History of Modern Money

Between 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trade; however, with the start of World War I, the gold standard was abandoned.

At the end of World War II, the conference at Bretton Woods, an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange. As such, an international monetary system, embodied in the International Monetary Fund (IMF), was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy.

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. What this meant was that the value of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.

From this point in, governments used fiat currency as the basis of the monetary system.  This system had two defining characteristics: (a) non-convertibility; and (b) flexible exchange rates. You need to recognise this major shift in history before you can understand why the economic policy ideas that prevailed in the previous monetary systems (based on convertibility) are no longer applicable. You cannot assume that the logic that applied in the fixed exchange rate-convertibility days translates over into the fiat currency era. The fact is that it doesn’t.

Gold Standard & Fixed Exchange Rates


10 responses to “History of Modern Money

  1. Senexx

    Thanks for the overview, Mr Senexx, sir.

    I have a few questions, but let me start with this one: in Prof. Mitchell’s blog article linked

    (Gold standard and fixed exchange rates – myths that still prevail)

    Prof. Mitchell explains the consequences of trade surplus and deficits for nations engaged in international trade. In short, for nations sustaining trade deficit, as they needed to ship out gold (which in reality means that, for all practical purposes, they were paying their deficits in gold), this had deflationary effects (including creating unemployment).

    With Bretton Woods we have that the monetary system is no longer directly based on gold, but on the US dollar.

    However, as the other currencies remain pegged to the dollar, one could conclude that the US dollar is now playing the same role as gold, under gold standard.

    On this basis, could one also conclude that the same kind of consequences would affect nations sustaining trade deficits?

  2. That is correct, which is why in 1971 Richard Nixon ended the Bretton Woods System as can be seen on YouTube and most nations around the world adopted a ‘fiat’ currency.

    • Well, the US had in 1970 and 1971 higher unemployment rates than the average during the period 1950-1971.

      So I guess this fits the theory, although the unemployment rate fluctuated a lot during those years:

      Year Unemployment (thousands)
      1950 3,288
      1951 2,055
      1952 1,883
      1953 1,834
      1954 3,532
      1955 2,852
      1956 2,750
      1957 2,859
      1958 4,602
      1959 3,740
      1960 3,852
      1961 4,714
      1962 3,911
      1963 4,070
      1964 3,786
      1965 3,366
      1966 2,875
      1967 2,975
      1968 2,817
      1969 2,832
      1970 4,093
      1971 5,016

      (Data from the Economic Report of the President, 1995)

      Unfortunately, the ERP does not include balance of payments figures for the same period.

      If I remember well, during those years the US sustained large deficits in its trade with nations like Germany and Japan, but considerable superavit with underdeveloped nations, which provided the US with raw materials.

      I imagine that the surplus was not enough to compensate for the deficits and, overall, the US position was in deficit. And this is what “Dick” Nixon was talking about.

      Is this scheme of things any different from simple mercantilism?

  3. seancarmody

    Mercantilism is, effectively, all about trying to ensure gold flows into your country and any means necessary to support that is to be encouraged, i.e. policies of protectionism to support exports and suppress imports. There are plenty of supporters of a gold standard (or equivalent alternative to fiat money) who would not characterise themselves as mercantilists as they would also support free trade. However, there is a certainly logic to the mercantilist position when you have a gold-standard currency: if you are running large trade deficits, your domestic spending power is eroded. Since fiat money vaporises that issue, it also undermines mercantilism. Having said that, few people seem to understand the significance of the change to fiat money and still cling to fear of trade deficits, while MMT advocates like Bill Mitchell actually argue that there is a sense in which a country benefits from trade deficits as the rest of the world is happy to provide them with real goods and services in return for financial assets, but providing those financial assets does no harm to the domestic economy as the fiat money ensures that domestic spending power need not be eroded.

    As for looking at the data, I would not expect the relationship between unemployment and trade surpluses/deficits to show up too clearly, because the trade balance would be only one factor among many. If you consider that, in the broadest terms, employment is driven by demand for labour, which in turn is driven by demand for goods and services as that demand needs labour to supply the goods and services, then the trade balance can affect the demand for goods and services, but so can other domestic factors (e.g. fiscal policy, external price shocks arising from things like oil price movements) and industrial relations policy will be another factor. So, there would be plenty of noise in the relationship between employment and trade balances during the gold standard/Bretton Woods periods which reflect movements in other variables affecting employment.

    • Hi, Mr. Sean, sir (and you too, Mr. Senexx)

      Thanks for the comments. This is getting interesting!

      “However, there is certainly a logic to the mercantilist position when you have a gold-standard currency: if you are running large trade deficits, your domestic spending power is eroded.”

      No doubt of that. As your spending power depends on your reserves of gold, and you are actually paying in gold for your trade deficits, you are devaluing your currency. Similarly when you operate under the Bretton Woods/US dollar scheme, as the gold vault is substituted by international hard currency reserves.

      This, obviously, is quite convenient, and welcome indeed, in a country running a trade superavit. It’s better still when this country is politically able to manipulate the terms of exchange. It’s much less palatable somewhere sustaining a trade deficit, living on a single export raw material and unable to influence the terms of exchange.

