International Paper-Money Systems, 1971–?

1. The Emergence of Paper-Money Standards

The Fed’s suspension of payments in August 1971 created in one mighty stroke a great number of paper monies. Before that date, all national currencies were basically fractional-reserve certificates for gold (via the U.S. dollar). The suspension “transubstantiated” these certificates into paper monies, with all the concomitant effects we have discussed above.

Many observers believed that the world would remain so fragmented. Advocates of paper money thought this was all well and good, because each government was now at last autonomous in its monetary policy. Others looked with horror on the reality of fluctuating exchange rates, which undermined the international division of labor and thus created misery and death for many millions of people. But the world did not long remain in monetary fragmentation. The events of the past thirty-five years illustrate that there is a tendency for the spontaneous emergence of international paper-money standards. Today the reasons for this development are not difficult to discern.^[1]

One driving force of this process was of course the presence of private individuals and firms operating in many countries. These persons and organizations constantly look for ways of saving money, for example, by minimizing the costs of holding money. One way to do this is to make the bulk of one’s payments in terms of only one kind of money. But this driving force, formidable though it might appear in our present time of multinational corporations, does not go a very long way in explaining the emergence of an international paper-money standard. The reason is that multinational corporations do not play a great role in a world of wildly fluctuating exchange rates. They operate profitably and grow to significant size only when the political framework has already stabilized the foreign exchanges. That is, by and large they come into play only once a monetary standard already exists.

This brings us to the main driving force of the emergence of international paper-money monetary standards, namely, the constant appetite of governments for additional revenue. Most governments that obtain income mostly from their own citizens—be it in the form of taxation or in the form of debt— have a rather small revenue base. To increase revenues they have by and large only two strategies: (1) induce foreign citizens to buy its bonds; (2) adopt policies that make their own citizens richer, so that they can pay more taxes and buy more government bonds.

No investor intentionally wastes his money. When he buys the bonds of a foreign government, he seeks to earn interest. He would abstain from the deal altogether if he had good reasons to believe that the money would be wasted. If he must fear, for example, that the debtor-government will simply print the money needed to pay back the credit, thus provoking a fall in the exchange rate, he will not buy its bonds at all.^[2] Thus the question is what a susceptible debtor-government can do to dispel such fears. The answer is that it must establish institutional safeguards against a falling exchange rate of its currency in terms of the currency used by its creditors.

The same considerations come into play if we turn to the second fundamental strategy for increasing public revenue. The idea is very simple: adopt policies that permit the citizens to make themselves richer so that they can pay more taxes and buy more government bonds. But the crucial point is that the productive capacity of a nation entirely depends on the capital stock it can use. This capital stock could be increased through savings from current income. But the accumulation of capital through savings can take many years and decades until it reaches any significant proportion. And during this time the government must keep the tax load as small as possible. Unfortunately such restraint requires more virtue than most governments have. The only remaining way out is, again, to encourage foreigners to provide capital that they have accumulated in their home countries—in other words, to make “foreign direct investments” in that country. But this reverts back to our previous consideration. In a paper-money world, foreign capital can be attracted only under sufficient institutional safeguards.

Four such institutions have played a significant role in the past thirty years. They go a long way in explaining the emergence of international paper money standards.

First, debtor-governments have floated bonds that were denominated in a foreign paper money, the production of which they cannot directly control; preferably this would be the paper money used in the country of its creditors. In the past twenty years, this has become a widespread practice. Today many governments issue bonds that are denominated in U.S. dollars or euros.

Second, the government and/or the monetary authority of the country in which the creditors reside could give explicit or implicit guarantees to maintain the market exchange rate. It is widely assumed, for example, that the U.S. Federal Reserve gave such guarantees in the 1990s to the governments of Mexico, Singapore, Malaysia, Thailand, and other countries of the Far East. The great disadvantage of this practice is that it entails moral hazard for the beneficiaries. The receiving governments can set out to inflate their currencies without fearing any negative repercussions on the exchange rate. And thus they are able to expropriate not only their own population, but also the population of the country in which its creditors reside.

In the above-mentioned cases, the exchange-rate policies of the Fed had the effect of making U.S. citizens pay for the monetary abuses of the governments of Mexico and other countries. (They pay by constantly delivering goods and services to Mexico that they could have enjoyed themselves and in payment for which nothing but peso-denominated paper slips are sent to the U.S.) Because no diplomatic solution could be found for this problem, the Fed eventually abolished its policy and thus provoked financial crises in Mexico (1994) and various other countries, especially in Asia (1997). Since then, there have been no new major experiments with exchange-rate stabilization.

