As explained in the page about the
anatomy of the economy, the
monetary system is to the economy what the operating system is to a
computer. Just as applications run on the computer's operating
system, economic institutions, such as government, households and
industry are like applications that run on the economy's monetary system.
The monetary (or operating) system
that applied during the Bretton Woods era* used fixed exchange rates
two sources of money:
Increased foreign reserves; and
credit (to the government or private sectors).
Money from increased foreign reserves generally represented an
increase in income (from exports) above spending (on imports).
The additional foreign reserves represented "national" savings as
the nation was earning more income than it spent. When the money created from these savings
was eventually spent on imports, the foreign reserves would
decline and this money would be withdrawn from the economy and cease to exist. This form of
money is endowed money: the foreign
reserves that created that money endower the money with a reciprocal
current obligation to supply goods in exchange for that money.
Note that spending on domestic
goods and services always equals the income from the sale of
domestic goods and services. (The spending of one person in
the nation is the income of another person in the nation.) If
national expenditure is to be greater than
national income, it must mean that spending on imports (and other
current payments) is greater than the income from exports (and other
Before considering money from
banking, let us consider forged money. This is money that
people print to buy goods without having to reciprocate and sell
goods to the economy. This money is unendowed: there is no
current obligation attached to that money to reciprocate and supply
goods for that money.
Money from increased bank lending
(lending greater than loan repayments and other forms of saving such
as changes in bank capital) enables the borrower to spend more than
their income. This money is like forged money: it is
unendowed money in the current time.
There is no reciprocal current obligation to supply goods in
exchange for this money. The obligation to supply is in the
future when the loan is repaid.
The growth in bank credit causes
spending to rise. Everyone else who have spent money have earned
it: that is, they are buying no more than they have produced.
But money from bank credit causes people to buy more than they have
produced. The only way these additional goods can be supplied
is from additional imports. This causes imports to exceed exports, depleting foreign reserves.
Under the fixed exchange rate
system, when money is spent on imports, it ceases to
exist. If that money were originally created from a rise in
foreign reserves, the foreign reserves that originally backed that
money is also lost. If the money originated from the
growth in bank credit, the
bank's asset backing (the borrower's debt) still remains. The money
spent on imports either reduces foreign reserves or it raises
As a general rule, countries in the
Woods environment managed bank lending, allowing it to increase provided that
it did not deplete foreign reserves. Excessive bank credit depletes foreign reserves or raises foreign debt.
Bank lending that is less than the
growth of savings is not a problem. When money from bank
credit is spent on imports it reduces foreign reserves and the money
that was originally saved and backed by foreign reserves is now
backed by bank debt. We can consider that the remaining money
now backed by bank debt has been neutralized: that is, the
excess spending caused by the bank lending has now been exercised.
The country now holds additional money
(from the original growth in foreign reserves) that is required for
day to day transactions but is now backed by bank debt.
(For a more detailed explanation of this, see:
Submission to the Australian Senate inquiry into Competition within
the Australian banking sector.)
Operating system post Bretton Woods
The US government abandoned the
Bretton Woods Agreement and floated the exchange rate because it had deregulated the
financial system and the growth in bank credit was depleting
foreign reserves. President Nixon had nominated Arthur Burns
as Chairman of the Federal Reserve with instructions to free up bank
lending so as to stimulate the economy ahead of the 1972
presidential elections so that Nixon could win a second term. Subsequently
floating the exchange rate removed the
pressure from the Federal Reserve to constrain the growth of bank
credit. The floating
exchange rate was a scheme to preserve US foreign reserves. It prevented the
future growth of bank credit from depleting
official foreign reserves. But it did not
prevent the underlying excess spending that raised the demand for imports
that continued to be financed by raising foreign
The floating exchange rate system
not only prevented the loss of foreign reserves, it prevented the accumulation of
additional foreign reserves. All
international transactions were required to be traded on a foreign
exchange market and those wanting to buy foreign currency were
required to trade with those wanting to sell foreign currency to buy
Hence, there was no opportunity to
create money from the growth of foreign reserves (i.e., from
national savings). This meant that bank credit was the
only source of additional money.
As considered in paragraphs 5 to 8 above, money from bank credit causes spending to exceed
The only way a country can spend more than it earns is
to import more than it exports.
Yet the foreign exchange market
requires international receipts and payments to be equal.
The only way that the constraints
on the foreign exchange market and the monetary system (in paragraph
15) is reconciled is if the international capital inflows (debt and equity)
are greater than international capital outflows by an amount equal
growth in bank credit.
In other words, the net capital
inflow must equal the growth in bank credit. This is evident
for the USA, Australia and
New Zealand. It
was the case also for the Philippines
until the Central Bank of the Philippines became aware of this relationship and modified its monetary
system. In India, the central bank had
managed the problem but when trade improved, they reverted to a
deregulated system. See also the formula for the
current account balance.
