Economic Catastrophe and Monetary Big Bang: a quick look at the genealogy of Contemporary Monetary System and its impasse

Some cases in history, economic catastrophes caused tectonic paradigm shifts in monetary regime. When that happens, an economic catastrophe in one generation could determine the monetary system design of the next generation in one way or another. In other words, a new monetary system could be designed to cope with economic problems that have infested the previous generation.

In retrospect, our contemporary monetary system came into being in the early 1980s as a response to the persistent inflation of the 1970s. The big bang of our contemporary monetary system took four steps throughout the 1970s: first, inflation which had already picked up in the late 1960s in the United States; second, the Nixon Shock in 1971, which paved a gradual path to un-anchored fiat money order by unilaterally abolishing USD’s gold convertibility of the Bretton Woods System; third, ensuing gradual passage toward floating of the exchange rate across currency pairs; and fourth, the emergence of new anchor devised by Paul Volcker, price-stability-oriented monetary policy, in the beginning of the 1980s. Cut a long story short, when Volcker, after being appointed as the Federal Reserve Bank’s chairman in 1979, demonstrated to the world FED’s commitment to combatting inflation, the fiat money world that had been unleashed during the 1970s became for the first time anchored by the central bank. It was the moment when our contemporary monetary system was founded — call it ”price-stability-oriented monetary policy standard of fiat money system”.

During the decade after the financial crisis of 2008, despite unconventionally massive scale of monetary easing — negative policy rates, quantitative easing (QE), and quantitative and qualitative easing (QQE of BoJ) — low inflation persisted in some advance economies during the 2010s. This suggests the presence of persistent deflationary pressure — if not ‘deflation’ per se — in our economic reality. And the deflationary pressure has excruciated central bankers across those affected countries. As they tried to bring long term inflation level back to normal, they ended up facing the undesirable side effects of their unconventional monetary policies during the 2010s: economic imbalances — such as excess leverage, asset inflation, the potential instability of the banking system (e.g. compression of the term spread induced riskier taking behaviours among banks and institutional investors), and wealth inequality.

Simply put, the general price level of goods and services and asset prices — these two price categories demonstrate different price behaviours. Cut a long story short, while the convention of our contemporary monetary policy is designed to have an intensive focus on the stability of the general price level of goods and services, it cannot regulate asset prices at the same time by design. Since such economic imbalances are shaped in a systemic fashion and impaired the social construct beyond the economic system in some cases, some fierce criticisms on these economic imbalances that could destabilise the system are sometimes directed toward central bankers. Here, Hyman Minsky’s emblematic phrase, “Stability is Destabilizing” resonates: the central government’s efforts in stabilizing economic imbalances in some parts paradoxically create economic imbalances somewhere else that ultimately destabilize the system.

Simply put, our contemporary monetary system was designed and devised to cope with inflation. It is symbolic that, born out of inflation, it faced its impasse under deflationary pressure during the 2010s. Should deflationary pressure regain its momentum to persist, our current monetary system might not be able to battle with it. The next ensuing economic catastrophe might make another historic case of causing a tectonic paradigm shift in our monetary system. This time, a new monetary design might need to be engineered to cope with deflation. Earlier, I wrote an article to address this issue. (A Call for New Monetary Regime — Liberation from Zero Lower Boundary)

Whether we like it or not, history tells us that a persistent deflation could emerge. And when it unfolds, it would dictate our life. The rest of the article will make a quick overview of the history of deflation in Part 1 and the evolution of monetary system in part 2 in order to outline the genealogy of our contemporary monetary system.

Part 1: Deflation in a historical perspective

Chart 1 illustrates historical inflation rates in the United Kingdom since the last decade of the 18th century. The grey shaded areas correspond to hegemonic war interruptions: the French Revolutionary War (1792–1802); the Napoleonic Wars (1803–1815); WWI (1914–1918); WWII (1939–1945).

Large scale wars involving battles in the homeland of hegemonic powerhouses — call them “hegemonic wars” — could disrupt secular price cycle. Historically, war time tends to cause structural inflation. (Goldstein, 1988, pp. 252–253) Chart 1 confirms that the inflation volatility (the red line) picked up during these hegemonic wars. It might be caused by multiple factors: partly due to the supply disruption caused by the conversions of manufacturing facilities for weapon productions; partly due to absence of price competitive import products; and partly due to a temporary expansion of money supply as a part of emergency measures to cope with extraordinary economic dislocations caused by a war. In this view, we treat war time disruptions and their aftermath as exceptions, as extraordinary externalities.

