Currency adrift – 50 years after the “Nixon shock”

Nikkei50 years ago a major event in the history of money occurred — the “Nixon shock” of August 15, 1971. The “floating exchange rate system” that became the norm after this spurred the development of the global postwar economy. However, it has also frequently caused crises in emerging countries. Recently “digital currencies” have begun to spread, and there are signs that the reserve currency system based on the dollar may be changing. How will the future of currency impact the global economy?

The beginning: chaos in the yen market in 1971

Long-term trends in the U.S. dollar and Japanese yen

At the start of the era of floating exchange rates, the yen rose against the dollar. The yen stood at 360 yen per dollar under the post-war fixed exchange rate system, but it nearly tripled to 100 yen per dollar after the full transition to the floating exchange rate system in 1973 and the Plaza Accord, which sought to address the dollar’s appreciation, in 1985. The yen is considered a relatively safe financial asset, and it reached a postwar high of 75.32 yen per dollar in 2011 after the massive earthquake and tsunami in northeastern Japan.

The rules of currency have changed Nixon shock

Modern currencies were backed by the fact that they could be exchanged for gold. The postwar international monetary system was also supported by the U.S. guarantee that gold could be exchanged for dollars at any time. However, as public finances in the U.S. deteriorated in the 1960s and 1970s with the growing military spending associated with the Vietnam War, gold flowed out of the country. Faced with a shortage of gold and inflation, U.S. President Richard Nixon shocked the world by announcing the U.S. would suspend the exchange of gold for dollars.

Start of the floating exchange rate system

After the discussions that followed the Nixon shock, the era of floating exchange rates, backed by the dollar as a reserve currency, began. Eliminating the exchange of gold made it easier for each country to adjust the amount of its currency in circulation, increasing the freedom of monetary policy. However, the ease with which capital could move across national borders made currency crises and price fluctuations due to sudden capital inflows and outflows more common.

The world’s 160 unsteady currencies

There are about 160 currencies in the world, and 31 countries, including 19 in the eurozone and Japan, have a free floating exchange system that allows the market to determine the currency values. Other countries actively intervene in foreign exchange markets to curb capital outflows, or maintain fixed exchange rates with the dollar or euro.

Global exchange rate systems

  • (darker blue) Free floating exchange rate
  • (lighter blue) Managed floating exchange rate
  • (darker orange) Fixed exchange rate
  • (lighter orange) Between fixed exchange rate and floating exchange rate
  • (pink) No separate legal tender

Source: IMF(2020)

No separate legal tender

Legal tenderCountry
U.S. dollarEl Salvador, Ecuador, Panama, Palau, Micronesia, Marshall Islands, Timor-Leste
EuroKosovo, Montenegro, San Marino
(*Countries outside the eurozone that have adopted the euro)
Australian dollarKiribati, Tuvalu, Nauru

13 countries do not issue their own national currencies and instead use the U.S. dollar, the Australian dollar or the euro. In Latin America, discussions of “dollarization” grew because of major currency crises and inflation, and El Salvador and Ecuador abandoned their own currencies in the early 2000s. After World War II, some smaller countries that became independent and had strong ties to the U.S. dollar continued to use that currency.

Dollar pegs in doubt

Reuters

Many emerging countries maintain a fixed exchange rate with the dollar by intervening in foreign exchange markets and adjusting interest rates. Their goal is to attract overseas capital by suppressing currency fluctuations. However, because their monetary policy is affected by the dollar’s movements, it often is not suited for domestic economic conditions. In Hong Kong, where China is tightening its grip, some speculate that the Hong Kong dollar’s peg to the U.S. dollar will be abolished.

Struggling with U.S. interest rate predictions

Turkish lira plummets

Source: World Bank, FRED

Because the U.S. dollar is the world’s reserve currency, the currencies of other countries with floating exchange rates are affected by the monetary policy and foreign policy of the U.S. Notably, capital tends to flow into the U.S. when the FRB raises interest rates, and the currencies of countries with current account deficits and insufficient foreign exchange reserves tend to be sold off. When the U.S. raised interest rates in 2018, the Turkish lira plummeted after then U.S. President Donald Trump imposed economic sanctions on Turkey. Other emerging market currencies also sold off. There are now worries that as the monetary easing spurred by the new coronavirus pandemic is scaled back, emerging currencies could once again weaken.

Structural problems with the monetary system

Unchecked monetary expansion

World money supply (% of GDP)

Source: World Bank (money supply includes cash, deposit currencies, and other securities)

With the switch to floating exchange rates, countries no longer needed to exchange their currency for gold and could issue more money than they had gold. Increasing the amount of money in circulation makes it easier to grow the economy. However, growth in demand could not keep up with the swelling amount of money, and crises were exacerbated by speculative transactions that used the surplus funds.

