History of International Monetary Systems - A quick and dirty guide

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In this paper, I aim to provide an introductory and reader-friendly understanding of the key international monetary systems over the last 200 years.

In this paper, I aim to provide an introductory and reader-friendly understanding of the key international monetary systems over the last 200 years.

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  • 1. History of Modern International Monetary Systems A quick and dirty guide Vikas Sharma, PMP®, Associate Director Public Sector & Government Practice Frost & Sullivan September, 2013
  • 2. History of Modern International Monetary Systems 2013 THE GOLD STANDARD – (1870-1914) • Lasted from around 1870 to the onset of World War I (had a short-lived revival in the late 1920s) • Was the first monetary system that was ‘global’. Participant nations were from the core (UK, France etc.) as well as periphery (US, Latin America, Asia). Countries did not exactly ‘adopt’ it as a conscious decision. It was more a deference to the economic might of the core countries like the UK. There were some examples in Asia of countries being on the silver standard (China and India) • It was a classic ‘fixed/pegged’ exchange rate system, with GOLD being the central anchor. Every currency exchange rate was fixed with respect to Gold, and in doing that, essentially, exchange rates among all currencies were fixed/pegged too. For e.g. if 1 USD = 0.1 Gold oz and 1 GBP = 0.2 Gold oz, then the USD/GBP rate was also fixed consequently at 0.1/0.2 = 0.5. • With respect to the impossible trinity of monetary systems, by design, the Gold standard had free capital flow and fixed exchange rates, but NO monetary policy independence. • Balance of Payment imbalances were managed automatically WITHOUT there being any need for monetary policy from the countries. Country A with a BOP deficit (i.e. a net debtor) would have to lose Gold to its creditor nation B. This outflow would mean less gold remains in A. Since currency exchange rate is tied to Gold, less gold in the country means essentially less money. Hence, country A is essentially forced to ‘contract’ its money supply. With less money chasing goods, prices in country A would fall (Deflation). With these lower prices, its exports become more attractive, and its tendency to import goes down. Hence, the BOP deficit reduces over time automatically. In the context of the gold standard, a BOP crisis would have meant that a country has outstanding gold payments to other countries that it is unable to make (due to severe trade deficits and/or outflow of capital from it). In that case, the country may have to devalue its currency against Gold (i.e. modify the existing parity with Gold to a new rate). In doing so, the country would essentially devalue its currency against ALL other world currencies. • Strengths: Did not require government intervention of any sort (seen as a good thing by many). Tying all currencies to gold meant stable exchange rates (beneficial for international trade). There were some instances of cooperation between central banks (for e.g. they would lend to each other to help tide over BOP imbalances – pretty much like what is done nowadays too by other central banks or by the IMF) • Weaknesses: Countries had no control over their monetary systems. Could not adjust monetary supply to counter economic needs. System was too dependent on the supply of a commodity (gold) and was susceptible to wild swings of inflation/deflation. The fixed rates were in no way ‘fixed’ in practice. Countries often moved out of the gold standard during times of economic stress, changed exchange rates with gold etc. Most of the countries on the system experienced mild DEFLATION. Reason: the supply of GOLD (money) did not keep up with the growth in output. So essentially, there were more goods chasing the same pool of money. HENCE deflation
  • 3. History of Modern International Monetary Systems 2013 THE WORLD WAR ERA (1914-1945) • With the onset of World War I, countries broke away from the Gold Standard and went into a period of (managed) floating rates for a few years. This was a chaotic period and had a lasting influence on post-war monetary cooperation • There was a brief attempt in the late 1920s to go back to the gold standard, led by the UK (1925). However, it was short-lived and could not bear the stress of the macroeconomic conditions prevailing (the 1929 depression). WHY? – because, in going back to the Gold standard, countries were giving up monetary policy independence. AND this was something that proved too prohibitive in the midst of the depression (when economies needed to be stimulated). Also, the growing movement in political economy towards democracy further weakened support for giving up monetary independence. Output fell in several countries and they had severe BOP imbalances, leading to numerous currency devaluations against Gold. • To guard their own economic interests, there were several ‘competitive’ currency devaluations (in a bid to increase trade prospects). This was also a period of severe capital flow controls (even back then, capital flows were regarded as suspects for financial crises). Basically, countries affected by the depression resorted to severe competitive and restrictive policies. • Post the gold standard attempt, countries tried managed floating rates again. However, on the whole, this was a period of chaos in the international monetary system. • With the onset of World War I, countries broke away from the Gold Standard and went into a period of (managed) floating rates for a few years. This was a chaotic period and had a lasting influence on post-war monetary cooperation
  • 4. History of Modern International Monetary Systems 2013 THE BRETTON WOODS SYSTEM (1945-1973) • At the end of World War II, 44 countries met at a small town called Bretton Woods in New Hampshire, USA to thrash out the a new international monetary system. The Soviet Union did not take part. • Under the BW system, Gold was back to being the key anchor in a way. The US promised to make its dollar freely convertible to gold at a fixed rate of USD 35/oz. All other countries, in return, pegged their currencies to the US dollar at declared exchange rates. These exchange rates were fixed but with some flexibility (were allowed to move +/- 1% against the USD). Hence, in essence, while under the gold standard, all currencies were linked to Gold directly, under BW, world currencies linked to the US dollar, which in turn was linked to the Gold. So world currencies were STILL technically linked to Gold, just in an indirect way. • The IMF and the IBRD (International Bank for Reconstruction & Development) were set up during these talks. IBRD was meant to be a temporary