During the 19th century, deflation was frequent phenomena. After the Napoleonic War until 1870 (1816–1870), deflation and inflation alternated one other to even out in the long run.. Then, in the last quarter of the 19th century, mild deflationary pressure persisted during 1874–1897. In the 20th century, deflation became rare. Persistent deflation emerged only during few years after WWI and during the Great Depression. Thereafter, since the breakout of WWII, persistent deflation almost disappeared from the scene.

Deflation in a Bond Yield Cycle Perspective

In hindsight, persistent deflationary environments emerged toward the end of the two historical bond bull markets. Chart 2 illustrates this point, adding the UK’s bond yield cycle to the same UK inflation/deflation history as Chart1. The grey shaded areas correspond to war periods. And the light blue areas highlight persistent deflationary period toward the peace time end of bond bull markets: namely the period during 1874–1897 and the 1930s before the outbreak of WWWII.

We treat the deflation period after the Napoleonic Wars and WWI as the normalization after the extraordinary inflation which had been caused by the wars.

Whether by coincidence or by some sort of cyclical imperative, the other two deflationary episodes — the deflationary period in the late 19th century (1874–1897) and the deflationary period during and after the Great Depression — emerged toward the peace time end of the bond bull markets: the peace time means that we exclude the period of hegemonic wars such as WWII.

If history is a guide, persistent deflationary pressure that has excruciated central bankers in our time might be due to its cyclical déjà vu, which manifested toward the peace-time ends of the past 2 bond bull markets. For now, let’s keep it as an open question.

In principle, deflation can be caused by supply-demand dynamism and/or monetary constraint. In other words, at least there are the following three causes:

• negative demand shock
• positive supply shock (e.g. innovation, supply expansion)
• the shortage of money (insufficient quantity of money to meet demand expansion)

In reality, deflation can be driven by a combination mix of these multiple factors. As an example, the Great Depression (1929–33) might have been exacerbated by all three factors: the excess supply created during the earlier bubble period; the collapse in demand during the deleveraging process; and the dry-up in liquidity, which was associated with the rigidity of the gold standard, in the aftermath of the financial crisis of 1929.

Part 2: A Historical Perspective of Inflation/Deflation and International Monetary System:

Now, let’s see the same UK inflation/deflation history along the historical transformation in the international monetary system.

Chart 3 traces the UK’s inflation/deflation history along the historical passage of the exchange rate (USD/GBP).

Chart 3 shows that there was no peace-time GBP depreciation against USD before WWI. (The big upward swing in the 1860s was the depreciation of USD due to the US Civil War) This is an evidence that the UK’s predominant position in defending the gold standard before WWI.

Segmented Period (before the 1870s):

Before the 1870s, the UK was the only country operating under the gold standard. (e.g. German speaking states operated under the silver standard; France and the United States operated under the bimetallic standards.) During the peace time before the 1870s, deflation and inflation alternated one another to even out in the long run. When we take the arithmetic average of inflation throughout the peace time between 1816–1870, the averaged inflation is around (-/minus) 0.02 %.

Convergence Period (the 1870s-1900):

Thereafter, during the period between the 1870s and 1900, there emerged a gradual convergence toward the international gold standard among contemporary industrialized economies: during this period countries such as Germany, France, Italy, and the United States joined UK in adopting the gold standard. The deflationary environment (1874–1897) nearly coincided with this period of the international convergence (the 1870s-1900). The arithmetic average of inflation throughout the period 1871–1900 was (-/minus) 0.39%, suggesting very minor but persistent deflation. As Chart 3-a below shows, the exchange rate USD/GBP was stabilized during this period.

