A View with a Point: Nishtha's Viewpoint: International Monetary System

Does the international monetary system require major reform? Discuss by drawing on the experience of the post-war Bretton Woods international monetary system and the system that has existed since the 1970s.

“All is well that ends,” said William Simon jokingly at the cocktail party that followed the conclusion of the Jamaica Accords in 1976, probably expressing the despondency of the members at failing to evolve a full-fledged, comprehensive reform of the International Monetary System guaranteeing the stability of the Classical Gold Standard and/or the Bretton Woods System and liquidising the problems of the same which had arisen with respect to changed scenarios. What followed was a system of Flexible Exchange Rates whereby the governments were permitted to intervene to smoothen the fluctuations, but not to influence the underlying value of exchange rates. Clement Rohee, the then Foreign Minister of Guyana and the chairman of the G-77, had described the current system in 1999 as “severely flawed.” So, it’s not surprising that the calls for major reforms are often heard in the economic, political and financial circles. The more recent history of the world monetary system shows, however, that it is easier said than done, for it is not only hard to reach consensus on its successes and failures, but equally difficult is to agree on the reforms required, and, eventually, get sound ideas put into practice. Robert A. Mundell has appropriately described the current situation in the following words,

“For thousands of years countries have anchored their currencies to one of the precious metals or to another currency. But in the quarter century since the international monetary system broke down, countries have been on their own, a phenomenon that has no historical precedent in the cooperative game known as the international monetary system.”[1]

The International Gold Standard, the first stable international monetary system that existed prior to the outbreak of the First World War, was characterised by the value of each currency being fixed in terms of weight of gold (‘gold parity’). It relied on the international economic, financial and military pre-eminence, i.e. ‘hegemony’ of Britain; which furnished the basis for rapid growth of international trade and investment. However, after Britain’s failed attempts in the inter-war period to re-establish the gold system and destabilising consequences of the world economic crisis in 1929, the lesson learned was, as Harry Dexter White, the principal architect of the Bretton Woods system, expressed:

“…the absence of a high degree of economic collaboration among the leading nations will... inevitably result in economic warfare that will be but the prelude and instigator of military warfare on an even vaster scale.”[2]

Hence, the decision makers were wise enough to sit together after the Second World War to establish a new monetary order in 1943. At Bretton Woods, New Hampshire, evolved a new international system which constituted the embodiment of the economic principles enunciated by President Roosevelt, represented by Harry Dexter White, and Prime Minister Churchill, represented by John Meynard Keynes, while 42 other countries played mute partakers. However, all the participating governments at Bretton Woods agreed that the monetary chaos of the interwar period had yielded several valuable lessons. A high level of agreement among the dignitaries on the goals and means of international economic management facilitated the decisions reached by the Bretton Woods Conference. The foundation of that agreement, which came to be known as the “Bretton Woods Agreement”, was a shared belief in capitalism.

The political base for the Bretton Woods system is enrooted in the confluence of several key conditions: the shared experiences of the Great Depression, the concentration of power in a small number of states, and the presence of a dominant power willing and able to assume a leadership role. It ventured to secure the advantages of the gold standard without its disadvantages. Thus, a compromise was sought between the polar alternatives of either freely floating or irrevocably fixed rates – an arrangement to gain the expediencies of both without suffering the drawbacks of either, while retaining the right to revise currency values on occasion as circumstances warranted. Since at the time United States accounted for over half of the world's manufacturing capacity and held most of the world’s gold, the leaders decided to tie world currencies to the dollar (‘par value’), which, in turn, they agreed should be convertible into gold at $35 per ounce (‘gold exchange standard’). Hence, being a system based on stable and adjustable exchange rates, it was an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value – plus or minus one percent – in terms of gold. Therefore, when a nation was faced with a chronic Balance of Payments deficit, deflationary policies were no longer a must. So, the adjustable peg was viewed as a vast improvement over the gold standard with fixed parity. Currencies were convertible into gold, but unlike the gold standard, countries had the ability to change par values. For this reason, Keynes described the Bretton Woods system as “the exact opposite of the gold standard.”

The delegates at Bretton Woods sought to establish a post-war international monetary system of convertible currencies, fixed exchange rates and free trade. To facilitate these objectives, the agreement created two international institutions: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (World Bank). The Bretton Woods Agreement was also aimed at preventing currency competition and promoting monetary co-operation among nations. Hence, the primary task for the IMF was to oversee fixed exchange-rate system. Exchange rate changes were allowed under the system, i.e. ‘adjustable peg’, but only with the approval of the IMF. Also, the system facilitated unrestricted current account transactions but inoculated controls on international capital flows. Therefore, the IMF was also charged with the responsibility to provide finance to bridge temporary payments imbalances by providing short-term loans to members with Balance of Payments deficit.

Since the U.S. dollar functioned as the international money, it served as the principal “reserve currency”. Meanwhile, in order to bolster faith in the dollar, the United States committed itself to convert foreign official dollar reserves for gold at the rate of $35 per ounce of gold. Hence, the dollar was now “as good as gold” and the U.S. currency was now effectively the world currency. Although current account convertibility could be implemented by developed countries only by 1958-59, followed by accelerated growth of international trade in 1960s, it was more or less a stable fixed exchange rate system and the exchange rate realignments were minor and infrequent.

