Last week, we explained some of the mechanisms by which individuals, companies, and financial institutions move money across international borders. Such networks are an important part of the global economy, connecting bank accounts around the world so that we can send money as easily as we can Skype. Today, we’d like to explore another form of international banking, and take a look at how nations send each other money.
All the Money in the World
An extremely abbreviated, extremely general history of banking is a narrative in which banks get bigger to accommodate the need for bigger loans. The Bank of England for instance, was founded in 1694 to support the post-revolution government during the Nine Years’ War against France. For the next two centuries or so, countries around the world chartered national banks when they needed more money than any existent institutions could offer.
See where this is going? When there’s a really expensive war, there’s a demand for more money than any bank has to lend. Especially if a country hasn’t finished paying for the last war, and most of the things that made its society productive—factories, houses, able-bodied young men—have been bombed to ruins. The guys who were in charge at the end of WWII also realized that WWII happened, in part, because the guys who were in charge at the end of WWI expected Germany to pay for the damage it had done. They decided that this kind of world problem would need some kind of world bank to help pay for cleanup.
Leaders of the Allied nations and their economic advisors met in Bretton Woods, New Hampshire to hash out plans for the organizations that would fund and oversee post-war reconstruction and international trade. The Bretton Woods system also established stable international exchange rates, to prevent any one country’s economy from collapsing beyond repair. If they hadn’t already figured out that an economically volatile nation was likely to cause problems, the World Wars proved that asking a bankrupt country for reparations was not a good way to foster world peace.
New Global Standards: What Could Possibly Go Wrong?
The Bretton Woods conference took place in July, 1944. My fellow WWII enthusiasts and those of you who paid attention in history class will note that the war wasn’t over at this point, but it was looking good for the Allies. It was looking especially good for the Americans, who had the unique advantage of territory and infrastructure that had not been bombed to ruins.
Delegates created the International Monetary Fund, the International Bank for Reconstruction and Development, and the General Agreement on Tariffs and Trade. This wasn’t the first time an international central bank had been established; prior to the start of WWII, the Bank of International Settlements (PDF) was responsible for collecting WWI reparations from Germany. The BIS, based in neutral Switzerland, could possibly have filled the role of the IMF, except that its vaults were full of looted Nazi gold.
Of course, a bank needs reserves, and there were disagreements as to what the international reserve currency should be. John Maynard Keynes, who represented the UK at Bretton Woods, wanted a new currency—”bancor, unitas, dolphin, bezant, daric, and heaven knows what”. The Americans successfully argued for US dollars, backed by the gold standard.
What is International Reserve Currency?
Keynes wasn’t arguing for one currency to be used worldwide for all transactions, nor did every country switch to dollars after the IMF adopted them as reserve currency. The Bretton Woods decision meant that money going in and out of the IMF happened to be dollars, whose value was supposed to be fixed on a gold standard.
When the IMF began operations in 1945, gold cost $35 per ounce. Since dollars were the international reserve currency, any country that held dollars could spend them, or convert them to gold. The US needed to provide enough dollars for all of the IMF’s activities on top of national spending. The gold standard prevented inflation, and nations could borrow and lend knowing that the currency wouldn’t devalue, because an ounce of gold cost $35, period.
See where this is going? Gold is a nice standard to have because it’s rare, and there is a decent amount of it, but it didn’t take long before the world needed more money than the supply of gold could back for $35 per ounce. This IMF history page explains the problem rather bluntly. We kept spending more and more money ourselves because we wanted to. Also, Korea. Also, Vietnam. Had we poured fewer dollars into the global marketplace, everyone else would have collapsed. But as soon as the rest of the world began to suspect that there were more than $35 out there for every ounce of gold, they started trading in their sweet, fragrant bank notes for shiny, precious gold—even if someone wanted $40 for an ounce.
Global is as Global Does
Spoiler alert: We dropped the gold standard. Rather, President Nixon did, in 1971, without asking the IMF what they thought of the idea. The IMF was already planning a move away from total dependence on the value of the dollar, and from 1970 to 1972 they created billions of units called Special Drawing Rights. Today, one SDR is worth sixty-six cents, eleven pence, twelve yen, and forty-two euro-cents. The unit is referred to as a “basket,” and the amounts of each currency are re-calculated every five years based on existent exports and reserves. Because they include multiple currencies, SDRs are relatively stable. For some, including People’s Bank of China president Zhou Xiaochuan, SDRs are a better option than any one currency or floating value, reminiscent of Keynes’ original vision for the IMF’s reserve unit.
SDRs aren’t exactly hot commodities, but the IMF has handed out 21.4 billion of them for countries to lend and borrow. They could potentially function like any other currency, with the IMF controlling the supply, except that they can’t really buy anything except other currency, and the IMF allocates more of them to wealthy nations. Furthermore, nations are actually supposed to just hang on to them, because the IMF gives everyone a certain number, and if you have fewer SDRs by the end of a given week because you traded some for pounds sterling, the IMF charges interest. Conversely, if you got some extra SDRs from someone, the IMF pays interest on your surplus.
A recent policy brief from the Peterson Institute for International Economics (PDF) suggests that SDRs might become more widely used in international commerce, but suffer from an oddly familiar problem: “no one has an incentive to be an early user of an asset whose appeal comes from its use by others.”
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