Thursday, August 11, 2011

Steve Baron: Understanding the International Monetary System

To understand the future we need to consider the past. In the turmoil from the international credit crisis, bank defaults and sharemarket crashes, what does the future hold and how did this international monetary system develop to what it is today?

In this article I will examine the changes in the international monetary system over the last 100 years. I will explain how this system has developed from the days of merchantilism and the international gold standard, to the hybrid system of today. I will explain how these changes came about, why they were considered a good set of rules at that time and why they were eventually superseded by the next order. The possible return to the international gold standard will also be considered. As will the possibility of a world central bank along with a single world currency and finally, I will suggest a new consideration that needs to be examined to ensure the international monetary system is delivering its full potential.

Singer-songwriter Bob Dylan sung—The Times They Are a-Changin'—and so it has been with the international monetary system. Gone are the days when ordering a new vehicle from the Ford factory meant you would wait months, if not years, for it to arrive. You could also choose any colour, so long as it was black. Even then you had to be wealthy and usually apply to the government to be allowed to send domestic currency offshore to pay for that new vehicle. International financial transactions are now conducted with the click of a computer mouse, touch-pad or touch-screen. So, what is this system we call the international monetary system and just how has it evolved? Mark Carney, the Governor of the Bank of Canada gave his perspective in a speech to the Foreign Policy Association in New York City in November 2009. He described it thus: “The international monetary system consists of (i) exchange rate arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions that govern its operation.”. Barry Eichengreen in his book Globalizing Capital described it as, the glue that binds national economies together. Its role is to lend order and stability to foreign exchange markets, to encourage the elimination of balance-of-payments problems, and to provide access to international credits in the event of disruptive shocks. But before we go any further, let's go back to the beginning and examine the path of the international monetary system since the days of merchantilism, when the monetary system evolved around that precious yellow metal we call gold.

The logic behind merchantilism was that gold and other precious metals symbolised a nation's wealth, and the goal was to encourage exports but discourage imports. Merchantilists assumed that trade was a zero-sum game and therefore, for every winner, there was also a loser. The fallacies of this logic were exposed by David Hume in 1752, with his specie-flow mechanism theory. This theory explained that it was not the amount of gold and silver a country held that was important, it was how many goods and services that could be bought with this gold and silver. So consequently, as gold and silver were amassed there was more currency in circulation (in the form of gold and silver) so this simply led to higher prices, therefore no one was better off. In fact most were probably worse off because that country's exports became far more expensive, so less goods were exported. Trade theory was expanded upon by Adam Smith in 1776 and David Ricardo in 1817, with their theories of absolute advantage and comparative advantage.

The international gold standard was the first major development in the international monetary system and was adopted by major countries from 1876 – 1913. Exchange rates were effectively fixed, because governments agreed to buy and sell gold at a fixed rate. This system of using gold to back national currencies ran quite smoothly until 1914 when World War I began. Problems continued right through until the end of World War II in 1944. These wars interrupted trade and the free movement of gold was suspended. The Great Depression of the 1930's was also a major problem with restrictions on trade causing this world wide depression to continue. At the time, countries were more concerned with their national economies rather than exchange rates and trade.

The next major development in the international monetary system was the Bretton Woods Agreement,1945-1971. Allied countries met and created the International Monetary Fund (IMF) and the World Bank after WWII. Article I stated its purpose as: “to promote international monetary cooperation, to facilitate the expansion and balanced growth of international trade, promote exchange rate stability, and to assist in the establishment of a multilateral system of payments”.

The reserve currency for which all signatories would fix their currency to was the US dollar. This is not surprising, because as Mundell also explained, “Historically, whenever there has been a superpower in the world, the currency of the superpower plays a central role in the international monetary system. This has been as true for the Babylonian shekel, the Persian daric, the Greek tetradrachma, the Macedonian stater, the Roman denarius, the Islamic dinar, the Italian ducat, the Spanish doubloon and the French livre as it has for the more familiar pounds sterling of the 19th century and the dollar of the 20th century.”

