Money..it's a gas!!

What do 3 Management graduates sitting in a conference room with time to kill talk about? The answer undoubtedly happens to be an exotic (err...esoteric) topic, mostly related to the economics, finance or politics..The fact that these conversations are intellectually heavy and emotionally charged is not in contention (well- the years of GD has prepped these guys to start shouting at the drop of the proverbial hat). However, the amusing part is that invariably the conclusions of these conversations are inconsequential :)

This time around in our case, it happened to be International Currencies-

What backs an international currency? Is it Gold, USD or its plain simple Fiat currency everywhere..

This blog seeks to answer this question and in the process understand a bit about the mechanics of the international Money markets.

I had an understanding that international currencies are backed by Gold. Is this true?? Well- the answer is both yes and no. I will try to explain the same in the following text-

International currencies can broadly be categorized into following 3 types-

1. Commodity money- is money whose value comes from a commodity out of which it is made. It is objects that have value in themselves as well as for use as money. Examples of commodities that have been used as mediums of exchange include gold, silver, copper, salt, cannabis, candy, barley etc. These items were sometimes used in a metric of perceived value (economics) in conjunction to one another, in various commodity valuation or price system economies.
2. Representative money- is money that consists of token coins, or other physical tokens such as certificates, that can be reliably exchanged for a fixed quantity of a commodity such as gold or silver. The value of representative money stands in direct and fixed relation to the commodity that backs it, while not itself being composed of that commodity.
3. Fiat money- is money whose value is not derived from any intrinsic value or guarantee that it can be converted into a valuable commodity (such as gold). Instead, it has value only by government order (fiat). Usually, the government declares the fiat currency (typically notes and coins from a central bank, such as the Federal Reserve System in the U.S.) to be legal tender, making it unlawful to not accept the fiat currency as a means of repayment for all debts, public and private.

Since the concept of currencies emerged, Gold has been the defacto means of monetory exchange along with Silver. Gold has served this role either thru issuance and recognition of gold coins or other bare metal quantities, or through gold-convertible paper instruments by establishing gold standards in which the total value of issued money is represented in a store of gold reserves.

However, the amount of gold in the world is finite and production has not grown in relation to the world's economies. With the sharp growth of economies in the 20th century, and increasing foreign exchange, the world's gold reserves and their trading market became a small fraction of all markets and fixed exchange rates of currencies to gold became unsustainable. At the beginning of World War I the warring nations moved to a fractional gold standard, inflating their currencies to finance the war effort.Owing to these imperfections due to the use of Gold as the commodity backing international currencies, gold was replaced by a system of convertible currency through an international mandate. Gold standards and the direct convertibility of currencies to gold have been abandoned by world governments, being replaced by fiat currency in their stead. Switzerland was the last country to tie its currency to gold; it backed 40% of its value until the Swiss joined the International Monetary Fund in 1999. Today, nearly all contemporary money systems at the national level are Fiat money systems.

Once the fact on the type of international currencies (Fiat) was established, the next logical question was-

If each currency is backed by a promise by the sovereign government and no commodity, why is there a disparity in the values of these currencies i.e. why should a country like India accept that its currency is 1/50th times that of US??

The answer to this question lies in the Bretton Woods System implemented in the post-IInd world-war scenario.

The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century. The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states.

Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries had ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments. In the face of increasing financial strain, the system collapsed in 1971, after the United States unilaterally terminated convertibility of the dollar to gold. This action created the situation whereby the United States dollar became the sole backing of currencies and a reserve currency for the member states.

All would have been fine had the suggestion made by John Maynard Keynes to make the reserve currency as bancor, to be managed by the IMF. However, the United States objected and (ironically) their request was granted, making the 'reserve currency' the U.S. dollar. This meant that other countries would peg their currencies to the U.S. dollar, and—once convertibility was restored—would buy and sell U.S. dollars to keep market exchange rates within plus or minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold standard in the international financial system.

Meanwhile, to bolster faith in the dollar, the U.S. agreed separately to link the dollar to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central banks were able to exchange dollars for gold. Bretton Woods established a system of payments based on the dollar, in which all currencies were defined in relation to the dollar, itself convertible into gold, and above all, "as good as gold". The U.S. currency was now effectively the world currency, the standard to which every other currency was pegged. As the world's key currency, most international transactions were denominated in US dollars.

The U.S. dollar was the currency with the most purchasing power and it was the only currency that was backed by gold. Additionally, all European nations that had been involved in World War II were highly in debt and transferred large amounts of gold into the United States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was strongly appreciated in the rest of the world and therefore became the key currency of the Bretton Woods system.

In conclusion, we live in an age where we claim all countries are honorable enough for their citizens to believe in their 'home-currency', but each in turn has to be dependent on Uncle Sam to gauge its currency's true worth!!

(Source- mostly Wikipedia

http://en.wikipedia.org/wiki/Money)