The Secret History of Oil and Money - Part 3

The Fall of Bretton Woods and the rise of Paper Money

To understand the background of the situation, you have to remember that the United States went off the gold standard in 1971 leading to the age of “Paper Money,” the main topic of Smith’s book. Today we might say “fiat currency.” The 1971 oil price spike certainly played a role.

When countries want to trade with each other, they need a common medium of exchange. If France and Britain trade, they can’t use French Francs or British Pounds because each would be worthless in the others’ country. What they use is precious metals. Gold, historically, but silver too. Neither of these is valuable in and of themselves, only that the other desires it. Historically, the country with the most gold can raise the biggest army.

However trade in gold has rarely been by exchanging gold coins or bars. Gold is very dense, denser than lead in fact; a bar of gold is heavier than a bar of lead the same size. Hard to transport. Plus you need to guard it constantly against thieves. You want to keep it in a vault. Small-scale trade may have taken place by gold and silver coins changing hands, but it was mostly limited to face-to-face transactions.

For example, consider the island of Yap in the South Pacific. The islanders used stones with holes in them to trade. The bigger the stone, the more valuable it was. Some stones were so big they were hard to transport, so they just transferred ownership “virtually” without actually moving the stones themselves. One stone even ended up on the bottom of the ocean during transport. Since the stone still existed, ownership of the stone on the sea floor circulated among the people as a medium of exchange, even though no one would ever be able to access it in real life. Gold and silver in Europe were much the same.

So in reality, trade in gold has always been virtual. It’s done via pieces of paper, letters of credit, guarantees, bonds, and so forth. It's much easier to use a currency than actual gold, as long as both parties value it.

The key currency is what the world uses as its denominator. The world has been used to saying, "How much is that in dollars?" When we talk about the dollar, we have an emotional involvement that goes beyond the denominator of the System, because this key currency is our currency, what we walk around with in our purses and wallets. 

Let's start with an easy example. The Saudis have sold a lot of oil. They want to build an industrial plant at Jubail, so they ask for bids. The South Koreans come in with the low bid. They send a whole army of workers to Saudi Arabia, who live in dormitories and work like beavers. They bring steel and valves and instruments and piping and plastics, and they put up the plant. Japanese ships bring the goods. The Saudi currency is the riyal. The Korean currency is the won. The Japanese currency is the yen. What do the Koreans get paid in?

The answer is none of the above. The Koreans get paid in dollars. The world trades in dollars. The dollar is the key currency. The deal may be between the Saudis and the Koreans—and this happens to be a real example— and the transfer may take place between the Saudi banks and the Korean banks—or it might go through London or Tokyo—but it is denominated in dollars. Everybody knows what a dollar is, though they argue about what it is going to be worth. And because the transaction is in dollars, sooner or later it has to end up on a ledger in New York.

...there is a whole world out there trading in dollars, banking dollars, investing dollars; and those dollars could ultimately be a claim upon us. Not only could they be used to whisk away the apples and computers and textiles we are about to reach for ourselves, but they allow the holders of those dollars to voice irritation about the state of the dollar.  And not just irritation. OPEC says, "You let the dollar go downhill, we have a lot of dollars in our savings account, we're going to raise the price of oil just to stay even." Then everybody who buys oil gets mad, not just at OPEC, but at us. Because with the oil price up, we have a bit more inflation as the cost is passed through, and the dollar goes down some more, and the price of oil goes up again--a disagreeable cycle. (pp. 111-112)

What are the characteristics of a key currency?

A key currency country has to have the same characteristics as a bank. Essentially, the nation acts as sort of a bank for the rest of the world. A bank with an army. What are these characteristics?

The first is safety. That's first. If you think you won't get your money back, you'll keep it in a mattress instead. "Safety means the bank still has to be there. The country has to be politically stable. A big bank account in Havana in 1958 doesn't mean a damn thing in 1960. So the country has to have solid institutions, a respect for law so that buyers of the key currency don't find the rules changed...That's why American banks advertise, 'Accounts insured to $100,000.'" (p. 113)

The second is liquidity. This means the an ample supply of money and the ability to turn assets into cash. "When you put your money in the bank, you want to be able to get it back when you want it. You don't want to be told 'Fill out this form and wait sixty days.' In other words, you want the bank to have the resources on hand so that you're not tied up...And the country has to protect the value of its currency both at home and abroad. The money has to stay worth what its worth. for that it needs a healthy economy, with economic growth and price stability. This will give it liquidity."(p 113-114)

