Currencies After the Crash

by Sara Eisen

  U.K. Sunset

  Sterling’s dominance in world trade started to slip before World War I, with the shares of the French franc, the German mark, and the U.S. dollar all increasing. Then World War I pretty much ended Britain’s leading role in the international economy as economic interdependence broke down. Britain suspended the conversion of sterling into gold during the Great War, then reestablished it in 1925 at about prewar levels; this greatly overvalued sterling because of massive inflation in the meanwhile. With the Great Depression, the United Kingdom, the United States, and most other developed countries abandoned public conversion of paper currencies into gold.

  With the rising power of the U.S. economy in global trade and finance, the dollar became the international currency starting in the 1920s, and it was crowned as the world’s primary reserve currency by the Bretton Woods Agreement in 1944. The dollar was linked to gold, and all other currencies were linked to the dollar; this gave other countries access to the U.S. gold hoard, which had leaped during World War II, while fixing international exchange rates. But a foreign government rush for U.S. gold in the inflationary early 1970s forced President Nixon to sever the link to gold, and floating exchange rates for major economies followed.

  The euro, introduced at the beginning of 1999, was heralded as a rival to the dollar as a reserve currency, reflecting the combined strength and size of the eurozone countries, which, together, had a GDP close to that of the United States. In the following decade, some countries moved a portion of their reserves to euros, and after an initial 30 percent drop from 1.18 euros per dollar to 0.83, the euro climbed steadily—until recent years (Figure 1-4).

  Figure 1-4 U.S. Dollars per Euro

  Source: Thomson Reuters

  The 2007–2009 Great Recession, however, revealed that joining the Teutonic north with the Club Med south under one currency but with no common fiscal policy was inherently flawed. It worked in the early to mid-2000s, when global economic growth covered up a multitude of sins, but not when tough times set in.

  Eurozone Crisis

  Germany and other strong countries in the Teutonic north have two unattractive options for dealing with the current crisis. They can continue, directly or through the European Central Bank, to bail out Greece and other weak countries, including potentially Spain and Italy. This strategy has no end in sight and is accompanied by rising resentment from their own voters. Or they can do nothing and wait for Greece to default on its sovereign debt, withdraw from the European Union (EU) and the eurozone, and devalue massively as it returns to drachmas, draculas, or whatever. Then there’d be a run on other Club Med country banks as investors yelled, “Who’s next?,” and contagion would force a disintegration of the eurozone as it is presently constituted.

  That would bring big troubles for German, Dutch, and other strong country banks that have considerable exposure to the weak economies. So those countries’ governments would have to bail out their own banks. As long as the crisis was confined to Greece, Ireland, and Portugal, it appeared manageable. Those three small countries combined account for less than 6 percent of eurozone GDP.

  But if the woes spread to the other two PIIGS (PIIGS 5 Portugal, Ireland, Italy, Greece, and Spain), Spain and Italy, the problems will become huge whether the strong countries bail out the weak countries or their own banks. Spain accounted for 11.5 percent of eurozone GDP in the first quarter of 2012, and Italy accounted for 16.7 percent. All five of the PIIGS have high government deficits and debts. All except Ireland, which has given itself some very stringent fiscal medicine, have more and more risky sovereign debt issues, according to credit default swap prices. European banks that hold weak sovereign bonds are in trouble, and the woes of French banks and the French economy resulted in the January 2012 downgrade of French sovereign debt; Standard & Poor’s also stripped Austria of its triple-A rating and reduced the ratings of Spain, Italy, and five other eurozone countries.

  So the strong eurozone members need to bail out someone, and I think that they will continue to aid the weak countries directly. Otherwise, the eurozone will disintegrate, ending the noble post–World War II experiment in Europe. After the war, the German and French leaders decided that they had to find a different way of interacting from their method that had been used since Napoleon 150 years earlier—all-out war. They reasoned that integrating their economies more closely would reduce the likelihood of military conflict. That set them on the path that moved from the founding of the European Economic Community in 1958 to the eurozone in 1999. Complete political or even economic integration in such diverse countries was not feasible, but a common currency was believed to be an important step.

  Sources of Strength

  This review of history shows that primary reserve currencies are those that dominate international trade and are issued by robust economies. But how did these economies become robust? Alexander the Great knocked off every nation in sight by military conquest, including much, much larger Persia. Rome was notorious for conquering foreign lands and then carting the loot back to Rome. Egypt became the source of grain to provide the Roman multitudes with bread while Egyptian obelisks were moved to Rome as parts of the circuses.

  Productivity Growth

  In recent centuries, another element has superseded the grabbing of land and loot as a source of economic strength—productivity growth. In their 1988 book American Business: A Two-Minute Warning (New York: Free Press) C. Jackson Grayson, Jr., and Carla O’Dell make a very convincing case for superior productivity growth as the key to global economic leadership and, therefore, to principal reserve currency status. They explain that rapid productivity growth is necessary for raising living standards and achieving and maintaining global economic leadership.

