I hear a lot of complaints about the U.S. dollar as the world's reserve currency. Many of the criticisms leveled at the buck aren't on the mark ... many are.

But there are good reasons the currency system evolved the way it did. It has served the world pretty well all things considered, and maybe we need to be very careful not to throw out the baby with the bathwater.

There is no perfect global monetary system. Some have been better than others, each with their strengths and weaknesses. All must be evaluated in context to political realities and differing global needs. There is no template for the perfect system in the real world, except for those existing inside heads of academics.

In today's column, I want to briefly examine and compare the last two monetary regimes — the Gold Standard and the Bretton Woods fixed rate system — to the current Floating Rate Standard, or Fiat Money Standard. I think if you understand the differences and how these systems evolved, you can better evaluate where we should be going and more quickly see through some of the nonsensical ideas that seem to pop up every day.

Gold Standard

The gold standard was a commitment by participating countries to fix the prices of their domestic currencies in terms of a specified amount of gold. The countries maintained these fixed prices by being willing to buy or sell gold to anyone at that price.

It is exactly this price stability that makes the gold standard superior to fiat currency. In fact, this period proved that deflation does not always lead to depression. There was a huge expansion of trade and production during the gold standard era and yet deflation in the price level ruled the day.

One of the reasons was the supply problem with gold. Since the gold price was fixed by central banks, the increased demand led to a corresponding decline in the price, which was exacerbated by quickly rising gains in global production and trade. Thus, we saw a period of deflation and real income growth.

With the gold standard, central banks controlled the price.

The classic gold standard period was far from perfect, financial panics still appeared. For example, the U.S. experienced The Panic of 1907, whereby stocks got hammered and banks went belly up. It was one of the primary motivating forces behind the establishment of the Federal Reserve Act of 1913.

But the gold standard era ushered in a degree of global monetary cooperation and a period of rapid growth the world had never witnessed before.

The cornerstone of this system was built on faith ... faith that governments and their central banks would make the necessary adjustments to maintain currency parities.

Why it will be exceedingly difficult to ever return to a gold standard in the current era.

The pressure that 20th century governments experienced to sacrifice currency stability for other objectives, such as full employment, did not exist in the 19th century.

Back then, workers susceptible to unemployment when the central bank raised the discount rate had little opportunity to voice their objections, much less kick out those responsible.

Wages and prices were relatively flexible. Therefore, a shock to the balance of payments that required a reduction in domestic spending could be accommodated by a fall in prices rather than a rise in unemployment. This further diminished the pressure on the authorities to respond to employment conditions. Consequently, the central bank's priority to maintain currency convertibility was rarely challenged.

Now we live in a world where the voters can vote themselves the goodies, and politicians maintain power by promising to dole out those goodies. Indeed, a far cry from the world during the gold standard era.

1946-1971 Bretton Woods System

This was an attempt at another gold standard — a gold-exchange standard to be precise. The dollar was at the center and could be exchanged for gold. There were three major flaws that ultimately led to the failure of Bretton Woods:

First and foremost was the fact that dollar-based credit flooded into the global economy as the U.S. ran a persistent balance of payments deficit. This credit was issued in a big way to fund the Vietnam War and the Great Society social programs.

Second, countries consistently fiddled with the original dollar parities to gain an advantage on trade. In fact, the European country parities were set quite low in order to help them rebuild after WWII. The Marshall Plan also forced dollar credit into Europe so they could buy U.S. goods. However, these parities were never revised upward as was originally agreed upon.

And third, the pegged system required capital controls and could not be sustained as the free flow of capital across national borders increased during this period, which is China's problem today. Pegged rates are artificial and cause speculation. And cross border flows become destabilizing in this environment, where as such flows were stabilizing under the classic gold standard.

This is why I say that China's pegged rate regime is untenable and leading to massive capital misallocation inside the country. It is a one-way bet by speculators who are driving hot money, which adds to China's woes when it comes to controlling credit growth given its dangerous inflationary environment.

1971-Present — Floating Rate System

Our current Fiat Money Standard allows major currencies to float against one another. The market prices are based primarily on supply and demand. It's a system that historically there is no parallel.

It really seems nonsensical that a global monetary regime can grow out of a fiat monetary system whereby there is no real backing of value for the currency other than promises by politicians. But following the breakdown of Bretton Woods that's the system we are stuck with, which has surprisingly served us better than expected. And the U.S. dollar is at the center.

The U.S. dollar is at the center of global trade.

Approximately 64 percent of foreign exchange reserves are denominated in U.S. dollars. That's up about 8 percentage points since 1995, but down about 20 points since 1973. And about 60 percent of world trade is invoiced in dollars.

Ultimately the dollar's position rests on faith of those who hold it and accept it as the standard ... there is no guarantee this faith will be maintained in the future. And rightfully many are concerned given turmoil of the credit crunch and related global imbalances, coupled with irresponsible fiscal spending and debt creation by the U.S. government.

When we add the weight of this to the Fed's dollar devaluation policy in an effort to reflate the global economy, it's understandable why many expect this to be the disruptive shock that alters the equilibrium and ushers in a new international money.

It's an argument that makes a lot of sense ...

But I firmly believe this system has much further to run because there is nothing on the horizon that seems a viable replacement, which we gather from the lessons of past monetary regimes. And despite the current momentum to the contrary, I think there is still a good chance the U.S. can restore some credibility to the system. It won't be easy, but it is very doable.

That said, I remain open to all potentialities if the U.S. doesn't soon show more respect for its reserve currency role in the world.

Key Lessons from Past Monetary Regimes

The classic gold standard served the world best during its reign. And as much as many wax nostalgic, the political realities of the twenty-first century and beyond likely mean we will never again see a similar system implemented. In fact, we are in a period where global cooperation among the leading powers seems to be waning as the new competitor, China, flexes its muscles and monetary nationalism seems to be growing. This is not a fertile backdrop for any new monetary regime to take hold.

Also, pegged rate monetary regimes for major economies are simply not viable in a world where capital is free to instantaneously slosh back and forth across borders. This hot money flow is too broad and becomes destabilizing under such a regime. One example: The hot money flow into China due to their continue attempts to suppress the value of their currency to the U.S. dollar.

As odd as a monetary standard based on currencies with no intrinsic value — fiat money — sounds on the face, it has served global growth surprisingly well thanks to establishment of one central reserve currency. But the system is highly flawed when the reserve country abandons its responsibility, or burden, to maintain confidence in the currency, as the United States has.

Chronic balance of payment deficits and general irresponsible credit creation has been the hallmark over the last decade.

Faith in the U.S. dollar can be restored. But it will take discipline from the U.S. government and monetary authorities — the kind of tough love we saw during the Paul Volcker chairmanship at the Fed in the early 1980's.

This is hardly a resounding vote of confidence in the current floating rate monetary system. But as bad as the current system is I have not seen a viable idea or plan that would improve on what we currently have in place given the divergent interests of the major powers.

I think Milton Friedman summed it all up in an interview he gave in July 1998,

"If a country is an attractive place for foreigners to invest their funds, then that country will have a relatively high exchange rate. If it's an unattractive place, it will have a relatively low exchange rate. Those are the fundamentals that determine the exchange rate in a floating exchange rate system. Let me emphasize that there's nothing special about exchange rates."

Editor's Note: If you are not getting a safe and secured 6% to 12% on your IRA or Roth IRA investments, click here.​

If you found this article helpful, please make a contribution to the site now. Every dollar helps keep this site available. Thank you.

Amount: $ One Time Weekly Monthly Annually

Next >