The third is yield. "[T]he use of money is worth something, so you want to interest, rent on the money...the yield will be taken care of by the supply of, and demand for, the currency. A higher rate of interest might make up for some decline in the currency. Supply and demand in the contemporary world come not only from the marketplace but from the government's bank, the central bank, and that bank must inspire trust." (p. 114)

Pegging a currency to a precious metal doesn't make it a key currency, but it helps to restrict the printing of paper money, because the amount of metal is finite, and thus it might be one sign that some faith in the currency will be kept. But the South African rand is partially backed by gold, and no one deals in it who dies not have to; it is too subject to controls or restrictions. The Swiss Franc and several other European currencies have some gold backing, and there is some devotion to keeping these currencies stable, but Switzerland is a small country, without military or political influence. The world is so hungry for something to denominate in, for something to be the key currency, that the Swiss, with a stable franc, have taken in money from all over the world and profited by handling it. But there simply aren't enough Swiss francs to finance the world's trade. (p.119)

Back in 1717 the British Master of the Mint, one Isaac Newton who also dabbled in science and mathematics, declared that English currency would be worth a specific amount of gold. This meant that British money became a key trading currency because it held its value. Because it could be exchanged for gold, it could be exchanged for what you actually wanted instead of gold because other people had faith in it. Thus trade in British currency took the place of precious metals.

 "As Master of the Mint, he said that one guinea, that is, 21 shillings, would be worth 129.4 grams of gold, and thereby he said, We intend this currency to hold its value, and thereby he created a key currency Almost....you need more than precious metals to have a key currency; you have to want to be the Bank, and history has to give you a place so that you can be the Bank. In the eighteenth century, traders around the world sent money to London, to be held in "sterling," which is what the British currency came to be called....For part of British financial history, sterling was fixed in terms of silver; 11 ounces, 2 dramweight of silver was 20 shillings thruppence." (p. 114)

There were two instances in that long history where the British suspended the convertibility of the dollar, one to fight Napoleon, and one to fight the Kaiser (World War One). The British needed to come up with a lot of money to fight those wars, so the convertibility was suspended. By the way, in order to not be in debt to banks, Napoleon financed his military exploits by selling the Louisiana Purchase to the United States.

After Waterloo, sterling met every test of a key currency. The government was stable, the institutions honored and intact. The Royal Navy sailed the world; trade followed the flag. Britain was first into the industrial revolution, so its manufactured goods spread over the world. The battles were always at the fringes of the empire. 

Every time there was a small crisis about the pound, the monetary authorities would raise the interest rates sharply. That might depress the domestic economy, but the high interest rates would draw in foreign exchange, and the pound would retain its value. Britain bought the raw materials, the commodities, and sent back the manufactured goods; and since the price of raw materials gradually declined, the pound increased in value.

The British government issued "consols," perpetual bonds. Fathers gave them to their sons, and those sons gave them to their sons, and the bonds actually increased in value as time went on. "Never sell consols," said Soames Forsyte, Galsworthy's man of property.

The world brought its money to London and changed it into sterling. London banked it and insured it. Cartographers colored Britain pink on world maps, and the world was half pink, from the Cape to Cairo, from Suez to Australia. In 1897, at Victoria's Diamond Jubilee, the fleet formed five lines, each five miles long, and it took four hours for it to pass in review at Spithead. British capital went everywhere....(p. 116)

It was this currency that bound the world together in trade, particularly the North Atlantic, for a few hundred years. It was used instead of gold, which was a lot easier. It was the “denominator” used in world trade. Trade was denominated in the Pound Sterling. England would never be out of debt for the next two hundred years.

Now, a word about “defending” currency - keeping its value (i.e. purchasing power) high. It all has to do with supply and demand.

If you raise the interest rate attached to a currency, you increase the demand for that currency, as people will want a higher interest rate. People don’t buy currency, they buy bonds denominated in that currency, so a higher interest rate will increase the yield, one of the big three attributes of a key currency as we saw above. A higher interest rate (in let's say in the U.S.) compared to another country's rate will cause the dollar's value to appreciate against that second country's currency (let's say the Euro).

An investor can borrow money in Euros at a lower rate and then buy US dollars and invest in a higher return investment. Since everyone is selling Euros and buying dollars, there is a higher demand for dollars and consequently the price of the dollar goes up. That's called a carry trade. Higher interest rates in the U.S. attract foreign direct investment, which means that foreign investors have to buy dollars in order to invest in the U.S. This also increases demand for the dollar and this increases the spot rate relative to other currencies.

Higher dollar value relative to other global currencies makes imports relatively cheaper but exports relatively more expensive to foreigners, hurting exports overall. Higher interest rates also decrease the amount of loans, slowing down the economy.

