Image: Matt Collins
The People’s Bank of China jolted the financial world in March with a proposal for a new global monetary arrangement. The proposal initially attracted attention mostly for its signal of China’s rising global economic power, but its content also has much to commend it.
A century ago almost all the world’s currencies were linked to gold and most of the rest to silver. Currencies were readily interchangeable, gold anchored exchange rates and the physical supply of gold stabilized the money supply over the long term.
The gold standard collapsed in the wake of World War I. Wartime financing with unbacked paper currency led to widespread inflation. European nations tried to resume the gold standard in the 1920s, but the gold supply was insufficient and inelastic. A ferocious monetary squeeze and competition across countries for limited gold reserves followed and contributed to the Great Depression. After World War II, nations adopted the dollar-exchange standard. The U.S. dollar was backed by gold at $35 per ounce, while the rest of the world’s currencies were backed by dollars. The global money stock could expand through dollar reserves.
President Richard Nixon delinked the dollar from gold in 1971 (to offset the U.S.’s expansionary monetary policies in the Vietnam era), and major currencies began to float against one another in value. But most global trade and financial transactions remained dollar-denominated, as did most foreign exchange reserves held by the world’s central banks. The exchange rates of many currencies also remained tightly tied to the dollar.
This special role of the dollar in the international monetary system has contributed to the global scale of the current crisis, which is rooted in a combination of overly expansionary monetary policies by the Federal Reserve and lax financial regulations. Easy money fed an unprecedented surge in bank credits, first in the U.S. and then elsewhere, as international banks funded themselves in the U.S. money markets. As bank loans flowed into other economies, many foreign central banks intervened to maintain currency stability with the dollar. The surge in the U.S. money supply was thus matched by a surge in the money supplies of countries linked to the U.S. dollar. The result was a temporary worldwide credit bubble, followed by a wave of loan defaults, falling housing prices, banking losses and a dramatic tightening of bank lending.
China has now proposed that the world move to a more symmetrical monetary system, in which nations peg their currencies to a representative basket of others rather than to the dollar alone. The “special drawing rights” of the International Monetary Fund is such a basket of four currencies (the dollar, pound, yen and euro), although the Chinese rightly suggest that it should be rebased to reflect a broader range of them, including China’s yuan. U.S. monetary policy would accordingly lose its excessive global influence over money supplies and credit conditions. On average, the dollar should depreciate against Asian currencies to encourage more U.S. net exports to Asia. The euro should probably strengthen against the dollar but weaken against Asian currencies.
The U.S. response to the Chinese proposal was revealing. Treasury Secretary Timothy Geithner initially described himself as open to exploring the idea; his candor quickly caused the dollar to weaken in value—which it needs to do for the good of the U.S. economy. That weakening, however, led Geithner to reverse himself within minutes by underscoring that the U.S. dollar would remain the world’s reserve currency for the foreseeable future.
Geithner’s first reaction was right. The Chinese proposal requires study but seems consistent with the long-term shift to a more balanced world economy in which the U.S. plays a monetary role more coequal with Europe and Asia. No change of global monetary system will happen abruptly, but the changes ahead are not under the sole control of the U.S. We will probably move over time to a world of greater monetary cooperation within Asia, a rising role for the Chinese yuan, and greater symmetry in overall world monetary and financial relations.
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22 Comments
Add CommentThere is science in this article? I see a history lesson with a touch of economics.
Reply | Report Abuse | Link to thisWe have SA Mind and SA Digital, why not make a new offshoot and call it Social Scientific America. It can have all the social science and politics so we can go back to reading about science!
As SJ Gould said, all science is political.
Reply | Report Abuse | Link to thisGeorge Soros will love this,as this will make monetary manipulation much easier for him to do.
Reply | Report Abuse | Link to thiseconomics is science, the study of money, i found the article very interesting
Reply | Report Abuse | Link to thiswhat about the study of literature, what about the study of the human body, study of buildings. These all have their own branch of education. Economics is mathematics and business. I am not saying it isn't worth studying, just give it its own damn magazine.
Reply | Report Abuse | Link to thisDon't forget theology, the study of God.... But that aside, there are some subsections to SA such as Health, Space, Technology, and so on. If you only want to look at a specific area, feel free.
Reply | Report Abuse | Link to thisI prefer to get a selection from the full spectrum of science than just one or two areas. Keep up the good work, SA!
I see you get my point, I think its time for another offshoot for the social (and political) sciences
Reply | Report Abuse | Link to thisyou mean like The Economist.com?
Reply | Report Abuse | Link to thisThe latest proposal from the People's Bank of China is in a speech delivered tomorrow, May 23, http://www.pbc.gov.cn/english/detail.asp?col=6500&id=178
Reply | Report Abuse | Link to thisIt favors resurrecting Keynes 1940 proposal for a "commondity based reserve money. " The best discussion of the advantages of such money is by Frank Graham of Princeton in his "Social Goals and Economic Institutions", published in 1942.
Milton Friedman, 1951, in his book "Essays in Positive Economics" discussess some of the potential problems with such an approach his essay entitled "Commodity-Reserve Currency.".
Clearly what is desired is a monetary system in which the quantity of money has some relationship to the underlying wealth of the issuing country/authority. This is probably a lot more than a basket of real commodities;it might include some conceptual "wealth" measures, like human capital, infrastructure, or some kind of adjusted GDP. Using the IMF SDF as a basket of existing currencies is a pretty weak substitute, in my opinion, though it might provide minor improvements in the churning of monetary values by speculators.
