History of the international monetary system

7/28/2019 History of the international monetary system

1/34

Chapter 21

The International Monetary System: A Brief History

Learning objectives

By the end of this chapter you should be able to understand:

the history of the international financial system over a century;

the development of currencies and exchange rates;

the gold standard and its basic adjustment mechanism;

the advantages and disadvantages of the gold standard its heyday before WorldWar I and its disappearance in the thirties;

how the Bretton Woods arrangement replaced the gold standard after World War II; the weaknesses and the demise of Bretton Woods;

the post Bretton Woods experience with flexible exchange rates;

the issues relating to the new international financial architecture.

In this chapter, we describe and analyze the evolution of the various exchangerate regimes over the past two centuries. Up to now, for the sake of clarity, themodels developed in this textbook have been based primarily on the two extremecases of fixed and flexible exchange rates. However, the list of exchange rate

arrangements adopted by various countries now or over the years is long. Table13.1 in Chapter 13 reproduces a table compiled by the IMF, cataloguing thevarious contemporary regimes.

First, we discuss the gold standard that prevailed until the beginning ofWorld War I. The period between the two World Wars displayed a return to thegold standard for some countries only and a lot of instability overall. With thehope of eradicating such instabilities, the Bretton Woods system was introducedin 1944 as an international agreement between most industrialized countries. Thedemise of the Bretton Woods agreement in the early seventies heralded a declinein the prevalence of fixed exchange rate over flexible exchange ratearrangements. The European experience with fixed exchange rates leading to the

onset of a monetary union is covered in Chapter 22. The currency crises (in LatinAmerica and Asia) are discussed in Chapter 23.

The Earliest Forms of Exchange Rates

The exchange rate is one of the most fundamental economic variables. With thedevelopment of ancient cultures, came the need to exchange goods, i.e. to trade.This rudimentary level of economic development gave rise to the introduction of

21.1


2/34

21 The International Monetary System a Brief History

a currency - shells1, or any other precious, rare object - to facilitate the means ofexchange and create a unit of account within that culture. As soon as a currencywas established in a specific culture, trade between different tribes or culturesrequired a rate of exchange between these primitive forms of currency (e.g., howmany of my pretty shells does it take to equal one of our precious goats2?).

Overtime, currencies based on shells or goats were replaced by currenciesbased on precious gems or metals because these materials were not only rare andalso durable. Sooner or later, all nations based their currency on gold and/orsilver. Based on means that in order to avoid having to carry around largequantities of gold or silver, governments eventually printed paper money thatcould always be exchanged for a precious metal. In essence, the governmentpromised to exchange a specific quantity of gold, say one ounce, for a specificquantity of paper currency, say $20.

In most European economies, silver was the currency of choice during theMiddle-Ages: it was sufficiently abundant to serve as means of exchange, andappropriately rare to avoid massive bouts of inflation since silver discoveries were

scarce. Many countries also adhered to a bimetallic standard based on silver andgold. Silver was scarce until the 16th century; then massive silver discoveries inAmerica forced most countries to give up silver and base their currencies on goldonly. By the 1870s, some of the main bimetallic nations like the U.S. moved to apure gold standard.

The Gold Standard

The gold standard became the prevalent international monetary arrangementfrom the second half of the 19th century to the first world war. Attempts at

returning to that system after World War I were not successful. It was based on anumber of principles and it seems that after the war, the conditions necessary fora successful monetary system did not exist anymore. The heyday of the goldstandard is considered to have lasted from 1880 to 1914.

TheGold StandardFour Crucial Principles

First and foremost, a government fixes the price of its paper currency to gold. Inaddition, it promises to always exchange paper money for gold at a fixed price.Second, the central bank fully backs all national banknotes and coinage with goldreserves. Third, the government allows the free import and export of gold. Andfourth, prices and wages are fully flexible.

i. Determining the Official Price of GoldIf a country wants to introduce the gold standard, it must announce a price, GP ,

at which it promises to exchange paper money for gold. As a result, citizens can

1Cowry shells were one of the most common form of money in many costal countries or islands of

the Indian and Pacific Oceans (used as late as the19th century in certain areas).2Cattle of all kinds were also means of exchange. The word capital originally referred to the

number of heads of a herd someone owned.

21.2


3/34


stop carrying around the heavy gold: they can exchange their gold at the centralbank for convenient banknotes at this set exchange rate.

ii. Backing Currency with Gold Reserves

As innocuous as it seems, fixing the price of gold in terms of units of its domesticcurrency has some important consequences. A government cannot just say, 1 oz.of gold is hereby declared to be worth $20 and then expect the forces of supplyand demand to clear the gold market. What if the government issued $1,000worth of banknotes, but only held 10 oz. or $200 worth of gold? If everyonewanted to exchange their banknotes for gold, the insufficiency of the goldreserves would become immediately apparent. Once the first $200 of currency isexchanged for gold, there is no gold left for the people who still want to exchangetheir currency for gold. The whole system would collapse and the governmentlose all credibility.

Clearly, each banknote must be backed with an equal amount of goldreserves. Citizens will exchange gold for paper money only if they believe that

they can redeem their paper money for gold at any time in the future at the exactsame price again. Consequently, the government cannot spend the gold itreceived: it must hold it in reserve in case citizens want to convert their currencyback into gold.

Formally, the first two principles imply that the money supply,MS, under the goldstandard is given by

MS= P

GG (21.1)

i.e. the price of gold,PG, times the amount of gold , G, held in the central banksreserves.

iii. Free Trade in Gold

Assume that the U.S. and the U.K. are both on the gold standard; the central bankin the U.S. promises to exchange one ounce of gold for $20 and the central bankin the U.K. promises to exchange one ounce of gold for 4. The exchange rate ormint3 parity (the term used during the gold standard period) between the twocurrencies can be immediately derived asE= $20/4 = 5; i.e. one pound sterlingbuys five dollars. This exchange rate can only hold if gold is traded across the twocountries. If import and export of gold are prohibited, the exchange rate ismeaningless as it would be impossible to establish an exchange rate based ongold.

iv. Prices and Wages Fully Flexible.

This last condition is essential for the existence of a smooth adjustmentmechanism. The system depends on perfect price/wage flexibility. Whenever atrade imbalance puts any pressure on the currency to differ slightly from the mintparity, a mechanism based on price flexibility insures that the mint parityremains the equilibrium exchange rate.

3A mint was the place where precious metals was minted into coins.

21.3


4/34


A devaluation is ineffective under the gold standard

If it becomes known that the amount of currency issued by a central bank exceedsthe value of gold reserves, people would panic and attempt to exchange all theircurrency for gold. To make sure that every person who holds paper currency getsat least some amount of gold, the central bank could increase the price of gold to

GG PP >' , say from $20 to $30. This implies that all of the sudden everyone

holding currency is a little poorer in terms of gold ($20 now buys less gold thanbefore).

A devaluation of the currency creates a time consistency problem. Ifthe central bank were in the habit of devaluing often, only extraordinarily gulliblepeople would be willing to carry the currency and believe the central bankspromise to keep the price of gold fixed. Indeed, the more often they are harmedby a devaluation, the less likely people are to hold that currency. They willabandon their currency for gold or other more stable foreign currencies. Insummary, the gold standard only works if there is a long-run commitment to a

specific price of goldand a stable 1-to-1 ratio between the currency in circulationand the gold reserves: this fosters the belief that the currency will not bedevalued at any time.

Adjustment under the Gold Standard

The simple rules of the gold standard carry some strong implications. Free tradein gold, together with the constant price of gold, has an important consequence.Imagine that the Conquistadors bring new gold to Spain. The central bank willdeposit the gold in its reserves and issue currency in exchange. If the goldreserves increase by say 1 ton of gold, the money supply will increase

proportionally. The discovery of new gold has resulted in an increase in themoney supply, potentially leading to inflationary pressures.

Restrictions of the model

The requirement that the government (gold) reserves be in a 1 to 1 proportionwith the money supply implies that, under a gold standard regime, the impact ofany increase in reserves on the money supply cannot be neutralized or sterilizedby the central bank. Recall that sterilization involves offsetting changes in(central banks foreign) reserves with changes in the domestic money supply.Central banks manage the money supply by altering the extent of domestic credit(DC) through open market operations. The mechanism of sterilization has been

explained in Chapter 13. The central bank buys (or sells) assets such as treasurybills to increase (or decrease) the money supply. If we ignore the role ofcommercial banks and the money multiplier, equation 21.1 representing themoney supply will then have to include domestic credit as shown below:

DCGPMSG

+= (21.2)

If domestic credit is added in the equation, the direct proportionalitybetween the stock of money and the stock of official gold reserves is broken.

