Transcript | 2. lecture: The functioning of the financial system and world reserve currency (Vladimír Vaňo) - University for modern Slovakia

The scare of unbacked money rotation was denied by the reality of the passed years.

 The reaction of the American Fed at the end of 2008 to the worst after-war global recession  was the expansionary monetary policy, which was after the crucial decrease of the overnight rate to the minimum (0.25%) followed by acts of the so called quantitative expansionary monetary policy in two waves, in year 2009 and end of year 2010. The cycle of the expansionary monetary policy was already started in 2007 by the American central bank, when the signals of the recession that started in December 2007 became perceivable.

• Especially after the start of the quantitative phase of the expansionary monetary policy were we in Slovakia witnesses of such opinions like “printing of unbacked money by the American central bank will threaten the price level stability and the exchange rate of the American dollar.” After some years we can state that these fearsome opinions were not in place.
• The inter-annual core inflation rate (excluding grocery and energy prices) was slowed down in the USA in 2009 and 2010. Even after the speed up since the beginning of this year (2.0%) is it from a historical point of view not in alarming levels. Similarly harmless was the development of price levels in the Euro-zone, even despite of the quantitative expansionary monetary policy.
• The exchange rate index of the American dollar against the exchange rates of Americas trade partners has noted in the last two years rapid fluctuations both ways, including the strengthening at the end of 2008 and beginning of 2010 and its current level is somewhere around the level as it was in October 2008, when the expansionary phase of the American monetary policy begun.
• So this is how the development of the consumer inflation and the exchange rate of the American dollar against its trade partners subverted the critique of the loudest critics of “printing of unbacked fiat dollars by the Feds.”
• The experience of the past 3 years is at the same time a good start to the introduction of why it is important to know the basic principles of the functioning of the current financial system characterizes by:
  • the so called “fiat money”,
  • regime of freely fluctuating exchange rates of the main world currencies,
  • a monetary policy directed towards the upkeep of a stable inflation close to the in advance set inflation goal
  • and two main world reserve currencies: the American dollar and euro.

 Why unbacked fiat money?

•  Memories of “money backed by gold” evokes the Bretton-Woods system on which the world’s major industrial states agreed after the second world war.
• The main world currencies were within its frame bound in arranged fixed exchange rates to the American dollar that was exchangeable for gold in a fixed ratio.
• However this rigid system lead in the 60’s to an outflow of gold and the backing of dollar with gold reserves was gradually decreased due to the worsened market balance of the USA, high inflation and foreign expenses.
• Besides that, the arranged fixed exchange rates weren’t taking into account the different development of the export power of the individual businesses and lead for example to the underrating of the German mark or the Japanese yen thanks to which the dollar exchange rate was overrated which put the German and Japanese foreign market in an advantage while the USA faced an outflow of gold reserves.
• This system proved to be unsustainable and so the USA at the beginning of the 70’s unilaterally cancelled the exchange of dollars for gold (though the decision of the president Richard Nixon on 15^th August 1971). After many turbulent years and fluctuations of the price of gold against the dollar, the concerned countries gradually cancelled the tie of dollar to gold and on February 1973 the Bretton-Woods system expired.
• The start of the “fiat money” and free floating exchange rates of world currencies era as we know it today is linked with the end of the Bretton-Woods system.

