Between 1879 and 1934 all the major nations of the world adhered to a fixed-rate system called the gold standard. In this system a country had to define its currency in terms of a quantity of gold, maintain a stock of gold which was a certain fixed ratio between its money supply and gold stocks. Last of all the mobility of gold was not to be hindered ie gold must be allowed to be freely imported and exported. The Great Depression in the 1930s led to the collapse of the gold standard.
The primary goal of afflicted nations at the time was the restoration of prosperity as domestic output and employment fell. They used protectionist measures and devalued their currencies. A series of such devaluation meant that the exchange rates were no longer fixed. As a major pillar of the gold standard had been undermined, the system broke down.
In 1944 an international conference of nations was held at Bretton Woods, New Hampshire to lay the ground work of a new international monetary system. Due to the Great Depression and the World War II the world economy was in a shambles. The nations gathered together to try to start anew and produced a new system: a modified fixed exchange-rate system called an adjustable peg system or the Bretton Woods system.
The Bretton Woods system tried to capture the advantages of the old system while avoiding its disadvantages. The International Monetary Fund was also created to make the system feasible and it prevailed with modifications until 1971. In this system each IMF member had to define its currency in term of gold or dollars. So this was the foundation laid for a dollar dominated world.
Under this system gold and dollar came to be accepted as standard reserves: the gold as a relic of the old system and the dollar because the United States had accumulated large quantities of gold, before it joined the war in 1942, by selling arms indiscriminately. Between 1934 and 1971 it became the major gold dealer in the world at a defined price of $35 per ounce. As the dollar was convertible into gold at any time it was deemed to be as good as gold.
The growing volume of dollars provided a medium of exchange for the expanding world trade, the discovery of new gold on the other hand being limited. But the United States experienced persistent deficits during the1950s and the 1960s which were paid mostly by dollars.
In 1971 the United States ended its 37 year old policy of exchanging gold for dollars and floated the dollar letting its value be determined by the market forces. With the withdrawal of the United States support of the Bretton Woods system, it sank into oblivion.
Since 1971 a, flexible system called managed floating exchange rates has been in use. Exchange rates among major currencies are free to float to their equilibrium levels and occasionally, interventions by governments take place to stabilise or alter these rates.
Now the question arises as to why the dollar has maintained its value and place in the international market even after being freely floated? Thanks to Alfred Marshall's brilliant plan, the United States lent all the wealth accumulated during the World War II, to the war torn world.
These loans were, of course, given in dollars. These loans were utilised by buying everything from infrastructure to basic commodities, mainly from the United States; the only major country on whose shores the war did not reach.
Thus the United States economy expanded to become one of the richest and most powerful economies in the world. Before America got rid of the Bretton Woods system, it integrated its currency in the international market to such an extent that most of the countries, even at that time held dollars as a major portion of their reserves, against which they floated their currencies.
The United States created a demand for dollars strong enough to support its currency before removing the gold base on which its currency leaned on.
THE DOLLAR DEMAND WAS MAINLY DUE TO THE FOLLOWING FACTS:
1. LEADING FOREIGN EXCHANGE RESERVE: The US dollar is the major shareholder in the foreign exchange market. In the pre euro scenario (end of March 1998) the share of the dollar in the market was roughly 61 percent, the D-mark accounted for 13 percent and European currencies together made up a share of some 20 percent.
2. PRINCIPAL INVESTMENT CURRENCY: The dollar is the major investment currency and at the end of March 1998 the share of the dollar in the international market for bond and notes amounted to 40 percent, the D-mark accounted for 10 percent and all the EU countries taken together made up one third of this market.
3. KEY TRANSACTION CURRENCY: The dollar, due to its high mobility, is thought to be the key transaction currency all over the world. At the end of March 1998 50 percent of global exports were settled in US dollars, the D-mark 15 percent and around 6 percent each in French francs and pound sterling.
Another question arises as to why if all this is true, then the dollar is in decline? The US economies growth rate has fallen from 8 percent earlier this year to 4 percent plus which is still comfortable and well ahead of Europe and Japan. But the expansion is out of balance.
The US consumers are buying imported goods and services in ever-increasing amounts and the country has to borrow to finance the trade deficit.
There are several reasons for these persistent trade deficits. First, since 1992 the US economy has grown more rapidly than the economies of several major trading nations.
This growth of income has boosted US purchases of foreign goods while Japan, some European nations and Canada have suffered a recession or slow income growth during this period. Thus export of US goods to these countries has not kept pace with the galloping rise in US imports.
Persistent trade imbalances with Japan are noteworthy. Secondly, the US annual federal budget deficits have been large. These deficits have required the federal government to compete with the private sector for financing, which bid up the real interest rates.
The high interest rates increased the foreign demand for dollars resulting in high international value of dollars which made US exports costlier and imports cheaper. Finally, a declining saving rate in the US has contributed to US trade deficit.