institution for war-related redevelopment but evolved into the World Bank later on. There was also an effort to set up an International Trade Organization (ITO) but it failed (later successful as the GATT/WTO). In this sense, the BW meeting represented the HIGH POINT of international monetary cooperation. • Also, as part of the BW agreement, countries were to ensure full convertibility of their current accounts. This conversion was overseen (monitored) by the IMF and some countries were provided contingent funds to help ease the transition. It is important to note that this convertibility was restricted ONLY to current account and did not include the Financial and Capital Account. This was a continuation of the FEAR/DISTRUST of capital flows that had emerged during the World War era. Even though it wasn’t declared as such, the BW system seemed to sympathize with restricted capital flows too. • The BW system represented in many ways a compromise on issues that had emerged over the years preceding it: o It offered a compromise between reverting back to the Gold standard and going completely OFF the gold standard o It offered a compromise between FIXED rates and flexible rates (by allowing +-1% bands) o Offered current account convertibility while still maintaining some capital flow controls • The BW system was OFFICIALLY in effect from 1945-1973. However, in essence, it only lasted for 10 years between 1958-1968. Most of Europe only joined in 1958. And by the end of the 1960s, it was effectively over as a system due to the frequent devaluations of the USD against Gold. • Strengths: While it was in effect, it was pretty successful - Low inflation, high economic growth and increased international trade. But this could have been due to the specific characteristics of the period it was operational in (50s-60s) such as tight capital flow controls, high public debt etc., rather than the merits of the system itself.
  • 5. History of Modern International Monetary Systems 2013 • Weaknesses: There were some fundamental flaws with the system: o Flaw 1: Keeping in mind the IMPOSSIBLE TRINITY - In the earlier years, capital flows were restricted/insignificant, and hence the system was able to allow for Monetary Independence and Fixed Exchange Rates. However, as liberalization set in and capital flows increased, it was impossible to maintain all three. o Flaw 2: With the US dollar as the key currency all others were pegged to, it basically implied that US monetary policy decided the monetary policy of the WORLD. How did this happen: If the US followed an inflationary monetary policy (printed more dollars), all other countries had to print more of their currency too (experience inflation) in order to maintain their pegs with the US dollar (similar to what China is doing now on purpose or several Asian countries have been doing). There was supposed to be an IMPLICIT trust that US policies are ‘Good’ for the whole world. And this trust was not so strong. Several countries especially in Europe (especially France) did not trust the US and at several points, demanded for their US dollars to be converted into Gold to test the US. • Fall of the BW System: As the US embarked on wars in Vietnam, it resorted to extreme inflationary policies (printing dollars) to finance the wars. There was widespread discontent in Europe and suspicion that the US does not have the GOLD reserves to actually map back to those new dollars (at the decided fixed rate of USD 35/oz). France started asking for its dollars to be converted to Gold. Under pressure, the USD had to be devalued against Gold several times, and world currencies set new parities against the USD. There were wide fluctuations during this period as currency markets froze for weeks in succession. In 1971, Nixon broke the link between the USD and Gold, canceling the convertibility of USD to gold. This essentially was the death knell for the BW system. This was followed by a series of USD devaluations and re-pegging of world currencies, till finally in 1978, with the signing of the Jamaica Treaty, the BW system was formally ended.
  • 6. History of Modern International Monetary Systems 2013 GENERALIZED FLOATING SYSTEM (1973 – PRESENT) • At the end of the BW era, exchange rates of most major world currencies (DM, USD, JPY) started to float against each other. It would be wrong however to say that this was the case with the rest of the world and that ALL world currencies started floating against each other. • In Europe, for instance, there was a strong move (over the years) to foster economic integration. And one of the ways to do so was believed to be Monetary Integration. Hence, Europe strove for stable exchange rates among its countries and took several measures to achieve this (SNAKE, EMS, ECU, and finally the Euro). The idea was for Europe as a whole to have stable exchange rates internally, while having floating exchange rates with the rest of the world. • Also, several countries in Asia continued to peg their exchange rates to the USD. This was primarily because the US was a key export market and hence, it was beneficial for trade to have stable exchange rates? This practice continues to this day and has led to some economists labeling Asia as following BW 2. Why? – because just like in BW, countries in Asia are pegging exchange rates to the USD. • As can be seen from the preceding point, while the USD was ‘expected’ to lose importance to the DM or to Yen, it actually reinforced its dominant position under this new system. • Under this system, essentially the key countries have opted for Monetary Independence and Free Capital Flows, and foregone their ability to fix exchange rates (though there are still some interventions sometimes). • The system has in no way been very stable and has had several crises (many due to the free capital flows allowed). Capital flows have been happening from the ‘core’ to the ‘periphery’ in search of investment returns. For instance, the wave of investments into Latin America, Asia etc. However, when these capital flows reverse, it leads to a financial crises • There are suggestions that Asia may go the Europe way and try to extend economic integration to having a common currency within Asia. • What’s next: There are several ways in which the future monetary system could evolve: o Continue like it is right now (USD as the key international currency for reserves and trade; major currencies floating against each other and other heterogeneous systems elsewhere on the periphery) o Several key currencies heading ‘poles’ or ‘zones’. Within these zones, the members have fixed exchange rates or common currency (for e.g. Euro for Europe, maybe RMB for Asia) and then floating exchange rates among the zones o The acceptance of the SDR as an international currency (will take a long time)