21.4


5/34


Clearly, if the central bank sells treasury bills to the public to offset the impact onthe money supply of the increase in gold, the central bank does no respect theone-to-one relation between money supply and gold reserves. Thus, non-sterilization is an essential tenet of the gold standard.

Changes in gold reserves are not only the result of new gold discoveries,

they are also the result of trade imbalances. It is that one-to-one relationbetween the gold reserves and the money supply that allows an adjustmentmechanism to take place. This basic adjustment is known as the Price-Specie-Flow Mechanism. Specie is simply an ancient word for precious metals.This mechanism refers to the balancing of international trade via the flow ofspecie from one country to another.

David Hume and the mercantilists

In 1758, the English philosopher, David Hume (reprint 1898), in his essayentitled On the Balance of trade, developed the price-specie-flow mechanism to

demonstrate the futility of the French mercantilist policies designed to amassmaximum amounts of wealth in terms of gold and silver. Mercantilism was aneconomic philosophy of the 16th and 17th century based on the idea that a countryshould always run trade surpluses in order to accumulate financial wealth. Toachieve such goals, trade policy consisted in high tariffs on imports and exportsubsidies thus generating gold inflows. David Hume wrote his treatise to provethat mercantilism is theoretically inconsistent. Hume showed with his price-species flow mechanism how the gold standard would automatically eliminatetrade imbalances, and that the trade surpluses under mercantilism could not besustained.

The price-specie-flow mechanism

We consider a two-country model, the domestic and the foreign country. If thedomestic country is running a trade surplus, it receives more gold for its exportsthan it has to pay for its imports. Recall that one of the tenets of the gold standardis free trade in gold allowing international transactions to be settled with gold. Atrade surplus for the domestic economy thus generates gold inflows into thecountry. With non-sterilization, these inflows result in an equal increase in themoney supply under the gold standard. Since the money supply rises while theproductive capacity of the economy has not expanded, the price level rises. Thisincrease in prices renders domestic products relatively more expensive compared

to foreign goods and foreign goods relatively cheaper. The result is decreasedforeign demand for domestic goods (exports) and increased domestic demand forforeign goods (imports). As exports fall and imports rise, the trade surplusdeclines and the money supply increases at a slower pace. The inflationarypressures come to an end when the money supply stops rising: this occurs whentrade is balanced.

A similar adjustment takes place in the foreign country. The domestic

21.5


6/34


countrys trade surplus is matched by an equivalent trade deficit in the foreigncountry. The trade deficit leads to a loss of gold, a decrease in the money supply,and a fall in the price level bringing back the foreign countrys competitiveness.When trade between the two countries is eventually balanced, gold stop flowinginternationally (money supply and price levels stabilize in the two countries) and

the equilibrium is restored.Since, in this scenario, gold actually moves from one country to another to

settle trade, additional costs, for transportation and insurance, are incurred.These costs create a wedge between the prices of gold in the two countries. Thetwo limits of the wedge are referred in the literature as the gold export and thegold import points. It simply means that, as the currencies are both defined interms of their gold content, this wedge allows the two currencies to fluctuatearound their mint parity in a small band corresponding to these costs.

In sum, under the gold standard, the central bank is allowing all changesin gold reserves to translate directly into equal changes in the money supplywithout trying to control the money supply nor the price level. Every time the

money supply changes, the domestic economy is at its whim. Basically, thecentral bank cannot manipulate the money supply (or the interest rate) fordomestic purposes: in practical terms, it loses its sovereignty on monetary policy.This very simple and seemingly effective system is not without some drawbacksweighting against its obvious advantages.

A modern application of the gold standard: the currency board

The gold standard is not a totally obsolete form of exchange rate mechanism.There are several countries today that use a version of the gold standard called

currency board. We listed this system in the table in Chapter 13 showing all thevarious exchange rate arrangements and we also mentioned it in Chapter 18 as aspecial form of fixed exchange rate. A currency board exists when the centralbank issues money only in proportion to its foreign currency holdings asunderlying asset. The currency board insures that the currency peg to a strongcurrency, most often the dollar, is irreversible. Countries adopt such systemhoping that it will impart some degree of stability to their foreign sector. Forexample, Hong Kong is on a currency board based on the U.S. dollar, meaningthat the entire Hong Kong money supply is backed by their U.S. dollar reserves.We make two modifications to equation (21.1). First, the country holds foreigncurrency reserves instead of gold and second, in a modern economy, the moneymultiplier,, is taken into account. This means that it is the monetary base thatis backed entirely by the foreign currency reserves.

vesrencyReserForeignCurEMS =

Instead of fixing the price of domestic currency to gold, currency boardsfix the price of domestic currency to foreign currency. Simply speaking, currencyboards fix the exchange rate. Under currency boards, central banks pledge tohold sufficient foreign currency reserves to back (fractionally) the money supply.So a version of the gold standard is alive and well in todays world in a number of

21.6


7/34


small economies (such as Brunei or Estonia), and even in some more importantones (such as Hong Kong or Bulgaria).

Advantages and Disadvantages of the Gold Standard

The gold standard is seen to have two crucial advantages. First, it automaticallyinsures that trade is always balanced between countries. Second, it instillsfiscaldiscipline in the economy. However due to its simplicity, it lacks the flexibilitynecessary to deal with external shocks such as fluctuations in the supply of goldor political upheavals of any nature.

Advantage 1: Balanced Trade A Desired Feature ofYesteryear

The automatic adjustment discussed above always restores equilibrium in thetrade balance, should this equilibrium be disturbed. When internationaltransactions took mainly the form of merchandise trade, balanced trade wasregarded as desirable. In our modern global economy, where capital flows freely,balanced trade may not be that important. When countries have different growthrates or in the case of developing economies, the question of tradebalances/imbalances must be recast in a different light.

Advantage 2: Fiscal and Monetary Discipline

The gold standard instills fiscal discipline, because it does not allow the centralbank to print money to finance government deficits. The central bank can onlyhand out currency in exchange for gold, never in exchange for the governmenttreasury bills. Does this mean that the government can never incur any debts?Not exactly.

The government can engage in deficit financing under specific conditionsonly: the total amount of the government debts must be covered by bond issues(such as US treasury bonds) and all bond issues must be bought byprivateindividuals and not by the central bank. If the central bank were to buy treasurybills, it would hands out dollars in exchange for something other than gold. Thiswould immediately imply that notall the currency in circulation would be backedby gold; the reserve requirement of the gold standard would be violated.

If the government dissaves (by running a budget deficit), other people inthe economy have to save (to finance the deficit): the private citizens. Since thecentral bank cannot simply print money to purchase treasury bills, thegovernment deficit is limited to the amount it can borrow from its citizens. The

gold standard imposes fiscal discipline on governments. Moreover, centralbanks are precluded from the inflationary practice of printing money for the solepurpose of financing a fiscal deficit.

Disadvantage 1: Gold Supply and Demand Imbalances

Not all that glitters is gold. While the gold standard contains a foolproof, simpleadjustment mechanism as well as imposing monetary and fiscal discipline, thissimple exchange rate arrangement does not come without severe downsides. On

21.7


8/34


the one hand, gold discoveries, like the Californian (1848) or Alaskan (1897) goldrushes, can lead to immediate inflation: if massive amounts of gold flood themarket resulting in an increase in the money supply that is not matched by anyincrease in the economys productive capacity, prices will rise.

On the other hand, periods of strong economic expansion (such as the

industrial revolution) amplify the demand for money to accommodate theincrease in output. Prices will remain constant provided that the money supplyincreases proportionally. If the central bank does not have enough gold reservesto support an increase in the money supply, the excess demand for gold will causedeflation. It would be a coincidence if gold discoveries were to increaseproportionally to the increase in output just when needed. This phenomenonoccurred during the industrial revolution as gold discoveries did not keep pacewith economic growth: prices fell by over 50% in the United States in the latterhalf of the 1800's shaking the U.S. economy and resulting in unemployment. Ingeneral, inasmuch as the discrepancy between stagnating gold supplies andeconomic growth was not too drastic, this system tended to impart a deflationary

trend on economies that was not unwanted.Disadvantage 2: Political versus Economic Realities

The gold standard was never able to withstand episodes of war. Wars are timeswhen sound economic policies give way to political necessities. After thegovernment has soaked out all private savings by issuing treasury (war) bondsand selling them to the public to finance the military effort, the government hasto turn to the central bank for further financing: it is the turn of the central bankto buy additional war bonds issued by the treasury. The central bank will pay withnewly printed money. As shown in equation 21.2,domestic credit now becomespart - in addition to gold - of the reserves supporting the money supply: these

operations clearly break the proportionality between currency and gold. Thegovernment has two options. First, it can restore the gold standard by resettinga mintparity that corresponds to a higher level of money supply supported by thefixed amount of gold: this is equivalent to a devaluation of the currency. Giventhat no economic statements by a government at a time of war can be trulycredible, people know that the devaluation will not be unique and furtherdevaluations are likely to follow if spending continues to exceed revenues: publicconfidence in the system is shattered and the gold standard system collapses.The other option is to leave the system altogether.

