History shows fall of monetary systems due to one or the other crisis. First monetary system called the Gold Standard fell during World War I. Second monetary system called Bretton Wood fell about 38 years ago.
During World War I, UK suspended convertibility of its paper notes against gold to fund military operation during World War I. If they hadn’t, all of its gold reserves would have been depleted. However, after World War I UK hesitated to return to Gold Standard because it had lost most of its gold reserve.
After the fall of Gold Standard, a new system was formed and implemented. It was called Bretton Woods. It took all the advantages of Gold Standard and removed its disadvantages. It had inherent mechanism to tackle inflation-deflation problems and also to minimize boom-bust effect. The growth of other countries leads depletion in US’ gold reserve. This caused due to several reasons one of them being people were converting their dollar in gold to invest in emerging countries as they promised more profits. Second being US’ balance of trade was deteriorating. All in all dollar’s value was declining so was its influence. US suspended its dollar convertibility and thus the fall of the Bretton Wood system.
Current monetary system is very intricate. It consists of Gold, Dollar reserve, Debt tools, foreign exchange, equity, foreign direct investment, etc. This system however has huge flaw, this system is unable to avoid boom-bust cycle. The cycle is caused by creation of large amount of credit and liquidity. Consider a simple scenario, assume US has to pay India for some of its imports say $1 million. What US does is, it issues bonds of $1 mil. This helps in two ways, by issued bonds of $1mil US increases its liquidity in the market. Secondly, when India received those bonds, it issues $1mil in INR in Indian market. So US is in debt of $1mil dollar. Here by using debt instruments US and India both has increased their liquidity, this increase in liquidity promotes faster development of the country. But it has a flip side; increase in huge amount of liquidity causes rapid increase in inflation and boom-bust cycle. Increase in liquidity usually finds its way through banking systems to investments, properties, stock markets, etc. Prices of the equities, lands, house/flat increase rapidly until consumer is no longer able to afford it. This causes rapid deterioration equity and property prices, which in term causes reduction in liquidity. Government seeing this reduces interest rates to inject more funds but fails to do so as there are no good investment opportunities for consumer to lend and invest in. This situation can be very closely related to current situation in India. India had increased it foreign exchange reserves by 65% in 2007. Most of the countries in the world increase their dollar reserves by exporting more to US than importing from it.
Devaluation of currency makes goods cheaper to US consumer in comparison to same US manufactured products at same quality. This is the main reason why US corporations are relocating their industries to such countries where currency of that country is devalued against dollar. It can be explained very simply with an example. Suppose an item costs $10 to a consumer and its being manufactured for say $8. The profit is of $2. Assume that item is manufactured in India when the conversion rate is say 20 INR ($1 = 20 INR). It would cost 160 INR to manufacture. Now say INR is devalued to say $1 = 40INR, the item would still cost 160 INR to manufacture (assuming raw material is not imported). While exporting, manufacturer can export it to US at as low as $4. Even if he exports it at $6,he is still making more profit from it and destroying the competition in process. Now if India starts converting all its dollar reserve to INR, INR will appreciate reducing exporters profit. If it appreciates too much, they might be in loss too. So governments normally take measures to avoid their currency appreciation against dollar. They do this by investing dollar in dollar dominated assets in US. This in term increases dollar liquidity in US which causes inflation. The current mortgage bubble is caused by such huge liquidity in the banking system of US.
US’ debt is increasing at mindboggling rate. Many economists believe that dollar would lose its credibility and starts depreciating. This would put whole world into recession including US. US when it gets into recession, in an attempt to increase liquidity, will start reducing interest rates. But due to unavailability of any profit making investment, this increased cash flow stays in bank’s account and never reaches consumer.
It has been foretold by many economist that this condition would arise but their warnings were discarded by monetarist. Monetarists are the economists who believe that every economic condition can be handled by increasing or decreasing liquidity. But what happens when interest rate becomes zero. It cannot be decreased further as it can never be less than zero. Answer to that is government can buy and sell bonds to increase or decrease liquidity. This can cause rapid increase in inflation rate.
Few other solutions provided by many economists. One of them being gradual increase in minimum wages of the workers in export based countries like China, Mexico, etc so that US debt reduces gradually in addition to development of the particular country. Currently wages in these countries are about $4-$5 per day which is very less as compared to US workers. Secondly, countries should shift their export led development to something other domain. They can also try to introduce new monetary system. This step towards new monetary system has already begun. The new monetary system is currently called Bretton Woods II. In November 2008, during G20 summit this system was discussed. Few also believe that if world operates on single currency this can be completely avoided.
All in all current system is too volatile and dangerous. The effects of this system can be watched in current market situation. Current monetary system can be closely related to house of cards its base being US. Unless drastic steps to improve current system are taken this house of cards is bound to fall.
