Relationship Between Money and War
By Melvin J. Howard
July 4th is a special day for me not only because of Independence Day. But also my first son was born on this day. I was there in the delivery room my wife at the time did most of the work. She did a great job because he did not want to come out. After I woke up he was here, needless to say. I have deep respect for expectant mothers but I digress. The topic is war and money I thought it a fitting topic. Since a war was the beginning of America. But lets talk about another war,World War II and the events leading up to it saw profound changes to the international monetary system and the mechanisms that countries would use to co-ordinate cross-border trade and financing. The most notable of these changes came in the form of the Bretton Woods agreements (named after the meeting place in the US where the agreements were drafted) which created the International Monetary Fund and the World Bank. Lets focus here on the IMF because this has more to do with contemporary monetary policy than does the World Bank. Much of what I am writing about comes from a couple of professors namely David Begg (Professor of Economics, University of London), Stanley Fischer (from the IMF and World Bank), and Rudiger Dombusch (Professor of Economics, MIT).
To understand what the IMF was really created for lets just take a peak at monetary arrangements before the Great Depression. Up until this time many countries were on the gold standard, whereby their own currency was backed by gold reserves at their central bank (The Central Banker is the creator of base money for any currency.), and paper currency could be converted to gold. Just as in Roman times this system meant that whoever had access to the most gold could do the most investing and acquire extensive ownership in foreign resources, and this was usually perfectly correlated with whoever had the most firepower and willingness to use it. This made Britain both the primary military and financial power in the 19th and early 20th century with a late boost coming from its discovery of gold in South Africa. Note here before I go on it always struck me as odd that South Africa had at one time one of the richest mineral deposits in the world. Yet the majority of the black population there did not share in the wealth. On the contrary they lived and still do in the most horrible conditions. The wealth of the country lay in the few hands of the British and Dutch colonists. But this is another story that I will explore later on let’s get back to the topic at hand.
One of the main complexities of the international monetary system, which is the mechanism through which all international trade and investing happens, is the determination of the value of one country's currency against another, known as the exchange rate. For example lets just say hypothetical the value of today's Australian dollar to the US dollar could be expressed as an exchange rate of almost 2 Australian dollars to 1 US dollar, or 1 Australian dollar is worth 0.5 USD. Before the Asian financial crisis the exchange rate was closer to 1 Australian dollar for 0.7 USD. So we say the Australian dollar has since devalued relative to the USD - it now buys LESS US dollars. This means that it is now more expensive for Australians to buy US products, and Australian products are cheaper for US consumers. The problem of managing exchange rates has troubled international relations for the past 2 centuries. On the other hand some currency traders have made huge bets against the unstableness of this market and won.
Any country involved in international trade would like their exchange rate relative to the currency of trading partners to remain fairly stable and predictable and not to suffer sudden shocks. For if their money suddenly loses value relative to other money their imports cost more and if it gains value their exports are less competitive. The gold standard provided a way to stabilize exchange rates because every currency was convertible into a single common commodity - gold. Up until the Great Depression and under the gold standard there was allowed a fairly free flow of capital between countries and this is what kept exchange rates stable. However, on the downside, the central banks or the government of a country weren't easily able to change their own money supply to deal with pressing domestic problems such as unemployment and price inflation, because this supply was already fixed by gold movement. Also, financial panics were more likely to collapse the whole system because everyone would rush to change their money into gold and the whole banking system would start to break down.
For these and other reasons the gold standard for domestic money holders was abandoned by most countries after the Great Depression. But this meant that there was no longer any natural way to ensure stability of the exchange rates between countries. It was recognized from the events leading up to the Great Depression and to World War II that some international agreement was needed to create a more stable international monetary system, and one that was to exist in the absence of a gold standard backing each individual currency. This is what gave birth to the IMF.
In the aftermath of World War II the United States was the dominant economic power because it was basically the child of the pre-war powers who had their economic infrastructure destroyed during the war. With the gold-standard gone it seemed to make sense to the powers-that-be for the world to move on to a US Dollar standard, where the value of every currency would be set against the value of the US dollar. In turn the US dollar was fixed against the value of real goods by settings its value against gold as US $35 for an ounce of gold. This was called the Adjustable Peg system and the IMF was created to administer this system and put out fires as needed.
Under the Adjustable Peg system then, many countries might hold US dollars, US government bonds and gold to back their own national currency and keep their exchange rate fixed against the US dollar. Central banks could redeem their US dollars for gold at the fixed price, and this gold was stored at the famous Fort Knox. Exchange rates would be stable as long as demand for US dollars remained fairly stable relative to demand for other currencies. Relative demand for any country's currency versus others depends on relative flows of imports versus exports and desire for investment domestically versus abroad. To keep things fairly stable, under the original Bretton Woods agreement, there were restrictions on cross-border capital flows or investments to help reduce sudden jumps in supply or demand for a currency that come with speculative capital flows.
The capital controls were necessary otherwise speculators could have had a field day by betting that a certain currency would go down by selling it off against the US dollar and thereby forcing it to go down purely from their speculative activity. Large financial firms with access to lots of US dollars could therefore force a foreign currency of a weaker country to collapse as they desired. The earlier restriction on capital flows is a key point this is a fundamental difference between the original Bretton Woods system and the commonly named post-Vietnam "non-system" that allowed the sudden attacks on, and collapse of, Mexican, Asian and Latin American currencies over the last decade. If a currency collapses people of the effected country become a lot poorer very quickly and things are much worse if the country has lots of debt denominated in, say USD. Guess what happens when bad economic policies get introduced. It is interesting to note that the two things that brought down the stabilizing mechanisms of the original Bretton Woods system were America's extensive cold-war military adventures and the world's lust for oil (through the 1970s oil shocks) remember the long lines at the pump.
Under the original Bretton Woods system with capital flow controls, the only thing that could change the relative demand for a currency against the US dollar peg, was a serious trade imbalance. That means a large imbalance between a country's imports and exports. For example, if a non-US country's imports from the US exceeded its exports to the US by a lot then its demand for US dollars exceeded the US demand for its currency. To make things balance it could either devalue its currency or get US dollars somehow, say by selling gold or borrowing US dollars. If a large temporary trade deficit came about the IMF could lend US dollars to the country to stabilize its currency value while the deficit existed. But if it was permanent the IMF would recommend a currency devaluation.
I should just say that the issue of management of trade deficits and barriers to trade, and associated demand for currency, provides the link between the IMF and the original GATT or General Agreement on Tariffs and Trade, which later changed into the World Trade Organization or WTO. It is interesting that both agreements and institutions jointly changed lanes drastically from their original post-WWII mission in the late 20th century after the collapse of the original Bretton Woods system. As I am currently involved in a trade dispute I will not expand on this further until it has been settled. I have therefore made my comments general in nature. But if you are interested just click on the Centurion Health Corporation link on the right side of the site for further details.
At one time under the original Bretton Woods system countries had some control over their own domestic monetary policy so long as it didn't effect their balance of payments too much, and under capital controls they were protected from excessive speculation. But then America's increasing military activity throughout Latin America, Asia, and Africa in the 1960's and 1970's followed closely by the OPEC oil price shocks radically altered the fundamentals of the monetary system throughout the rest of the 20th century. So if you want to know where the currency is going just look at the military efforts at any given time. As this is election year and as both US presidential candidates are vying for our votes. Their stance on war becomes all the more important to speculators watching closely. War is a complicated issue its just like marriage easy to get into harder to get out of.