Disadvantage 3: Possible Adverse Economic Consequences

Theoretically, the adjustment mechanism under the gold standard is grounded on

a crucial assumption: prices are fully flexible (they adjust immediately) and, as aresult, economies are always at full employment. These assumptions correspondto the monetarist model developed in the previous chapter (see Figure 20.4).Since prices are nominal variables, their fluctuations4have no effect on the realvariables and the economy is not affected by the adjustment mechanism itsimpact is neutral. How realistic is this assumption? If prices do not adjust

4We assume homogeneous price changes.

21.8


9/34


immediately, some of the burden of the adjustment will have to fall on othervariables. In this case, a decrease in the money supply will result in an increasein the interest rate: the adjustment will then create losers and winners at least inthe short run.

This is best illustrated with an example. Suppose two countries, Britain

and the United States, adhere to the gold standard. A trade deficit for Britain setsup the following sequence: British gold flows to the U.S., the U.S. money supplyexpands while the British money supply shrinks. The reduction in the Britishmoney supply boosts the interest rate discouraging capital investment andleading to a contraction in the economy and consequently to layoffs. Theeconomic contraction directly discourages imports. In addition, increasedunemployment eventually depresses wages and lower production costs leads to areduction in the price of British goods. As British prices drop, British exports riseand imports fall even further until the trade balance returns to zero. The oppositewill happen in the U.S. economy. In this case, the income-reserve flowmechanism described in Chapter 15 kicks in first, followed overtime by the price-

specie-flow mechanism, to complete the adjustment.When countries tried to reinstate the gold standard after World War I,

these painful economic adjustment aspects lessened the desirability of thesystem. We will highlight these problems in our post World War I discussion.

The Heyday of the Gold Standard - Pre World War I

Well into the 19th century, most nations used a bimetallic standard: gold and silver.5

However, England effectively adopted a gold standard in 1717 under the Master ofthe Mint, Sir Isaac Newton. Eventually England was the first nation to write thegold standard into law in 1819. The United States, although formally on abimetallic (gold and silver) standard, switched de facto to gold in 1834 by fixingthe price of gold at $20.67 per ounce a price that was kept constant for 99years. Like Britain, the U.S. did not write the gold standard into law until later(1900). All major countries joined the gold standard by the 1870's.6

The period between 1880 and 1914 corresponds to the heyday of thesystem. The reasons for the success of the system during this period have beenpinned to various factors. No major war took place in the period. Economieswere open to trade and capital mobility was fairly unchecked. England held a keyrole in the system, as London was the main financial center for the system. Long-term capital flows from the richer and stable European economies to newly

5 The official name of the British Pound used to be Pound Sterling. Sterling is 92.5% pure silver,so the British currency was literally called one pound of silver. Initially 240 pennies were coinedout of a pound of sterling silver. But King Edward I (1239 1307) was the first to allow inflationand by the time of Queen Elizabeth I (1533-1603) came to power, one pound of sterling silveralready yielded 744 pence! Note that 310 percent inflation (going from 240 to 744 pence perpound of sterling silver) over 300 years is not bad, considering that just between 1969 and 1999inflation in the US was 354 percent!6 Germany, 1871; Scandinavia, 1874; Holland, 1875; Belgium, Italy, Switzerland, 1873; France,Spain 1876; Austria; 1879; Russia, 1893; India, 1898.

21.9


10/34


industrialized economies helped with the adjustment mechanism. Theparticipants in the system were mainly the richer industrialized countries. Wheneconomic historians analyze the price fluctuations during the period, they notethat although long-run prices were rather stable, their short-run variability washigh. In fact, there were quite a few financial and banking crises during the

period.Another notable observation was that, in general, the price fluctuations

were not large enough to fully credit the price-specie-flow mechanism forachieving the adjustment. This implies that governments might have reinforcedthe process by tampering with domestic credit: restricting it in the presence of atrade deficit and expanding it in presence of a trade surplus. In fact, a limitedamount of gold was transferred internationally as countries would settle theirbalance of payments disequilibrium through capital flows.

The demise of the gold standard was a consequence of World War I.During the war, nearly all nations either placed restrictions on gold convertibilityor issued non-convertible paper money. If the convertibility of gold is restricted,

people can no longer exchange their paper currency for gold at the central bank.Once this happens, it becomes clear that the central bank does not have sufficientgold reserves to back all its paper currency and the system collapses. Spurred bythe necessities of war, many countries had to relinquish the gold standard.

Reconstruction and Exchange Rates after World War I

World War I ended in 1918 with the Treaty of Versailles. Most Europeancountries found themselves in a dire economic situation. They were highlyindebted as they had to pay for past war expenditures that were financed byprinting money. In addition, they needed to raise further funds for the currentreconstruction efforts. Many governments continued to print money resulting in

chronic inflation. The situation was even worse for Germany, as a clause of theTreaty of Versailles involved war reparations to be paid to the victors. To meet allthese commitments, the German government could only print paper money. Theresult was a period of extreme inflation (hyperinflation) in the 1920s.

Longing for the monetary stability of the pre World War I years, manycountries decided to return to the gold standard. The U.S. was able to restore itsgold parity in 1919, soon after the war ended. On the other hand, the countriesplagued with hyperinflation, Germany and Austria, had no hope of joining thesystem any time soon. By 1928, most of the major currencies did eventuallyrestore their parity to gold. We mentioned in the previous chapter the problemof reestablishing a realistic parity with gold and the use of purchasing powerparity to determine it. Unfortunately, governments did not pay much heeds tothe advices of economists: Great Britain set the pound at too strong a level,leading to chronic trade deficits (see box), and France did the opposite, hopingthat a weak Franc would boost their international competitiveness. Sadly, theseerratic settings did not enhance the general confidence in the gold standard, onthe contrary!

Circumstances were different and some of the conditions necessary for the

21.10


11/34


gold standard adjustment process to work smoothly were not in place anymore.Social laws had given more rights to workers and democratically electedgovernment could not afford to maintain fiscal discipline in light of labor unrest.Fiscal policy, barely used in the pre World War I era, became a central tool ofgovernment policy; budget deficits made their appearance. In addition, it is well-

known that social laws reduce price and wage flexibility; thus another importanttenet of the adjustment process had been weakened.

We are now used to active monetary policy: the central bank president isexpected to keep the price level constant. The gold standard required exactly theopposite. Under the non-sterilization assumption, it stipulated that the centralbank stays out of the business of managing the money supply, and simply servesas a storage facility for gold and as a printing press for a determined amount ofcurrency. In fact, as mentioned earlier, under the rules of the game, centralbanks often facilitated the adjustment mechanism by reducing domestic credit incase of trade deficit and vice versa. Monetary policy for domestic purposes wasnot part of their mission. The role of central banks was secondary in that

period7

. The post World War I period saw a lot of economic distress:straightening the problems in the domestic economy became more importantthan allowing the automatic adjustment to take place. Central banks in manycountries (the United States, France) did intervene to sterilize the effect of thegold flows on the money supply: the non-sterilization rule was broken.

The British experience

After years of rampant inflation, the British Chancellor of the Exchequer,Winston Churchill, returned Britain to the gold standard in 1925, hoping toconjure up the pre World War I period of stability. His decision highlights

another difficulty with the gold standard: how to choose the right gold parity. Inthe previous chapter (box), we suggested, the purchasing power parity approachto find a realistic parity. If the value of the domestic currency in term of gold isset too high, the mint parity or exchange rates with the other currencies will betoo strong (overvalued). As a result, domestic residents will import excessivelywhile their exports drop. A trade deficit will arise with dire economicconsequences as implied by the price-specie-flow mechanism.

