International monetary system

Eliminate balance of payments problems [KA + CA]

Lend order and stability to foreign exchange markets
Provide access to international credits [in the event of disruptive shocks]
Features
Trilemma: (i) perfect capital mobility; (ii) fixed exchange rates; (iii) monetary independence
o Capital mobility?
o Fixed rates or monetary independence?

Pre WWI (1870-1914): Gold Standard + Free Capital Mobility
o Gold standard adopted internationally in 1860s. No formal convention. Rather Britain and
Germany, which traded in gold, were industrialising and becoming leading global powers.
Surrounding countries had an incentive to peg to gold, to minimise exchange rate
fluctuations and promote trade/financial flows.
o In practice, there was variation in how gold standard operated. In most countries, central
banks issued convertible paper currency, but did not have to hold an equivalent level of gold
reserves (proportional systems about 35% of eligible liabilities; fiduciary systems fixed
level of money supply can be unbacked). Other East Asian countries held foreign exchange
as reserves.
o How did gold standard work to aid BOP adjustments?
o Humes Price Specie-Flow mechanism
Simplifying assumptions: (i) only current account transactions (ii) only gold
in circulation (no paper currency, no central banks)
Gold is transferred from deficit to surplus countries; money supply falls in
deficit country and rises in surplus country; price level in deficit/surplus
country falls/rises accordingly; deficit country becomes more competitive,
while surplus country becomes less competitive, eventually correcting trade
balance.
Shortcoming: (i) absence of international gold shipments on scale predicted
by the model; (ii) assumptions increasingly simplistic.
o Cunliffe Committee
Introduced convertible paper currency (eg Sterling/Francs).
France (surplus country) earns sterling from England (deficit country) and
presents this at Bank of England for gold. Then convert gold to Francs at
Bank of France. Similar to Humes model, money supply/price level adjusts
to correct trade deficit.
Shortcoming: also cannot account for absence of international gold
shipments.
o Activist central bank
Central bank maintains gold reserves proportional to paper currency issued.
It can issue more paper currency by lowering the discount rate and
extending credit (increasing its NDA).
When there is a payments deficit, and drain of gold, central bank can
respond pre-emptively by raising interest rates, thus (a) reducing money
supply and price level and increasing export competitiveness and (b) making
it more attractive for foreigners to lend gold to the country.
Insulated from domestic politics, central bank could thus adjust interest
rates to maintain currency convertibility (i.e. maintaining sufficient level of
reserves proportional to outstanding paper currency).
Policy credibility added stability to the system. Investors would
automatically shift money to countries with payments deficit, knowing that
the central bank would raise interest rates to defend the currency.
o Limitations of gold standard
o Lender of last resort
By WWI, stability of gold standard compromised by rise of fractional reserve
banking. Central bank in dilemma over whether to act as lender of last
resort or provide only as much credit as consistent with gold standard.
Overend and Gurney crisis, 1866 concerned about level of its own
reserve, BoE did not extend assistance to banks. Panic was severe.
In fact, lender of last resort function could be counterproductive under gold
standard. Worries that currency convertibility could be suspended would
accelerate shift out of deposits and currency, leading to more bank runs.
But some escape clauses:
Country could temporarily suspend gold convertibility.
For major countries, foreign counterparts willing to extend aid. E.g.
Baring crisis, 1890 BoE borrowed gold from foreign counterparts
and extended liquidity to banks, thus maintaining both currency
convertibility and financial stability.
o But foreign aid was not available to peripheral countries of
lesser importance, who were even more susceptible to
banking crises (see point below).
o Instability at the periphery
Peripheral countries without central banks had no control over domestic
money supply. External shocks could induce large swings in money supply, in
turn leading to instability in banking sector.
External shocks could be amplified. If export revenues fall, doubts over
whether country can service foreign debts. Financial flows dry up. Exports in
turn suffer from scarcity of credit. Shocks to current and capital account
reinforce each other.
o Deflationary bias of gold standard
Became apparent by 1880s (too little metal chasing too much goods). By
1890s, US price level had been declining for twenty years. Increased burden
of mortgage debt.
1890 Sherman Silver Purchase Act government must issue more money,
ideally in the form of silver coin (appeased aggravated silver miners).
But reversion to hard money with passage of Gold Standard Act of 1990.
New discoveries of gold + fractional reserve banking initially reduced
deflationary pressure.
As gold discoveries receded, concern resurfaced about adequacy of gold
supplies to meet needs of expanding world economy.
o Challenge to single-minded pursuit of convertibility at expense of internal balance.
Rise of labour unions resulted in slow adjustment of wage and consequently
prices to changes in the money supply.
Extension of franchise increased political pressure for monetary policy to
maintain growth and employment.