Why would the Fed want to keep interest rates low and consequently the dollar lower? If the dollar is cheap, its products are cheaper and thus it can sell more exports which means American companies and by extension the economy, get more business. Low interest rates are typically used to stimulate and economy by enticing people to take out loans. But as we saw above, if the dollar's value went down, because oil is sold in dollars, the price of oil went up to compensate. More dollars means that each individual dollar is worth less. Increase the supply and the demand goes down. More dollars also means less inflation, as more dollars compete for goods and investment opportunities.

So lower interest rates lower the relative value of a currency, but stimulates the domestic economy. More exports, cheaper loans. No inflation. So the theory goes.

You can avoid this by “pegging” a currency, for example saying that one dollar gets you 40 rupees (or whatever) no matter what. Thus, the ratio always remain the same and fate of the two currencies are linked. The Chinese used to do this with the dollar, ensuring their exports would always be cheap no matter what the dollar did.

That said, let’s move on.

The sun would eventually set on the British Empire, as economic gravity shifted to Germany and the United States. The expense of the war doomed the British currency. Eventually, it could no longer defend it and had to let its value fluctuate, that is, "float."

In 1931 the British let the pound "float"; they abolished its convertibility. It was not pegged to gold via a fixed exchange rate, and on any given day it would sell for whatever buyers and sellers agreed on. The international monetary system collapsed. There was no key currency. Trade died. In the United States a quarter of the work force was unemployed. For two hundred years it was the pound that was supreme. The Bank of England stood for riches and power. In the Depression the world broke up into blocs, and each bloc tried to gain an advantage by depreciating its currency so that it could increase its exports and put its people back to work. That game is called beggar thy-neighbor, and it was a disaster. (pp. 117-118)

This, coming in the wake of thee 1929 Wall Street crash, led to ten years of Depression.

Now, the causes of the Depression are in dispute. I would argue that the oversupply of goods compared to what people could actually buy due to things like the electrification of the production line, meant that you needed to dump goods somewhere else, that is, export them. But everyone was in oversupply, and everyone needed to dump their excess goods somewhere to keep the production lines moving and enough people employed. So you get every country simultaneously trying to weaken its currency and countries trying to restrict imports (e.g. the Smoot-Hawley tariff). This "trade war" brought down the currency regime, including confidence in the pound.

After the war, it was decided that the world once again needed a medium of exchange to rebuild. Since the U.S. had loaned all the money out to the allies, and it’s industrial base was untouched, it collected its debt in gold and printed enough dollars to help the world rebuild.

In 1944 the finance and treasury ministers of forty-four countries met at the mountain summer resort of Bretton Woods, New Hampshire. And all the currencies were set in a fixed relationship. If you were a central banker and you brought $35 to the United States, you could have an ounce of gold. (Americans could still not own gold.) All the other currencies were pegged to the dollar.  

The dollar met all the criteria of a key currency. The United States honored its obligations. It had military and political power, its institutions were stable. It had every opportunity for economic growth and price stability. And there was an even more overwhelming criterion: there wasn't anything else. 

Pegging a currency to a precious metal doesn't make it a key currency, but it helps to restrict the printing of paper money, because the amount of metal is finite, and thus it might be one sign that some faith with the currency will be kept...The nations that met at Bretton woods wanted to avoid the currency wars of the 1930s and to have cooperation. Out of the agreements at Bretton Woods came the international institutions of the System: the International Monetary Fund, to govern international monetary relations; the International Bank for Reconstruction and Development, to rebuild the world; and the General Agreement on Tariffs and Trade. (pp. 118-119)

By 1958 the System was so successful that trade was booming, all the major currencies were convertible into each other, and the dollar was better than gold. Better, because why bother with gold? If you really wanted it, you could turn dollars in for it; but gold is sterile, it earns no interest, you have to pay storage charges on it. It was dollars everyone wanted. Now it was the American Navy that prowled the world. American banks with all the flags in their foreign capitals, and American companies that owned, worldwide, the nickel mines and auto parts plants.

...Economists worried about a "dollar gap"; how would the world get enough dollars to trade? It seems a very long time ago, but in the 1950s the United States was producing half of the world's oil, half of its automobiles, and 40 percent of its industrial output...(p. 120)

It turned out this wasn't a problem. The dollar’s status as a reserve currency led the demand for dollars, as did balance of trade deficits. The Marshall Plan sent millions of dollars to Europe after the war to rebuild. Americans traveled abroad and spent dollars. American companies opened subsidiaries abroad. People changed money into dollars, since every currency was pegged to each other. The proliferation of dollars meant that when people changed dollars into their local currencies, the foreign banks had to print enough to cover the difference – the U.S. was exporting a bit of inflation. The foreign banks would then use those excess dollars and buy U.S treasury bonds. The U.S. Treasury would take the dollars back, giving an lOU—a bond—and a promised date for repayment. That financed the deficit.

