The Making Of A Strong International Currency

Over centuries of complex monetary systems and convoluted denominations, there has always been a currency or two which stood out and made a significant impact on international economic and financial structures. From the Greek drachma of the third century BC to the US dollar of the 20th century, one currency has always risen at any point in time to dominate the global monetary system.

An inherent feature of an important international currency is its stability. This in turn is hinged on several factors which Robert Mundell, an economics professor and Nobel Prize winner, enumerates in his 1998 paper about the euro. Mundell identifies five factors that affect the stability of a given currency, namely: size of transactions domain, stability of monetary policy, absence of controls, strength and continuity of issuing state, and fall-back value.

1. Size of Transactions Domain. The market size on which the currency is circulated affects its liquidity and its ability to withstand financial and economic crises. The German reunification in 1990, for instance, became such a heavy burden to the country's economy that it almost brought about the latter's collapse. An increase in government spending had to be financed by loans and the fledging economy of East Germany had to be revived. The total cost of the reunification was estimated to be 1.5 trillion euros. Now, imagine if that had happened to the much smaller economy of Malta. While it took Germany less than two decades to recover, it would have taken a smaller country much longer to get itself out of the pits and the consequences would have been much worse. Consider also that a currency used by 100 million people is definitely more liquid than a currency circulating among a population of 10 million.

2. Stability of Monetary Policy. A stable monetary policy involves a controlled inflation rate and no abrupt and wide ranging fluctuations of a currency's exchange rate. Taking another example from Germany's history, the hyperinflation of the German mark in the 1920s rendered it almost worthless that a new currency had to be issued. Mundell said there are several ways to achieve a stable monetary policy. Focusing on a stable exchange rate would be the best move for a small, open economy that is situated near a financial giant (like Belgium to Germany). For bigger states, controlling the inflation rate would be a more effective means of ensuring a sound monetary policy.

3. Absence of Controls. Foreign exchange controls are restrictions imposed by the state on the purchase/sale of foreign currencies by residents or the purchase/sale of local currency by nonresidents. These restrictions are allowed by the International Monetary Fund for transitioning economies but would be a ridiculous thing to impose on a currency that is targeted to be heavily involved in international transactions. The currency would not be effective in the international monetary systems if it is largely inconvertible.

4. Strength and Continuity of the Central State. Political stability is a prerequisite of monetary stability. Simply put, a collapsing state takes its currency down with it while a strong state makes way for a stable currency. The Swiss franc, for instance, is considered a haven currency because of Switzerland's political neutrality. The military power of the United States is also cited as an important factor in maintaining the dominance of the dollar.

5. Fall-back Value. The important currencies of the past had a good thing going for them:n they were convertible to gold or silver. That was their fall-back value. The US dollar was also equivalent to gold during the Bretton Woods system. After turning into a fiat currency, the dollar's strength depended on the reputation of the United States as a strong state and a military superpower. On the other hand, the euro as an emerging major currency has yet to establish its fall-back value.