Confusing political power with economic might, Winston Churchill andPrime Minister Sir Alec Douglas-Home insisted on a strong (overvalued) Britishcurrency. By choosing the pre-war gold parity for the pound, they set the exchangerate (mint parity) between the dollar and the pound to be identical to its prewarrate, $4.87, although Britains economy had been devastated by its war effort andthe purchasing power of the pound had declined substantially. Economist likeJohn Maynard Keynes warned Churchill against overvaluing the Pound. TheChancellor of the Exchequer failed to listen and referred to Keynes suggestions

7However most European countries had central banks during the heyday of the gold standard,the U.S. were the only exception its central bank, the Federal Reserve Board, was not createduntil 1913.

21.11


12/34


simply as "feather-brained."8

The overvaluation of the pound was at the root of serious trade deficits,triggering gold outflows. The adjustment resulted in a monetary contraction.The conditions in the twenties were different than in the pre World War I era.Prices fell and interest rate increased. Instead of the expected boost to the

economy from restoring a strong pound, the adjustment threw Britain into arecession. The demand for domestic goods dropped due to the initialdeterioration in the balance of trade and the adverse impact on investmentcaused by the increase in the interest rate. The level of unemployment roseputting downward pressures on wages. As prices were not that flexible, especiallydownward, real wages fell. In addition, company defaults rose, unsettling banksand lending institutions. Economic historians estimate that more than half of theBritish unemployment in the 1920s was due to the overvalued exchange rate.9

The combination of increased unemployment and falling wages was anuntenable situation in the early 20th century, when labor laws and unions hadtaken firm hold in Europe. By the end of the decade, the British governmentdecided it could no longer allow further reductions in wages and employment. In1931, Britain abandoned the gold standard for good.

It is interesting to note that there was a scarcity of gold after the war. TheEuropean central banks, specially affected by the shortage, began to hold reservesin the form of strong currencies (dollar) that were redeemable into gold. Thedirect link between gold reserves and the domestic currency was thus broken; thesystem between 1925 and the early thirties had degenerated into a gold-exchange standard.

Most countries eventually had to leave the system. One of the lasteconomies holding on to the gold standard was the United States. When

President Roosevelt took office in 1933, unemployment had soared to nearly 25percent. His inauguration took place literally in the middle of a third bank panic.Roosevelt immediately intervened. He declared a "banking holiday" that closedbanks to the public for eight days, to prevent further withdrawals. Then he tookthe U.S. off the gold standard between 1933 and 1934, when the dollar wasredefined at a lower parity in terms of gold (from $20.67 to $35 per oz of gold).

The remaining year in the thirties were plagued by economic instabilityeverywhere. The Great Depression began in the U.S. and spread around to theother industrialized countries, resulting a collapse of their own banking system.Every country tried to solve their domestic problems at the expense of their tradepartners with so called beggar thy neighbor policies. This included thecompetitive devaluations described in Chapter 18. Countries also tried toimprove their balance of trade with protectionist trade policy: the U.S. passedthe Smoot-Hadley Act with dire consequences on their struggling trade

8Keynes, John Maynard (1925), The Economic Consequences of Mr. Churchill, in Keynes, Essays

in Persuasion, p. 246.9 D.E. Moggridge, British Monetary Policy 1924-1931: The Norman Conquest of $4.86: Ashgate

Publishing Company 1972.

21.12


13/34


partners. Retaliation by the other countries only made matter worse. By 1933,the overall level of international trade had dropped substantially and mostcountries suffered sluggish economies throughout the decade. During theinterwar years, countries experimented, not by choice, with all kind of exchangerate setup. Most countries were unable to remain on the gold standard, so they

tried to peg their currencies to a stronger currency, but would end up devaluing,by necessity (corrective devaluation) or just to gain an advantage (competitivedevaluation). Other countries eventually floated their currencies. The intrinsicinstability of the period was illustrated by wild reserves fluctuations for thepegged currencies and wild exchange rate fluctuation for the floating currencies.The whole international payments system fell into chaos and trade as well ascapital flows severely were curtailed.

The U.S. eventually got over the depression by the onset of World War II.The war effort provided a strong stimulus to the U.S. economy and, in contrastwith the other countries involved in the war, the U.S. territory was not attackedso the U.S. did not have to go through a painful reconstruction period. On the

other hand, the other economies were shattered by the war and it was clear thatmajor planning was needed to restore the world economic order. Manyunderstood that the economic upheavals following World War I were a majorfactor in the resumption of the hostilities between the participants of that firstwar: the road towards a longer lasting peace was grounded on a stable economicorder. The key question was how to insure such economic stability. The informaland unstructured gold standard system had failed to restore internationalfinancial stability after the first world war, it had become obvious that the worldnow needed a new formal and more rigorously structured system.

The Bretton Woods SystemBretton Woods is an American ski resort in New Hampshire: it became famous asthe birthplace of the new international financial arrangement. Towards the end ofWorld War II, finance ministers from forty-four nations met there to discuss anew international exchange rate agreement. The discussions were dominated byplans developed by Harry Dexter White (U.S. Treasury) and John MaynardKeynes (U.K. Treasury). Having learned that the absence of monetary or fiscaldiscipline can lead to economic instability and that post-war periods exertsignificant strain on governments, the participants sought to create a more stableinternational monetary system.

In the context of the Bretton Woods arrangement, the U.S. would retain itsgold parity at $35 per oz of gold while the other industrialized nations involvedwere to maintain a fixed exchange rate regime between their currency and theU.S. dollar. As a consequence of accumulating a lot of gold during the war, theU.S. would be in a position to allow for international convertibility of dollar intogold, but this would be restricted to foreign governments or central banks.However domestic convertibility would not be permitted and U.S. citizens werenot allowed, by law, to hold gold assets. From the point of view of Europeans,this system presented a welcome feature. As a result of the war, their gold

21.13


14/34


reserves were nearly depleted and a one to one proportion between gold reservesand money supply was out of question. Fractional reserves had become thenorm anyway even before World War II. Lower reserve requirements in theEuropean central banks freed important capital to rebuild Europe.

In addition to installing a new exchange rate regime, the Bretton Woods

agreement established two new international financial institutions under theumbrella of the United Nations. The International Monetary Fund (IMF), wascreated to provide short-term (a maximum of 2 years) reserve loans to supportcentral banks facing difficulty in maintaining their fixed exchange rate withdwindling reserves. The other institution, the International Bank forReconstruction and Development (IBRD, also known as the World Bank), wasoriginally charged with the reconstruction of Europe through loans for long-termdevelopment projects10. In this chapter, we focus mainly on the IMF, since it wasthe organization charged in overseeing the new Bretton Woods internationalfinancial system. Developments at the World Bank and interactions with the IMFare the subject of an appendix.

Bretton Woods main tenets

1. On July 1, 1944, the U.S. dollar was defined in term of gold, at $35 perounce of gold.

2. Member countries were to peg their currencies to the U.S. dollar, but didnot need to hold (gold) reserves. Article IV stated that a member could alter theexchange rate of its currency only to correct a fundamental balance of paymentsdisequilibrium, and only after consulting with the IMF.

3. All exchange transactions between member countries were not to diverge

by more than 2.25% from the pegged exchange rate.

4. Upon entering the IMF, a country was to submit an exchange rate in termsof gold or US dollar.

5. If the IMF objected to changes in the exchange rate, but the memberdevalued anyway, that member became ineligible to use IMF resources.

6. Article VI allowed members to control capital movements in and out oftheir country to discourage speculation.11

7. Article VIII forbade members to set any restriction on the current account.Existing tariffs were grandfathered.

8. Article XIV allowed a member country to retain the exchange controls that

were in effect when the country entered the IMF. Once a member country

10By the mid 1960s, the IBRD had accomplished its original reconstruction task. However, at

that time, its US director, Robert McNamara, decided to expand the charter of the bank to reducepoverty around the world, start an agricultural green revolution, and help developing countries

with economic support.11 Non-convertibility of foreign currency meant that citizens who earned foreign currency had toredeem it at the central bank; they were not allowed to open private bank accounts to hold foreigncurrency.

21.14


15/34


abolished its exchange control, it could not re-impose controls again without IMFapproval.