Interwar Period (1914-1936): Breakdown of Gold Standard; Restriction of Capital Flows
o Abandonment of gold standard and free float (1914-1925)
o During war, gold became important for purchasing war supplies. Countries imposed
restriction on gold exports, effectively ending gold convertibility. Exchange rates
began to float.
o Large government deficits to finance war efforts led to monetisation and
hyperinflation. Differential inflation rates caused exchange rates to vary widely.
o Were floating exchange rates de-stabilising? The Case of the Franc:
Friedman: No. Currency volatility simply a reflection of volatile fiscal and
monetary policies.
Nurske: Yes. Even with restoration of budget balance and removal of serious
sources of reparations uncertainty in 1925, Franc continued to depreciate.
Depreciation led to higher inflation, in turn reducing real value of tax
collections relative to public spending. Case of destabilising speculation.
Counterargument: there was uncertainty over capital levy would be
imposed. Prompted capital flight, which ceased once this was
banished from fiscal agenda in 1926.
o Reconstruction of gold standard (1926-1931)
o Three types of countries:
First countries to re-establish gold convertibility were those who endured
hyperinflation (Austria, Germany, Hungary and Poland). Issued new
currencies governed by provisions of gold-standard laws.
Countries experiencing moderate inflation stabilised their currencies and
restored gold convertibility (Belgium, France, Italy). Had depreciated
significantly since the war; chose to stabilise exchange rates around
prevailing levels.
Countries with contained inflation restored pre-war price of gold and
traditional dollar exchange rate (US had not altered dollar price of gold).
In particular, Britain returned to pre-war parity in 1925, which
prompted critical mass of countries to follow.
o The New Gold Standard
To stretch supply of reserves, some countries augmented gold with foreign
exchange (gold-exchange standard). But no international cooperation on
this matter.
o Problems with new gold standard:
Britain ran persistent BOP deficit from 1927-1931, losing gold.
Return to pre-war parity left Britain uncompetitive, as prices had
risen substantially.
BoE forced to raise interest rates in 1925 at cost of depressing the
economy. Slow growth and double-digit unemployment for rest of
decade blamed on Britain returning to pre-war parity.
France and Germany ran persistent BOP surplus over the same period,
absorbing gold.
France had returned to gold standard at more competitive exchange
rate.
In both France and Germany, monetary policy was tighter vis--vis
other countries (France adopted statutes prohibiting central bank
from expanding domestic-credit component of the monetary base;
Germany maintained higher interest rate). This (i) prevented prices
from rising, keeping exports more competitive; and (ii) attracted
foreign investment.
Stemmed appreciation pressures by accumulating foreign exchange
and in turn presented these for conversion into gold.
US BOP position also strengthened.
War-debt related transfers to the US between mid-1926 and mid-
1931 totalled US$1bn.
Wartime disruptions allowed U.S to overtake Europe as main
exporter to Latin America.
By 1926, was largest holder of gold (45% of worlds supply), with a
quarter exceeding the 40% backing required by countrys gold
standard law in 1926.
But price-specie flow mechanism did not operate as US lent its
surplus back to Europe and other parts of the world.
In 1928, Fed raised discount rate to discourage stock market
speculation. Heightened strains on debtor countries, and others on
gold standard which were forced to respond with discount rate
increases of their own.
Eventually prices begin to fall in debtor countries (as capital stopped
flowing in and interest rates rose sharply), but provided limited
boost to exports with onset of great depression in 1929.
o Breakdown of gold standard (1932 onwards)
o Developing countries experiencing simultaneous capital/commodity market shocks
chose to suspend convertibility and let exchange rate depreciate.
o In industrial countries, trade-off between (i) maintaining gold standard and (ii)
expanding base money to counter recessionary forces/act as lender of last resort.
o Capital movements became destabilising as speculators expected government to opt
for (ii), which in turn became self-fulfilling.
Britain suspended convertibility on September 19, 1931, following Austria
and Germany. Other countries followed.
o By 1932, international monetary system had splintered into three blocks:
Residual gold-standard countries, led by the US
Sterling area (Britain and other countries pegged to the pound)
Central and Easter European countries, led by Germany, where exchange
controls prevailed
Others: Canada and Japan followed Britain off the gold standard but did not
join the Sterling area.
o Eventually, US forced to go off gold standard.
Depreciation of Britain and partners eroded BOP position of the US. Capital
flight. Commitment to gold standard led country to ratchet up interest rates,
aggravating unemployment, prompting doubts over sustainability and even
more capital flight.
Central banks (France etc) scrambled to convert dollars to gold, amidst fears
that convertibility would be suspended.
Eventually, Roosevelt devalued dollar by 40% against other gold-standard
currencies in 1933. Pressure on remaining members of gold bloc to abandon
the gold standard.
o By 1936, gold standard gave way once more to floating rates. But this time, it was
managed.
Exchange equalisation accounts set up to intervene in markets.

