This is the continuation of the Bitcoin series where we had discussed what is a Bitcoin blockchain and how it helps build trust-less and decentralized transactions
In the previous blog, we looked into The story of money – Part 1, where we saw how money came into being and how central banks & governments started creating different layers of money, with gold at the apex and in due course the lower layers became fractional reserves of gold. In this blog, we will see how things transitioned until the present day
Lender of the last resort
In 1873, British writer and founder of The Economist magazine, Walter Bagehot, is credited for nominating the central banks to be the lender of the last resort in the time of crisis, through his book Lombard Street: A description of money market
What he meant was, in the event of a crisis where the private sector bills of exchange lose liquidity, then central banks should jump in and provide liquidity, so that the faith of the banking system will be upheld amongst the public. To this day, central banks follow this guidance
The central banks creates the second-layer of money in abundance when the economy needs to be stimulated and reduces the supply when the economy heats up, thus causing the economic cycle of boom & bust which we are familiar with nowadays
The rise of US Dollar
Until the turn of the twentieth century British pound remained the world’s reserve currency however during industrial revolution the innovations from the US caused the world to need dollars to purchase goods, services and shares
The earthquake of 1906 in San Francisco changed the landscape further. Most of the properties were insured in London and British insurers had to settle claims and there was a flurry of capital pouring into US which weakened the ‘pound to dollar’ exchange rate
To defend the pound from a free fall, Bank of England raised their interest rates by 2.5% to attract capital away from US dollars. This worked and the American economy entered a contraction leading to financial crisis
This made institutions and people withdraw their deposits and hold the higher layer of money i.e. gold. However as we have seen previously, the second and third layer money are fractionally reserved
There are not as much gold as the circulating money!
So if everyone demanded gold in exchange of their second & third layer of money, there would not be enough gold for all!
Creation of Fed
After an extensive study, US realized the need for a Central Bank and the Federal Reserve system was created in 1913, after much deliberation
The Federal Reserve ensured that it established a unified and accepted second layer of money called reserves, which the banks could use and Fed notes which people could use. This removed the existing decentralized mix of second layer money across each state in US and placed private sector money issuance as the third layer. The Fed Act also allowed the Fed to buy Commercial papers i.e. short term debts issued by banks and corporations in the event of any distressed economic condition
The Act maintained that the gold coverage ratio is at least 35% against the liabilities in the second layer. At that time the gold represented ~84%
The Fed thus created a three layer monetary system which allowed private sector banks to create the third-layer through their balance sheets
During the first world war in 1914, US had to finance the war, therefore US Treasuries were made equivalent to Gold, at the top of the pyramid
US Treasuries are government debt instruments to finance government spending
Thus from a 1:1 hard asset i.e. gold, we moved to fractionally reserved currency and then to where government debt sat as an “asset” next to gold
The end of Gold standard
During the US stock market crash in 1929 the Fed could not revive the economy with the second layer money due to the 35% gold coverage ratio, therefore President Franklin Roosevelt gave an executive order that all gold have to be handed over to the government, thereby making it illegal to hold gold, the first layer of money
In order to retain public confidence for the third layer of money, US government passed the FDIC insurance law, where each depositor was guaranteed $5000/- in case of a default by the bank (it is at $250,000/- in 2023). Thus people’s fear of not being able to hold the first layer of money (gold) was annulled
Bretton Woods Agreement
In order to make commerce easier, the group of 44 allied nations, which included the US, got together in 1944 and formalized a fixed currency exchange rate using the gold standard. It was agreed that US will ensure US dollar convertibility to gold and all other currencies will be a form of third layer to US dollar i.e. other currencies needed to be converted to US dollar to redeem gold. The gold to US dollar was pegged at $35 per ounce (~28.35 grams). This change caused the central banks across the world to convert their reserves, securities to US dollar
As foreign nations accumulated dollars, they started converting it to gold. The peg of $35 / ounce of gold could not be maintained and US gold reserves started depleting. Finally in 1971, Richard Nixon pulled the plug and suspended the gold convertibility from the dollar, thus ending the gold standard
The golds disciplinary constraint on money elasticity was thus removed
Petrodollar
Meanwhile in 1945, President Franklin D Roosevelt signed an agreement with Saudi Arabia to accept only US dollars for oil export payments from other companies, for which they would get military protection and business training. These ‘petrodollars’ would be ploughed back into the US by giving business to US companies for the development of Saudi Arabia
Eventually US dollar became the standard international settlement currency and thereby the world’s reserve currency
Significance of the reserve currency
The reserve currency has the stupendous responsibility in ensuring economic stability not just within US but across the globe; especially the third world countries will be affected adversely when there are wide movements in the interest rates
With no hard constraints, the Fed plays God by warming up and cooling down the economy through quantitative easing and tightening. When money is available cheap, the economy heats up through risky bets. While we have been going through the expansion and contractions, the global recession in 2008 is what caused Satoshi Nakamoto to invent Bitcoin. We will look into that in the next blog
As I write this, US has hit the debt ceiling (borrowing limit) once again – since 1960, it has been increased 70 times & currently stands at $31.4 Trillion – and is waiting for Congress to approve it. You can find the live US debt clock here