Originally, the IMF was designed to facilitate the operation of the Bretton

Woods exchange rate arrangement. However the system lasted less than thirtyyears and was all but scrapped at the beginning of the seventies. As a result, therole of the IMF had to be readjusted afterward. During the Bretton Woods era,the IMF traditional role was to lend to countries experiencing balance ofpayments difficulties. In the Articles of Agreement (Purposes of the IMF), theIMF was established to promote international monetary cooperation, exchangestability, and orderly exchange arrangements; to foster economic growth andhigh levels of employment; and to provide temporary financial assistance tocountries to help ease balance of payments adjustment. The purposes are stillthe same but the IMF now focuses on surveillance, financial assistance, andtechnical assistance as world economic conditions evolve. The membership alsoshot up from 44 to 185 countries by now. We will first describe the workings ofthe early IMF and the difficulties faced over the years.

Mechanism and Adjustment with the IMF/Bretton Woods

Foreign exchange reserves in the fund were held as gold, dollars, a fewother reserve currencies, and as positions at the IMF, so the system was regardedas a gold-exchange standard. The primary purpose of the IMF was to lend hardcurrencies to countries experiencing excessive foreign exchange reserve losses. Asan international fund, the IMF had to depend on its members contributions;thus its activities were financed by the quotas contributed by the member

countries. Each member was allotted a quota to pay in the fund the size ofnational quotas being based on the size of their economies. Part of the quota hadto be paid in gold or convertible foreign currencies, with the remainder could bein the form of each countrys own domestic currency. The first part of the quota,known as the gold tranche, counted as part of a countrys reserves at the fund andcould be borrowed without question. Each country could also borrow beyond itsgold tranche under terms of conditionality; this implied that the country had toadjust its macroeconomic policies in order to repay the loan within a reasonableperiod of time.

Quotas and voting rights/post Bretton Woods - still unsolved in thesecond millennium

The size of these quotas have changed over the year with the U.S. share fallingwhile some other countries share went up. The U.S. quota is now around 17%,Japan and Germany around 6% each, and France and the U.K. around 5% each.At the present time, a quarter of the quota must be paid in the form of specialdrawing rights (SDR) when a country joins and the other 75% can be called onanytime and paid in the countrys own currency. The IMF can also borrow

21.15


16/34


beyond the quotas from private banks or individual members government.

The IMF decisions are made by a weighted voting system; the weights aredetermined by a countrys quota. This is obviously not a very democraticapproach, lending to much squabbling between members: there is a need toreallocate the quotas as they do not reflect the new economic strength of

emerging economies. At a recent international meeting of the IMF in Singapore(September 2006), the members agreed to provide additional votes to China,South Korea, Mexico, and Turkey. Moreover there is also a consensus towardsreviewing the underlying formula for calculating votes. Another issue concernsthe EMU countries. Since these countries share a currency, the euro, and have acommon monetary policy administered by one central bank, a single membershipin the IMF and a single quota would make sense. Note that the sum of theindividual EMU countries quota is larger than the U.S. quota.

The adjustment process foreseen by the Bretton Woods system had three

stages, depending on the seriousness of payments problems.1. For what were believed to be temporary or transitory imbalances,

questionable policies were to be avoided, and financing was to be pursued.Deficit countries ran reserves down, surplus countries accumulated them, andboth were presumed to sterilize.

2. For more serious problems, deficit countries were expected to adopt morerestrictive monetary and/or fiscal polices, and surplus countries had an equaland parallel responsibility to adopt more expansionary policies. The systemwas explicitly designed to avoid the contractionary bias of the gold standardwhen surplus countries refused to expand and instead sterilized gold inflows,

thereby forcing the deficit countries to carry severely restrictive policies.3. For what were referred to as fundamental payments disequilibria, deficit

countries were expected to devalue, but only to do so after consultations withthe IMF to insure that the devaluation was not excessive or designedprimarily for mercantilist purposes. The competitive devaluations of thethirties were not to be repeated. A country with a large and persistent surpluswould be expected to revalue.

Weaknesses and Collapse of the Bretton Woods system

In the fifties and sixties, the system did not exactly function as expected by its

charter. In fact, the arrangement eventually turned out to be deeply flawed. Thefundamental causes of its demise are described below.

1. Merely financing disequilibria, and avoiding painful adjustment policies, wenton for far longer than justified by the original plan. Central banks found waysto borrow from each other and thereby avoid conditionality. The quotas wereexpanded, making larger loans possible.

2. Surplus countries, expected to adopt expansionary macroeconomic policies to

21.16


17/34


facilitate the adjustment, refused to do so. However, it would be hard toblame the German Bundesbank, a central bank committed to keeping lowinflation through very conservative policies, for not abandoning its principlesjust to help out more profligate countries. The burden of the adjustment wasthus placed mainly on the deficit countries, making the tightening of policies

that they would have to pursue more severe. The intended outcome thatdeficit and surplus countries would both contribute to the adjustment wasdefeated.

3. There also was an intrinsic flaw in the system. This was not due to a lack ofcooperation by the members as in the last section. This problem was calledthe N-1 question. There were N countries and thus N-1 independent bilateralexchanges rates to manage. As the dollar was pegged to gold, it was theresponsibility of all the other members to keep their exchange rate pegged tothe dollar. This meant that the U.S. never had to intervene on behalf of thedollar and could use their monetary policy for domestic purpose. Thissituation was very irritating to the European central banks. The centralposition of the dollar in the Bretton Woods era and its consequences arediscussed in greater detail in Chapter 22 - European monetary integration.

4. By the end of the sixties, the post-war regime of open trade and capital flowswas in serious danger of collapse. Despite the existence of large and chronicpayments disequilibria (inflows), surplus countries were reluctant to revalue.They viewed an undervalued currency as useful in spurring exports andrestricting imports, meaning that exchange rates were used for mercantilistpurposes. Chronic deficit countries, like the United Kingdom, put offdevaluations until a balance of payments crisis, triggering massive speculativecapital outflows, compelled a parity change. It was obvious by the early 1960sthat the sterling was overvalued at $2.80, but London fought off a devaluation

until the fall of 1967, when its reserves were largely exhausted.The U.S. balance of payments difficulties

In the late forties, the United States had huge reserves and an unrivalled financialand economic position, in part because its capital stock had not been damaged bythe war. The rest of the world lacked sufficient reserves, a situation that wasreferred to as a dollar shortage. During the fifties, the United States started torun consistent payments deficits for two reasons: first, many countries haddevalued sharply against the dollar at the end of the forties, thereby gaining acompetitive advantage, and second, Americans were making large investmentsand loans in Europe and in the rest of the world. In the early fifties, the U.S.deficits were deemed desirable as they allowed countries with badly depletedforeign exchange reserves to accumulate reserves again thus stimulating worldtrade. By the end of the fifties, however, the U.S. deficits were sufficiently large asto create the impression of the so-called dollar glut. Eventually, in the earlysixties, the situation got worse and the United States faced a serious paymentsdeficit.

In 1964, the United States adopted capital controls in the form of theInterest Equalization Tax: a tax levied on interest received from lending

21.17


18/34


abroad aimed at discouraging capital outflows. This tax, combined withrestrained U.S. macroeconomic policies, lead to an improvement in the U.S.balance of payments and many observers thought the U.S. problem was largelysolved. This relief was temporary. The Johnson administration got involved in acostly war in Vietnam in addition to increasing social welfare expenditures, under

the Great Society program; all that without raising taxes. U.S. monetary policyremained relatively expansionary in the late sixties, despite large budget deficits.The results were predictable. The U.S. current account deteriorated, and capitaloutflows accelerated. The Johnson administration responded with a morethorough set of capital controls introducing a brief respite.

Dollar glut and demise of the system

If the original reserve shortage hampered trade and growth, the opposite, excessliquidity in the form of large dollars reserves held by the rest of the world, createdserious potential problems: among these, world-wide inflationary pressures or adecline in the confidence in the dollar would break havoc in the system. In thearrangement, foreign central banks could redeem all their dollars into gold. As

long as there was enough gold under Fort Knox, the site of the U.S. bulliondepository, to support the foreign dollar reserves, everything was fine. But theYale economist, Robert Triffin, anticipated that, eventually, this situation wouldturn around, as the gold supply was not increasing fast enough; then a loss ofconfidence in the dollar would occur. In fact, by 1970, the amount of foreignexchange outstanding exceeded the amount of gold reserves. A revaluation ofgold (i.e. a devaluation of the dollar) was out of question for two reasons: it wouldreduce the value of the foreign countries dollar reserves and it would give anunfair advantage to the main gold producers countries, no other than the U.S.S.R.and South Africa. Anticipating the problem, the international response led to thecreation by the IMF of Special Drawing Rights (SDR) in 1967. The SDR did not

help that much in this instance, but they still play a role in transactions betweenthe IMF and the various members central banks.