Exchange rates: market strength and automatic stabilisers

• And so the main world currencies function since the 70’s in a regime of freely fluctuating exchange rates set by the development of the demand and offer on the global foreign exchange market.
• That the market power has a greater effect on the main world currencies than the wishes of the central banks has been repeatedly shown to the Bank of Japan when it attempts to reverse the pressure to strengthen yen by interventions, one of those times was in August of this year: the weakening of the exchange currency intervention by 4% from that time lasted literally only a few days before it reverted back to the level of before the intervention.
• The development of the exchange rates takes into account and is in the long term affected by a number of macroeconomic variables:
  • The development of inflation between trade partners. The rule of one way assumes that if the price of marketable goods doesn’t develop on two markets the same way, the free market should lead to export of the goods from the cheaper country to the more expensive one where the result will be a trade surplus of the cheaper country that is pressuring to strengthen its exchange rate to even out the mutual prices. The so called Purchasing Power Parity (PPP) is probably the most known fundamental tool for determination of equal exchange rates. For example in the case of the exchange rate of euro to dollar it has shown to be some kind of a long term anchor around which the exchange rate oscillates in a broad spectrum: at the current rates it is, compared to these theoretical exchange rates of euro to dollar, still overrated.
  • Trade balance between each trading country: surplus of foreign trade, so more foreign currency gained from export than paid for import affects the strengthening of the domestic currency with a market surplus and vice versa: the countries with a trade deficit are facing a pressure to weaken their currency.
  • The flow of direct foreign investment: the raw flow of direct foreign investment causes the strengthening of the domestic currency and vice versa. The interest of foreign investors is affected by the quality of the domestic business and investment environment, but also a prospective economic growth and macroeconomic stability as it is indicated for example by the rating of government’s commitments.
  • The flow of portfolio investments: inflow of foreign portfolio investments buying domestic securities and other tools of the financial market (including the money market) contributes to the strengthening of the domestic currency, on the contrary their outflow leads to a weakening. Similarly as in the case of direct foreign investment they are influenced not only by the prospective for economic growth but also for example by the interest rates levels.
  • Individual fundamental factors influencing the development of the world currencies intersect and complement each other, they cannot be evaluated separately. For example the USA is facing a deficit of the foreign trade which gets compensated by the raw inflow of foreign capital. The rapid strengthening of euro in March and April of 2011, even despite of the lowered rating of numerous Euro-zone members was the work of an early start of the interest rates increase by ECB.

Basic functions of money

• Since 1973 we’ve been witnesses to the regime of unbacked “fiat money”, of which elimination by the central bank is not given by the backing with rare metals. However this doesn’t mean that the emission of new generally accepted legal tenders were “unlimited”. For the upkeep of trust towards the “fiat money” it is important to be able to fill the basic functions sufficiently good:
  • Function of an accounting entity to express the financial value of transactions and assets.
  • A tool for market exchange of goods and services.
  • A tool for saving of financial surpluses.
• Especially due to the last mentioned function, but also due to the other two, is the development of inflation, general growth of the price levels, so the depreciation of their purchasing power the basic parameter for the evaluation of the credibility of  “fiat money”.
• That’s why is the preservation of a stable inflation development in this regime the most important goal of monetary policy of central banks.

Inflation and the process of interest rates expansion

• So inflation is the increase in consumer prices mainly during a strong business growth due to which the consumer demand after goods and services increases faster than their offer.
• According to the so called money theory is the inflation mainly the result of the process where the amount of goods and services that is being produced by the economy growing slower than the amount of money supply, which is trying to “catch up”. According to this theory is inflation always the result of the disproportionally rapid increase of money supply, which should be regulated by the monetary policy of the central bank.
• To understand the relationship between the steps of the central bank and increase of money supply it is important to remember the function of credit expansion during the overall money supply in the economy. A deposit in the banking sector is after the subtraction of minimum reserve requirements offered for the purchase of investment goods, the money from this is then further deposited and after the subtraction of reserves used again for further credit investments.
• So the overall amount of money supply in the economy (M2 in case of the USA, M3 in case of the Euro-zone) is with this multiple times higher than the amount of the most liquid money (M1) which is directly influenced by the central bank during the quantitative expansionary monetary policy.
• The central bank influences the pace of the money supply growth through the change of interest rates, which influence/decrease the demand after loans, or a change of minimum reserve requirements.
• In situations where the interest rates are close to zero and the central bank wants to further support the economy, it can come to a quantitative release of money policy: however this isn’t by “printing money” that influences the inflation, but only supplying the most liquid part of the money supply. If and to what extent they will become the overall money supply M2 that influences the development of inflation depends on the demand after loans. And that is weakened during the time of recession.
• The relationship between the expansionary monetary policy and the development of the overall money supply M2 is illustrated by the experience of the last 2 years in the Euro-zone and the USA: despite that the quantitative release of monetary policy of central banks lead to a faster growth of the money aggregate M1 (most liquid money), due to the weak demand after loans has the growth of the money supply M2 in the USA as well as the Euro-zone slowed down.
• The slowdown of the money supply M2 growth explains why not even an expansionary quantitative monetary policy during the serious recession didn’t threaten the inflation (not in the USA nor in the Euro-zone). On the contrary, the increase of unemployment and an accompanying decrease of consumer demand contributed to the slowdown of inflation to exceptionally low levels (if it affected Slovakia in year 2009 and 2010 too).