The saving rate (Savings/Total Income) in the US has declined. At the same time, the investment rate (Investment/Total Income) has remained stable or even increased. The gap has been met by foreign purchases of US real and financial assets, creating a large capital account surplus.
Because foreigners are financing more of US investment, US citizens are able to save less and consume more, including consumption of imported goods. The financing of US trade deficit has resulted in a larger foreign accumulation of claims against US financial and real assets than the US claim against foreign assets.
Internationally this fall and the decline in the value of dollar have caused major concerns. Some important views are given below:
1. ALAN GREENSPAN (CHIEF OF THE US FEDERAL RESERVE) Greenspan has warned that the deficit in US trade with the rest of the world cannot be sustained indefinitely. He said in mid-November, "It seems persuasive that, given the size of US current account deficit, a diminishing appetite for adding to the dollar balances must occur at some point."
He further added that he was not predicting a catastrophe. But the implications are clear that the inevitable adjustment might come in disruptive form. However, to avoid panic Greenspan in a speech delivered to the G-20 conference said, "Current account deficits even large ones, have been defused without significant consequences, but we cannot be complacent."
2. JEAN-CLAUDE TRICHET (PRESIDENT OF THE EUROPEAN CENTRAL BANK) The European Central Bank president has described the decline in the value of the dollar against the euro as "unwelcome".
He said, "Recent moves on exchange markets of the dollar versus the euro are unwelcome." Trichet also expressed his support for the US treasuries stated "strong dollar policy".
3. RODRIGO RATO (CHIEF OF THE INTERNATIONAL MONETARY FUND) IMF chief has said that the US needs to do more to reduce its deficits, the main engine driving the dollar to record lows. He said, "The question is whether the build-up is sustainable, and there's growing evidence that (it) is very big and the markets are asking for a change of policy."
4. CHARLES BEAN (CHIEF ECONOMIST OF THE BANK OF ENGLAND) Another warning, regarding the ongoing weakness of the US dollar, by Charles Bean has made the outlook for the US economy more uncertain. He said that with the US budget deficit at a record level of 413 billion, overseas investors are unlikely to continue buying assets across the Atlantic (especially due to low interest rates compared with the rest of the world).
That meant the potentially "substantial" decline in the dollars value could go ahead as the Bush administration acts to cut the budget deficit.
The US businessmen have declared this decline in dollar value as welcome and long overdue. The dollar weakness has promoted fears around the world that the strong euro could have a serious effect on European and Asian economies in 2005 as a weak dollar makes it more expensive for Asian and European exporters to sell their goods in US.
On the other hand the US businessmen feel that the US suffers the least of all due to this decline. Although United States rampant consumers will find it harder to slake their thirst for imports, its companies will become far more competitive, reaping profits and boosting jobs.
While many people felt, that there was a possibility of a further fall in the value of the dollar the opposite was equally probable; the general consensus on this fall is that the pressure on the dollar will persist: although the declining dollar has hit the headlines recently, the factors behind it are long-term structural issues that are not going to disappear in thin air.
On November 19th George Bush signed a legislation by which the ceiling of the US public debt was increased by 800 billion. This takes the total debt allowable to $8.2 trillion.
The deficit for the budget year 2004 alone was 413 billion following a deficit of $377 billion in 2003. The deficit in US international trade last year was more than $500 billion more than 5 percent of the country's economy.
Since 1985 till 2001 dollars real trade-weighted value fell by 17 percent against a basket of major non-European currencies, and by 35 percent against West European currencies. In recent months dollar has been beating all sorts of records.
The pound is way out in front and is currently at a twelve-year high. The Euro is also at an all time high, but it has only existed sine 1999; elsewhere in Europe, the Swiss Franc is at its strongest since 1995 and the Swedish Krona has hit post-1997 highs.
The Yen has been somewhat held in check by Japan's central bank, but is still at a level last seen in January 2000. The euro the currency everyone seems to be watching has now gained more than 10 percent against the dollar in the past six months, and fully 58 percent since its historic low of 84 US cents in July 2001. If, as is predicted, the dollar keeps on declining a domino effect may take place.
It is believed that at present, the estimated holding of US government paper is $11 trillion globally: a confounding amount. If the dollars value keeps falling and no concrete steps are taken, then a catastrophe is very likely.
Recently, the Shanghai-based China Business News reported that China had cut the size of its US Treasury bond holdings in foreign exchange reserves to $180 billion to avoid losses from a weakening US dollar.
While Russia's Central Bank is reported to have said that the bank was reviewing its foreign exchange reserves "with the highest priority". Though euro already accounts for 25 to 30 percent of Russia's reserves, commentators believe she is craving for much more.
Developing countries may diversify their reserves to avoid catastrophic situations. Regional cooperation between various groups of countries may provide a way out to a more stable world.