Repeated currency crises

Movements in the Thai baht

Source: FRED

Thailand financial account balance

Source: IMF

Crises because of sudden inflows or outflows of funds are more likely because of the ease with which capital moves across national boundaries. In the 1980s-90s, there were currency crises in Latin America, such as the Mexican peso crisis, and in 1997 the Asian financial crisis was triggered by the collapse of the Thai baht. At that time, the country still had a weak economic system despite a rapid influx of funds thanks to high expectations for the emerging industrial nation. The led the baht to be overvalued, causing investors to sell. The country’s bubble economy suddenly shrank due to capital outflows, and the crisis spread to other Asian countries.

Contradictions of the dollar as a reserve currency

The global economy will be greatly disrupted if confidence in the dollar — the reserve currency at the heart of trade and financial interactions — is shaken. But the dollar’s status as the reserve currency is a contradiction for the U.S. too, and something of a double-edged sword.

For dollars to circulate throughout the world, the U.S. needs to supply dollars by buying goods and services from other countries. But the continued supply of dollars means the U.S. must run a current account deficit, causing confidence in the dollar to waver. This contradiction is known as the “Triffin dilemma,” named after the economist who first noted it.

U.S. current account balance

Source: U.S. Department of Commerce

If the Biden administration’s massive spending leads to an unchecked increase in the current account deficit, confidence in the dollar will waver. Market participants are worried about the potential risk of a sharp drop in the dollar.

The future of the monetary system

What does the future of currency look like? Much of the focus will be on the “dollar hegemony.” In the past, the economist John Maynard Keynes proposed a supranational currency, and many since then have continued to question the dollar hegemony. Some predict a multi-polar era in which multiple currencies will be the center of trade and settlement, and Facebook has sparked a global debate on the future of “digital currencies.” In 2021, El Salvador will become the first country to recognize Bitcoin as legal tender, and others may try to break away from their “dollar dependence.”

I. The idea of a supranational currency

Keynes represented the U.K. at the Bretton Woods Conference, which laid out the postwar monetary framework. He proposed the major countries form a monetary union and create a shared supranational currency.

The U.S. opposed this idea, leading to an international monetary system with the dollar as the reserve currency.

II. Questioning the hegemony of the dollar

Immediately after transitioning to floating exchange rates, the global economy was hit by an oil shock. Friedrich Hayek, a liberal economist, noted that rising prices and an uneven distribution of wealth are inevitable in a system where the state has a monopoly on seigniorage (profits from currency issuance). He argued that the world should shift to a system of “free monies” in which non-state actors could freely issue money.

Paper euros entered circulation in 2002 and national currencies were abolished

After the financial crisis, the U.S. was one of the first countries to introduce quantitative monetary easing to help the economy recover. Professor Barry Eichengreen of the University of California, Berkeley, noted that it is an “exorbitant privilege” to be able to issue a reserve currency, which allows for low interest rates and expansionary fiscal policies without regard for exchange rates. He predicted that the U.S. would lose this privilege if it could not keep its budget deficits in check, and a multipolar era of multiple currencies would ensue.

III. The emergence of digital currencies

Facebook announced the idea of “Libra,” a global payment method that is not tied to a specific nation and is backed by multiple legal tenders.

Facebook abandoned the idea after facing opposition from regulators in various countries, who said it would undermine monetary policy and currency stability. The system was changed to be linked to a single currency, like the U.S. dollar.

Mark Carney, former governor of the Bank of England, noted the risks of a monetary system dependent on the dollar at a meeting of central bank leaders and economists from around the world. He called for countries to work together to build a digital “synthetic hegemonic currency” to rival the dollar.

System will officially come into place in 2022 after testing at the Beijing Winter Olympics.

Although it has abandoned the idea of creating a supranational currency, Facebook wants to reboot its idea as a digital currency that is linked to a single currency, such as the U.S. dollar. As a first step, the company plans to issue “Diem (renamed from Libra) USD,” linked to the U.S. dollar, by the end of 2021.

Currencies auguring the future of the economy

Monetary regimes that encourage free capital transactions have made the global economy both more developed and more vulnerable. With the recent spread of digital currencies, the prospect of a new monetary regime has become more realistic. However, international debate over mechanisms for guaranteeing credit and the nature of monetary policy has only just begun. It remains to be seen how currencies will change the future of nations and economies around the world.

Editors: Mio Tomita, Kazuya Manabe, Yusuke Matsuzaki, and Takashi Nishioka

Web Direction: Hiroyuki Miyashita

Design: Kentaro Watanabe

Mark up: Toru Yamada

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