Evolution of the International Monetary System

In response to the policies enforced by the Bank of England, insolvent central banks that suffered a significant loss in their gold reserves resorted to their domestic asset holdings so that they could push interest rates upwards, which would then attract short-term capital and limit the outflow of fresh capital. In turn, this reactionary policy would strengthen their domestic economies.

In addition, under the gold standard regime, sterling bills were the only worldwide-accepted currencies that also simultaneously retained the privilege of substituting for real money in other European countries.

While the Bank of England, as the central decision-making monetary authority of the classical gold standard era, had unlimited access to international markets. This allowed it to arbitrarily determine national interest rates of other countries as well. Therefore, it would not be a far-fetched argument to claim that the classical gold standard was after all a system based completely on the British sterling.

With the outbreak of WWI, governments and central banks around the world were forcefully confronted with a need to finance high levels of military expenditures with an extremely limited source of tax revenue. Driven by the need to out compete each other in the race for war, many belligerent countries have gradually started abandoning the gold standard to issue un-backed paper currencies (which then would cause massive hyperinflation levels in these countries) while the Bank of England had temporarily suspended gold convertibility which meant that it had abolished the gold standard until after the war.

The Inter-war Period (1918-1939)

At the onset of WWI, most industrialized nations of Europe have started issuing fiat currencies (un-backed paper) in an effort to fuel the war machine. This was a period in which precious metals such as “gold” and “silver” had become a critical resource for the procurement of war material. As a consequence of the rising value of gold and silver, governments have pursued protectionist policies to prohibit the export of such precious metals while continuing to issue fiat currencies without any value.

The arbitrary creation of these currencies to support war efforts at different rates has caused wide variations in the exchange rates among European countries to the extent that some had faced severe hyperinflation in their national economies. Some of the countries like; Germany, Hungary, Austria, and Poland of which hyperinflation had taken a very heavy toll on, have made several attempts to re-establish gold convertibility to fix the fundamental disequilibria in their balance of payments. However, the British Sterling, which had been providing the strongest foundation for the harmonization of economic policies prior to the outbreak of WWI, was no longer enjoying its hey day.

Especially after the decline of the British industrial and commercial hegemony, countries that were previously renowned as international creditors have started losing their elevated positions after becoming heavily dependent on capital imports from the United States in exchange for maintaining a stable balance of payments equilibrium. After a while, it became evident that pre-war exchange rates could not be restored.

During the inter-war period, national price levels and interest rates rose to unprecedented proportions as each developing country, including the ones in the “most-industrialized” periphery (i.e. Germany, Japan), experienced both inflation and deflation in their domestic economies. The dissolution of Europe in the aftermath of WWI disrupted the orderly process of the gold standard and led to a period of persistent economic uncertainty. The Bank of England ceased issuing loans, as governments around the world, particularly in Europe, defaulted on their loans and their debt repayments for war reparations. Each country in Europe gradually started abandoning the gold standard. In the aftermath of WWI, strategic economic alliances that were made prior to the war all broke down with the possible advent of an even more destructive war.

As a result of this scenario, most of the belligerent countries have found their remedy in the procurement of arms and weapons by printing out of massive amounts of money to finance their military expenditures and to support war causes, even though almost all of them have declared moratorium on their payments post-WWI. One example of such a case was Germany, as the industrial heartland of Europe suffered one of the most severe hyperinflations in world history with highest military spending.

In the ensuing political conflict after WWI, the structure of the world economy, including those of financial centers were also profoundly devastated. Countries that engaged in war started to yearn increasingly for the pre-war parities (as goods and services had become overvalued and undervalued) and for the restoration of the gold standard.

The decline in the Bank of England's wealth as the world's leading financial center followed by persistent stagflation in Britain failed to inspire confidence in the world markets. As a result of the British Central Bank’s ineffectiveness in carrying out its obligations and because of her failure of commitment to maintain a stable currency value, foreign holders of British pounds converted their pound holdings into U.S. dollars. However, between the 1939-1942 period, Britain had already depleted more than half of its gold reserves after purchasing ammunitions from the U.S. In short, there was not enough money supply to resume the gold-standard system as the war had led to the complete depletion of gold stocks in Britain.

On the other hand, the U.S. economy was also suffering from a similar predicament during the inter-war period. Governments around world that were operating on the gold standard were being limited from expanding their money supplies and thereby from lowering their interest rates. The imposition of this rule had pushed some countries to break the rule and secretly print out more money to tackle deflation in their economies. However, to show its commitment to the gold standard, the U.S. Federal Reserve did not pursue an expansionary monetary policy and kept interest rates at relatively high levels during the war periods. But the gold stocks of the Federal Reserve were also rapidly contracting and were causing a sudden devaluation of the U.S. dollar “In the U.S., the Federal Reserve was required by law to have 40% gold backing of its Federal Reserve demand notes, and thus, could not expand the money supply beyond what was allowed by the gold reserves held in their vaults.”