Trust in Fiat money: trust in anti-inflation monetary policy

• Despite of many popular discussions about how the central banks should support the economy growth, the academics, but also the central bankers agree that the best contribution of the monetary policy in a long term business growth is the sustainment of a long term stable inflation.
• By the words of the ECB president Jean-Claude Trichet, during the determination of the monetary policy is “ in the compass of ECB only one shot- the stable development of inflation.”
• To achieve this goal, the central banks influence the level of basic interest rates, which are the key for market interest rates of longer expiration.
• Ideas about what can be considered a stable inflation development in economy differ: the consumers and savers would like to have the lowest inflation, some sellers might like a bit higher thanks to which their revenue would increase a bit faster. That’s why the experience of monetary policy management from decades led to the conclusion that it is best to publish a transparent and generally known inflation goal, which the central bank is trying to achieve- in case of a faster than intended inflation by higher interest rates. In the case of ECB is the inflation level lower, but close to 2%.
• The regime of the so called inflation targeting makes the monetary policy easier readable and foreseeable: the slowing by higher interest rates it to be expected if the inflation exceeds the level of the inflation goal and vice versa.
• Besides, this regime of inflation targeting helps to adequately set the inflation expectation of the public. Adequate inflation expectations of the public contribute to a stable price development. The reason is a self-fulfilling character of the inflation expectations: if the sellers expect a higher inflation, they will include this into their plans for the next year. If the consumers expect a higher inflation they will include it into their area requirements for a flat wage increase. Additionally they accept the sellers price increase faster because it fits their expectations, and so they won’t limit the demand to show that the price increase is unreasonable.
• Unreasonably high inflation expectations could contribute to a faster price increase and an increase in interest rates by the central bank, which slows down the economy growth. By contrast, adequately set inflation expectations that fit the inflation goal of the central bank contribute to a stable development of price levels even without the need for the central bank to slow down the economy growth with high interest rates.
• That’s why it’s important for the independent central bank to do everything that is necessary to fight inflation that is higher than the inflation goal. Only then is the monetary policy in eyes of the public able to keep their trust and a credible inflation goal leads to the formation of adequate inflation expectations.

The central bank as a party pooper

• Historically bad experience with the depreciation of the purchase power of paper money is linked with countries that didn’t secure the independence of the central bank from the government which is responsible for the fiscal policy.
• The effective management of monetary policy therefore expects the independence in decisions of the central bank from the government. Especially in case of a fight with inflation by higher interest rates are the decisions of the central bank about the increase of interest rates unpopular (as in households, companies so in deficit managing governments).
• Historical experiences also show that if the development of inflation and inflation expectations of the public gets out of control, the slowdown of inflation is more expensive. High interest rates necessary for the slowdown of inflation could deepen the economic weakening.
• A credible anti-inflation policy, that reacts with an increase of the key rates already to the first signs of an inflation acceleration to keep up the trust towards its inflation goal, is unpopular, but less expensive than the monetary policy with frequent and distinct changes of interest rates.

Dollar as the reserve currency: spotless credit- the lowest possibly achievable risk on the market of securities

• Despite that the American dollar is not backed by gold since 1971 it’s still enjoying the status of the most important reserve currency of the word.
• According to the International Monetary Fund is more than 60% of foreign exchange of the world central banks in dollars.
• The foreign exchange reserves aren’t held in cash: they are portfolios of securities with the lowest possible risk rate.
• In case of the dollar foreign exchange reserve, the national debenture of the American federal government functions as an asset reserve.
• The status of the most important reserve currency of the world belongs to the dollar thanks to a number of most important factors:
  • Spotless loan credit: the American federal government belongs to a small elite club of countries that historically were never defaulted, so they always fulfilled their commitments stemming from the payable government bonds within deadlines.
  • Sufficiently big and liquid secondary market where American federal bonds are marketed. Since the foreign exchange reserves are practically a portfolio of securities, for the central banks it’s also important to know whether there is a big enough market where a higher amount of bonds can be bought and sold without causing negative fluctuations of it market price.
  • The upkeep of the position of the most important world reserve currency also indicates that even without the backing with gold is the anti-inflation monetary policy of the Feds considered to be trustworthy enough.
  • The exceptional amount of foreign exchange reserves that the foreign banks invest into the American federal national bonds contributes to a lower revenue towards its expiration, which the investors on the bonds market demand from the American government.
  • The same factor, thanks to which the dollar is the reserve currency number one (spotless credit), is the reason why the American federal national bonds are a “safe heaven” for private investors in times of increased turbulences.
  • To countries with the highest amount of foreign exchange reserves of the world belong China, Japan, Russia, Saudi Arabia (and the members of the oil cartel OPEC), countries of south-east Asia, so the export orientated economies. Their foreign exchange reserves stem generally from the excess of foreign market.
  • That is how China worked itself up in the last two decades to the position of a country with the most foreign exchange reserves, which growth has been pulled mainly by the export industry, for which USA is the most important outlet.
  • In order to avoid an excessive strengthening of its own exchange rate which would weaken the price competitiveness of its export, China invested the dollar surplus from foreign trade back into the dollar assets, the federal national bonds.
  • The increase of Chinese reserves invested into American federal national bonds are therefore a part of a transpacific symbiosis: the surplus from the foreign market, pulled by the demand from the USA helps to refinance the public debt of the American federal government.

