The backing of money

Index

1. Presentation

2. What is the support or the real value of the dollar and gold?

3. The exchange rate

4. What is the utility of to support the currencies in dollars and gold?

5. Is there a limit to the amount of money that countries can issue?

6. Does the growth of liquidity cause a bank run?

7.  How to face the danger of a run on banks

8.  Exchange control

9. The ideal level of liquidity

10. Fiscal deficit and austerity

11. Conclusions

1. Presentation

Gold was the backing of currencies and Sterling Pound the world trade coin until the end of World War II. From that time (Bretton Woods Agreement 1946), emerged a new economic order in which the dollar of the United States of America became the currency of support from other world currencies and, in turn, in the money of international trade, while gold and Sterling Pound went to play a secondary role. This placed the United States as the leading economic power in the world.

Since then, the world accepts as an axiom, as indisputable, the dollar of the United States of America and gold, in second place, as the backing of the countries’ currencies. Consequently, the coins must have a backup value with both instruments.

I make these reflections because I have seen how some economists in Latin American countries such as Venezuela, talk about inorganic money or unbacked money as a cause of inflation and not sufficiently explain what these concepts mean. I imagine that they refer to money without enough support in dollars or gold. In this work I will explain why a full backing in dollars or gold is relative and not a vital or essential condition for the good development of currencies.

2. What is the backrest or the real value of the dollar and gold? That is the key question.

The answer to the question is very simple: the money circulating in the world, including the U.S. dollar has no intrinsic value or tangible support and its only value is its acceptance as a mean of payment, i.e. a fiduciary value, it means based on the confidence of the giver and the recipient. Gold, in turn, despite being something tangible, has a relative value, especially given because it is used as an instrument of reserves by central banks of the world countries but, in reality, gold has too few practical applications. Hence we can infer that the world's currencies that sustain its value in gold have no solid backing, but only the good faith of issuers and users of these currencies, because none person can eat or drink gold and, as was said before, its use in other economic activities is also restricted. We can say, then, in the form of metaphor, that gold is also a fiduciary instrument.

3. The exchange rate

Governments set the exchange rate regarding the dollar according to their political interests and its position in the international economy. Some countries keep their currencies at par with the dollar while others depreciate to improve their competitiveness in international markets. Britain and the European Union do the contrary; they maintain their currencies revalued regarding the dollar and, however, have a privileged position in the international trade; this fact demonstrate that a depreciated exchange rate is not the key determinant of the position in the world trade.

4.  What is the utility of to support the currencies in dollars and gold?

The backing of currencies in dollars or gold serves theoretically for two purposes: a) to limit the amount of money in circulation and b) to ensure the conversion of national currencies into dollars or other currencies to buy or pay in external markets.

5. Is there a limit to the amount of money that countries can issue?

Theoretically, the amount of money in circulation in a country must be related to the amount of foreign reserves accumulated in its Central Bank. The implicit exchange rate of a currency is determined by dividing the monetary liquidity between the total of the international reserves. Nevertheless, it is necessary to underline that the implied exchange rate is not always fulfilled in reality; it may be less, equal to or greater than the ideal figure.

The truth is that governments can issue all the money they need in their local currencies, i.e., increase liquidity to meet the internal needs of the economy with no limitations but those that suggest prudence and good sense, without altering the official rate of the national currency regarding the dollar. This means that the implicit exchange rate does not necessarily have to be the rate of change in the market. The reason will be explained in the next paragraph.

6. Does the growth of liquidity may cause a bank run?

Under normal economic conditions, it is assumed that all citizens of a country are not going to present in the banks on the same day and same time to withdraw their money in national currency or change the currency for dollars or other currencies. That is the principle on which is based the existence of banking and insurance, because all depositors do not draw back its money simultaneously neither all people insured suffer mishaps at the same time. For the reason explained above, in a situation of relative stable economic conditions the implied exchange rate does not necessarily have to match with the rate of change of the market.

 The situation is different when the economy suffers a currency crisis or instability that makes economic actors seek refuge in hard currencies. In that case may appear the phenomenon of bank runs, i.e. the massive withdrawal of funds in domestic and / or foreign exchange. But this does not happen as a surprise. The behaviors of economic agents always give signs that allow foreseeing the storm.

7. How to face the danger of a run on banks and / or foreign currency

There are three alternatives: a) to establish a strict exchange control before occur the run and / or b) accumulate a high level of foreign exchange to meet the emergency, and c) to set limits to the withdraw of money in national currency.  Note that in either case we must bear in mind the figure of the lender of last resort; in the case of dollarized countries is the Treasury of the United States and in non-dollarized countries is the respective Central Bank in each country, which is responsible for issuing money to meet the contingency. A bank run is a money problem and is solved with money. Different is a natural disaster that is not solved with money.

8. Exchange control

In extreme situations of weakness in the money market and foreign exchange, the countries sometimes have no other choice but to impose an exchange control.  This measure may be a temporary solution but at long term usually the exchange control creates other distortions that prevent the normal development of the economy, like the emergence of parallel currency markets that exceed many times the official rate of exchange.

9. The ideal level of liquidity

Money is the instrument that drives the economy of a country, therefore, what determines the recession or expansion. The growth of the amount of money in the economy must be related to the behavior of the economic activities.

10.  Fiscal deficit and austerity

In recent times, the deficit of the public finance of nations has become the great sin to atone. That is what has happened in the United States where some institutions of the government suspended its activities in October 2013 because the Congress did not authorized an increase in public spending and debt levels. Europe, since 2008, also has implemented a strict austerity program to reduce or eliminate the public finance deficit of the countries, especially the least developed nations such as Greece, Iceland, Portugal, Spain and Italy. These austerity measures have led to increased unemployment levels and reductions in the quality of the public services that hurt the vast majority of the population of these countries.

The public finance deficit should not exist, neither the policy of austerity; the reason is very simple: because governments have the sovereign power to issue money to meet the needs of its domestic economy. But, usually, governments choose the hard way: cut public spending, thus causing recession and unemployment of millions of people.

What does constitute a real problem for governments is when the country has not enough foreign exchange to buy or attend international commitments. In that case, there are two ways: a) produce more to sell more in international markets and obtain more foreign currency and/or b) borrows dollars from international banks.

11. Conclusions

- Money circulating in the world, including the dollar has neither intrinsic value nor enough support in gold.

- The value of gold is relative because their value of use is limited.

- The only value of money is its acceptance as payment means, it is therefore, a fiduciary instrument.

- The concepts exposed in this work have demonstrated why the backing in dollars or gold is something relative and not a vital or essential condition to fulfill the role of currencies as mean of payment inside the borders of each country.