The financial markets are currently in turmoil. The impact has yet to hit the stock market, but bond markets all over the world are creaking. The problems seem to have started in Japan where the country’s currency, the yen, is in free-fall. So far interventions by both the Japanese and American governments appear unable to stem the bleeding. Japan sneezed and the whole world caught a cold. Bond yields across the West are rising rapidly and many analysts are bracing for a major market event.
If this comes to pass, in the coming weeks and months many will focus on the short-term drivers of these problems. But in reality, they are the culmination of decades of poor economic management. To understand this a little history is needed. Prior to the First World War, the main currency used in global trade and held in reserve was the British sterling. In the interwar period, sterling dominance started to collapse, and the world slid into a Great Depression. After the Second World War policymakers were intent on not allowing this to happen again so they implemented the Bretton Woods system.
The Bretton Woods system fixed exchange rates in the Western world. Other countries pegged their currencies to the US dollar, and the US dollar was in turn pegged to gold. The system was designed to ensure that there were no serious trade imbalances in the global system. If a country began to run large trade deficits – say, Italy, who was a serial offender – it would be pressured to devalue its currency until its exports became cheap enough and its imports became expensive enough that the trade deficit was eliminated. The United States itself was constrained in running trade deficits because, since the US dollar was pegged to gold, if it ran sustained trade deficits gold would flee Fort Knox as foreign creditors cashed in their surplus dollars for gold.