Third, debtor-governments have set up currency boards, thus transforming their currency into a substitute for a foreign paper money. This technique too is widely used today, for example, in Hong Kong, Bulgaria, Estonia, Lithuania, Bosnia, and Brunei.

Fourth, debtor-governments have abandoned the use of the national currency altogether and adopted the use of the paper money used by the creditors. Economists call such a policy “dollarization,” even when the government adopts not the U.S. dollar, but a different foreign paper money. Among recently dollarized countries are Ecuador, El Salvador, Kosovo, and Montenegro.^[3]

We conclude that the driving force for the emergence of an international paper-money standard is the quest of governments for additional funds, which most of them can obtain only from abroad. And our analysis also explains which paper monies will tend to be chosen as international standards: the paper monies that are legal tender in the territories with the largest capital markets. In the period under consideration, these territories happened to be the U.S., Japan, and Europe. It is therefore not surprising that the U.S. dollar and the yen have emerged as regional monetary standards of the world economy.

The operation of the same mechanism could be observed in the case of the German mark, which during the 1990s was used as a (unofficial) parallel currency in many countries of the former East Bloc. And it currently brings about a wider geographical circulation of the euro, which was only created in early 1999, and which did not exist in the form of banknotes before the year 2002. The creation of the euro is of some interest because here an international standard did not emerge through the unilateral adoption of paper money used on foreign capital markets, but through merger. This form of monetary integration could play a role in the future development of the international monetary order. We will therefore take a brief look at it.^[4]

2. Paper-Money Merger: The Case of the Euro

After the demise of the Bretton Woods system in 1971, the countries of Western Europe for a few years fell into monetary disarray and the fiscal anarchy that typically goes in hand with it. Each national government issued its own paper money and started piling up public debts to an unheard-of extent. The newly available funds were used to expand government welfare services. For a while, things looked rosy and only a few fiscal conservatives bemoaned the new laxity. But soon even the champions of the new policy began to understand that the new monetary order affected their interests in very tangible negative ways. Exchange rates fluctuated very widely and effectively prevented the further development of international trade. The division of labor in Europe, one of the most densely populated regions of the world, lagged behind the American economy and even—or so it seemed in those days—the Soviet economy. It was therefore but a question of time until tax revenues would fall far behind the revenues of the great competitors of the European governments: the governments of the U.S. and of the Soviet Union. Something had to be done.

The first attempts at stabilizing the exchange rates between European paper monies had failed miserably. Then, at a December 1978 conference in the German city of Bremen, the core governments of the European Economic Community, as it was called in those days, launched a new attempt at integration: the European Monetary System (EMS). The EMS was a cartel of the national paper-money producers, who agreed to coordinate their policies in order to stabilize exchange rates between their monies at certain levels or “parities.” As in the case of the previous international banking cartels, the EMS essentially relied on the self-restraint of its members. “Coordination” meant in practice that the least inflationary money producer set the pace of inflation for all others. If for example the supply of the Italian lira increased by 30 percent, whereas the supply of French francs increased only by 15 percent, it was very likely that the lira would drop on the foreign exchanges vis-à-vis the franc. In order to maintain the lirafranc parity, it was necessary either that the Banque de France increase the production of francs, or that the Banco d’Italia reduce its production of lira. As we have said, the EMS essentially relied on self-restraint; thus in our example the Banca d’Italia would be expected to reduce its lira production. If for political reasons it was unwilling to do this, there would be a “realignment” of the parity, and stabilization would henceforth seek to preserve the new parity.

Now by far the least inflationary money producer happened to be the German Bundesbank. Accordingly, for the next twelve years or so, the main problem of European monetary politics was that the Bundesbank did not inflate the supply of the Deutsche mark quite enough to suit the needs of foreign governments. The latter were therefore forced to cut down their money production. It also came to frequent changes or realignments of parities. The problem was settled only in the early 1990s, when the German government sought to take over former communist East Germany and needed the consent of its major western partners. The price for that consent was the abdication of the Deutsche mark.^[5] Within a few years, the political and legal foundations were laid for merging the different national paper-money producers into one organization: the European System of Central Banks (ESCB), the coordination of which lay in the hands of the European Central Bank (ECB). The ESCB started its operations in January 1999 and three years later issued its euro notes and coins.

From an economic and ethical point of view, the euro does not bring any new aspects into play. It is just another paper money. In public debate, the introduction of the euro has often been justified by the benefits that spring from monetary integration. It is true that such benefits exist. But, as we have repeatedly emphasized in our study, these benefits can be obtained much more conveniently and assuredly by allowing the citizens to choose the best money they can get. If this had been the policy of the European governments, it would not have prevented European monetary unification. But this would have been a spontaneous unification. Gold and silver coins would have been the harbingers of monetary integration under the auspices of liberty and responsibility.