During this period, innovations developed in the lead country, the UK, were gradually disseminated among the follower states in Europe. It facilitated the follower countries to make a catch-up in their productivity growth. Across the Atlantic, the USA was already ahead of the UK in productivity growth in some areas: especially, ‘manufacturing’ and ‘transportation and communication’. (Broadberry, 2006)

“In part, prices declined during the 19th and the early part of the 20th century because of the constraints imposed by the Gold Standard. Under this regime, money was freely converted into gold at a set price so the supply of money was linked to the size of a country’s gold reserves. When the world’s gold supply could not keep pace with the growing supply capacity of the world economy, this frequently led to periods of falling prices (IMF (2003)). Since this was often caused by an increased supply of goods and services and not by a shortfall of demand, the resulting deflation was benign.” (Groth & West, 2009, p. 39)

“The deflation of the late nineteenth century reflected both positive aggregate supply shocks and negative money supply shocks. However, the negative money supply shocks had little impact on output. This we posit is because the aggregate supply curve was very steep in the short run during the period. This contrast greatly with the deflation experience during the Great Depression. Thus our empirical evidence suggests that deflation in the nineteenth century was primarily good.” (Bordo, Lane, & Redish, 2004, Abstract)

The expansion of colonization also characterises this period. Access to cheap labour and supply expansion in raw materials in colonies might well have accounted for deflation during this period. (For more on the deflation episode during 1874–1897, please visit “Deflation Anecdote 1874–1897: Integration, Convergence and Deflation”)

Overall, the deflation during the last three decades of the 19th century can be summarized as follows:

• Deflation was low but persistent. (1–3%) in most countries.
• Productivity growth was rapid among the follower countries.
• The real economy was growing in general.
• The price level might have been depressed by the limited supply of gold relative to the growth expansion of the global economy.

As aforementioned, this period is positioned toward the end of the bull bond market of the 19th century.

Integrated Economic Order under the International Gold Standard (1900–1913):

During the prosperous period of globalization between 1900–1913, the international gold standard operated . Throughout the international gold standard, the international trade became more integrated.

“European currencies had been effectively interchangeable under the gold standard that prevailed until 1914.” (Eichengreen, 2011, p. 69)

The prosperity during the international gold standard (1900–1913) exhibited near zero low positive inflation in the United Kingdom. The arithmetic average throughout this period is 0.74%.

As Chart 3-a shows, the exchange rate USD/GBP was rock-solid fixed throughout this period.

Disintegration Process (1914–1945) through WWI, Interwar Period, and WWII:

After 1914 until 1945, two great wars raptured the economic substance of the UK and impaired the conduct of its gold standard. During the interwar period, the UK restored its pre-war gold parity in 1925; so did France after devaluing its currency, franc, in 1926. Nevertheless, the UK’s experience with the interwar gold standard was very far from its pre-war experience of prosperity. Chart 3-a above shows that during the interwar peace period (1919–1938) GBP demonstrated two large down swings: these are the depreciations of GBP against USD: the UK were no longer capable of sustaining its peace-time gold convertibility.

During the 19th century, Benjamin Disraeli, who served UK prime minister in the late 1860s (1868) and the 1870s (1874–1880), already made a prognosis to expose a myth of the gold standard:

“It is the greatest delusion in the world to attribute the commercial preponderance and prosperity of England to our having a gold standard. Our gold standard is not the cause, but the consequence of our commercial prosperity.” (Bernstein, 2000, p. 258)

Much later, a prominent British economist of the 20th century, John Maynard Keynes, was also sceptic about the automatic adjustment mechanism of the gold standard. Keynes made the following remark:

“To suppose that there exists some smoothly functioning automatic mechanism of adjustment which preserves equilibrium if we only trust to methods of laissez-faire is a doctrinaire delusion which disregards the lessons of historical experience without having behind it the support of sound theory.” (John Maynard Keynes) (Eichengreen, 2008, p. 91)

Despite various theories and myths about how the gold standard might have worked, the cornerstone of the gold standard was the central bank’s ability — not only its willingness — to commit to the gold convertibility: in other words, its sustainable gold reserve level. Economic dislocations caused by WWI impaired the UK’s economic substance, thus, its ability to manage the balance-of-payments. In other words, the war ruptured the UK’s ability to maintain its gold reserve. Before WWI, market participants could take for granted the ability of the Bank of England to maintain its gold parity. And accordingly, market forces acted on the presumption to reinforce the maintenance of the gold reserve, thus the gold convertibility. After WWI, in contrast, whenever the currency weakened, market participants, no longer able to assume the credibility of BoE, took flight away from GBP. The adjustment mechanism of the gold standard was proven nothing but a myth. On the contrary to the myth, the gold standard after WWI rather magnified the balance-of-payment imbalances than adjusted it. As the Great Depression exacerbated deleveraging process, the UK suspended its gold convertibility in 1931 during the peace time. (Eichengreen, 2008)