  They also note that earlier, the lack of productivity growth wasn’t caused by a lack of technology. Ancient China, for example, was very technologically advanced, having invented gunpowder, umbrellas, movable type, paper making, and the magnetic compass. The strength of the Roman Empire, some argue, was the result of its advanced military technology. But ancient societies didn’t apply their technologies to economic growth because they didn’t want to upset the balance of power, vested interests, and stable societies.

  No Growth

  As a result, for millennia, world economic growth only kept up with population growth, and GDP per capita was static (Figure 1-5). According to Grayson and O’Dell, from 1500 to 1700, annual income rose from $215 per capita in current dollars to $265, a mere 0.1 percent per year. So it was a zero-sum world. Whatever Alexander or Rome gained, someone else lost.

  Figure 1-5 Growth in GDP per Capita

  Source: C. Jackson Grayson, Jr., and Carla O’Dell, American Business: A Two-Minute Warning (New York: Free Press, 1988)

  But the Crusaders introduced Western Europeans to the East and its different cultures and products. Marco Polo and others developed the Silk Road to obtain spices, silks, and other things that were unknown in the West, and the desire to get to China by water led to the discovery of the New World. That not only shook up the old order but also gradually, very gradually, introduced conditions that promoted productivity and competition, not through arms but via commerce. And productivity became the means of raising living standards.

  Now, let’s be clear: productivity enhancement was not any nation’s policy during the Age of Discovery or even in 1700, when it began to grow. Columbus got the backing of King Ferdinand and Queen Isabella to sail west to obtain gold and other riches, not to raise Spanish living standards. But the rise of towns in the Middle Ages and the circumnavigation of the globe worked to break down rigid controls and allowed Adam Smith’s invisible hand, or the self-regulating nature of the free market, to get through the resulting crack in the door. With free markets, he argued, the pursuit of individuals’ best interests increased the welfare and living standards of the whole community.

  The Dutch

  By 1700, global trading was the hot new technology, as mentioned earlier, and
the Dutch were its masters from then until about 1785. They controlled not only the mouth of the Rhine, the water gateway to Europe, but also most of the trading routes to Southeast Asia. Grayson and O’Dell point out that in 1700, Dutch GDP per capita was about $440, or around 50 percent greater than England’s $288. The Dutch had considerable expertise in producing woolens and linens, beer, ceramics, soap, and ships. Their fleet was bigger than England’s, and, on a per capita basis, so was their international banking and insurance industry. Their low-cost textiles killed competitors in Genoa, Venice, and Milan.

  The guilder was the international trading currency of the seventeenth and eighteenth centuries, as noted earlier. By the late 1700s, however, the Dutch got fat and happy and spent lots of time enjoying life and having their portraits painted by the successors to Rembrandt, van der Meer, and the boys. And they weren’t carefully watching the ascendancy of the Brits.

  Up until then, Dutch productivity exceeded that of England, but Holland’s productivity growth slowed and even fell 0.1 percent annually during the latter part of the eighteenth century, according to Grayson and O’Dell. Meanwhile, English productivity growth accelerated to about 0.4 percent per year. The English gained on the Dutch in both agriculture and trade, and by 1760 they had overtaken the Netherlands to become the world’s biggest trading nation.

  U.K. Dominance

  The United Kingdom’s dominance really picked up steam with the unfolding there of the Industrial Revolution in the late 1700s. Among early inventions, the spinning jenny and the steam engine hyped productivity manyfold compared to hand spinning and weaving, and human and animal power. The Industrial Revolution, like any new technology, grew rapidly but started from zero, so it took decades before the effects on British productivity were appreciable. Productivity in England rose only about 0.5 percent annually in the last several decades of the eighteenth century, but combined with stagnation in the Netherlands, British productivity surpassed that of the Dutch by about 1785.

  The Industrial Revolution also had a profound effect on society. Think of the transformation from the days of Jane Austen’s Pride and Prejudice, when jobs were beneath the dignity of the country gentry and prospective husbands were measured by their annual pensions from their families, to the wealth and power attained by the nineteenth-century industrialists and financiers, as exhibited by their “cottages” (mega-mansions) in Newport, Rhode Island.

  The Middle Class

  I’ve long believed that the greatest effect of the Industrial Revolution was to create vast middle classes. Earlier, European economies were two-class societies. Those on top owned almost everything and controlled most of the income. They spent lavishly on their palaces, entertainment, armies, and so forth, but they still had large saving rates. Those on the bottom spent all their income to subsist, but they had very little. Therefore, potential output was far in excess of domestic demand, and those countries tried to export it in return for gold. This, of course, was the strategy of the mercantilists, who held sway before the Industrial Revolution. But with the Industrial Revolution came the middle class, all those people who wanted a better life, conspicuous consumption, and education for their children. And they now had the money to pay for these desires. Hence the advent of domestic spending–led economies in developed countries—except in Japan, which clings to its feudalistic “export or die” mentality.

  The rise of the middle class in Europe was reflected in the size of music halls. Earlier, classical music was composed for the nobles and church officials who were patrons of the musicians, and it was performed in rooms in their palaces—the chamber music of the Baroque and Classical periods. When J. S. Bach visited Frederick the Great at Potsdam in May 1747 and accepted the king’s challenge to turn the 21 random notes that Frederick tapped out on a piano into his famous “Musical Offering,” concerts, including flute concertos composed and performed by the king, in that magnificent palace were given in relatively small rooms with a dozen or so musicians.

