Unit 9 Lecture Notes

The new global monetary system that emerged after World War II placed every government in control of its country's economy in an unprecedented and dangerous manner. Understanding the role of central banks in managing the international cash reserve and settling the international balance of payment accounts, and how these functions interact with monetary policy and banking regulation is pivotal to understanding the nature of the catastrophes and crises that have befallen developing countries in the past decades.

Under an ideal gold standard, or Hayek's homogeneous international monetary standard, the monetary unit would be uniform the world over. Under monetary nationalism, each country's government and central bank decide on the provisioning of the money supply while also being the only entity capable of performing international settlement. The confluence of these two monopolies has been at the root of many economic disasters, particularly in the context of countries indulged by foreign benefactors who supply it the global reserve currencies on which it survives globally.

Under the modern monetary system of the twentieth century, there are four functions of central bank reserves, the intermingling of which is the fundamental design flaw at the heart of most economic problems of the twentieth century. The four main functions of the central bank reserves can be classified into:

1. Backing the value of the national currency. While statist economists like to speak of the state's ability to decree what money is, central bank reserves' existence strictly debunks that. No government is able to decree its own debt or its own paper as money without offering some kind of reserve for redemption. Even if a government were to force its people to accept its paper at an artificial value, it would not be able to force foreigners to accept it; if its citizens want to trade with the world, the government must create a market in its currency in other currencies. Unless the government accepts foreign currencies in exchange for its own, then that market cannot emerge and its own currency is rendered worthless since nobody would want to hold it. There has never in history been an example of a form of money that emerged purely through government fiat. All moneys that exist today are issued by central banks that hold gold in reserve, or central banks that hold in reserve currencies issued by central banks that hold gold. This thought experiment not only illustrates the absurdity of the state theory of money, it also illustrates the fundamentally unworkable nature of political money at an international level. If every government issues its own money, how can they trade next to one another, and at what value? The answer in the current system is that the backing happens with the US Dollar, which is the currency of the country that had accumulated the largest gold reserve at this system's inception, and whose monetary role was only secured through backing by gold in the first place. Thus, for any government to issue a currency, it must have global reserves it can use to settle its international trade deals. This means it must make its currency tradable for its reserves, and that the quantity of reserves is pivotal in determining the value of the local currency.

2. The international cash account. Central bank reserves also settle the international current account (which includes international trade transactions) and the international capital account (which settles international movements of capital). All international payments to and from a country have to go through its central bank, allowing it a strong degree of control over all international trade and investment. Central bank reserves are thus enriched when foreign investment flows into the country or exports increase, but reserves are depleted when foreign investment leaves the country or imports increase. As individuals across national borders seek to transact with one another, they must necessarily resort to a system of partial barter, as Hoppe termed it, wherein they need to buy a foreign currency before buying the good. This has led to the emergence of the enormous foreign exchange industry, which only exists as an artificial middleman to profit from the arbitrage opportunities generated by the ever-shifting values of national currencies. This also effectively makes the government and central bank a third party in every international transaction involving the citizens of the country.

3. Banks' reserves. Central bank reserves are what ultimately back the reserves of the banking system. The essence of central banks was to be the entity where individual commercial banks would hold part of their reserves in order to settle with each other without moving cash reserves around. With a fractional reserve banking system, the central bank also uses its reserves to provide liquidity to individual banks facing liquidity problems. This means that credit expansion by the banking system that leads to a boom and then an inevitable credit contraction will be remedied by the central bank using its reserves to support illiquid financial institutions, in effect increasing the money supply. Although the banking system in each country primarily deals with the local currency, the central bank nonetheless makes a market in its currency and foreign currencies, and when its own currency's supply increases while the reserves remain unchanged, the currency would be expected to depreciate compared to foreign currencies.

4. Buying government bonds. The modern central bank and government song-and dance routine adopted the world over involves the central bank using its reserves to purchase government bonds, thus financing the government. Central banks are essentially the main market maker in government bonds, and the extent of a central bank's purchase of government bonds is an important determinant of the value of that national currency. As a central bank buys larger quantities of its government's bonds the value of the currency declines, since it funds this purchase by inflating the money supply. As time has gone by and monetary continence has continued to erode, central banks today do not just buy government bonds but are also engaged in the monetization of all kinds of assets, from stocks to bonds to defaulted debt to housing and much more.

The intermingling of these four functions in the hands of one monopoly entity protected from all market competition is ultimately the root cause of the majority of crises afflicting the developing world. It is easy to see how these four functions can conflict with one another, and how a monopolist will have the perverse incentives to look out for their own interest at the expense of the long-term value of the currency and thus the wealth of the citizens.

Maintaining the value of the currency would arguably best be served by using hard assets as reserves, in particular gold. But the second goal, settling payments abroad, is only doable with the US Dollar and a handful of government currencies used for international settlements. So central banks' first conflict is between choosing a monetary standard for future needs vs one for present needs. This dilemma of course would not exist in a global homogeneous monetary system such as a true gold standard, since gold would offer liquidity across the world today, as well as into the future.

As governments ultimately control central banks, in spite of the constant protestations to the contrary, it is quite possible for them to lean on the central banks to purchase bonds, allowing for more government spending. As a result, the local currency's money supply is inflated, and selling pressure for it increases compared to international currencies. Governments are also likely to lean on their central banks to engage in expansionary monetary policy to "stimulate the economy", which similarly inflates the money supply and bring its value down compared to international currencies. As governments centrally-plan their economies using inflation, they do so while endangering their foreign reserves: individuals start looking to sell the local currency and hold on to better currencies, which creates more selling pressure on the currency compared to the international currency; this forces the central bank to sell some of its international reserves. These individuals will also seek to send their newly purchased international currencies abroad to be invested in foreign countries, which could then lead their government to impose capital controls to stop that flow in order to maintain its foreign reserves.

Similarly, as these individuals expect the value of their national currency to decline, they are also more likely to purchase durable goods rather than hold on to cash balances. This can mean a lot of imports of expensive foreign goods, which also depletes the central bank's foreign reserves. The government is then likely to retaliate with trade barriers, tariffs, and subsidies. The rationale for trade barriers is to reduce the local population from converting their local currency to international currency and sending it abroad. The rationale for tariffs is to reduce the flow of foreign exchange abroad, and to force importers to hand over part of their foreign exchange to the government as they import. And the rationale for export subsidies is to promote local exporters to increase the inflow of foreign reserves. We can now understand how the collapse of the global inflationary bubble of the 1920's, and the presence of a global system of national reserves used along with gold, was ultimately one of the main drivers of protectionism in the 1930's.

The last two points are extremely important for the developing world because they are enormously significant to the only three drivers of economic growth and transformation: capital accumulation, trade, and technological advancement. As governments restrict the ability of individuals to accumulate or move capital and goods, it becomes harder and harder for individuals to engage in capital accumulation, trade and specialization, and importing the most advanced technologies.

The global monetary system built around government monopoly central banks effectively puts the entirety of the local capital markets and all imports and exports under government control. It is able to dictate what can enter and exit the country through its control over the banking sector. The fact that it can always squeeze import/exports and capital markets for foreign exchange revenue makes the government a very attractive borrower for international lending institutions. The entirety of the private economy can now be used as collateral for the government to borrow from the global misery industry, which is built to lend. Understanding the monopoly function of international central banks, and how it interacts with the monopoly function of international development agencies is key to understanding how destructive the global monetary system and the misery industry have been to the world's poor.