(Edward C. Simmons, Elasticity of the Federal Reserve Note, http://www.jstor.org/stable/1807996 (http://www.jstor.org/stable/1807996))

The maintaining of high interest rates would translate directly into a deflationary pressure on the dollar, which then had caused a significant reduction in investment in U.S. banks overtime. Because of this scenario, both investors and depositors have started withdrawing their funds from U.S. banks after the emergence of a widespread speculative fear that the value of the U.S. dollar would decline.

In spite of some burgeoning international economic corporation in the period preceding 1930's, there was much considerable turbulence in the world markets. Trade barriers were mainly imposed and the widespread repudiations of domestic and international debts were accompanied by uncertainty in economic policies. Governments' efforts to improve the effects of foreign exchange markets proved problematic and incessant deflation led to increased rates of unemployment as the stock markets around the world have crashed. This period in history was called the “Great Depression.”

During the world-wide depression, many countries that were agitated by the suspicious arrangements made for the exchange of unreliable currencies assumed an uncooperative behavior. It was precisely during this period when the need for the creation of a monetary order that would govern international monetary relations among independent states became evident. This new international monetary order was called the “Bretton Woods System.”

The Bretton Woods System (1944-1971)

“To suppose that there exists some smoothly functioning automatic mechanism of adjustment which preserves equilibrium if we only trust methods of laissez-faire is a doctrinaire delusion which disregards the lessons of historical experience without having behind it the support of sound theory.” (J.M. Keynes, 1980)

The quarter-century following WWII, has clearly demonstrated the fundamental disadvantages of the fully-flexible exchange rates. By 1944, many countries have extracted important lessons from the tragic experiences of the Great Depression and made important strides to avoid repeating the same mistakes of the past.

One of these intended critical measures was to put into practice an international monetary order that would regulate and oversee the international transactions of independent states. Although many countries had divergent views on the macro-economic management of their national policies, almost all of them agreed upon the idea of establishing an international monetary system that would regulate the international economy primarily through the two main principles of capitalism; “through private ownership” and “through adjustable market mechanisms.” (Two examples of this particular case were France and the U.S., where the French government sought greater planning and intervention in the markets, whereas the American government favored a relatively limited level of intervention.)

The era following the Great Depression was one in which many countries implemented “beggar-thy-neighbor” policies by shifting away the demand for imported goods to domestically produced goods by imposing tariffs and quotas. This was done with the objective of fighting against domestic unemployment and trade deficits. At the same time, most of the debtor nations were also seeking to reduce their balance-of-payments deficits by implementing monetary policies that would devalue their currencies and increase the competitiveness of their exports around the world. In the end, these frivolously managed currency devaluations and beggar thy neighbor policies have backfired and led to the following to occur: 1-) plummeting of national incomes, 2-) a sharp increase in unemployment rates, 3-) contracting demand for goods and services, 4-) and eventually to the overall decline of global international trade.

Therefore, in an attempt to reverse this situation and to rebuild the international economic order with a stronger foundation, “730 delegates from 44 Allied nations gathered in Bretton Woods, New Hampshire, U.S. to sign the Bretton Woods Agreements in the first three weeks of July 1944.”

(http://en.wikipedia.org/wiki/Bretton_Woods_system (http://en.wikipedia.org/wiki/Bretton_Woods_system))

The Bretton Woods Agreement, in essence, fundamentally departed from the direction of the gold exchange standard in many distinct paths. The first striking feature of this agreement that differed from the gold standard was the establishment of two international credit lending institutions:

In July 1944, representatives from 45 countries convened at the Mount Washington Hotel in New Hampshire, United States to sign an agreement that would lead to the creation of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD).

In hopes of devising a constructive international monetary system, the purpose of creation of the IMF was (i) to regulate the macroeconomic policies of its member countries, (ii) help countries that were having a fundamental disequilibrium in their balance of payments by receiving deposit from surplus countries and giving out those loans to deficit countries (mainly poor countries) with varying degrees conditionality, and (iii) to ensure price stability in financial markets without imposing any tariffs or restrictions on trade and (iiii) to contribute to the overall development of emerging economies through its lending policies. On the other hand, the purpose of creation for the IBRD was to have a focus on the reconstruction of nations devastated by WWII.

The price stability component of the IMF’s responsibilities was to be ensured by what is called “the fixed exchange rate system” (also known as the pegged exchange rate system or the adjustable peg). This system offered multiple benefits; (I) first, maintaining of fixed exchange rates would facilitate the cross border transaction of goods and services, (II) second, it would ease political tensions and would bring about economic stability, (III) and third, it would also aid in the removal of tariffs and barriers and help governments ensure equilibrium in their balance of payments. In a sense, the newly established rules of the Bretton Woods system resembled those of the pre-war gold standard era only with the exception of the U.S. dollar, which was accepted as the worldwide currency in lieu of gold with the consent of the member countries.