But the European governments never intended to grant their citizens the sovereignty that they have according to the letter of written constitutions. The governments wished above all to stay in control of monetary affairs. It was out of the question to abolish the privileges for paper money. European monetary integration had to be built on paper money, for the sole reason that paper money is the source of virtually unlimited government income, at the expense of the population. This is a point that cannot be emphasized enough. The euro was not introduced out of any economic necessity. All true benefits that it conveys could have been conveyed much better through commodity monies such as gold and silver.

The story of the euro is not a success story, unless the standard of success is to be seen in the expansion of government power. Yet the euro story could be seen as a model for further monetary integration on a global scale.

3. The Dynamics of Multiple Paper-Money Standards

The international monetary order at the outset of the twentieth-first century is characterized by the presence of several competing paper-money systems. Each of these systems is hierarchical, with standard paper money on the one hand, and a plethora of secondary and tertiary currency on the other hand. The three most important standards are the yen, the dollar, and the euro. Only these standard monies are true monies—paper monies or electronic monies. The secondary currencies in each of the three systems are not monies at all; rather they are national certificates for the standard money, issued on a fractional-reserve basis by a national authority (usually called a “central bank” or “currency board”). And then there are tertiary currencies that are also fractional-reserve certificates, in particular, the demand deposits of commercial banks.

We have already discussed the dialectical power relationship between national central banks and commercial banks under the gold standard. Similar considerations apply in the present case. The difference is, of course, that there is no longer any commodity-money standard that could act as a natural restraint on the drive to inflate. Even more to the point, it is at present equally impossible to restrain this drive by legal means, because the principle of national sovereignty still holds.^[6] As a consequence, the secondary and tertiary layers have, in the present order of things, far greater power to inflate than they ever had before. Let us explain this in more detail.

The producers of international paper money have the privilege of picking those who receive the newly printed notes first, and they have political leverage on the producers of the secondary currencies in times of crises. But this dependency is mutual. Consider that, within each nation, the commercial banks can exploit the moral hazard of the central bank. They can push inflation with the good hope that the central bank will bail them out in times of a liquidity crisis. In an international paper-money system, the same mechanism bears on the relationship between the producer of the standard money and the producers of the secondary and tertiary currencies. The latter have an incentive to push inflation and speculate on bailouts.

If the producer of the standard money gives in to these demands, the exchange rate of his money will drop and the price level will increase. Both events will tend to make his money less attractive as a financial asset. Moreover, both events will tend to make the economies in which his money is used less attractive places to invest in. If he undertakes a major bailout, he even risks a hyperinflation and subsequent destruction of his product.

But our producer of standard money also runs into difficulties if he does not give in to any bailout demands. Consider the following scenario. The hypothetical country Ruritania has a currency board issuing Rurs backed up with dollars. The dollar exchange-rate of the Rur has been set at a very low level in order to encourage exports to the U.S. The dollars that stream into Ruritania as payment for these exports are not spent on U.S. products, but stockpiled as reserves in the vaults of the local central bank. Suppose further that the commercial banks of that country have created a huge amount of credit out of thin air (inflation) and are now in a liquidity crisis. The Ruritanian currency board turns for help to the U.S. Fed, but the Fed refuses to bail out the Ruritanian banks. At that point, the currency board could threaten to sell all its dollars for euros, thus putting the country on the euro standard. Depending on the size of Ruritania, this action would have a more or less notable impact on the dollar-euro exchange rate. It would harm the U.S. capital markets and thus provide an incentive for investors to leave Manhattan and Chicago, and to turn to Frankfurt and Paris. Moreover, if we assume that Ruritania is a very large country with substantial dollar reserves even by world standards, then the mere announcement that the Ruritanian government will switch to the euro standard might incite other member countries of the dollar standard to do the same. This could precipitate the dollar into a spiralling hyperinflation. The dollars would sooner or later end up in the United States, the only country where people are forced to accept them because of their legal-tender status. Here all prices would soar, possibly entailing a hyperinflation and collapse of the entire monetary system.

The same considerations apply, mutatis mutandis, to all other international paper-money standards. The point is that, in the present regime of virtually unhampered international flows of capital, it is out of the question to prevent the outflow of standard money into foreign countries. And the more of that money that accumulates abroad, the more its producer risks being subject to the sort of blackmail we have already discussed.^[7] Notice the irony that the potential for such blackmail is greatest precisely when the institutional safeguards against fluctuating exchange rates are strongest—in the case of currency boards and dollarization.