If other countries needed dollars, they had to export enough to earn them. The U.S. just had to print them. Eventually, many of these dollars became Eurodollars.

A Eurodollar is simply a dollar-denominated account at a bank outside the United States They apparently began when a Russian banker moved his money out of Rubles (which nobody wanted) into dollars in a Soviet-controlled bank with a British charter during the Hungarian uprising in 1956 for safe keeping. The dollars were later loaned out.

As we saw, central banks and governments can regulate the amount of currency via interest rates, tax policy, etc. Because these dollars were located outside the United States, they could not be regulated by the Federal Reserve board or the banks, meaning that the Eurodollar market could operate on narrower margins than banks inside the United States.

International bankers loved Eurodollars, and they began to proliferate. They tended to move offshore banks like the Bahamas and the Cayman Islands, where not only could they escape banking regulations, but also the taxing authorities. The Eurodollar market expanded as a way of avoiding the regulatory costs of dollar-denominated financial intermediation. (Investopedia)

All these Eurodollars were a problem. There simply wasn't enough gold in the United States, or maybe even the world, to cover them all! Too much money had left the United States, the demand for dollars was just too great. Because of higher oil prices, more and more people were showing up at the "gold window." Heading them off that the pass was the safe option, and that's exactly what happened:

In August 1971 the United States Treasury stopped selling gold for dollars altogether. The potential claims on the gold were too great. The claims, from overseas, were in the form of a curious currency called the Eurodollar, which was simply a dollar abroad. Brought to the United States, it was like any other dollar, except that in foreign hands it could be presented for gold...There were too many dollars for the gold; everyone could see that if the Euro holders all cashed in their dollars. Fort Knox would be bare in a day ...When the United States cut the tie between the dollar and gold, the key currency no longer had any kind of backing in a precious metal....The neat, classical world devised in 1944 at Bretton Woods had had the dollar as its centerpiece, gold at $35 an ounce backing the dollar, and all the other currencies fixed in their relationship to the dollar. Now that system was coming apart. (pp. 121; 129)

So what to do now? The major countries tried to patch up the system, to no avail.

The ten leading industrial countries met at the Smithsonian Institution in Washington. They tried a replay of Bretton Woods: a higher price for gold, a devaluation of the dollar, and new fixed rates for all the currencies. But the fix did not even last for eighteen months. During the period of the fix, the world's money suply took another flip upward...More yen, more marks, more everything, in fact...One by one, the world's central banks peeled out of the fixed-rate relationships. The exchange rates floated everywhere. A dollar was worth, on any given day, what the buyers and sellers said it was worth.

"When we left the pound, we could go to the dollar," said Jelle Zijlstra, then of the Bank of the Netherlands. "But where could we go from the dollar? To the moon?"  (p. 129)

Such was the situation in 1971, when the oil prices started their upward climb. Going back on the gold standard presented several problems:

Gold...was reality, a brake on printed money. Alas, in the 1970s ...the crises came; the markets went down and gold went up twenty times and can go anywhere that fear and paper money will take it. Keynes called gold "a barbaric relic"; he believed that rational men could conduct their affairs rationally. Western industrial governments have not been enamored of gold as a standard because it is too confining; it gets in the way of their programs and benefits the two major gold producers, South Africa and the Soviet Union. The industrial democracies do not want to depend on those two countries for the additional gold they would need to increase the reserves behind a currency. 

The Soviet Union, in fact, has the largest unmined gold reserves in the world: about 5 billion ounces in the ground. The total unmined gold reserves in the world are estimated at 7 billion ounces. Thus the Soviets have gold, at current prices, worth roughly $3 trillion. On a full gold standard, the Soviets could give up skirmishing with the West and buy it.

If gold was a brake on the spending of governments, what else could be a brake? There is no automatic brake. The answer is a social consensus in a society that understands the effects of inflation and is willing to take the measures that end it. (pp. 141-142)

The "measures that end it" would be staggeringly high interest rates throughout the 1970s by Paul Volcker, chairman of the Federal Reserve, who vowed to "break" inflation. It worked, but at the price of a decade of painful stagnation. Inflation would not come down through the 1980's, in the aftermath of the 1978 oil crisis, 1981 was the most painful recession since the Great Depression. But eventually they did come down during the reign of the new U.S. president: Ronald Reagan.

Next up - The Second Oil Crisis.