The problem with using U.S. dollars as the ‘lead currency’ was that its supply was determined as a by-product of the United States’ Balance of Payments. So as long as the U.S. experienced huge trade surpluses, it functioned smoothly. With a continuous rise in the overseas aid and military expenditure along with overseas direct investments in Canada, the United States experienced a gradual fall in its trade surplus and the emergence of a small overall Balance of Payments deficit in the 1950s. There were fears of the slowdown of the process of international trade as the rest of the world received very little of the currency required by them. Postwar world capitalism suffered from a huge ‘dollar shortage’. The United States was running huge balance of trade surplus, and the U.S. reserves were immense and growing. It was necessary to reverse this flow. There were discussions regarding introduction of a new form of international money in the form of ‘Special Drawing Rights’ by IMF, which, due to United States’ disfavour, was a classic case of too little too late (as it could materialize only in small quantities in 1970-71). By 1960s though, due to declining trade surplus of United States, faced with competition from Western Europe and Japan, and at the same time the growing Balance of Payments deficit, the reverse flow was realized. Further, increasing overseas military expenditure (Vietnam War) and rising overseas direct investment (mainly in Europe) gave rise to a dollar ‘glut’. Therefore, the foreign official reserves of dollars exceeded the U.S. reserves of gold.

Although United States tried to restrict capital outflows by measures such as ‘voluntary investment restraints’ (1965), it only gave rise to Euro-dollar markets i.e. bank lending in U.S. dollars in London. As the pressure on dollars continued in late 1960s, France chose to be on the safe side and sell dollars for gold. This was a big blow to the mounting pressure on dollar as it could lead other countries to follow suit and ultimately put United States at the receiving end of astronomical demand for gold reserves which it was unable to furnish all at once. Although West Germany agreed not to purchase gold from the U.S., in return for a promise to maintain its military defence, the speculations for devaluation of dollar against gold gained ground. In 1968, on United States’ request, Britain suspended free market for gold, ‘London Gold Pool’, but to not much use. The Bretton Woods system finally ended on August 15, 1971 when U.S. President Nixon unilaterally ended the convertibility of dollar for gold leaving the other countries stuck with huge dollar foreign official reserves and thrusting them onto a ‘dollar system’. In short, the United States’ failure to adjust exchange rates, its expansive monetary and fiscal policy, the growth of international capital flows, and the decline in U.S. hegemony, all together led to the demise of the Bretton Woods System.

The shock of August 15 was followed by efforts under U.S. leadership to develop a new system of international monetary management. In December 1971, the G-10, meeting in the Smithsonian Institute in Washington, created the Smithsonian Agreement which devalued the dollar to $38 an ounce of gold and revalued Deutsch Marks and Yen, with 2.25% trading bands. It was criticized at the time, and was by design a “temporary” agreement. It failed to impose discipline on the U.S. government, and with no other credibility mechanism in place, fixed exchange rates were formally abandoned in March 1973.

The Flexible Exchange Rate system existing since 1973 is difficult to describe. As per Robert A. Mundell, “An international monetary system in the strict sense of the world does not presently exist. Every country has it own system… The present international monetary system neither manages the interdependence of currencies nor stabilizes prices.”[3] The exchange rates are determined by the supply and demand in foreign exchange markets. Since, most of the countries found themselves forsaken with huge dollar reserves, the U.S. dollar continued to function as a principal form of international money. When governments met at the ‘Jamaica Accords’ and agreed on intervention only to smoothen fluctuations in the foreign exchange markets without influencing the underlying value of exchange rates, the theoretical debate between Neo-classical Economists and Keynesian Economists, respectively in favour of and against flexible exchange rates, surfaced.

“Under flexible exchange rates the effects of terms-of-trade shocks on growth are approximately one half that under pegged regimes.”[4]

The Neo-classical economists believe that ‘market knows best’. For them exchange rates are just another price; hence, flexible exchange rates are nothing but an automatic mechanism for equilibrating the balance of payments. Their analysis was basically based on trade/current account, i.e. if a country has a trade deficit; it essentially means that it is buying more than what the rest of the world is buying from it, therefore, its exchange rate falls resulting in exports becoming cheaper and consequent elimination of trade deficit. However, the neo-classical economists ignored the growth of international capital flows which emerged in 1970s in the form of international banking and later in 1980s in the form of international portfolio investment. This led Keynesian Economists to argue that since the foreign exchange transactions are dominated by capital flows, the markets behave akin to asset markets. Hence, the exchange rate instability leads to great uncertainty further leading to a slower growth of international trade. In fact, the international trade has indeed grown more slowly since 1973 than before it.