Special Drawing Rights (SDR)

Special drawing rights are baskets of strong currencies that were created in thesixties to supplement dollars and gold as international reserves. Since theintroduction of the euro in 1999, they now comprise four currencies only: dollar,euro, yen, and pound ($, , , ). The weights of the four currencies arerespectively 44% for the dollar, 34% for the euro, and 11% each for the yen andthe pound. The exchange rate $/SDR is calculated using the exchange rate of the

3 other currencies with respect to the dollar and aggregating proportionately totheir weight in the basket. The exchange rate as of August 27th 2008 is$1.57/SDR. The SDR interest rate is determined as a weighted average of theinterest rates on short-term financial instruments in the markets of thecurrencies in the SDR basket. The use of SDR is restricted to central banks: theyfeature in the official reserves account of a countrys balance of payments.

Eventually, in the late sixties and early seventies, doubts arose about the

21.18


19/34


competence of the leadership of the Federal Reserve Board and the wisdom ofU.S. fiscal policy decisions: it then became clear that the dollar gold parity couldnot be sustained. A massive speculative run against the dollar began, rapidlydraining U.S. gold holdings. On 15 August 1971, the Nixon administrationsuspended gold sales, imposed asurtax on U.S. import tariffs, and urgently

requested an international conference to negotiate new parities with themembers currencies. The Smithsonian Conference of December 1971 inWashington heralded a devaluation of the dollar relative to gold and arevaluation of the currencies of the surplus countries (Germany, Switzerland). Toavoid a severe worsening of U.S. protectionism, the surplus countries went aheadwith the proposal.

The new exchange rate schedule survived for just over a year. At the end of1972, U.S. trade numbers were not much better, monetary policy was obviouslytoo expansionary, and there was a perception that the Nixon administration waslargely preoccupied with the Watergate scandal. The result was anotherspeculative run on the dollar, and the adoption of floating exchange rates by the

major industrialized countries in early 1973.

A Brief History of the Float after Bretton Woods

It is important to remember that the industrialized countries embraced flexibleexchange rates in 1973, not by preference for such system, but because BrettonWoods failed. The March 1973 adoption of flexible exchange rates by the majorindustrialized countries was widely expected to be temporary. Fixed exchangerates were still viewed as the normal and preferred system; it was thought thatwhen the floating rates eventually settled in a narrow range, they could be re-fixed. Through the Committee of Twenty (C-20), the IMF had already begun

discussions on a reform of the system.The oil embargo of 1973, resulting in oil price hikes from $3 to $8 per

barrel in 1974, changed everything. The OPEC12 countries suddenly acquired ahuge current account surplus (over $70 billion in 1975, declining to the $40billion range in following years), and there was no way to predict how or wherethis money would be invested. In light of the payments instability that couldresult from shifts in OPEC investment patterns, as well as other uncertaintiesassociated with higher oil prices, it did not appear feasible to return to a set offixed parities. Flexible exchange rates then became the normal system forindustrialized countries, despite widespread opposition among central bankersand finance ministry officials. This change was formalized in amendments to the

IMF Articles of Agreement, adopted in Kingston, Jamaica, in 1976.To be more precise, the Jamaica Accord allows countries to adopt

whatever exchange rate regime they wish as long as it does not impact negativelytheir trade partners. So as shown in Chapter 13 (Table 13.1), there exist allshades of regime between fully floating and pegged exchange rates. Managedfloats and concerted or coordinated intervention, unheard of during the

12Organization of Petroleum Exporting Countries a cartel restricting the supply of petroleum.

21.19


20/34


Bretton Wood era, are now common practice. The majority of the countriesfollow some form of floating exchange rate and reserve the right to intervene inthe foreign exchange markets when needed: many Asian countries make sure thattheir currency does not strengthen too much against the dollar. The Plaza

Accord and the Louvre Accord in the eighties (see box) were attempts,

through intervention by the industrialized countries, to weaken a dollar that wasdeemed too strong in 1985 and to stop the slide of the dollar a few years later. By2001, the newly introduced euro had lost about a third of its value against thedollar since its introduction in 1999. Intervention by both the U.S. FederalReserve (Fed) and the European Central Bank rescued it. These three cases areexamples of coordinated intervention taking place when an important currencyseems to follow an erratic trend. In general, the industrialized countries go alongwith a so-called benign neglect approach; they carry out their monetarypolicy to achieve domestic goals without paying much attention to its impact onthe currency. Indeed, fearing a recession, the chairman of the Fed, BenBernanke, has been cutting interest rate repetitively in 2007, totally ignoring thenegative impact of the policy on the already weak dollar.

The Dollar and U.S. Current Account Deficits since 1973

After leaving its gold peg, the U.S. dollar depreciated in 1973, then recovered inthe following 3 years. By 1975-6, the new system had settled into a relativelystable pattern. Unfortunately, the dollar came under speculative attack in thesummer and fall of 1978, necessitating, in late 1978, a rescue package organizedby U.S. trade partners. In addition, worsening U.S. inflation continued to sappublic confidence in the dollars future.

In late 1979, however, the newly appointed chairman of the Federal

Reserve Board, Paul Volcker, presided over a sharp tightening of U.S. monetarypolicy. In early 1981, in part because of increasing market confidence thatChairman Volckers policies would succeed in breaking U.S. inflation, a largevolume of capital began flowing into the United States and the dollar began along appreciation. By the time it peaked in early 1985, the dollar had appreciatedby over 60 percent in nominal effective terms and by approximately 40 percent inreal terms resulting in huge current account deficits.

This appreciation can be seen as resulting primarily from an extremelyunusual set of macroeconomic policies in the United States. The Kemp-Roth taxcut of 1981 combined with a large increase in military expenditures to producelarge federal budget deficits. The unavoidable increase in U.S. Treasury

borrowing coincided with a tight monetary policy, resulting in very high interestrates causing capital inflows that bid the dollar up to levels at which U.S.products became uncompetitive in world markets. The economy of the industrialand agricultural Midwest, particularly dependent on export markets, was shaken.On the positive side, the overvalued dollar forced U.S. tradable goods prices downand helped break the long-standing inflationary spiral of the late seventies.

In early 1985, the dollar started to depreciate due to an earlier easing ofthe U.S. monetary policy. In late 1985, the secretary of the treasury met with the

21.20


21/34


finance ministers of the major industrialized countries at the Plaza Hotel in NewYork, where they agreed that the dollar was still too high and coordinatedintervention should be used to weaken it. Fearing an increase in Americanprotectionism, the U.S. trade partners went along. The dollar continued todecline in 1986 and early 1987, leading to another meeting of the finance

ministers at the Louvre in Paris; they concluded that existing exchange rates wereapproximately correct and no further depreciation of the dollar was needed.

In the nineties, the dollar fluctuated moderately due to various economicor political events, rising overall. It appreciated further from late 1999 to the endof 2001, having risen by about 35 percent from its 1995-7 lows. Since then, thedollar has been in a free fall against the Euro, the Canadian dollar, and the Britishpound; by August 28th 2008, it had stabilized around $1.48/ from $0.90/ eightyears before. The dollar slide against the Asian currencies has not been asdramatic as these countries central banks have intervened to maintain theirinternational competitiveness (following a managed float system).

U.S. current account deficits, hovering in the $100$200 billion range inthe 1980s and early 1990s, worsened late in the decade, reaching levels of over$400 billion by 2001-2 and $711 billion for the year ending August 28 th 2008.These deficits are ultimately the gap between U.S. investment and nationalsavings rates. Investment has not been particularly high as a proportion of GDP,but national saving rates have been very low, even negative. During the eightiesand early nineties, large public sector dissaving (budget deficits) offset much ofan otherwise normal private saving rate. As the reduction of U.S. militaryexpenditures, following the end of the Cold War, and large tax increases in 1990and 1993 brought budget deficits down and even produced surpluses late in thedecade, private saving rates declined. Unfortunately, the budget deficits havesoared at the beginning of the 21st century, due to a policy of tax cuts when

wagging a war while private savings reached new lows; inevitably, the currentaccount deficits have widened. Hopefully, the weaker dollar and a possibleslowdown of the U.S. economy might reduce the extent of these current accountdeficits.