Euro as a reserve currency: credibility that saves money

• The second most important reserve currency of the world and the only real competitor of dollar is the united European currency – euro.
• According to the IMF, more than 25% of the foreign exchange reserves in the world central banks are invested in euro assets.
• Since the Euro-zone doesn’t give out common federal bonds like the USA, the national bonds of the member countries of Euro-zone are the reserve assets.
• Foreign central banks expect euro, as the second most important reserve currency, to have a credibility similar to the one of the dollar reserve assets.
• The worst scenario in case of the peripheral members and their national bonds (Greece, Ireland, Portugal) could so seriously threaten the credibility of the whole project of the monetary union.
• The global bonds market has a long and rich history of default countries. But for the group of reserve currencies were only two monetary blocks qualified (USA and Euro-zone), in which case is such extreme “accident” considered to be the least probable. The damage to the credibility of euro could weaken the trust of foreign central banks.
• The weakening of the foreign central banks demand, or a possible close-out sale of the euro national bonds could mean that all members of the Euro-zone would pay for the damage on credibility to a different extent by increasing the interest rated of the expenses for the handling of their own public debt – even though to a various extent.
• The functioning of the common monetary policy by textbook assumes also the existence of a common budget policy, as its the case with the federal finance ministry of the USA. This, besides others, helps regions that temporarily end up in a bad economical situation through  fiscal transfers.
• The Euro-zone worked during the first two decades of its existence in a regime when the individual countries despite the common currency retained a sovereignty in the area of budget policy. This contrasting combination was conditioned by the agreement of the member countries to coordinate their own budget policy in the frame of the agreed terms (Stability and Growth Pact). Their breach in combination with the use of a common currency (about which the central banks assume a credibility equivalent to a reserve currency) contributed to the current tensions.
• The upkeep of the common European currency and the advantages linked to the credibility of a reserve currency will therefore in the future require an immediate revaluation of the current model of the completely independent functioning of the budget policy and that either:
  • in form of delegation of the “regular competency” to transitional European authorities (that would have the competence to timely and effectively sanction unhealthy development of the public financing of national governments) or
  • in form of delegating parts of the fiscal competencies to a quasi-federal ministry of finance.

Is gold still a safe heaven?

• Gold has in the last years become a popular goal of businessmen in the commodity market, thanks to which the inflow of capital cause an exceptional increase of its price.
• Gold is a commodity, the possession of which brings no passive income, not in the form of dividends, nor coupon payments (as it’s the case with bonds), additionally come with its possession considerable transactional expenses, as with the purchase so with the sale, as well as its keeping.
• Investment into gold is therefore based purely on the speculation of the increase of its market price. And this was in the past years deformed by and exceptional inflow of new capital that found rare metals to be an investment class.
• This made from gold an exceptionally volatile commodity going through rapid duplex fluctuations (decrease of nearly 30% in year 2008, fall of 20% in September 2011).
• Exceptional duplex fluctuations and a speculative nature of the massive demand after gold leads to gradual doubts about whether it is still possible to consider it to be a “safe heaven” as it was in the past.

Where did paper money come from? China.

• The first paper money was discovered in China in the 9^th century in a province that suffered from lack of copper that was used for minting of coins. And so already in the Middle Age was in China paper money effectively complementing/substituting traditional money minted from (rare) metals. Fiat money is used in China even today, even thought it is not yet a currency freely convertible.
• When in the USA or the Euro-zone the inflation got scared by the influence of monetary policy, the rate of money supply growth (M2, M3 respectively in the case of Euro-zone) was due to the decrease of demand after loans slowed down. However at the same time not only the expansionary monetary policy of the central bank but also the support of the interest rate expansion process (which is simplified by the state ownership of businesses or banks) led China to a faster inter-annual growth of money supply M2 by nearly 30% in 2010. This was followed by a faster inflation, by the process we described above. The Chinese central bank reacted by a change of the basic rates as well as an increase of the minimum reserve requirements in order to slow down the process of interest rate expansion.