This system was seen as a tool to create a stable world monetary system, which made international balance of payment settlements much easier as well as world trade. Unfortunately the system started to fall apart in the 1960's when US President, Lyndon Johnson, started to fund his “Great Society” programme, which produced large deficits and created balance of payments problems. A number of external shocks then brought about a lack of confidence in the US dollar, which markets started to sell off. Then in 1971 US President, Richard Nixon, suspended official purchases or sales of gold. In 1973 the US dollar came under attack for being over-valued and many countries allowed their exchange rates to float against it, because it had become unsustainable for central banks to prop up their currencies due to a lack of large quantities of international reserves. Currencies were then traded on foreign exchange markets,which encouraged the free flow of money which has also opened up trade. Given current circumstance surrounding the US, it is unlikely this will continue for much longer without a dramatic economic turnaround in the US.

The IMF is an intrinsic part of the international monetary system and helps keep it stable. It is controlled by the governments of its member countries and represented through a Board of Governors. The Governor for each member country is usually the Minister of Finance or sometimes the Central Bank Governor. The IMF loans emergency funds money to countries that have found themselves in financial difficulties. This is often due to poor economic management or a financial crisis outside of their control although at present these problems have mostly been self inflicted. In order to qualify for these loans the country needs to meet certain criteria as stated from time to time by the IMF. The IMF is funded through quotas based on the size of the national economy. Surveillance and reporting of world capital markets has become a large part of the activities of the IMF. In many ways it might be considered a watchdog and now also considered as a lender of last resort. The IMF has also grown from the 44 states from the Bretton Woods days to now incorporate 187.

The World Bank was instituted at Bretton Woods at the same time as the IMF. The World Bank website states, “Our mission is to fight poverty with passion and professionalism for lasting results and to help people help themselves and their environment by providing resources, sharing knowledge, building capacity and forging partnerships in the public and private sectors.” The World Bank is made up of two unique development institutions. The International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD aims to reduce poverty in middle-income and creditworthy poorer countries, while IDA focuses on the world's poorest countries. These organisations provide low-interest loans, interest-free credits and grants to developing countries for a wide array of purposes that include investments in education, health, public administration, infrastructure, financial and private sector development, agriculture and environmental and natural resource management. The IMF and the World Bank do have their critics, Joseph Stiglitz, a renowned economist, Nobel Laureate, Chairman of Bill Clinton's Council of Economic Advisor's and World Bank Chief Economist stated, “The IMF prescribed outmoded, inappropriate, if 'standard' solutions, without considering the effect on the people in the countries told to follow these policies.”

An interesting development in the international monetary system has been the creation of the European Union and the Euro currency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxembourg and the Netherlands forming what was to be known as the European Economic Community. This group had grown out of the 1951 Treaty of Paris that formed the European Steel and Coal Community, which was designed to help reconstruct the European economy after World War II had destroyed it. Today, this group has expanded into twenty-seven member countries and is now known as the European Union. In January 2002 a new currency called the Euro came into use in the European Union. The United Kingdom and Denmark chose to opt-out of the Euro and still use their own currency alongside the Euro.

The monetary union that was created is nothing new. Previous examples are the Latin monetary union, comprising France, Belgium, Switzerland, Italy and Greece, which existed from 1865 until 1927. The Scandinavian monetary union of Sweden, Denmark and Norway lasted from 1873 until 1924. The German Zollverein, which was a customs union between German principalities in 1834, is often held up as the most successful example. It produced a central bank, the Reichsbank, and a single currency, the Reichsmark, in 1875.

The concept of an EMU is to integrate independent states and their economies to help them achieve economic efficiencies, break down barriers that exist between the states and strengthen their resolve to any external shocks. By doing this, custom tariffs can be removed, free trade can flourish, goods - capital - labour will have free movement, and a single currency with a centralised and harmonized fiscal and economic policy will promote currency stability, growth and economic power for the region. For the EU this is controlled by the European Central Bank. The EU has had its problems ever since, with several countries needing expensive bail-outs. The EU has had its benefits however. Not the least being the opening up of trade and the removal of trade barriers between all members. Inflation has been stabilised and the likelihood of wars in the region has been dramatically reduced. Although the value of the Euro has continued to drop against the US dollar since first launched, it has acted as a major world currency and an alternative reserve currency to the US dollar. The jury is still out on its continuance and benefits to the international monetary system.

