How
The Oil-Standard Kicked Out the Gold-Standard of our Money
supply
By Melvin J. Howard
To understand this let us first understand how the
original Bretton Woods system collapsed. Throughout the 1960s the United States
was spending massive amounts of money (US dollars) abroad to fund various
military operations, the "war against communism", was ultimately
buying insurance on investments and economic interests abroad. While certain
capital controls existed to prevent speculative pressure on currencies U.S.
investors still had many economic interests throughout these regions. A rise in
democracy may have nationalized natural resources, created land reforms and
otherwise collapsed the value of U.S. investments. In turn this would have had
serious ramifications on the U.S. stock exchanges and reverberated throughout
the whole financial system. This big military spending abroad on Vietnam and
other adventures caused America to have a big and rather permanent trade
deficit and greatly increased the supply of U.S. dollars abroad relative to U.S.
gold reserves at home. President Nixon was forced to break the peg of the U.S.
dollar to the fixed price for gold in 1971 and then the US dollar kept
decreasing in value with respect to gold as the U.S. increased its military
activities abroad.
This caused a huge disturbance in the international
monetary system and soon the whole adjustable peg system had broken down. The
IMF should have disbanded at this time because its founding mission didn't
exist anymore now that the Adjustable Peg had broken down.
Then OPEC came along and presented the world with its
oil price shocks and a lot of large nations started running significant trade
deficits with the Middle-East because the price of oil was now so high. This
might have been oil's way of saying that now that the gold standard was
completely dead it would take over as the real gold against which currency
value should be assessed, which was appropriate since much of the human fighting
stopped being about gold and became about oil. The oil shocks and America's
military spending seem to have created pressure to break down the system of
earlier capital flow controls so that the Western countries could balance their
currency outflow from trade deficits with some inflow of capital from the OPEC
countries who were making the big oil profits.
So much money then rushed in to the West as so-called
petro-dollars that many financial institutions then turned around, in the
absence of capital controls and the gold peg, and lent the money as U.S. dollar
denominated debt to many Latin American countries to earn some higher returns.
Interestingly a lot of this debt incurred in Latin America was being used to
fund the purchase of military equipment by the U.S. favored regimes to assist
in the "war on communism". But the expansion of the U.S. money supply
and the oil-shocks led to such bad inflation problems that by the end of the
1970's the US Federal Reserve decided to reign them in by spiking up interest
rates, which is the same as shrinking the U.S. dollar money supply. Many Latin
American borrowers were on variable interest rates and this spike in interest
rates forced them to be about to default on their U.S. dollar loans.
This threat of default marked the rebirth of the IMF,
who had lost its founding mission upon the collapse of the Bretton Woods system
during the Vietnam War, into a wholly new entity governing of an international
monetary system. To prevent financial panic spreading to the West upon such
defaults the IMF stepped in as lender of last resort to protect the Western
creditors from getting hit by defaults. By giving such a blessing to the
reckless behavior of international banks the IMF introduced serious distortions
favorable to these banks in the form of "moral hazard" that is still
with us today. Moral hazard comes about when large investors are enticed into
excessive speculation by the knowledge they will get bailed out if their bets
go bad.
Under today's international monetary system, we have
free flow of capital. To make matters worse these countries have large amounts
of U.S. dollar denominated debt, much of which originated as the petro-dollars,
and the IMF has made itself understood to be there to back up the big Western
banks that get into trouble. This Moral Hazard combined with the loss of the
original capital flow controls has created a very bad situation for the
majority of people in the developing world.
So, how did a reasonably stable post-WWII
international currency regime get so nasty. Recall that under the
pre-depression era gold standard, exchange rates were automatically fixed, and
there were pretty free investment capital flows. But countries couldn't do very
much about their own money supply to help with domestic policy, unless they
went out and dug up more gold. Then under the post WWII real Bretton Woods
system there were fixed exchange rates, and countries had some ability to
control their money supply for domestic policy purposes such as unemployment
and inflation. This was possible because there were controls on investment
capital flows.
But now after the collapse of the Bretton Woods system
there are few capital flow controls and many of the smaller economies have
tried to peg their exchange rate to the U.S. dollar. Smaller economies try and
fix their currency relative to the U.S. dollar because for most countries the
U.S. is a major trading partner and because they want to attract funds from U.S.
investors so they want their currency to appear stable relative to the USD.
However, some currency attacks have made this a recipe for disaster and
regularly smashed smaller economies.
The British economist John Meynard Keynes
was very critical of this move of England back to the Gold Standard saying that
"In truth, the gold standard is already a barbaric relic." This is
because the gold standard forced prices and wages to be set by international
traders and speculators, rather than the needs of workers and consumers. Today,
these are still set by international speculators in our current environment of
free capital flow and domination by a single reserve currency although that
seems to be changing although I would still like to see the greenback continue
to be the reserve currency of the world.
The move by the Federal Reserve in 1927 to lower interest
rates to help England stay on the gold standard encouraged stock speculators to
borrow money at these low rates from the banks and then plow these borrowed
funds into the stock market. The banks themselves were engaged in a lot of
these speculative activities because many of them also operated investment
banking and brokerage businesses.
This speculation continued until 1929 when in
August the Federal Reserve raised interest rates. Stock prices reached their peak in September the Dow
Jones Index having doubled in just over a year. But then with the higher
interest rates on borrowed speculative funds and nervousness that stocks were
overvalued, stocks started falling in October. Banks started calling in the
loans used to buy stock. On October 29, 1929 (Black Tuesday) the Dow-Jones
Industrial Index crashed enough to wipe out this doubling of the Dow. The Dow
and the markets as a whole started on a downwards spiral that bottomed out in
1932. Many people just couldn’t pay off their loans and banks started going
bankrupt all over the place from this and from the collapse of their own stock
investments. There was at this time no Federal Insurance of bank deposits and
people saw not only their stock markets investments disappear, but also their
bank accounts vanish. For, even under the gold standard, bank money is nothing
but the confidence that it can be used in trade. When that confidence
disappears, so does money, and so does everything you worked for and
transferred into those mysterious bank credits.
America was still on the gold standard. So compounding
all these problems the massive loss of confidence in the banking system caused
the worst thing of all for the financial system - a run on banks - with people
wanting to redeem their bank deposits and Federal Reserve Notes for gold. But
of course there isn't enough gold under fractional reserve banking and such a
run on banks will always collapse it. Expectation of bank collapse is a
self-fulfilling prophecy, as it is with the stock markets, and as it is with
any currency try to remember whatever your thinking that’s what you’re bringing about.
When you have such lost confidence in the financial
system, where there has just been complete dependence on it, the whole monetary
system collapses - money disappears because all it was confidence anyway.
