset prices and economic growth were chimerical. The recent relapse represents a recognition that the losses have merely been transferred on to sovereigns’ balance sheets.
But what next? The Panglossian answer is that those imbalances are slowly but surely put right: indebted countries borrow less and repay their creditors. But countries rarely go gently: what seems more likely is that the next stage of the crisis represents a crisis of confidence in the very system which, founded as it is on trust rather than measurable yardsticks, has no reliable, inbuilt way of righting itself.
So are we nearing the end of this economic era? All the hallmarks are there. We’ve been through the periods of faith in the system, peaking with the certain belief in the 1990s and early 2000s that inflation targets really would help keep governments on an even keel.
We’ve had the financial crisis that usually marks the beginning of the end of established monetary systems. And now we are seeing the debasement.
Consider the price of gold, which has recently scaled new highs. Since the 1970s the price per ounce has risen from below $40 to an astonishing $1740. The price reflects many factors, including economic growth, but chief among them is a diminishing faith in the ability of fiat currencies to maintain their value.
Ignore the oil price shock and the mild fluctuations over time: it is no coincidence that the price really started to spike (in other words faith in currencies versus gold plunged) in 2001, which just so happens to be the year central banks first started experimenting with quantitative easing (QE) – in Japan.
That the price has since reached record highs as the Bank of England and Federal Reserve followed suit by printing money more recently reinforces the point. Even the European Central Bank has now gone one step closer towards QE (bringing it to what Sir Mervyn called “the outer limit of what a central bank can do”) by agreeing to buy up Spanish and Italian debt.
No doubt gold is in a bubble, but all bubbles start with the germ of a good idea, which in this case is that the present system for running the world economy is close to breakage. It would be nice to believe that policymakers could ferret their way out of their current pickle without further debauching their currencies, but, politically at least, that is always the easy way out.
Unfortunately, currency debasement is a competitive sort of thing, as countries vie to reduce the value of their money (and hence their debt). There has been some talk of “currency war” in recent years, but this is nothing in comparison with the competitive devaluation and protectionism in the 1930s as the inter-war gold standard came to an end. However, the precedent is ominous.
As ever these days, any hope, such as it is, lies in China. It is fast realising that its investment in US debt will not be fully repaid.
However, in the long run it has two options: to allow the US to debase or default; or to negotiate, forgive a chunk of the debt and dramatically reduce those imbalances.
It can afford to do so economically; whether it can afford it politically is another question. However, such a bold move (and I do not expect it any time soon) would at least mark a fitting gesture from an economy which will help construct the
next international monetary system.