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Globalizing Capital, a History of the International Monetary System

Barry Eichengreen

posted on 14 March 2007

reviewed by Joseph L. McCauley

The basic idea of complexity is the absence of scaling laws, the absence of attractors and symbolic dynamics, and instead the occurrence of surprises at all length scales. In a complex system the future, given a precise initial condition, is not even statistically predictable. Goldenfeld has recently written some interesting papers challenging this description but I haven't yet understood them. Markets are known to be complex, yet we can describe the noise making up finance markets in our era (the last 17 yrs.) via simple stochastic dynamics. We cannot describe the expected return in any useful way. Complexity enters financial markets in at least two ways: via the expected return, and through unexpected shifts in the noise distribution.

According to Eichengreen, whose history of the gold standard and its demise reads as close to a novel as is possible for such a dry but important subject, there was a fundamental shift in the FX noise distribution after WWI. Until the Great Depression the Western countries tried more or less to stay on a gold (or, in the case of Brittain, silver) standard. The main job of central banks and parliaments was to keep the currency from falling too far below or above a value backed by gold. Before WWI speculators, confident that governments could be relied on eventually to react to maintain the currency, applied negative feedback to any deviations, expecting a profit in the long run. If true, this would mean that financial markets were approximately asymptotically stationary in that era. After WWI FX markets became volatile and nonstationary: speculators, expecting any sign of devaluation of a currency to reflect the inability of a government to maintain the gold-value of the currency, applied positive feedback and bid the currency lower. That shift in agents' expectations is attributed in part to the fact that government spending on social programs was largely negligible before WWI, but had to be taken seriously by 1930. FDR's famous Bank Holiday was not a consequence directly of The Great Depression, but rather of a run on gold by speculators getting rid of the dollar: they expected social spending and consequent inflation (Keynes's recommendation for getting out of the slump). So in 1935 FDR outlawed the ownership of gold by Americans, recalled all gold coins (excepting coin colectors), and fixed the price of gold artificially at $35/oz. The US could spend freely on public works projects and get away with it because we had the largest gold reserves in the world (France and surprislingly, Germany, were not far behind). As an anecdote, my (German originated from Colonial times) Grandfather on my mother's side told how his father (a farmer in the hillie billie land of Eastern Kentucky, where I grew up) dutifully (under threat of serious punishment for violators) dug up jars of gold coins and handed them in. After WWII came the Marshall Plan, and by this mechanism US gold reserves were effectively transferred to Europe via massive postwar spending to rebuild Germany, France and England. By 1964 the Dollar was weak enough that silver coins were worth more than their face value, so LBJ stopped minting them (had I understood the meaning of that act I could have made money, alas, understanding generally comes too late). The Vietnam War caused inflation, as do all wars (no well-off population would ever choose war were the costs explained in advance, and were it understood that the war must eventually be paid for via either higher taxes, inflation, or generally by both). So by 1971 France held enough Dollars to demand payment in gold that would have cleaned out Ft. Knox, the US gold depository in Kentucky. Therefore, Nixon deregulated the dollar (he first raised the official price of gold to $38) and the rest is history. By 1973 gold hit $800/oz., the Arabs, being smart businessmen understood (a lot better than I did!) and raised the price of oil drastically. A VW Beetle that had cost $700-800 in 1968 cost $1600 by 1974, and the oil price had doubled in dollars as well. One can count this as the beginning of deregulation in American politics. The inflation became so bad ('stagflation') that Volcker let interest rates float to 13.5%, killing the inflation by 1983, and Reagan-Thatcher-Friedman omics began its (until recently) unchallenged heyday, with Reagan busting the US budget worse than any President aside from W.

Today, instead of gold, we the IMF and other agencies that try to play a quasi-regulatory role in maintaining quasi-stability of currencies, although stability is certainly the wrong phrase here. Currencies remain strong when a strong enough country pays higher interest rates, which also is a deflationary mechanism. A weak currency like the US Dollar, with trade and budget deficits running through the ceiling since W took office, can finance its debt only through attracting foreign money via high enough interest rates. A small country like Argentina cannot do that: the US gets away with it only because speculators do not believe that the US will allow the dollar to collapse (which reminds us vaguely of the way that the gold standard worked before WWI). I.e., the whole edifice is built on air.

Gold had to be eliminated. The worldwide economic growth that we've experienced in the last 50 yrs. is due to liquidity: credit. Without fractional reserve banking and extensive credit, economic growth is impossible. Money is literally created by the tap of a computer key when you use your credit card. Governments in our era use interest rates to try and keep this in check (for reference, when I first went to Germany in 1985 one could not buy a car on credit, and credit cards were useless in restaurants and at gasoline stations). As Eichengreen describes it, it was a small increase in interest rates that caused the 1929 Crash, the central bank saw the bubble and wanted to let the air out. One saw exactly the same effect in 1999-2000 when Greenspan popped the dot.com bubble by several small but systematic increases in interest rates. Econophysicists and financial engineers do not appreciate the enormous effect that a sequence of small interest rate increases can have. We don't know how to model things like that correctly, unfortunately. The history of globalizing capital can therefore be seen systematically as the history of the increase in liquidity and deregulation. It was, in fact, only a few years ago that the Glass-Steagal act was trashed by the believers in free markets who dominate the US congress, allowing banks to go back into the stock market business. The entire program in deregulation is based on an uncritical belief in a nonexistent stability of unregulated markets.

I've given only a birdseye view, Eichengreen provides all the details. It would be interesting to analyze the claimed shift in noise empirically, but unfortunately the data are too sparse for any attempt to be worthwhile.