      Obviously, this applies equally under gold standard and under Bretton Woods, as it did during the mercantilist era.

      To put a concrete historical example: this is how the Spanish and Portuguese colonial empires worked. Against what people seem to believe, the metropolis in these empires (paradigmatic of mercantilism), far from abstaining from international trade, forcefully “encouraged” trade colony/metropolis, imposing how the trade was to be conducted.

      “There are plenty of supporters of a gold standard (or equivalent alternative to fiat money) who would not characterise themselves as mercantilists as they would also support free trade.”

      What they call themselves is irrelevant, I would argue, as the free trade they advocate is hardly free (see previous comment).

      (As a joke, I would probably call them other names, but I rather keep these to myself. ;D)

      At least in underdeveloped countries, during the 1980s, these “free-traders” opposed and successfully campaigned against the “import substitution” policies then in vogue in underdeveloped countries, which often suffered from chronic trade deficit. [&]

      As this “import substitution” was largely based on things like tariff/import quotes on imports, I would think that they might have been justified, after all. Let’s remember that we are talking about economies operating under the gold standard/Bretton Woods scheme.

      And, although I confess am not familiar with the economic history of South Korea, India and Taiwan, I’ve heard explanations of their relative success based on the idea that they did not abandon the import substitution polices.

      “MMT advocates like Bill Mitchell actually argue that there is a sense in which a country benefits from trade deficits as the rest of the world is happy to provide them with real goods and services in return for financial assets”

      I reckon I understand your meaning: in essence, you are paying with bits of information, for real goods.

      As this may be a sensitive point, let me first state that I don’t mean to be controversial here and if I am mistaken, apologies in advance.

      However, I find disturbing this unqualified eagerness some chartalists seem to manifest for world trade (and I leave open the possibility that I may have misunderstood Prof. Mitchell).

      And I say it’s disturbing for a multitude of reasons, not the least of which is what you, Sean, have already acknowledged: “few people seem to understand the significance of the change to fiat money”. In other words: whatever the possibilities fiat money opens, if a government refuses, or is not allowed, to exploit them, any pernicious effects of world trade will not be overcome by an expansionary fiscal policy, simply because the fiscal policy will not be expansionary.

      I sustain that this has happened at least in the US and part of my reasoning coincides with the Krugman note about ideology, inequality, indebtedness and financial crises.

      Some further related criticisms were leveled against world trade in a post about China at billyblog (where, if memory serves, Prof. Mitchell was referring to a post by Krugman about China), maybe a couple of months ago. About the same time I posted a reference at the Stable. Perhaps you or Senexx remember.

      There is a couple of observations that I would like to add: world trade by necessity implies an expansion of the financial services industry. By this I don’t mean only an increase in the volume of money handled, in toto or by individual financial institutions, but also an increase in the level of complexity of the financial instruments used and on the speed with which transactions take place.

      It may sound presumptuous of me to mention this you, guys (working as I suppose you both do in the financial industry), but world trade also enhances the financial aspect of otherwise non-financial industries: say, an iron ore mine that otherwise would be marginally profitable, can suddenly become viable if financial investors, for whatever reason, decide to put money in it; it can become again non viable if they change their minds.

      All of this, also by necessity, introduces a lot of complexity and instability to the whole system.

      Anyway, again thanks for the food for thought and apologies if this somehow appears controversial.



      Import substitution industrialization

      See also

      Dependency theory

      Singer-Prebisch thesis

      • That’s some comment! Almost a blog post in itself. I’ll have to take some time to digest it all. After all, I am a humble mathematician not an economist. One very small comment I would make is that when you say “you are devaluing your currency”, I would say that, strictly speaking, your currency is not devalued, you just have less of it (as gold leaves the country, the central bank takes currency out of circulation).

  4. seancarmody

    Further to my last comment, here’s a relevant quote from a recent Mitchell blog post:

    “The modern policy framework is in contradistinction to the practice of governments in the Post World War II period to 1975 which sought to maintain levels of demand using a range of fiscal and monetary measures that were sufficient to ensure that full employment was achieved. Unemployment rates were usually below 2 per cent throughout this period.”

  5. Fiat money came into use well before the gold standard ceased. Indeed even when our ancestors used barter as the means of exchange, the writing of time-limited promissory notes was practiced. These notes soon became recognized as a kind of money too. In order to expedite their use and hurry the release of the bond to which their writers were held, “clearing-houses” were established in Europe, if not the US too. These preceeded the banks, where for a smaller amount of gold that the face-value of the note, a claimant could collect his universal transferable unit of value and emigrate. These notes therefore became the first form of money before coins were used.

    • This is discussed in the more advanced literature available on this subject. It is not discussed on this blog. It is late otherwise I would find a link and present it. What you state is largely correct. It is made relatively clear in the first chapter of L. Randall Wray’s Understand Modern Money, I think.

    • Coins minted by the state, even if gold, are fiat, too. E.g. seignorage of varying degrees is added to the face value.

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