The Ethics of Money Production, Chapter 17

17. International paper money systems 1971-?

1. With the Fed's suspension of payments was created a large number of paper currencies, their exchange rates fluctuated wildly and every country could set its monetary policies as it desired. But very soon, international paper currencies have dominated the scene.

International businesses can of course profit from using a widespread currency, but how does a currency become widespread and how can it avoid overt fluctuations?

The reason is not hard to find. States have always need for more income. But for most states is living off their citizens insufficient. They can try to attract investments from foreigners, or try to make their own citizenry wealthier. But to accumulate wealth takes a lot of time and little interference, and few governments are willing to wait, denying themselves tax income. It is better for if foreign capital comes in. Since investors don't like to throw away their money, they must be persuaded, that the money won't be simply printed, letting the exchange rates fall and ruin their investments. There are several institutional precautions.

First, the states can produce bonds in a different currency than their own; many float bonds in Euro or the U.S. dollar.

Second, they can give public or implicit guarantees that the exchange rate will be maintained. They can inflate at will and dispossess their own people as well as the foreigners. It is assumed, says Hülsmann, that the Fed gave such guarantees to several countries in the 90s. When it was finally abolished, financial crises in the debtor countries followed (Mexico 1994, Asia 1997). This tactic was not attempted again.

Third, the debtor states have created currency boards, issuing notes backed by foreign paper money. Their own currency becomes a mere substitute for another paper money. It is used by e.g. Hong Kong, Bulgaria, Estonia, Lithuania, Bosnia and Brunei.

Fourth, they can abandon their national currency completely and use the currency of their lenders. This is called "dollarization" (does not have to be U.S. dollars). Recent examples include Ecuador, El Salvador, Kosovo and Montenegro.

International paper money is brought about by governments seeking more income sources. Preferred will be the currencies, that are legal tender in the largest capital markets. Thus have the Yen, Dollar and newly the Euro risen to the top.

2. After the fall of the Bretton Woods system began the governments of Western Europe to amass public debt to grow their welfare states. But it was soon recognized their wildly fluctuating currencies hindered international trade and could so undermine their income.

The first attempt to stabilize their currencies was the European Monetary System (EMS, founded 1978). It was a cartel of paper money producers, who agreed to stabilize the exchange rates between their currencies at certain levels, or parities. In practice, those inflating the least would determine the inflation rates of all others. If someone were to inflate more, they would have to persuade others to do the same, or risk a change of parity.

As it happened, the German Bundesbank was the most conservative of the central banks, so the pressing issue for other governments was to push the German Mark towards more inflation, to keep up with their own financial demands. It was only the rejoining of East and West Germany, that changed this. The price for the agreement of other western states, says Hülsmann, was the German Mark.

Within a few years were the paper money producers united in the European Central Bank (ECB, started operation in 1999). The Euro, lauded as a great boon for the citizens of European states, was just another means to control the money supply and secure the unlimited source of income, that paper money represents.

3. The current international monetary order is shaped by several competing currency systems, each based on a standard paper currency and a number of secondary and tertiary currencies. The most important are the U.S. dollar, euro and yen.

The relationship between these currencies are similar to those between a central bank and commercial banks. But there is no commodity money, that would limit inflation, and more importantly, there are no legal means to force them to cooperation. National sovereignty rules and the secondary and tertiary producers can inflate at will. This is compounded by the fact, that the primary producers will likely bail them out, in yet another manifestation of moral hazard.

Bailing out others by printing money means of course the all of rates and rising prices, and both currencies will be less attractive for investors.

But not bailing out is risky too: a country in a crisis could threaten to switch to another standard, which could damage the standing of the primary currency. If countries started to avoid it, it would eventually travel back to where it has legal tender privileges, raising prices and potentially even create a hyperinflation. Since all countries are free to switch to a different currency, the more money is in foreign countries, the more likely is the primary producer to accept this blackmail.

The American central bank is aware of the risk and pays some of the foreign countries for their cooperation. But that is not enough. Cooperation between the producers of standard money may be required to stabilize currencies in times of crisis.

Why would the competitors help each other out? For once, those, who would blackmail their peers, could also blackmail them. And second, profiting from a currency crisis of someone else could easily backfire, once their competitor's crises is over.

Paper money producers have the same motivation as on the national level to increase their production, because their competitors are likely to bail them out. With such a moral hazard, inflation on a large scale is inevitable.

One way to escape this mess could be to completely avoid international trade - probably an even more destructive option. But what if all the paper money producers fused into one (possibly with a worldwide regulation of banking and capital markets)?

4. As was shown, there is a strong tendency to form currency blocks around paper monies used in the largest capital markets. States with a small income (or too small for their taste) have to turn to these standard currencies as well.

Even competitors are motivated to cooperate and eventually fuse. One currency for the whole world would be the logical continuation; and it was already called for, by Lord Keynes in Bretton Woods in 1944.

But even if all political hurdles were overcome, and "the humanity" was united, even if the secondary destructive effects were curtailed and all politicians became noble paragons of virtue and defenders of liberty... even then would the monetary union fail to bring the promised stability.

A global paper currency cannot escape the fate of the national ones - it must either collapse in hyperinflation, or force the state to regulate everything, and subject all economical resources to a total control. Or both.

But there is still hope, closes Hülsmann. We can still return to natural production of money, to the only defensible monetary system.