Bretton Woods System (1944-1973): Fixed exchange rates, restrictions on capital flows

Formation of Bretton Woods
Bretton Woods System differed from gold-exchange standard in three ways:
o Adjustable pegs (to correct fundamental disequilibrium)
US pegged to gold; other currencies pegged to US dollar.
But there was a taboo against adjusting pegs.
o Restrictions on international capital flows
Effective only until 1959, when current account also non-convertible.
Countries employed import restrictions so as to stimulate economy after
war while maintaining trade balance.
o IMF created to monitor national economic policies and extend BOP financing.
Scarce-currency clause authorising import controls on countries that ran persistent
payments surplus
But had blunt teeth.

Compromise between Keynes (UK) and White (US) plans.
o Keynes: Clearing union to provide for extensive BOP financing. Surplus country
obliged to finance drawing rights of deficit countries. Exchange rates to be flexible.
o White: Oppose Clearing Union for involving unlimited liability for potential creditors.
o In the end, quotas limited to US$8.8bn, and US obligation to US$2.5bn. Exchange
rates to be pegged with room for adjustment.

Post-War Reconstruction: European Trade Deficits & Import Restrictions
Post-war Europe had immense reconstruction demands. Led to trade deficit vis--vis US
surplus over first few years of operation.
European/Latin American countries employed import restrictions to reconcile achievement
of full employment and external balance. Exchange rate would have been overvalued
without these restrictions.
While increased exports could have earned foreign currency necessary for imports, this
required other countries to liberalise too. However, failed to achieve this over multiple GATT
negotiations. (1947, 1949, 1950-51)

Devaluation, Fiscal Tightening and Restoration of CA convertibility in Europe
In the UK, CA convertibility restored in 1947. This was followed by huge losses in reserves.
Sterling underwent forced devaluation in 1949, and 23 additional countries followed suit
(main exceptions were the US, Japan, Switzerland and Lat Am countries). In total, European
currencies devalued by 30% in September 1949.
In other European countries, adjustment had to be complemented by fiscal/monetary
tightening.
o Germany suffered BOP crisis in 1950 (Korean war raised price of imported raw
materials). Exhausted quota in first five months of EPUs operation. Introduced taxes
to restrain consumption. BOP strengthened by mid 1951.
o Similar BOP problems in France, due to over-spending by socialist government.
Eventually resolved through devaluation and fiscal retrenchment.
Devaluation aided adjustment. US current account surplus halved from 1949-50 (though
also due to Korean war).
Strengthening trade balances in Europe paved the way for fuller restoration of CA
convertibility in 1958.
o European Payments Union (1950-end 1958) created to coordinate removal of
current account restrictions in Europe.
Code of Liberalisation to coordinate removal of CA restrictions.
Countries running deficit against EPU would get credits, subject to quota.

The Triffin Dilemma
Triffin dilemma: Countries need to accumulate dollar reserves. However, when dollar
reserves grow large relative to US gold reserves, convertibility will come into question,
leading to flight out of dollars.
o Related to De Gaulle problem: System was reliant on dollars for liquidity needs.
America thus had an exorbitant privilege, being able to finance its deficits cheaply.
o By 1960, US foreign monetary liabilities exceeded its gold reserves.
Need to substitute dollars/gold for other forms of international liquidity to meet expansion
of economic activity.
o Special Drawing Rights created by the IMF in 1969, to substitute for an international
reserve asset.
o By the time they were introduced, however, global economy was not suffering from
liquidity shortage, given glut of dollars associated with US deficits and individual
countries expansionary monetary policy stance.
o Currently, SDRs allocated to countries based on their size in global economy.
Countries can voluntarily exchange SDRs amongst themselves for usable currencies.
IMF can also designate countries with strong external positions to purchase SDRs
from countries with weak external positions.

Declining Controls and Rising Rigidity
With CA convertibility in 1960s, capital controls harder to enforce.
o Scope for both independent monetary policy and fixed exchange rates more limited.
(Before, CAD might create BOP pressures, but not overwhelming. Can be gradually
corrected).
At the same time, countries less willing to adjust pegs. Perceived as admission of weakness
that could spark greater speculative outflows.
Survival of Bretton Woods till 1971 owes primarily to international cooperation. Industrial
countries established swap lines, banned interest on foreign deposits, and formed a Gold
Pool (pledging to refrain from converting dollars to gold, and selling gold out of their
reserves to relieve pressure on the US).
o But eventually countries withdrew support, as they became aware of Americas
reluctance to adjust domestic policies to defend the dollar.
- Sterling, perceived as the second reserve currency, depreciated by 17% on November 18,
1967.
- Flight from the dollar into Germany, Switzerland etc forced European countries to revalue
their currencies in 1971. Nixon suspended gold convertibility on August 13.
o Poorer economies of Europe and Japan were industrialising rapidly, leading to higher
inflation via Balassa-Samuelson effect. There were limits to how much liquidity they
could absorb from the US. [Limits to international cooperation]
o Smithsonian agreement in December 1971: US to peg dollar to $38/ounce.
o But not effective. Further flight from the dollar forced countries to float in 1973, and
marked the demise of Bretton Woods.