Since relinquishing its role as supervisor of the Bretton Woods system, the IMFhas adopted new responsibilities. The Fund now exercises surveillance over theexchange rate policies carried out by its members. It has also underlined anumber of specific principles to guide its members, expecting them to abide tothese standards. For instance, members are not supposed to manipulate their

exchange rates to gain unfair advantage over their trade partners or to preventbalance of payments adjustments (e.g. trying to maintain a surplus). Membersshould be considerate when they use other countries currencies to intervene asthese operations could destabilize other currencies. However, the IMF does nothave the power to settle disputes nor to discipline countries that violate theserules. Basically, the IMF is not in a position to deal with international financialinstability it can only issue some guidelines hoping to reduce erratic exchangerate setting behaviour by its members. Indeed, in a world of high financial

21.21


22/34


integration, the exchange rate becomes practically a secondary issue. Theinstitutions that have to be regulated are the international financial entities,whether private or public banks or others; often they are stateless or so-calledmultinational. In addition, the development of offshore finance has acquired animportant security aspect since 2001 and has added to the push for greater

transparency and international standards. Debt crises and subsequent exchangerate instability have often been traced to imprudent and greedy behaviour bythese international financial institutions. Fortunately, there is an internationalagency that exercises surveillance and drafts guidelines to regulate theseinstitutions, the Bank for International Settlements (BIS). The problem is thatthe sprouting of all types of international financial entities and of new financialinstruments has been so rapid and so extensive that it is a challenge to keep upwith regulating them.

The New Financial Architecture: The Basel Accords

The threat to the solvency of many large banks, brought about by the LatinAmerican debt crisis of the early eighties, underscored the importance ofimposing harmonized regulation on international banks. A rapid increase ininternational banking, as banks branched or set up subsidiaries outside theborders of their home countries, made it almost impossible for a singlegovernment or central bank to regulate its national banks. To avoid home countryregulations, banks only had to set up subsidiaries in a jurisdiction with looserregulations. Jurisdiction shopping became a common practice as banks set upoperations wherever they would escape stricter national regulations.

The world-wide collapse of banks in the thirties made it all too clear thatan unregulated banking system was risky, leading to the idea of imposinginternational standards in bank regulation, at least for the industrialized

countries.Basel I

The bank regulatory authorities of the industrialized countries begandiscussions in 1986 at the Bank for International Settlements in Basel,Switzerland; they intended to coordinate their efforts improving the soundness ofthe international banking system. The negotiations were directed at four issuesfacing international banks. Each of these issues potentially threatened banksolvency and the stability of the worlds banking system:

1. Capital adequacy. Many of the largest banks had grown very rapidlythroughout the seventies and eighties without selling additional common

stock or retaining large earnings. As a result, their net worth declined as apercentage of their total assets; even rather modest losses, owing to bad loans,could thus threaten their solvency. An insolvency crisis could translate intoenormous risks for government insurance agencies such as the FederalDeposit Insurance Company in the United States.

2. Excessively risky loans. Latin America was not the only area where riskyloans, generating huge losses, had been made. U.S. banks lost large sums ofmoney in Zaire and the Sudan. The decline in the U.S. commercial real-estate

21.22


23/34


market, in the late eighties, inflicted large losses on banks from variouscountries, including Japan. Many banks simply did not appear to besufficiently prudent in making large loans.

3. Excessively concentrated loans. Partially in order to reduce administrativecosts, banks prefer making a few very large loans to making a large number of

small ones. In addition, they often concentrate lending in a few industries orcountries. Such concentration greatly increases the risk that the bank will failif a single country or industry experiences serious financial problems. At onetime Citibank had 75 percent of its net worth loaned in Brazil and over 100percent of its net worth loaned in Latin America.

4. Exposure from off-balance-sheet items. International banks were becomingincreasingly involved in foreign exchange forwards, futures, options contracts,and many of these activities created potentially large risks that were concealedfrom the public. How could these risks be evaluated and limited?

The Basel Accord on Capital Adequacy of July 1988 began to address some of

these problems. Most importantly, it set a minimum level of 8 percent for capitalas a share of risk-adjusted assets. That 8 percent included both net worth andsubordinated (non-deposit) debt. At least half of the 8 percent had to bestockholders equity, including accumulated reserves. Loan types were rankedaccording to the degree of risk they carried, with loans to OECD governmentsleast risky and loans to developing-country governments in the riskiest class.These risk weights were used to determine minimum capital requirements; if abank makes more risky loans, it must maintain more net worth. The 1991 failureof the Bank for Credit and Capital International (BCCI) and the more recentproblems of many large Japanese banks make it clear that the Basel Accord hadnot solved all the problems of excessive risk (and sometimes of fraud) in

international banking, but the agreement was an important step in the rightdirection.

Basel II

Perceived inadequacies in the original Basel Accord led to negotiations to revisesome of its terms. Basically, the new proliferation of securitisation changed howbanks did business. Instead of carrying loans in their balance sheet, they slicethem and repackage them as tradable securities that are in turn sold on thefinancial markets. Banks are now in the moving business, not in the storingbusiness according to the Economist (On Credit Watch, Oct 18 2007). Althoughit seems that securitization would allow banks to spread the risk more evenly, thisdid not happen as the banks chose to keep in their balance sheets those securities

yielding the highest returns i.e. the more risky ones. In addition, a host of newfinancial entities, that were not bound by the rules of Basel I, sprouted alongsidethe traditional banks, with the purpose of avoiding these rules.

What is now called Basel II was finalized in 2006 and it addresses someof these problems, unfortunately the pace of adoption of these new rules issluggish. Basel II is based on three pillars: a more sensitive classification of risk,more disclosures by banks, and more overseeing power by regulators. The risk-

21.23


24/34


weighted capital requirements on banks are now more intricate in order toaccurately reflect the risks in various asset types. As mentioned above, Basel Itreated loans to all OECD members as equally low in risk, without distinguishingbetween members (e.g. Turkey versus the U.K.) and viewed all loans todeveloping countries (e.g. Hong Kong) as being riskier than loans to any OECD

member. In addition, Basel II requires far more public disclosure of their riskprofiles by individual banks; this encourages the market (stockholders anddepositors) to impose risk-reducing discipline. Basel II also expands the role ofcentral banks and other financial authorities concerning prudential regulationwhile overseeing the risks that banks are allowed to undertake.

The challenge for Basel II was to balance the need of an enhancedinternational regulatory system that really does reduce the risk of major bankfailures with the potential downside of a more complicated system that couldstifles bank lending and burdens taxpayers and bank stockholders.Unfortunately, the sub-prime crisis that sprouted in mid-2007 illustrated theshortcomings of the new rules. Basel II relies heavily on risk rating, but the

institutions that are in charge of the rating (e.g. Moody, Standard and Poor) arealso involved in the new securitization business. It was thus in their interest toboost these ratings. By summer 2007, this bias became apparent and thesesecurities lost their appeals to investors, putting strains on the banks dependingon the securitization process. A liquidity crunch resulted, affecting interbankrates, and requiring intervention by central banks.

Basically the root of the upheaval had little to do with the capitalrequirement rules and a lot to do with the need for more judicious financialsupervision to avoid such illiquidity crisis. At this point, regulators agree thatBasel II needs to be scrutinized. First, in an effort to refine the ratings, the newrules gave more say to the rating agencies; this is part of the problem as the rating

agencies main sources of revenues come from the companies they rate. What isactually rated by these agencies presents another problem: the rating agenciesfocus mainly on whether a debt will be defaulted at maturity (credit risk) and noton liquidity management by individual financial institution (the cause of therecent sub-prime crisis). In addition, some newly created forms of financialentities fall through the regulation net. Finally, each country seems to have itsown approach towards banking supervision; different agencies are in charge andthe degree of stringency differs. The question that regulators will have to answeris whether there a need for more harmonized international supervision (with allthe potential drawbacks)?

PaymentCrisis in Heavily Indebted Developing Countries

Another aspect of what may become a new financial architecture forinternational finance is a proposal by Anne Krueger, a former Deputy ManagingDirector of the IMF; could the concept of corporate bankruptcy be adapted tohelp heavily indebted developing countries facing a payments crisis. The purposeof such procedure is twofold: first, to avoid chaotic attempts by internationalbanks to repossess their financial outlays before a countrys foreign exchangereserves are exhausted; second, to institute some binding system for creditors

21.24


25/34


allowing them to negotiate partial payments and/or longer-term structures forold debts. Bankruptcy laws in existence in various countries are being studied tofind an effective solution to help sovereign nations that cannot service or repaytheir debts.