  In the nineteenth century, however, the rising middle class had money to spend on classical music, and musicians shifted to playing with large orchestras in huge concert halls to oblige these new patrons. Hector Berlioz went over the top in 1844 with a Paris concert that involved 1,022 performers, including 36 doubles basses for Beethoven’s Fifth Symphony, 24 French horns for Weber’s Der Freischütz overture, and 25 harps for Rossini’s Prayer of Moses. In 1855, he followed with a spectacular performance featuring 1,200 players plus choruses and five subconductors.

  Nineteenth-Century England

  With Britain being the first major country to industrialize and its resulting 1.5 percent annual productivity growth between 1820 and 1870, it dominated the nineteenth century in manufacturing, global trade, and finance, and in political and military power after Napoleon met his Waterloo in 1815, despite the United Kingdom’s relatively small land mass and population. In 1870, according to Grayson and O’Dell, Britain’s trade was greater than that of France, Germany, and Italy combined and three times that of the United States. And, as noted earlier, sterling dominated in international trade and was the world’s reserve currency, and the sun never set on the British Empire that stretched across the globe.

  But like the Dutch before them, the British became complacent in the late 1800s and let their productivity growth slip below that of two upstarts—Germany and the United States. Probably because of its physical proximity and differences in culture and language, the threat from Germany was expressed more frequently in the British press, Parliament, and business community. A Royal Commission in 1885 found that in the production of goods, Britain had few, if any, advantages over Germany and that the Germans “appeared to be gaining ground on British business.”

  Nevertheless, the two world wars in the first half of the twentieth century knocked Germany out of the box, at least temporarily. And with the American Industrial Revolution in full flower in the late 1800s and railroads spreading across the continent, the United States became the major challenge to Britain.

  As noted earlier, the Industrial Revolution in America commenced in New England in the late 1700s, at the same time as its genesis in England, but it came into full flower and became big enough to drive the economy only after the Civil War. Agricultural value added was almost twice that of manufacturing at the beginning of that conflict (Figure 1-6), but the explosion of factory output equalized the shares of the two by the mid-1880s. At the end of the century, factories outproduced farms by almost two to one. Between 1860 and 1914, employment in manufacturing and construction tripled, and the physical output of manufacturing rose six times.

  Figure 1-6 Value Added in U.S. Commodity Output by Sectors, 1859–1899

  Source: Robert E. Gallman, Trends in the American Economy in the Nineteenth Century, Conference on Research in Income and Weatlh, (Princeton, NJ: Princeton University Press, 1960)

  Railroads

  Railroads were first developed in England in the mid-1700s, but only after the Civil War did this new technology become big enough to drive the U.S. economy. Railroads pushed across the continent, uniting first North and South, then East and West. In 1860, the United States had 30,626 miles of track, mostly in the East, Midwest, and South; by 1900, the United States had 198,964 miles of track. Trains crisscrossing the nation carried people westward and brought agricultural products and minerals east, thus opening up vast acreage for farmers, ranchers, and miners.

  More Productivity

  Overall, U.S. productivity after the Civil War grew at a sustained rate unequaled during any other period in history. Real GNP per capita grew at an average annual rate of 2.1 percent from 1869 to 1898, and the population grew at about the same rate, encouraged by waves of immigrants. Consequently, real GNP grew 4.3 percent per year in the greatest period of sustained growth in American history. That compares with 3.7 percent in the unsustainable salad years of 1982 to 2000.

  Notice, in comparison, the much slower growth in the United Kingdom and France during
the latter part of the nineteenth and early twentieth centuries (Figure 1-7). Without meaningful immigration, population growth was much slower than that in the United States, and the Industrial Revolution bloom was off the rose, especially in the pioneer industrialist nation, the United Kingdom. Canada, naturally, resembled the United States.

  Figure 1-7 Growth by Country, 1869–1914

  Source: S. S. Kuznets, Economic Development and Social Change (October, 1956)

  After Bismarck assembled the various German states into one nation and industrialization commenced, the country’s growth was strong, but the immigrant population growth of the United States was missing. The same was true of Japan after Commodore Perry’s show of American naval and industrial firepower in 1854 convinced the leaders there that feudalism had to go in favor of industrialization.

  U.S. Ascendancy

  In 1870, the U.S. productivity level was fourth, behind not only England, the leader, but also the Netherlands and Belgium (Figure 1-8). However, the United States overtook Holland in the 1870s and Belgium in the 1880s, and then bested the United Kingdom. American productivity growth averaged 2.1 percent per year from 1870 to 1890, far exceeding the United Kingdom’s 1.3 percent rate. As that 0.8 percent gap compounded, American productivity levels spurted beyond those of Britain in the 1890s. Not surprisingly, by 1901, U.S. per capita GDP exceeded that of the United Kingdom.

  Figure 1-8 1870 Productivity Levels

  England 5 100

  Source: C. Jackson Grayson, Jr., and Carla O’Dell, American Business: A Two-Minute Warning (New York: Free Press, 1988)