The operating system

1. 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.
2. The monetary (or operating) system that applied during the Bretton Woods era* used fixed exchange rates and had two sources of money:

   • Increased foreign reserves; and
   • increased bank credit (to the government or private sectors). 

3. 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created from these savings was eventually spent on imports, the foreign reserves would decline and this money would be withdrawn from the economy and cease to exist.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.  
4. 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 current receipts).
5. 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.
6. 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. 
7. 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. 
8. 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 foreign debt. 
9. As a general rule, countries in the Bretton 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.
10. 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

10. 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 debt.
11. 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 domestic currency.   
12. 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. 
13. As considered in paragraphs 5 to 8 above, money from bank credit causes spending to exceed income. 
14. The only way a country can spend more than it earns is to import more than it exports.
15. Yet the foreign exchange market requires international receipts and payments to be equal.
16. 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 to the growth in bank credit.
17. 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. 

 

Implications

18. 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 exports.  
19. 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. 
20. 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.
21. 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)
22. 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. 
23. 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.
24. 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
    • foreign debt.
25. Therefore, besides the inflationary effect, there is a need for central banks to regulate the growth of bank credit to minimise the international imbalance.   
26. Monetary growth under the Bretton 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.
27. 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.
28. 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.
29. 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. 
30. 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. 
31. 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 imports.) 
32. 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 economy.)
33. If the US government attempts to borrow to stimulate its economy, it may be able prolong its life before its eventual demise.
34. 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. 
35. There are feasible solutions this monetary dilemma, such as the optimum exchange rate system or the guided exchange rate and liquidity system.  Whatever happens, the coming few years will be an interesting period for economists.
36. 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.
37. 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.        

 

* 1945 to March 1973.

 

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  Last update: 14 March 2012