However, the current system is neither a rigid fixed exchange rate system nor a floating exchange rate system. So, as Robert Blecker points out,

“What has emerged in the quarter century since that time is not a pure system of floating rates, but a hybrid system: several major currencies (such as the dollar, the yen, the euro) are floating, while many individual countries have adopted various forms of managed exchange rates, ranging from rigidly fixed rates to crawling (frequently adjusted) pegs to dirty floats (floats with occasional intervention) to joint floats (such as the European ERM prior to January 1, 1999).”[5]

So, while the United States follows a policy of ‘benign neglect’ i.e. allowing the market forces to determine exchange rates and intervene temporarily and only when the results threaten its financial stability, whereas the European Union has formed a European Monetary System (March 1979) to follow a coordinated monetary policy.

The Flexible Exchange Rate System and the concomitant uncertainty and volatility have given voice to the demand for reforms. To put it in the words of Peter Kenen and Alexander K. Swoboda,

“Interest in reforming the international monetary and financial system, like recent capital flows to emerging markets, tends to come in waves. It surges with crises and ebbs when calm returns, even temporarily. Interest in reform has thus surged in recent years, stimulated by the succession of crises that began with the European exchange rate mechanism (ERM) crisis of 1992-93 and continued with the “tequila” crisis of 1994-95 and, in the span of less than two years, the Asian, Russian, Long-Term Capital Management (LTCM), and Brazilian crises.”[6]

The fundamental issues are not new, although the specific proposals that are being considered to strengthen the architecture of the international financial system reflect concerns arising from the particular characteristics of the recent crises. So, on one hand, there have been calls for major new international institutions and/or reform in the role of the existing international institutions, especially the IMF, in order to stabilize global financial markets, and on the other hand, vociferations for limitations on international flows of short term capital by a number of measures like ‘Tobin Tax’ on foreign exchange transactions have also arisen. The latter is also in demand to prevent destabilizing inflows and outflows of speculative hot money.

The proposals for reforms mainly focus on the issues of making capital markets work better, and these hypotheses enlist the following as possible interlinked and supportive solution areas, (1) regulating capital flows, (2) reforming international financial institutions; (3) managing exchange rates; and (4) coordinating macroeconomics policies. Among these regulating capital flows and reforming international financial institutions, namely, IMF have gained more support over the years. The Tobin Tax, i.e. a small percentage (about 1% to 0.5%) levy on all foreign exchange transactions, is expected to solve the problems of ‘hot’ money by discouraging the short-term capital movements that have exacerbated exchange rate stability. As regards the IMF, some people believe that it has become redundant since its original function of managing exchange rate stability has come to an end with the collapse of the Bretton Woods system. Also, with the opening up of international capital markets, developed countries have private capital markets to look up to for funds. Following the Third World debt crisis in 1982, IMF was believed to have found a new role, but it has been severely criticised for its harsh conditionality. Also, its critics have become more vocal ever since the East-Asian Crisis where they believe that IMF made the situation worse than it would have been without its involvement. Hence, the IMF opposition calls for a complete transformation of the organisation into a more responsive and functional institution for global financial management with respect to, (1) replacing the current leadership; (2) opening up its organisational structure to allow for greater accountability and more democratic governance; (3) changing its long-term mission to put more emphasis on macroeconomic prosperity and social justice; and (4) redesigning rescue packages to better meet the needs of individual countries and shift more of the adjustment burden from debtors to creditors.

With the benefit of hindsight, it seems logical that the original ‘gold standard’ was replaced by the ‘gold exchange standard’ after the Second World War, and that this system, in its turn, was abandoned in 1971 when the United States, because of its growing indebtedness to the rest of the world, could no longer guarantee the dollar’s value in gold. The demise came shortly after Robert Triffin’s early warnings about the instability of a global monetary system based on the U.S. dollar (or any other national currency). The past three decades, owing to the growing U.S. Balance of Payments deficit, supply testimony to the inherent problems of a fixed exchange rate system. However, even the current system is flawed with some weaknesses, like serious volatility of exchange rates, dramatic swings in capital markets, harmful uncertainty and misleading signals to private investors and policymakers, as well as a lack of global macroeconomic policy coordination. The quest for reforms is still on. There have been a number of suggestions by learned economists like Stephany Griffith-Jones, Jeffrey Sachs, Henry Kaufman, Catherine Mann, Barry Eichengreen, Giovanni Olivei, Jacquez Mélitz, and others. But, the consensus for a ‘new financial architecture’, which could free the world of the volatile financial flows that have plagued the global economy in recent years, though urgently required, still seem out of bounds.

Refrences:

Trevor Evans, Professor International Economics, MIDE Program (SS05) at FHTW, Berlin; Lecture Notes

Ronald McKinnon, ‘The Rules of the Game: International Money in Historical Perspective’, Journal of Economic Literature, vol. XXXI, pp. 1-44

Mica Panic, ‘The Bretton Woods System: Concept and Practice’ in Jonathan Mitchie and John Grieve Smith, Managing the Global Economy, 1995, pp.37-54

Robert E. Blecker, Taming Global Finance, 1999, chapter 3

A View with a Point: Nishtha's Viewpoint

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Saturday, February 3, 2007

International Monetary System

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