Barry Eichengreen portrays the disintegration of the gold standard during the interwar period as follows (2008, pp. 46–47):

If France’s stabilization (the restoration of the gold standard) in 1926 is taken to mark the reestablishment of the gold standard and Britain’s devaluation of sterling in 1931 its demise, then the interwar gold standard functioned as a global system for less than five years. Even before this sad end, its operation was regarded as unsatisfactory. The adjustment mechanism was inadequate: weak-currency countries like Britain were saddled with chronic balance-of-payments deficits and hemorrhaged gold and exchange reserves, while strong-currency countries like France remained in persistent surplus. The adjustments in asset and commodity markets needed to restore balance to the external accounts did not seem to operate. The global supply of reserves was inadequate: it declined precipitously in 1931 as central banks scrambled to convert foreign exchange into gold.

WWI ruptured the substance of the international gold standard as well as the economic substance of the UK.

In 1933 the USA also benefited from USD devaluation, by increasing the price of gold by 69% to $35 from $20.67. The USD devaluation, together with the New Deal Policy initiatives, boosted industrial production by 60 percent and reduced unemployment from 25 percent to 14 percent during 1933 and 1937. (Bernstein, 2012) Devaluation temporarily alleviated deflation and restored inflation level during the period.

In this light, this interwar period represents a disintegration process of the international monetary system and demarcates the period between the international gold standard (1900–1913) and its demise thereafter. After WWII, as Chart 3-b shows, GBP continued to depreciate against USD in several steps. The UK’s interwar effort to restore the gold standard was ironically proven abortive.

New Convergence Age (1945-the 1980s):

In retrospect, since the 1st Industrial Revolution the international monetary order went through multiple regimes: a segmented order (until 1879), a convergence process (1870–1900), an integrated order (1900–1913), and a disintegration period (1914–1945). Now, toward the end of WWII, a new cycle of convergence (consolidation) emerged.

From an inflation perspective, history after 1945 can be divided into three phases: the Bretton Woods era between 1945–1971; the post Bretton Woods period until the debut of Paul Volcker (1972–1980); and thereafter until today.

In 1944, one year before the end of WWII, the Bretton Woods Conference was convened to design as a variant of the gold-exchange standard, which allowed central banks to substitute foreign exchange reserves for gold reserves. Effectively, it transformed to a de-facto gold-USD standard — in which USD played as a predominant currency convertible to gold and other currencies were loosely pegged to USD (adjusted peg) . By its statute, the Bretton Woods System did not prohibit the gold convertibility of non-USD currencies. Nevertheless, economics made it a de-facto gold-USD standard, as the rest of the world increasingly demanded USD as gold-reserve substitutes because of the US’s predominant economic position.

Peter L. Bernstein portrayed the loose gold convertibility of the Bretton Woods System as an American pragmatic monetary design that avoids “the suffocating deflations and unemployment that blind adherence to the old gold standard had mandated in the past.” (Bernstein, 2000) Now, from Bernstein’s insight we can derive one corollary about the evolution of monetary system: economic catastrophes in one generation could determine the monetary system design of the next generation. In a way, the Bretton Woods was a reflection of the interwar economic lessons: e.g. the Great Depression and the British “chronic balance-of-payments deficits and hemorrhaged gold and exchange reserves” (Eichengreen, 2008, pp. 46–47).

The post-WWII economic dislocations made it impossible for many countries to make an immediate transition to the Bretton Woods System. Arguably, it took 16 years of transition period for countries to make a series of political compromises to the system to start a new regime. [“On December 31, 1958, the countries of Europe restored convertibility on current account. The IMF acknowledged the new state of affairs in 1961 by declaring countries in compliance with Article VIII of the Articles of Agreement.” (Eichengreen, 2008, p. 112)] In this perspective, the Bretton Woods System might be seen a short lived: it arguably operated only for a decade between 1961–1971.