Post Bretton Woods: From Floating to Monetary Unification

Large countries like US, Japan floated.
Smaller countries attempted to peg. Some had currency boards.
In Europe, European Snake in 1970s (fluctuation bands); European Monetary System in 1980s;
breakdown in EMS in 1993; in 1991, moved towards plan for European Union.

1970s more concerted intervention, more extensive use of capital controls, greater willingness to
adapt policies to imperatives of the foreign exchange market.

US Dollar

US dollar appreciated from 1979 to 1983 due to higher interest rates during Volckers term. High
interest rates in turn needed as fiscal spending was too expansionary. In 1984, exchange rates
continued rising despite US interest rate differential falling, pointing to speculative bubble. Sharp
rise in exchange rate was hurting domestic producers of tradeable goods, leading to threats of
protectionism.

Plaza Accord signed in 1985, to allow for orderly appreciation of non-dollar currencies. Signalled
policy shift. By 1986, dollar had lost 40% of its value against the yen from the peak the year before.
Created cost competitiveness problems for Japanese industries.

Europe

European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins
European Commission where most nations of the European Economic Community (EEC) linked their
currencies to prevent large fluctuations relative to one another.

After the demise of the Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to
maintain stable exchange rates by preventing exchange rate fluctuations of more than 2.25% (the
European "currency snake"). However, it suffered from an accountability deficit, as the Bundesbank
set the tone for monetary policy but was not itself influenced by any other country*.

In March 1979, this system was replaced by the European Monetary System, and the European
Currency Unit (ECU) was defined.

The basic elements of the arrangement were:
1. The ECU: With this arrangement, member currencies agreed to keep their foreign exchange
rates within agreed bands with a narrow band of +/- 2.25% and a wide band of +/- 6%.
2. An Exchange Rate Mechanism (ERM)
3. An extension of European credit facilities.
4. The European Monetary Cooperation Fund: created in October 1972 and allocates ECUs to
members' central banks in exchange for gold and US dollar deposits.

Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank
soon emerged as the centre of the EMS. Because of its relative strength, and the low-inflation
policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside
the system.

Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but
after 1986 changes in national interest rates were used to keep the currencies within a narrow
range. In the early 1990s the European Monetary System was strained by the differing economic
policies and conditions of its members, especially the newly reunified Germany, and Britain (which
had initially declined to join and only did so in 1990) permanently withdrew from the system in
September 1992. Speculative attacks on the French Franc during the following year led to the so-
called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.

Factors leading to EMS Crisis
- Prior to 1987, pegs were adjusted. Thereafter, pegs were hardened. Countries avoided
devaluation, perceiving it as an embarrassment.
- Capital controls were relaxed, in lead up to further integration.
- Timetable for monetary union was announced.

Three explanations for EMS Crisis:
- Inadequate harmonisation of past policies
o Italy, Spain and UK had not brought inflation rates down to those of ERM partners.
Excessive inflation cumulated into overvaluation (and also reduced real interest
rates), aggravating CA deficits.
- Future policy shifts
o German reunification in 1987 led to higher inflation. Bundesbank responded by
raising interest rates. Other ERM countries had to follow suit, leading to rising
unemployment. Investors knew this was not sustainable, leading to a sell-off.
o Further intensified by negative results of national referendums on whether or not to
sign the Maastricht Treaty.
- Speculative attack
o Selling pressures cause central bank to hike rates, exacerbating unemployment, and
making the peg more costly to keep.

*With pegged exchange rates, main question is, which country will be the leader in setting policy,
and which will have to adjust accordingly?
France Deficit Germany Surplus
If adjusting, will have to raise interest rates to
ward off depreciation pressures. This will also
reduce expenditure and reduce deficit.

Whether contraction is right in the first place
depends on where country is vis--vis potential
output.

Alternative is to adjust exchange rate
downwards.
If adjusting, will have to lower interest rates to
ward off appreciation pressures. This will also
increase expenditure and reduce surplus.

Whether expansion is justified in the first place
depends on where country is vis--vis potential
output.

Alternative is to adjust exchange rate upwards.