More important is constraining the issuing sources of money and credit from allowing leveraged money creating transactions to exceed a factor of five (See analysis of this in a meeting of the German Physical Society, as reported in the journal Science, April 24, 2009.
In general, there is little science behind any proposals, and the construction and simulations of such ad hoc proposals, based on real world data available via the Internet is just beginning to be investigated. Don't hold your breath!.
artg - that speech was delivered in March (you've mistaken the date at the top of the page for the submission date, which is at the bottom of the article).
Reply | Report Abuse | Link to thisRe. the SDR approach, something along those lines, but much more flexible, is probably in the works (I'd say more flexible in that in an ideal world a country would manage its currency with respect to those of trading and investment partners, rather than to just the four of five big economic powers). Assuming that major central banks have finally learned that stability and trade facilitation as primary goals are more worthwhile than short-term political gain (a big assumption to be sure), perhaps we'll see a lot more of the currency agreements between nations along the lines of what China is already establishing.
A further benefit is that economics might actually start moving from alchemy to science....
We could return to a Gold or Silver based Monetary System. U.S. hs tons of Silver & would quickly stabilize this crisis. Besides Silver is very heavy, has comercial value, and easily fixed to currency values. This just might even stabilize all commodity markets. Emerging Nations would like a tangible unit to solidify each of their own currencies. But solutions are not what politicians want. RJH. Omaha, NE.
Reply | Report Abuse | Link to thisWe could return to a Gold or Silver based Monetary System. U.S. hs tons of Silver & would quickly stabilize this crisis. Besides Silver is very heavy, has comercial value, and easily fixed to currency values. This just might even stabilize all commodity markets. Emerging Nations would like a tangible unit to solidify each of their own currencies. But solutions are not what politicians want. RJH. Omaha, NE.
Reply | Report Abuse | Link to this"European nations tried to resume the gold standard in the 1920s, but the gold supply was insufficient and inelastic."
Reply | Report Abuse | Link to thisEconomics is also a science and perhaps the Scientific American should have had this article peer-reviewed.
Just two sentences previously, Mr Sachs wrote: "Currencies were readily interchangeable, gold anchored exchange rates and the physical supply of gold stabilized the money supply over the long term."
So, which is it? An inelastic gold supply stabilized the money supply over the long term or the inelastic physical supply of gold caused a monetary squeeze? In any economy, a shortage is caused by too low of a price. After WWI, Britain tried to resume the Gold Standard at the pre-war price, but all the fiat paper money inflation had increased the supply of money. There was no shortage of gold, the British government fixed the price of gold at too low of a price.
Mr Sachs is wrong in his economics, wrong in his history and wrong about today.
mr sachs has always been wrong on such matters, unless you consider the US in need of getting knocked down to what mr sachs would call a "co-equal" level to be a positive thing. mr sachs, and other anti capitalists seem to think wealth is only accumulated at the expense of someone else. in other words, if youre rich it's because you stole it from someone else more deserving, and all that hard work you did to get rich, well, that's irrelevent. sachs is a creep, just like austin goolsbee. these guys couldn't run a lemonade stand, and their ivory tower musings are more then tiresome.
Reply | Report Abuse | Link to thisI think the new currency exchange should be based upon each country's energy capacity, natural resources minus environmental degradation and human development index. In this way, we can create a sustainable and more human future instead of current consumerist system which is solely based upon manufactruring capacity.
Reply | Report Abuse | Link to thisMr Sachs should read "China's Dollar Trap" by Paul Krugman (4/2/09). He describes it as it is: the Chinese hold so many dollars that they don't know how to get rid of them, and they want the rest of the world to bail them out now!
Reply | Report Abuse | Link to thisThere is actually a great deal of science behind Economics and monetary policy that is rooted in psychology. The "zero sum" game is a good example of this.
Reply | Report Abuse | Link to thisHowever, I don't agree with the basket of currencies for several reasons. First, is that a currency can be backed by any commodity and not just gold. We could simply back our currency with Federal Land, grain or any other commodity. Secondly, throughout history gold has been debased or discovered and the monetary system expanded. Lastly, I believe dollars were always easy to counterfeit for a reason. It expanded its influence and our power during the Cold War and led to the defeat of the Soviet Union.
you must have found it interesting enough to finish reading.
Reply | Report Abuse | Link to thisyes, i was looking for the part of the article that had anything to do with science.
Reply | Report Abuse | Link to thisyes economics is a science, I just don't see any in this article.
And finished it? Its less than a page long!
In the USA religion and government are supposed to be independant. Yet every dollar note has clearly written on it : 'In God We Trust'. So if the US starts printing money to reduce its debt then it will depreciating God.
Reply | Report Abuse | Link to thisWe do need a modern scientifically based way of evaluating 'worth', but not 'price'. The latter of which can be manipulated by speculators...
Sachs fails to mention the most important fact of all - that China pegs the Yuan to the dollar in order to underprice their exports. If they want a truly fair system then let the yuan float. China uses free market policies when they benefit
Reply | Report Abuse | Link to thisChina and centralized planning when it benefits China.
May-be Sachs fails also when he forgets that at the very beginning in was commodity or product which was exhanged against other c&p. Real and material things corresponding to real needs mostly, be it among the participants could be a trader making a profit of it all. Shouldn�t we try and base the whole of our "rethink" on that beginning.
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