In the United Kingdom, during this period of 1945–1971, inflation was in the range between 0.6% (1959) and 10.65% (1952): 4.5% on average throughout the 26-years-period (Chart 3-b). When we compare this inflation record with the inflation history before WWI (Chart 3-a), the USD’s gold convertibility of the Bretton Woods System does not seem effective as a price stability mechanism as much as the gold standard before WWI. Of course, this period had the overriding priority, beyond the price stability, of the post-war reconstruction of allied nations and the Vietnam War (1955–1975) in the context of the Cold War: it was characterised by extra-ordinary fiscal expenditures.

“Big Bang” of Contemporary Monetary System

Now turning into the 1970s, there emerged the passage to the “Big Bang” of our contemporary monetary system. This decade gave birth to our contemporary fiat money system. The “Monetary Big Bang” did not happen in one single shot. Instead, it took several steps to complete. Despite many ways to slice this process of the “Monetary Big Bang”, I would break it down into the following four steps: first, persistent inflation which had already picked up in the late 1960s in the United States; second, the Nixon Shock, which unleashed un-anchored fiat money order by abolishing USD’s gold convertibility of the Bretton Woods System in 1971; and third, ensuing gradual passage toward floating of the exchange rate across currency pairs; and fourth, devising the new anchor, price-stability-oriented monetary policy.

First, the late 1960s unfolded inflation momentum which persisted until 1980. Chart 4 shows that the US annual inflation rate surged above 5% in 1968 and registered 5.86% in 1970; it came down temporarily in 1972, then, resurged in 1973 and remained above 5% until 1982. During the period 1973–1980, the volatility of inflation rate was magnified: in the United States inflation ranged between 6.18% and 13.55% (Chart 4); in the United Kingdom inflation ranged between 7.2 % to 22.7%; (Chart 3-b). The passage of inflation is better described along with other three steps in the following paragraphs.

Second, the removal of the USD gold convertibility. In 1971, with the Nixon Shock unilaterally abolishing the USD gold convertibility, the world entered an open laboratory, a passage toward un-anchored fiat money world. The context of the Cold War was overarching: it did bind the Western allies. After making an abortive experiment of adjustable USD peg of the Smithsonian Agreement, another de-facto USD Standard, they took years to shape a new international monetary order under a full-fledged floating exchange rate regime.

The end of the Bretton Woods System manifested by the Nixon Shock amplified inflation momentum and volatility. Chart 3-b shows the UK inflation of this period (1972–1980) ranging from 7.19% to 22.70% (13.29% on average).

In hindsight, the Bretton Woods System turned out to be a footstep toward fiat money system.

Third, relaxing of the fixed exchange rate by an ‘adjustable peg’ regime. The increased capital mobility and market liquidity during the 1960s made it very costly in the 1970s for governments to intervene the market in order to defend the new adjustable USD peg that the Smithsonian Agreement set forth. Market participants, who saw their pursuit of their profit-making more relevant than the Cold War geopolitics, waged a series of speculative attacks in piecemeal basis. By 1973 they gradually made success in forcing the allies to go off the adjustable USD peg. As result, even the adjustable peg of the Smithsonian Agreement failed in 1973. The failure of the currency arrangement in 1973 accelerated inflation rate above 9% in the UK.

Although even after 1973 some efforts to establish adjustable peg were made regionally (e.g. European Monetary System during the 1980s), the age of high capital mobility made it highly costly thus unsustainable. Chart 3-b above shows that USD/GBP breaks to another level deeper down during the 1970s.

Overall, the Nixon Shock resulted in three things, a passage for an wild un-anchored fiat money world, a further disintegration of deterministic fixed exchange rate regime, and an escalation in inflation. This chaotic environment shaped pre-conditions for the birth, or the big bang moment, of our contemporary monetary policy.

After his inauguration as chairman of the Federal Reserve Board in 1979, Paul Volcker demonstrated to the world the new anchor to fiat money system, price-stability oriented monetary policy.

As mentioned earlier, in history a catastrophe in one generation could shape the monetary system design of the next generation. Paul Volcker made another case for our contemporary monetary system.

In brief, economic catastrophes of the 1970s — a long chaotic passage to the floating exchange rate regime that was accompanied with intensifying inflation — gave birth to our contemporary monetary system: fiat money system anchored by central bank’s price-stability oriented monetary policy — call it PSO-MPS fiat money regime (where PSO-MPS stands for price-stability oriented monetary policy standard).