The Hybrid International Monetary System we now have has evolved since the Bretton Woods agreement fell apart in 1973 and now appears to have been broken into two blocs. Most advanced nations have floating exchange rates, but a larger number of emerging and less developed countries have opted to peg their currencies to currencies like the US dollar or the Euro. China, for example, originally fixed the renminbi to the US dollar but now fixes it against a basket of currencies. However, since the collapse of Argentina’s currency that was pegged to the US dollar, many are doubting that this is a feasible option. Others that moved from soft pegs to floats have been highly managed, but doubts must also be maintained about these actions as the same theory about the gold standard failing still applies in this situation. Small countries like New Zealand, have little power in their exchange rate interventions, because they do not have unlimited funds. Many speculators hold far more reserves in their investment funds and a country like New Zealand could never compete with them in exchange wars. According to a study by Eichengreen & Razo-Garcia, in the next two decades 30% of countries will have pegs, 30% will have floats, and 40% will have intermediate regimes. Compared to the current situation this shows that intermediate arrangements will have declined further, but only modestly.

In 2008 the world faced an international credit crisis, which threatened the international monetary system and continues to this day. This began with the collapse of investment banks like Lehman Brothers. This mostly came about due to sub-prime loans to people who could not afford to pay them back and consequently defaulted as property values plummeted. The world is still recovering and we know it is over yet. The credit crisis that has ensued has raised many issues that effect the international monetary system. In some ways this is not too different to the wave of crisis that swept through East Asian economies, Russia, Argentina, Brazil, and Turkey during the 1990s. They have made the world focus on financial mechanisms, governance, transparency and the threats that economic bubbles pose. It has also made world powers realise just how economically integrated the world has become. Due to the credit crisis, some commentators like US Congressman Dr. Ron Paul have called for a return to the gold standard.

Returning to the gold standard would appear highly unlikely. Nothing has changed in the world to expect that what happened back in the days of the original gold standard would not happen again. Gold in itself has very little intrinsic value or real use, just like fiat currency. Talk of a world currency is not new either. Harry Dexter White, the chief international economist at the U.S. Treasury from 1942 – 1944, floated the idea of a world currency he called the unitas. World renown British economist, John Maynard Keynes, floated the idea of a world currency he called the bancor. Neither took off at the time because there was an advantage for the country whose currency was the reserve currency, not having to balance their balance of payments. Although a world currency, by whatever name, may encourage world trade even more, and also remove uncertainties of currency fluctuation, the problems of a lack of fiscal responsibility and discipline that are currently affecting the EU will also haunt a world currency. There also needs to be competition between currencies, for as surely as communism failed due to lack of competition, so too would a single world currency. The major problems that need addressing by world powers are transparency in our financial institutions, public expenditure, deficits and limiting quantitative easing, all of which are the core of monetary stability and the international monetary system.

One issue rarely considered by economists or Reserve Bank Governors, is the cost of creating new money when it enters the financial system (not to be confused with quantitative easing). The money supply of a country usually needs to expand as the amount of goods and services in a country expands, so that there is enough money to purchase these good and services. This is a fine balancing act, too much money in circulation leads to inflation, but too little also leads to deflation, as was experienced during the Great Depression. However, as this money comes into circulation through government open market operations and consequently the money multiplier effect of the banking system, it enters society as an interest bearing debt. This cost has a compounding effect and must certainly create an unnecessary cost to society. If more money is required to keep the wheels of our monetary system greased, then perhaps governments need to find a way to inject this money into society without this cost? An empirical study into this cost would be an interesting exercise and perhaps an eye opener for future Ministers of Finance and Reserve Bank Governors. Perhaps the lead needs to be taken by a small country like New Zealand, to show the rest of the world how systems can be improved?

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