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Investment Sector: Currencies Submitted by Denese 
9 months ago Tags: dollar pegging currencies macr-economic reviews Bretton Woods Denese Sinclair Add Tag |
Is the Dollar Out Of the “Woods”?
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Bretton Woods – the Introduction of Currency Pegging
In 1944, in a war torn world, the Bretton Woods Agreement was born in an attempt to secure peace and monetary stability in war-ravaged Europe. Major central banks opted to peg their currencies to the U.S. dollar while the United States agreed to peg the dollar to gold at $35 an ounce. This was called the Bretton Woods Agreement and its major objective was the reconstruction of the European economies. In the lofty words of Henry Morgenthau in the opening address: the aim was, the “Creation of a dynamic world community in which the peoples of every nation will be able to realise their potentialities for peace." With that world leaders left behind gold as a currency, pegging instead to the US dollar, which was used as the standard currency for all trading between capitalist countries. The main terms of this agreement were:· The formation of the International Monetary Fund and the International Bank for Reconstruction and Development (presently part of the World Bank). · Adjustable peg Foreign exchange market rates system: The exchange rates were fixed, with the provision of changing them if necessary. · Currencies were required to be convertible for trade related and other current account transactions. The governments, however, had the power to regulate ostentatious capital flows. · As it was possible that exchange rates thus established may not be favourable to a country's Balance of payments position, the governments had the power to revise them by up to 10%. · All member countries were required to subscribe to the International Monetary Fund's capital.Pegging and Inflation
By the late 1960s, the dollar peg was creating a problem of inflation. The United States was flooding the world with more dollars than were desired at the pegged exchange rates. The only way that the French and German central banks could maintain their currency pegs versus the dollar was to inflate their own economies. The pegging Central Banks had to buy U.S. dollars in the foreign exchange market with their own currencies, in order to prevent the dollar from falling. The dollar-buying central bank gets its own currency by figuratively printing it and therefore floods its economy with its own base money, resulting in inflation – inflation in the prices of goods/services and inflation in the prices of assets. The demise of the Bretton Woods Agreement occurred in August 1971 when the peg between the U.S. dollar and gold was severed. Europe started a long process towards monetary union, via an exchange-rate mechanism, which resulted in a single and free floating currency 30 years later and an era of floating exchange rates was ushered in. The US did not however entirely lose its status as the world’s reserve currency and today the US$ is still used as a peg by many developing and trading nations, particularly in the Middle and Far East. The peg would bring developing nations financial credibility and would provide them with stable trading conditions while trading with the world’s most voracious consumer.The Role Of Pegging In the US Deficit
The dollar’s role as the world's reserve currency has allowed for its excessive and growing deficit. In 2006, the US ran a current account deficit of more than 6 per cent of gross domestic product., Being the major Reserve Currency Asian countries tie their currencies to the dollar at highly competitive levels and use their reserves to lend money to the U.S. by purchasing its financial assets, especially Treasuries, allowing these nations to pursue an export-oriented economic-development strategy, to maintains growth and keep their large populations employed. In return, an overvalued dollar permits Americans to keep consuming cheap imports, spend more than they save and borrow from Asia at low interest rates.
In 2003, the economists Michael Dooley, David Folkerts-Landau and Peter Garber analyzed this phenomenon and dubbed it the Bretton Woods II theory.Bretton Woods II
“The idea is based on the observation that newly industrialized countries peg their currencies to the dollar at an undervalued exchange rate in pursuit of export-led growth. In return, they reinvest their loot back into the US, which acts as an anchor and consumer of last resort.” Wolfgang Munchau ``Some have called it the world's biggest vendor-financing scheme,'' Barnes says. ``The U.S. gets to satisfy its insatiable demand for cheap imports, and Asia keeps its factories running.'' “In some respects, Bretton Woods II appears like a giant money laundering cartel. You buy my goods and, in return, I give you the money back in the form of a loan. It is, perhaps, no surprise that it took a credit market crash to bring that macroeconomic scam to an end. “Wolfgang Munchau The Bretton Woods II theory says that this excessive deficit is both desirable and sustainable, which has not convinced all economists and in fact America's reliance on others to fund its deficits has accelerated the rise of new powers that will challenge its hegemony and the US may become the victim of globalisation, rather than its champion. If the dollar continues to lose ground, and it has fallen by 52 per cent against a trade-weighted basket of currencies since 1985, other countries may not find it worthwhile to invest in dollar-denominated assets (which helps to offset the US current account shortfall) whether they be equities, American Government bonds, mortgage-backed securities or even highly rated US corporate debt. What could cause the loss of ground to become a landslide would be a decision bythe Chinese and Saudi central banks to eliminate the pegs of their currencies to thedollar. Both countries are experiencing inflation as a by-product of pegging their currencies to the dollar. So – out of the woods?Did you find this article useful?
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