Global currency Dollar

Subject: Economy

Context:

Many countries have started settling trade transactions in local currencies rather depending on dollar

Concept:

• Since the early 19th century, countries struggled to find the best way to settle trade balance.
• It was not easy as each had its currency with no check on more printing. Finally, most countries agreed to settle trade deficits through the exchange of gold. This system continued up to Word War I.
• Then many countries stopped their currencies’ convertibility to gold so they could print more money to finance the war effort. Disappearance of gold as a common anchor led to the collapse of the global financial system and became one of the reasons leading to great depression in the early 1930s.
• Realising the importance of an anchor like gold for promoting stable trade and finance, countries on the winning side of Word War II agreed to establish a robust global financial system.
• US proposed that the new system should rest on both gold and the US dollar. Except for the Soviet Union, all 44 participating nations signed the Bretton Woods agreement in 1944 at Bretton Woods, New Hampshire, US.
• The member-countries agreed to maintain a fixed exchange rate which could be adjusted if deficits or surpluses persisted. The International Monetary Fund (IMF) was created to lend to member-countries in need of foreign exchange.
• The price of gold was fixed at $35 per ounce. The US agreed to supply gold at this price in the exchange with dollars held by other countries.
• The gold for dollar system worked during 1950-70. But it came under strain as the US started printing and spending a large value of dollars on post-war reconstruction efforts. When countries holding these dollars went for exchange with gold, the US gold reserves started vanishing.
• Gold supply was finite, but the dollar printing knew no limits. The story came to an end in August 1971 when the US reneged from its commitment to convert the US dollar to gold.
• De-linking gold with dollar made the US the linchpin of global finance. Other countries need to earn foreign exchange by exporting; the US Fed has just to hit the print button. Fed has almost become the central bank of the world. Central banks all over the world must calibrate their policies to be in sync with the Fed’s.
• A country’s economy is ransom to Fed’s actions. If Fed increases the interest rate, dollars flow back to the US, and if it lowers rates, dollars move to the world to take advantage of growth stories or interest rate arbitrage of individual countries.