This chapter took us from the nineteen century with the gold standard,

through the more recent Bretton Woods era after the second world war, andfinally to the modern era. Now the main issues are not necessarily exchange rateproblems, but rather the fear of international financial instability. These dangerscan only be addressed through closer international cooperation to regulate thenew stateless financial institutions. Individual countries have lost their sovereignpower to regulate them. It is obviously in the interest of these institutions towork with their so-called regulator, the Bank for International Settlements, toavoid payments crises and their dreaded consequence, contagion, as the crisisspread to other countries through the interwoven international financial grid.International financial crises will be the topic of the last chapter. In themeantime, we will pick up the history of the international monetary system in the

seventies to present in the next chapter the unique experience of Western Europein replacing Bretton Wood by a monetary union.

Summary of key concepts

1. The evolution of the standard from a bi-metallic standard (silver and gold) toa pure gold standard was achieved by the end of the nineteenth century.

2. With the gold standard, the value of national paper currencies would bedefined in term of the weight of gold they could exchange for at the centralbank. Since all currencies were defined likewise, their exchange rate or mintparity was simply the ratio of these weights of gold.

3. Central banks had to back any amount of currency in circulation by gold

reserve and be ready to redeem the paper currency for gold.4. In order to settle trade imbalances, gold could be freely traded

internationally and the adjustment mechanism was crucially dependent onprice and wage flexibility.

5. A deficit country would lose its gold reserves, resulting in a decrease in themoney supply. With perfectly flexible prices, prices would drop and thecountry would regain it international competitiveness.

6. Under the rules of the game, not only central banks were not supposed tosterilize reserves changes, but they were expected to enhance the impact ofthe adjustment mechanism through credit loosening (surplus country) ortightening (deficit country).

7. From 1880 to 1914, the gold standard was quite successful at stabilizing itsmembers economies. Trade as well as international capital flows were notimpeded by much control during the period.

8. The attempt to return to the gold standard after World War I was notsuccessful and the industrialized nations fended disastrous depressions inthe thirties. The consequence was a resort to protection and competitivedevaluations to try to solve domestic problems.

9. Aware of the importance of a stable world economic order as a crucial

21.25


26/34


foundation for peace, the Bretton Woods arrangement was entered by 44countries at the end of World War II. The International Monetary Fund wasto manage the system.

10. With Bretton Woods, the dollar was defined in terms of gold while the othercurrencies had to uphold a fixed exchange rate with the dollar. They did not

need to hold reserves in term of gold. This was a gold-exchange standard.11. The dollar was the anchor in this system. As long as the US economy wasdoing well, the system worked smoothly and was significant in helping theother countries rebuild their war-shattered economies. In the sixties,circumstances had changed and by the early seventies, for various reasons,Bretton Woods fell apart.

12. Efforts at salvaging the system were doomed and the world abandoned fixedfor floating exchange rates.

13. Both nominal and real exchange rates have been far more volatile than hadbeen expected when floating rates were adopted, and this volatility has beenvery disruptive, the 19815 appreciation of the dollar being particularlyharmful to the tradable sector of the United States.

14. After the demise of Bretton Woods, the role of the IMF was recast towardssurveillance, financial assistance, and technical assistance as worldeconomic conditions evolve.

15. A new financial architecture, Basel I and II, has also been designed under theumbrella of the International Bank of International Settlements (BIS).

Case studies

CASE STUDY I

Financial Reform - Reality check at the IMFApr 20th 2006From The Economist print edition

The fund needs a gentle overhaul, not a fundamental rethink

The International Monetary Fund cannot seem to win. Every financial crisis is thecue for the world's economic Pooh-Bahs to declare that the organisationdesperately needsreform. This year there is a conspicuous lack of crises, and yet,as they prepare for the IMF's spring meetings this weekend, the great and the

good are at it again. Mervyn King, governor of the Bank of England, says thefund's role is obscure. Tim Adams, the main international man at America'sTreasury, has accused it of being asleep at the wheel. Critics warn that the IMFfaces irrelevance unless it reinvents itself radically.That seems an extraordinary assertion. Less than a decade ago the world wasrocked by emerging-market financial crises in which the fund was called on tosave the day. Thanks to today's abundant liquidity, emerging economies haveenjoyed easy access to private capital and hence no need for the IMF. But no one

21.26


27/34


expects such liquidity to last forever. A temporary lack of fires does not removethe need for a fire brigade.So what is really prompting the calls for reform? One disreputable reason tochange is the internal workings of the IMF's budget. Bizarrely, the IMF makesmoney to pay for its staff only when it lends to countries in crisis. The lack of

recent crises means the organisation faces a 30% drop in its income over the nexttwo years. That suggests the IMF needs a new source of money, not a new role.On two counts, however, the critics have a point. On the world's most intractablemacroeconomic challenge, unwinding the imbalances between excessiveborrowing in America and excess saving elsewhere, the IMF has almost no clout.Worse, many of the fund's potential clients in the emerging world are the mostexcessive savers.They are doing their best to ensure that they never have to turn to the IMF again,by building up enormous foreign-exchange reserves, a hugely expensive andinefficient use of their resources .Most financial bigwigs think the fund's future lies in helping to sort out the bigglobal imbalances. Mr King wants the IMF to follow Keynes's dictum and offerruthless truth-telling when countries are going wrong. Endless proposals offeradvice on improving multilateral surveillance and on making the IMF's boardmore independent.Sadly, the fund's ability to tell rich countries what to do is extremely limited. Richcountries have not borrowed from the IMF in decades and will be deaf to thefund's wise words unless it suits their own domestic interests. Only if the fundhad the ability to punish non-borrowing members (as, in theory, it did in 1944),would the focus on surveillance amount to much. But no rich country will givethe IMF that power. It is naive to believe the fund can become a global financialguardian.The IMF's futurerather like its recent pastlies with emerging markets, whereaccess to international capital is more precarious than you might think. Shouldglobal financial conditions become less forgiving, many countrieswhetherIndonesia, Hungary or even Brazilmight once again need access to the IMF'scash. Even the strongest would be better pooling risks within the IMF than goingit alone by building up huge independent reserves.For that to happen, emerging economies must believe the IMF represents them.This calls for a shift of power away from Europe. It is absurd that Brazil, Chinaand India have 20% less clout within the fund than the Netherlands, Belgium andItaly, although the emerging economies are four times the size of the Europeanones, once you adjust for currency differences. Emerging countries are keen tocontribute more cash (and thus get more votes), and they have the support of

Rodrigo de Rato, the IMF's Spanish boss. The Europeans, too, should supportthis reform. A smaller voice in a useful organisation is better than power over amoribund one.

An IMFurance policyWith more sway over the fund, emerging economies could shift the organisation'spriorities. One sensible idea, recently raised by the IMF's chief economist, would

21.27


28/34


be to pool some of their reserves in the IMF, in effect, using it as an insurancefacility that offers rapid access to cash if strong economies are hit by financialturbulence. Some rich countries worry about the perverse incentives that wouldcreate. It is a dilemma: the risk is real, but so is the cost of a crisis. If many of thefund's clients want such a scheme, rich countries should not block it.

Doubtless, the agitators want much more. But, unlike their grand ideas, givingemerging markets a bigger voice and useful products would at least make theIMF more useful.

Copyright 2007 The Economist Newspaper and The Economist Group. Allrights reserved.

Case Study Questions:

1. Why does the IMF clout diminish when the world is awash in liquidity and nofinancial crisis is looming?2. Why are the IMF revenues lagging these days?3. Is the IMF in a position to give advices to the richer economies? Why or whynot. Shouldnt the IMF scold the US for its excessive borrowing, low privatesavings, and for causing major global imbalances?4. The IMF managing director is traditionally European while the chiefeconomist is American doesnt that sound like a rich countries club?Comment.5. Since the emerging nations are the main users of the funds, shouldnt theyhave more say in the running of the IMF? Comment.

CASE STUDY II

IMF quotas - Monetary misquotationsAug 24th 2006From The Economist print edition

A long-overdue shake-up at the IMFTHE IMF was founded during a moment of high statesmanship at Bretton Woodsin New Hampshire. But when they divvied up the power in their new creation, itsfounders practised some low numerical arts. Each country's quota of votes wascalculated according to an elaborate formula, which blended the economy's size,

reserves, openness and volatility. But according to the man who invented it, thisformula was a subtle contrivance, carefully designed to deliver a result pre-cooked by the Americans.Singapore is a long way from New Hampshire. But as the fund prepares for itsannual meeting in the Asian city-state next month, it is still trying to rid itself o

History of the international monetary system

Documents

Transcript of History of the international monetary system