Weekly “fun with controversies” topics

• Free Trade v. Protectionism

Day #3 – Currency “issues”

• Is the dollar losing its credibility as the world’s reserve currency?

• If yes, what do we replace it with?• Although it may seem like a minor question, a

reserve currency of sum form is need to rationalize international trade in goods.

Bretton-Woods and the Dollar Standard

Bretton-Woods System

•Henry White (U.S.) negotiated with John Maynard Keynes (U.K.) to establish the post-war economic arrangements

Famous Plaque on the Door of the Bretton Woods Resort

• Bretton-Woods established both the IMF and the World Bank– Both had very specific (and separate) goals

• Recognizing that Europe could not be the basis for a new monetary system, the “dollar system” was adopted

System worked by indirectly linking currencies to gold

• All currencies backed by gold, but only through dollar

FF $ Gold–Only the U.S. was in danger of a currency

attack (gold outflow)

• System stable until 1971 (Smithsonian Accord)– Then, U.S. formally departs gold standard in 1973, leaving

$11B in gold at Fort Knox, valued at $42/oz.– $335 billion at today’s price of gold

• World now uses Fiat (funny) money– Recent fiscal carelessness and high money supply

expansion led to devaluation of dollar • until euro-zone looked even worse after the crisis with the PIIGS• China is now using a market-basket of currencies• Has even started using a complete substitute with Australia

The Currency Issue and the “Search for Stability”

• After the collapse of the dollar-standard, nations immediately began searching for another way to stabilize currencies

• Gave birth to the ecu (the precursor to the euro)– Nations of EU formed the European Monetary

System (EMS)• Pegged their currencies against the ecu, which

indirectly pegged them against each other’s currencies

• Currencies only allowed to move in a narrow band around a fixed value to the ecu

• Initially thought that the ecu would be common currency, but “European Currency Unit” didn’t have a very good ring to it.

• When euro adopted, ecu eliminated.

• In end, because many countries didn’t join the EMS (or joined and then left), a common currency was considered a better option

• Euro came into being in 1999 (as a unit of account)– Became a full currency in 2001

• What are some other potential reserve currencies?SDR

Why do we need a reserve currency?

• Currency cross-rates would become meaningless without a hard currency

• Hard-pegging and soft-pegging systems impossible

• Several nations (e.g. Ecuador) have dollarized – not sure what a replacement would look like– Resulting instability for developing nations that

prefer a system like this.

• Maybe SDR (IMF “dollars”) or commodity money– How commodity money works (Benjamin

Graham):1 cocoadollar (CO$) = 1 pound of cocoa– If price of cocoa ↑, people trade in CO$ for stockpiled

cocoa – market price comes back down again– If price ↓, people trade in cocoa for CO$s, removing the

excess supply and raising prices.

• What about return to gold standard?– $11 billion in gold at Fort Knox (@$42 per ounce)• Actually = $314 Billion at $1200/ounce

– Could be used as a start to backing up a currency, but gold-standards are unstable also

• Or the world will adopt a multi-currency model

This is most likely outcome

• Nations will begin using a basket of currencies as a “peg” ($, euro, British Pounds, with a smaller component of the C$, Japanese Yen and Swiss Franc).– As a side benefit, it substantially reduces

exchange rate risk.

End of Day #3

• Questions and Suggestions?– International trade is on the agenda for next time.