allAfrica.com: Kenya: Reserve System in the Spotlight As Dollar Slides (Page 1 of 2)

As the dollar continues to slide, questions are being raised over what may have caused this and what can be done to deal with it.

The problem is really a consequence of the monetary policy known in economic terms as 'the reserve system', in which bankers everywhere ensure that any currency is backed by either a commodity like gold or a more stable currency.

This system originated in medieval Europe where villagers would deposit their gold or silver coins with the local goldsmith in exchange for an IOU note. The goldsmiths noticed that most of their clients preferred to use the IOUs for ordinary cash transactions rather than repeatedly redeeming their coins. In effect, these IOUs became the forerunners of modern currencies and were backed by coins deposited with someone.

Goldsmiths became the ancestors of modern bankers when they noticed that at any given time, 90 per cent of the coins remained undisturbed in their vaults and could therefore be used as backing for new IOUs to be lent out. They started issuing IOU loans many times in excess of their coin holdings, coins which really belonged to their clients. In the process they also discovered monetary patterns like inflation and deflation.

Before and during the Second World War, a large amount of gold from European countries was transferred to the US to pay for goods, at the end of the war it had accumulated to 80 per cent of the world's gold. To sort out the financial chaos, the Bretton Woods agreements of 1944 established the US Dollar instead of gold as the international reserve currency for countries which ratified them.

Only America retained gold as the reserve for its currency and this was fixed at $35 per ounce, making the dollar the international trade and reserve currency.

America's subsequent economic growth and entanglements in costly adventures such as the Vietnam War, forced it to print money to pay for its expenses. The total amount given out far exceeded the gold reserves of its treasury.

As a result, in August 17, 1971, President Richard Nixon abolished gold as a reserve for the dollar despite opposition from leading beneficiaries of the system. Some think this is the real reason he was ousted from office, not the Watergate scandal.

At the same time America's domestic demands raised oil production to its peak leading to the risk of energy resource depletion. America's production could not satisfy demand and this necessitated importation. It decided to secure reliable oil supplies and simultaneously safeguard the dollar; this was done by ensuring that Saudi Arabia, the leading producer, sold its oil only in dollars. To achieve this, the kingdom was provided with social as well as military support.

The rest of Organisation of Petroleum Exporting Countries (OPEC) was also roped in and still deals in dollars, importers like Kenya must engage in trade first to earn the currency before purchasing oil. This is where the World Bank and the IMF comes in; if a country cannot earn enough dollars to back its own currency and engage in trade (buying oil), then these two institutions issue loans.

These are obviously lent in dollars and repaid with interest, in dollars. A strong demand is created in such a situation, yet America only has to print the currency for trade, debt payment and oil purchases. For almost three decades this arrangement, the dollar-oil standard, was maintained reasonably well.

Saudi Arabia and other oil producing Gulf States such as Kuwait and the United Arab Emirates even went ahead and established fixed exchange rates on their currencies with respect to the dollar.

A rise in the value of the dollar would produce a corresponding rise in these currencies and vice versa, enabling them to ride on the successes and failures of the US economy.

As a result Saudi Arabia's accumulated foreign reserves topped $200 billion by 2004 due to its faithful trade with America and the ever increasing demands for oil over time.

However, at the time of the Bretton Woods conference, no one imagined China could grow as fast as it has in the last 25 years. The Chinese did something similar to the Gulf States; they pegged their currency to the dollar but at a grossly undervalued rate. This remained the case until 2005 and meant that for almost 20 years China could produce goods and services at a fraction of the cost in America.

This made the superpower its leading trade partner and its exports soared until it had accumulated an estimated $1.7 trillion in reserves by March this year. It is during this process that a new problem arose.

An increased supply of dollars needed for international trade eventually led to inflation. In addition, 11 European countries created the euro on January 1, 1999, and formed a monetary union around this currency. Many abolished their dollar reserves and released billions into the international currency markets, increasing inflationary pressure on the dollar.

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