Tuesday, April 7, 2009

An Analysis of International Monetary Relations – Part 1: How We Got Here

No economic event in the 20th century had a greater impact on world affairs than the Bretton Woods Agreement. The regime of fixed exchange-rates that it established and the collapse of that system after 25 years under the strain of its internal contradictions are both watershed events in the history of the world in general and finance in particular.

The foundation and the driver of the Bretton Woods system was the convertibility of the U.S. dollar to gold. The U.S. undertook to deliver 1 troy ounce of gold for every $35 dollars that foreign nations’ central bank presented to it. The exchange rate of major currencies was fixed against the dollar and, by extension, one another, to prevent manipulative devaluations. At the time of the signing of the Agreement in 1944, approximately 75% of the world’s gold stock was in the U.S., so there was no question about the country’s ability to honor its promise. (The stock was created because the U.S. companies that sold goods to the warring parties sensibly refused the European currencies for payment and demanded gold instead.) Dollar holdings, furthermore, earned interest. Gold did not, and had additional insurance and storage costs. So the foreign central banks that got hold of dollars did not convert them into gold. They kept them in dollar-denominated assets and earned interest. The dollar became as good as gold – even better.

In this way, a national currency became the means of settling the international balance of payments. It was an unprecedented regime. The U.S. could create dollars from thin air – via either bank reserves or the actual printing of paper money – and present them as payment for the goods and services that it acquired from abroad. This was an extraordinary power and privilege that solidified the 20th century as the American Century.

You know the rest. To finance his expensive War on Poverty and an escalating war in Vietnam, President Johnson resorted to creating money. Soon, the volume of dollars in the international channels of circulation reached a point where it was impossible to redeem them at the rate of $35 per ounce of gold; the redemption would have emptied Fort Knox many times over. The time had come for the Bretton Woods Agreement to go.

On August 15, 1971, President Nixon went on TV to announce a series of measure to fight inflation – as dollars were now everywhere, causing a rise in prices – and mentioned, almost in passing, that the U.S. would no longer honor conversion of dollars to gold; if you were holding dollars, you were stuck with them. That was the end of the Bretton Woods system and the regime of fixed exchange rates.

For the next couple of years, an informal arrangement by the major central banks managed to hold the exchange rates within a narrow band. In 1973, that arrangement, too, collapsed. Currencies were thrown into the market place to find their “correct” exchange rate in the interaction of supply and demand.


The “oil crisis” hit the U.S. in 1973. Virtually overnight, the price went from $2 to $8 a barrel.

Everyone knows the crisis was caused by the “oil embargo”, a piece of knowledge qualitatively on par with knowing that Mrs. O’Leary’s cow caused the Great Chicago Fire.

Here is what happened.

Prior to 1973, a barrel of oil was at $2:

What would happen if the left side of the above equality increased? We would then have:

In economic parlance, this condition is called an oil glut. In an oil glut, oil is cheaper because the same $2 would now buy more oil.

Now, what would happen if the right side of the equality increased?

In this situation, confronting the same barrel of oil is many more dollars; more dollars correspond to one barrel of oil, which is another way of saying that more dollars are needed to buy oil.

This condition is not called dollar glut. It is known as the “oil crisis”.


Just how many dollars were in circulation could be surmised from the price of gold that passed $800 in the 80s, which is why, long after the “embargo”, the oil price kept going up. The driver of the price was not the scarcity of oil, but the abundance of dollars.


Conservatives applauded the collapse of Bretton Woods. The gold would now stay in the U.S. (The Wall Street Journal still calls the event “closing the gold window”, implying a beneficent banker to the world who got tired of being beneficent.) Milton Friedman, given open access to the media, endlessly made the case that floating-rate mechanism would solve the balance of payment problems once and for all. If a country’s balance of payments deteriorated, its currency would weaken, resulting in less import and more export. This would restore “the equilibrium”. That is what he actually said.

More astute, less partisan people, though, mourned the collapse of the Bretton Woods. They though it signaled the end of the U.S.’s global supremacy. Indeed, it was difficult to see how the loss of a proverbial golden goose – the ability to print dollars to pay for goods from all over the world – could be anything but a setback. Even an astute practitioner of international finance such as Paul Volker titled his book, Changing Fortunes, by which he meant the fortunes of the U.S.


The realm of finance capital is the realm of theory. Practitioners know as little about it as biased ideologues and outright fools, which is why no one saw what was coming.
In the post-Bretton Woods chaos, it became impossible for corporations to plan with any degree of confidence. An adverse exchange-rate movement could wipe out the hard-earned profits of a full quarter or even a year. There had to be a regulating mechanism. In the absence of government authority, the only remaining source of discipline was private finance–finance capital–which stepped in and assumed the role of regulator.

Governments achieve stabilization through decree; finance capital does it through arbitrage. The most important point in the rise of arbitrage trading is that the practice develops logically from hedging and, on paper, is indistinguishable from it.

I showed in Vol. 1, how, from the ashes of Bretton Woods, speculative capital rose to dominate the financial markets. The new phenomenon seemed to have the potential for boundless expansion, only if the “stifling regulation” inhibiting its growth could be done away with. That brought Reagan to power. And then Thatcher.

Awestruck academics could not see the speculative capital. It was too abstract a concept to lend itself to their comprehension. What they noticed was that a “new paradigm” had taken hold in the U.S. and U.K where credit could be expanded on-demand without limits.

The currency of the new paradigm, the material form in which it manifested itself, was the dollar. It had to be, thanks to its abundance, ease of conversion and universal acceptability. So, once again, the U.S. and its currency assumed centrality in the world of international finance, only this time, the U.S. could issue dollars without any accountability or the need for keeping an anxious eye on its gold reserves. Good times were going to be had by all involved.

The “paradigm” lasted about 25 years, the same time it took for the Bretton Woods to collapse. This one ended in 2007.

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