September 28, 2009

One World Currency?

Good question. I think that “one world currency” is not a workable system. Changes in currency exchange rates act as shock absorbers between economies. In order for more than one country to share a currency, those countries have to abandon control over their own monetary policy and use one common central bank. Thus, the creation of the Euro required the creation of the European Central Bank. One world currency would require the creation of one world central bank. I do not think that countries would be willing to give up that kind of control over their own economies.

An alternative similar to a common currency in effect is the use of a commodity based system, such as the Gold Standard, which was used for most of the 19th Century and the early 20th Century. Under such a system, everyone agrees to define their currency in terms of a certain weight in gold and then the exchange rates come from the relative amounts of gold that can be obtained for each currency. For example, if a UK pound was defined as an ounce of gold, the Euro as a half ounce of gold and the dollar as a fourth ounce of gold, then a pound would be worth two Euros or four dollars.

However, the gold standard had its own problems. For example, when new sources of gold become rare, the result tends to be deflation. A big new gold strike creates inflation. Countries have to hold enough gold to make the system work (they always have to be able to hand gold over in exchange for their currency). Normally, countries do not have enough gold to cover all of the currency they have outstanding. If people lose faith in a country's ability to exchange gold for its currency, then there is downward pressure on the value of the currency as everyone rushes to exchange the currency for gold. This is the national equivalent to a run on a bank. During WWI, most of the world was forced off the gold standard in this way. As a result of fears about war in Europe, most of the world's gold made it to the US. European countries no longer had the reserves to establish a gold standard for their currencies.

As countries struggled to reinstate the gold standard after the war, they enacted policies that ultimately helped create an asset bubble in the US, and contributed to the Great Depression. Specifically, in an attempt to help the British increase gold reserves and reestablish the gold standard, the US significantly reduced interest rates, so that the relatively high rates in the UK would attract gold from the US. These low interest rates facilitated the run up of US stock prices, which finally crashed in October of 1929. In other words, there are some serious problems which have been caused by policies that try to maintain very stable exchange rates between countries.