The implications of this are
extremely significant for the economy. While the Bretton Woods system
was in force, the process of neutralizing the money created by the
growth of bank credit was by reducing national savings in the form
of foreign reserves. The net outcome was an economic environment in
which international trade was relatively balanced: the additional
imports being offset by foreign reserves generated from additional
In the post Bretton Woods economy,
it has not been possible to neutralize the money created by the growth of bank
credit. There are no additional savings created by the growth
of foreign reserves. Yet unendowed money in the form of bank
credit continues to cause national
spending to be greater than national income. Therefore, it produces an economic environment in which international
trade is unbalanced. The only way that the inherent excessive
spending can be honoured is if the additional imports demanded are paid for by increasing foreign debt.
This money created by the banking
system cannot be said to be neutralized:
instead we can call it indebted money. This money is
doubly indebted: it has been created by a domestic debt and has
generated a foreign debt. If the
inherent excess demand in the unendowed money were not met by
foreign debt, the unendowed money would be likely to cause
hyper-inflation. So, it is better that unendowed money be
transformed into indebted money than being left as unendowed money.
Even so, the indebted money created by the growth bank credit
causes some inflation whereas the endowed money created from national
savings (the growth of foreign reserves) and neutralized money reflect growth in income and do not have the same
inflationary effect. (See Money and
Inflation occurs when the growth
rate of the money supply exceeds the real growth
rate of the economy.
Under the Bretton Woods arrangements, monetary growth from rising
foreign reserves directly increased national income and the
money supply. Therefore, it raised both the numerator (money) and the
denominator (GDP). So inflation was low.
Unendowed money and indebted money (from bank credit)
raises the numerator (money) but they do not directly increase
the denominator in the same way as money from the growth of
foreign reserves. Thus these forms of money are more likely to cause inflation.
When there is inflation, the economy needs more
money to grow. The post Bretton Woods era began with a
recession called the "Oil Crisis". This recession was caused
by the inadequate growth of the money supply. To further
stimulate the economy, the financial system was
further "deregulated" to allow banks to increase lending and provide more
money to stimulate the economy. As we have discussed, in the post Bretton Woods
environment, the growth of bank credit resulted in the simultaneous growth of two
types of debt:
domestic debt, in the form
of bank debt; and
Therefore, besides the
inflationary effect, there is a need for central banks to
regulate the growth of bank credit to minimise the international
Monetary growth under the
Woods system had the capacity to generate rapid growth, full
employment and low inflation. Monetary growth under the post
Bretton Woods system does not have the same capacity.
Furthermore, as the economy continually
needs more money (bank debt) to grow, the quality of the debt declines over
time. This became blatantly clear when the US monetary system
collapsed in what was called the Global Financial Crisis.
While the Australian monetary
system has not collapsed in the same way, it is heading in the
same direction. As in the USA, Australia has relied upon the
poor to borrow, encouraging them through programs such as the first home buyers scheme.
Unless Australia changes its
monetary system, it will eventually run out of people with a
capacity to increase borrowing. At that point, the lack of
additional money is likely to lead to a reduction in the rate of
economic growth. That is likely to cause many borrowers to default and
that would lead to the collapse of the monetary system.
Another implication of the
float is that the rate of
economic growth has declined in the post
Bretton Woods era.
Consequently, the growth in real wages have declined also.
While the world has experienced
globalization, world trade is lower than
it otherwise would have been. This is because the real
exchange rates of countries like Australia and the US have
increased, making their products less competitive on the world
market, reducing their exports and also reducing their income, which
would otherwise have generated more imports. That is, both
exports and imports (trade) would have been greater within a Bretton
Woods environment than they have been in the post Bretton Woods
environment. (The increase in the real exchange rate can be
seen in the proportion of GDP spent on
The post Bretton Woods system is
unsustainable in the long term. The US government has bailed
out the financial system following the Global Financial Crisis.
However, the US economy continues to rely on the financial system to
expand the money supply. So far, this is not happening and
bank credit in the US is declining, contributing to a major US
recession. (Note that this is unchartered territory for the US
If the US government attempts
to borrow to stimulate its economy, it may be able prolong its life
before its eventual demise.
It seems foolish that the US
government discarded a stable monetary system in order to improve
the re-election prospects of President Richard Nixon. This
short sightedness has meant that the US economy has collapsed and
now stands on the brink of disaster.
Solutions, such as the optimum
exchange rate system would enable countries to neutralize their
indebted money. These solutions create foreign reserves in the banking
system that can be used to repay private sector debt (both bank and
non-bank). When this is done, the foreign debt is eliminated
in much the same way as imports neutralize unendowed money.
A country converting its
indebted money to neutralized money would experience rapid growth,
high employment levels and low inflation. The rapid growth
comes from exporting more than is imported shifting demand to
domestic products thereby raising GDP.
This leads to high employment. However, as production or
supply is greater than spending or demand, the country does not
experience the same inflationary pressure.