Overview:

We briefly made a rough sketch about the genealogy of our contemporary monetary system. The inflation of the 1970s gave rise to our contemporary monetary system — price-stability-oriented monetary policy standard of fiat money system — in the 1980s. Given inflation that got out of control, the new monetary order was designed to cope with inflation.

It is symbolic to see that during the 2010s the system struggled with mild deflationary pressure, or persistent low inflation rate around near zero level. Born out of inflation, would it face its demise with deflation?

When we take a look at the historical chart of inflation/deflation, persistent deflation emerged toward the peace time ends of the previous two historical bull bond markets: the 1880s-90s and the 1930s (excluding the WWII period). Now, today, we are living through the historically low bond yield environment. It might suggest that the persistent deflationary pressure today be another replay of the cyclical force.

Now, the deflationary pressure of the 2010s persisted despite the unprecedented growth in monetary base. This suggests that this time deflationary pressure is not monetary phenomena: then, it would logically require some other measure than monetary policy to alleviate the deflationary momentum. Say, fiscal measures. Nevertheless, some advanced economies are constrained with high levels of government debts which would restrict the room for fiscal manoeuvre. Structural reforms are typically held back by an inherent nature of democracy: political representatives have intensive focus on those agendas which would yield short-term political gain from which they can benefit during their political career life. In this context, there tend to be only weak political incentives for them to take initiatives in long-term structural reforms. This is an inherent nature embedded in the architecture of democratic political reality. In addition, innovations are overtaking conventional jobs. Decreasing demand in conventional jobs on one hand, increasing demand in IT related jobs on the other. Skill gap might be creating job market imbalances. This would create uncertainty in wage and unemployment going forward. Retraining of workforce is an urgent need for society to make a smooth transition in the age of innovative destruction (or “creative destruction” coined by Joseph Schumpeter).

Constraints on fiscal manoeuvre would inhibit government from creating positive demand shock. Innovative disruption is creating positive supply shock. Both dynamics in combination would likely account for deflationary force. Here is a conditional statement: Should deflationary pressure re-emerge, monetary authority would need to engineer a new monetary system to cope with deflationary pressure. In our contemporary fiat money system, cash excruciates central bankers under negative interest rate regime. Its physical and non-interest-bearing features create the asymmetric architecture of our contemporary monetary reality. While central bankers could raise interest rates as high as they wish in their efforts to contain inflation, they face zero lower boundary (ZLB) in their battle with deflation. I discussed the problem of Zero Lower Bond (ZLB) and explore possibilities to liberate monetary system from ZLB in my other content, “A Call for New Monetary Regime — Liberation from Zero Lower Boundary”.

Simply, the general price inflation and the asset price inflation demonstrate different behaviours. By design, our contemporary conventional monetary policy cannot manage the general price level and asset prices simultaneously. If conventional monetary policy is not a perfect instrument by design, we might need to complement the imperfection of monetary policy with some other tools. While the conventional monetary policy aims at the stability of the general price level, macro-prudential policy and agile regulatory responses need to be mobilized to contain excess leverage and asset inflation. In this sense, the tax reform on “negative gearing” in Australia and the regulation on “interest only loans” might alleviate excess leverage and asset inflation. The question might be whether there is any political will among political representatives to do such things. Long-term social necessity for all might be sacrificed for the short-term political interest for the few interest groups.

REFERENCES

• Bernstein, P. J. (2012). The Power of Gold: The History of an Obsession. Hoboken, New Jersey: Wiley and Sons, Inc.
• Bordo, M. D., Lane, J. L., & Redish, A. (2004). Good versus bad deflation: lessons from the gold standard era. Cambridge: National Bureau of Economic Research.
• Broadberry, S. (2006). Market Services and the Productivity Race, 1850–2000; British Performance in International Perspective. New York: Cambridge University Press.
• Eichengreen, B. (2008). Globalizing Capital: A History of the International Monetary System. Princeton: Princeton University Press.
• Eichengreen, B. (2011). Exorbitant Privilege. Oxford: Oxford University Press.
• Goldstein, J. (1988). Long cycles: prosperity and war in the modern age. New Haven: Yale University Press.
• Groth, C., & West, P. (2009). Deflation. Quarterly Bulletin, Q1, 37–44.
• MacFarlane, H., & Montimer-Lee, P. (1994, 5). Inflation over 300 years. Bank of England Quarterly Bulletin, 156–162.