The leadership of the U.S. Federal Reserve is aware of this situation. To guard itself against the danger of switching, it has developed a program of shared seignorage. That is, U.S. authorities actually pay foreign governments for dollarizing their economies, and especially for maintaining the dollarization.

However, such schemes for the integration of standard monies and secondary currencies have been applied, so far, only in relatively unimportant cases. The only realistic scenario that could curb the expansionary drift of monetary blackmail as analyzed above is cooperation between the producers of standard paper money. For example, if in a dollar crisis the euro producers commit to stabilize the dollar-euro exchange rate on the downside, then the financial incentives for going out of dollar-denominated assets and into euro-denominated assets would largely disappear.

But why should producers of standard money such as the euro be willing to assist a competitor in dire straits? There are at least two good reasons for such cooperation. First, they might wish to discourage monetary blackmail by the producers of secondary currencies, because in the next round they themselves could be the victims of such attempts. Second, they themselves would be negatively affected in the event of a currency crisis hitting their competitor. It is true that in the short run they would benefit from investors rushing into euro-denominated assets. However, they could not prevent that the same investors rush out again once the dollar-crisis has been solved, for example, through some monetary reform. Standard paper-money producers would thus be ill-advised to play cat and mouse with international investors, in the hope to profit from a currency crisis hitting one of their competitors.

Now the crucial point is that all relevant parties know all this and that therefore moral hazard comes into play again. Paper-money producers have a strong incentive to expand their production because they know that their competitors, acting in their own interest, would be likely to assist them whenever they are threatened with a currency crisis. Thus we find the same strong incentive for expansionary collusion between paper-money producers that we have already described in earlier sections for the case of domestic fractional-reserve banks. This monetary expansion path results from the very nature of paper-money competition, just as the expansion of fractional-reserve certificates results from the very nature of competitive fractional-reserve banking.

Is there any way out of this monetary quagmire? One solution would be the return to autarky, cutting all ties with the international currency and financial markets; but this would entail misery and starvation, and is therefore not really an option. Another solution would be to merge the standard paper money producers, possibly along the lines of the European System of Central Banks and possibly along with international regulation of capital markets and the banking industry.^[8] But is world paper-money union a viable solution?

4. Dead End of the World Paper-Money Union

As we have seen, there is a strong tendency for the formation of currency blocks around the paper monies used in the countries with the largest capital markets. The driving force in this process is the quest of foreign governments for additional revenue. The governments that control the large capital markets have little incentive to adopt the currencies controlled by other governments. But governments that control only a small tax base and cannot tame their appetite for more money must at some point turn to international capital markets; and this sooner or later forces them to adopt a foreign paper money, or to merge its paper money with the paper monies controlled by other governments.

We have also seen that the connectivity between international capital markets creates an incentive for competing standard paper-money producers to cooperate and, eventually, to merge. This consolidation and centralization process is at present far from being completed. Today’s international monetary order is an order in transition. In the preceding section we have analyzed some of the problems that could manifest themselves in the next few years if political leaders do not take appropriate action. We have pointed out that one way of avoiding a world of spiraling hyperinflations and currency wars is global monetary integration on a paper standard. There would then be just one paper money for the entire world, possibly with a few remaining national paper currencies that serve as money certificates for the global money. The great project that Lord Keynes unsuccessfully promoted at the 1944 Bretton Woods conference would then finally have come true.

We have already pointed out all essential implications of such an event. Even a national paper money is a powerful engine of economic, cultural, and spiritual degradation. How much more would this be the case with a global paper money? Such a monetary regime would provide the economic foundation of a totalitarian nightmare.

It is true that we are still far away from this scenario. Great obstacles stand in its way, because it would require no less than a political unification of mankind. But let us assume for the moment that these problems could be overcome in the near future. And let us also assume that fears of totalitarianism could be dispelled by an appropriate moral education of political leaders, who would then excel in the art of self-restraint. Would this solve the problem of monetary constitution? Would it give the world a true monetary order that did not bear in its very bosom a tendency for self-destruction, a tendency inherent in all fiat monetary systems?

In light of our general discussion of paper money, the answer is patent. All paper-money systems, be they national or international, labor under the presence of moral hazard. In the long run, therefore, a global paper money cannot evade the fate of national paper money. It must either collapse in hyperinflation or force the government to adopt a policy of increasing control, and eventually total control, over all economic resources. Both scenarios entail economic disruptions on a scale that we can barely imagine today. The inevitable result would be death for many hundreds of millions of human beings.

There is hope, however. Mankind is free to return at any time to the natural production of money, which is in fact the only ethically justifiable and economically viable monetary order.