The current monetary system has been noticeably struggling for some time. The pandemic and most recently the war in Ukraine have been blamed for the current inflation and recessionary environment, however issues existed before these events.
Most references in this piece will be to USD (United States Dollar) as the United States has the world’s largest economy (GDP) and the largest reserve currency (currency held by central banks). The Dollar is also the currency currently used in global trade.
In order for the current monetary system to be sustainable, economic growth needs be constant. When growth stalls or declines this becomes unstable and if prolonged can ultimately lead to collapse.
One of the main reasons for this is due to the monetary system being based on debt. Money is created by banks’ lending it into existence, in other words, the total amount of money in circulation is always greater than the amount of physical currency at hand. This debt-based system creates a vicious cycle of borrowing and lending, which ultimately can lead to financial instability.
Banks have evolved over the decades into extremely powerful institutions, the power they have over the economy cannot be underestimated. The biggest central bank in the world is America’s Federal Reserve who delegate to the private banks. These banks have the power to create new money and make decision on interest rates as opposed to the government which many believe leads to a system of financial inequality.
The Gold standard.
The gold standard was a monetary system in which the standard economic unit of account was based on a fixed quantity of gold held in reserves. The gold standard act was passed in 1900 and gold became the unit of exchange ranging from funding trade and financing wars to an exchange for services and goods for people to use.
In 1913 the gold standard was built into the framework of the Federal Reserve. The law required the Federal Reserve to hold gold equal to 40 percent of the value of the currency it issued which at the time was referred to as ‘Federal Reserve Notes’ which became known as the Dollar.
Gold stocks held by Banks were increased by the Federal Reserve increasing interest rates. This encouraged people to deposit in banks and encouraged foreigners to invest in the United States. This led to increased gold reserves in Federal Reserve and Bank vaults.
The beginning of the end.
This continued to be the case until the financial crisis of 1933 when large quantities of gold flowed out from these vaults. Foreign nations as well as individuals and firms in the United States claimed back their gold due to a loss of faith in the value of the dollar.
As the Federal Reserve’s Gold stores dwindled and the Federal Reserve Bank of New York could no longer honour its commitment to convert currency to gold, a suspension of all transactions was declared by President Franklin Roosevelt (In March 1933). This ‘Bank Holiday’ lasted a week and it was hoped the situation would correct itself, but gold outflows continued and new policies were drawn up leading to a halt to the gold standard, Private ownership of gold was banned in an attempt to increase Bank’s Gold stores again.
Previous to this, Britain suspended the gold standard on a number of occasions due to economic pressure mainly as a result of the first world war and eventually departed the system completely in 1931 as a result of the great depression.
In 1946, The Bretton Woods System was created. This system allowed other governments to sell their gold to the United States and continued until 1971. The growing cost of the Vietnam war and a trade deficit caused the United States to make the decision to print more money. Other countries began to question America’s ability to cover all the American currency in circulation with gold.
The end.
The first country to leave the Bretton Woods system was West Germany. Seeing this, other countries (Belgium, France and the Netherlands) began demanding that the United States turn over gold in exchange for currency fearing that the USD would lose its value.
The most notable signal for the end came in August 1971 when Britain requested to be paid in gold. The system was ultimately abandoned by the United States. The convertibility of the US Dollar to Gold was terminated to prevent economic meltdown. This series of events ended the dollar’s formal connection with gold. The international currency market, which had been reliant on the dollar had now begun the era of fiat currencies.
The Fiat system.
Although the gold system was not perfect it did initially provide stability as currency was backed by the precious metal. Today’s system of ‘Fiat’ currency is subject to fluctuations and are not backed by any asset. Fiat money means, ‘inconvertible paper money made legal tender by a government decree’ (Oxford Dictionary). Fiat money is a currency that is an official order and backed by the issuing government that issues it. As these currencies are not based or backed by a commodity (Gold, Silver, Bitcoin) their value is based on the trust the citizens have in the country issuing it. In other words, the money that has been created and printed does not have any value. Instead, the value is based on the issuing government’s economy and the performance of it.
Essentially, fiat money has value because the government says it does and lenders in other countries believe in the government’s ability to repay debts. It is considered legal tender and is accepted globally. When confidence in a government or economy decreases, so does the value of their fiat currency. Issues such as unemployment and increasing government debt cause a country’s fiat currency to lose value. A common response to these issues is to print more money thus increasing supply. This in turn reduces the currency’s value which increases inflation rates.
Inflation today.
In recent years printing by governments has increased to levels never seen before in an attempt to stimulate economies.
Payments made during the recent pandemic are examples of this. The intention of governments (particularly the United States) was to boost their economy. Free money caused demand for goods and products to rise. This in the end lead to supply issues, which has helped lead to inflation. While some inflation is normal in a growing economy, many countries are experiencing record-breaking inflation rates and are struggling to control these.
According to a report by NASDAQ, by mid-2021 the United States had printed $13 trillion. This figure is more than their 13 most expensive wars combined mainly due to the effects of the pandemic, and QE (Quantitative easing).
To date, the rate of inflation in the UK is 6.8%, while the rate in the United States currently sits at 3.7%. Both have set their yearly targets at 2%
The figure below illustrates the amount of dollars that are in existence. A sharp increase is evident from 1971 when money stopped being backed by gold and printing of money became easier.
A similar trend exists with the UK money supply, a sharp increase in supply (billions) is evident from the 1980’s.
To help control inflation, monetary systems need to be backed by an asset. With a return to a gold standard unlikely, due to the difficulty in managing and proving actual physical reserves, it has been suggested that alternatives such as a ‘Bitcoin Standard’ or Sovereign money are plausible. Since the money supply would be limited by the reserves of the asset, it would make it difficult for governments to print too much money and cause inflation.
A new way…
Economist, Christ Watling, writing for the Financial Times in 2021 called for a reset of the financial system. He suggested a reset is needed due to the debt spiral which existed. Now in 2023, the landscape has worsened and many of the concerns he raised have shown no signs of easing.
No system will be perfect, however many suggest the current monetary system is broken and a solution is needed. Many proposals exist but the only fair solution is a new system which is backed by an asset.
A currency with limited supply would help to prevent inflation. This would ensure the value of the currency would not be diluted by an excessive supply.
Portability is also an important characteristic of an effective currency. It should be easy to carry and transport making it convenient to use for everyday transactions. A currency which is easily divisible into smaller units is also essential to usability.
Currency should be verified easily; this helps to prevent counterfeiting and fraud. It is also important that all production and movement of currency should be transparent helping to maintain trust.
For a system and currency to function correctly and be accepted by all, the characteristics mentioned are essential. A certain mystery surrounds the creation of Bitcoin. The end product of it’s development seems to have had these characteristics central to development. The only thing that remains is the acceptance of a more sustainable, fairer and more robust system for all.