The pegged exchange rate was a system whereby countries would first and foremost peg their national currencies to the key currency, vis-?-vis to the U.S. dollar. Each country was obligated to declare a “par value” rate for their national currency by intervening in their foreign exchange markets while the exchange rate for each currency was allowed to move by 1% above or below parity. While nations that were willing to convert their gold reserves or assets into paper currency would do so through this anchor currency. After the U.S. dollar became the only currency convertible to gold, then the price of gold was also decided to be fixed at $35 per an ounce of gold. This was because of the following reason: “For the Bretton Woods system to remain workable, it would either have to alter the peg of the dollar to gold, or it would have to maintain the free market price for gold near the $35 per ounce official price.”

(http://en.wikipedia.org/wiki/Bretton_Woods_system (http://en.wikipedia.org/wiki/Bretton_Woods_system))

The application of this rule meant that the U.S. dollar would take over the role of gold and assume the responsibilities of that which it had played during the gold standard system. Once the U.S. dollar had become the only currency exchangeable in terms of gold with the greatest purchasing power, all the indebted European countries who had been involved in WWII decided to transfer massive amounts of their gold reserves to the U.S. contributing to the appreciation of the dollar and to the economic leadership of the U.S. in the world.

Furthermore, in accordance with the conditions listed in the agreement, poor countries also had the right to alter their par value rate to correct the fundamental disequilibrium in their balance of payments. But this decision was contingent upon the IMF which would first have to determine if the country’s balance of payments was in a serious fundamental disequilibrium.

The IMF was also provided support with a special fund that largely comprised of each member country’s contributions of gold and their own national currencies to the fund. A member country experiencing a trade deficit in its current account would be able to borrow foreign currency from the Fund in amounts that would be determined by the size of its contribution (also known as quota). Meaning, the greater the contribution was, the higher the amount of funds that a member could borrow from the IMF. Once the money was borrowed, the member state was required to repay its debts within a time limit of 18 months to 5 years depending on the magnitude of the balance of payments disequilibrium in that country.

Even though there was a belief that as long as the Bretton Woods agreements were strictly observed and adhered to by the member countries, the balance of payments issue would resolve itself with the support of the national monetary reserves backed by loans and credits given by the IMF. However, it turned out over time that the IMF’s credits would prove unworkable in tackling Western Europe’s enormous balance of payments deficits. This was because in the era following WWII, there was a huge dollar shortage as countries were imposing tariffs and barriers to each other which caused a heavy demand for the U.S. dollar.

Under the Bretton Woods System, no other currency was convertible to gold other than the U.S. dollar which also added greater emphasis on the demand for the U.S. dollar. In order to satisfy this demand, the U.S. Federal Reserve started increasing the dollar supply. However, as the dollar supply increased on other currencies (i.e. the exchange rates of other currencies), the value of dollar started depreciating as other country’s currencies started appreciating. As a result, other countries were forced to gradually increase their money supply.

By the 1960s, many European countries did not want to increase their domestic money supplies but the system compelled them to do so. Among those countries that reluctantly increased their money supply were Germany, Switzerland, and France. These countries have faced the most severe hyperinflation rates in their economies in the periods preceding the Great Depression. By 1971, the European countries wanted to form the “European Common Market” and decided to abandon the Bretton Woods System.

From 1971-1973, the Bretton Woods System became inoperable. In 1973, President Nixon cut the dollar system which allowed for the collapse and the disappearance of the link between the U.S. dollar and gold. The demise of this system has concretely taught us four important lessons: (I) the lack of operational adjustment mechanisms, (II) the great adversity of running a system of fixed exchange rates (or adjustable peg) in the presence of highly mobile international capital, (III) that there was strong international cooperation and close coordination among participating governments and central banks around the world which was very easily distinguishable from the last quarter of the nineteenth century since the possibility of international economic coordination or collaboration was virtually non-existent during the gold standard era. (IV) Even though there were strenuous efforts being made by the member countries to defend the parity, sustainability of this system turned out to be impossible as keeping the parity at a stable rate would require unparalleled foreign exchange market intervention as well as international support at all levels.

Post-1973 International Monetary System

After the collapse of the Bretton Woods System, the sudden rise of cross-border capital mobility has drastically transformed the very essence of international monetary relations. Throughout much of the operational phase of this system, much of the countries were able to avoid balance of payment deficits to some degree since they were able to avail themselves to the protection of the pegged exchange rates. This breathing space provided by the Bretton Woods agreement has also enabled countries to freely re-direct their monetary policies in the direction that they considered necessary.

Following the collapse of Bretton Woods, countries were completely free to control the supply of their own currencies. They could increase their money supplies without the backing of any precious metal required for that increase in the money supply. Governments also realized the fact that there was a profit to be made just by printing their currency. The profits made by governments are called “seigniorage.”

However, by the late 1970s, some countries have gotten too greedy for seigniorage, meaning that they allowed changes in their domestic currency largely. It was during this time when many countries have fixed their exchange rate systems.

Some of the benefits of this system included: (i) the minimization of uncertainty for the future exchange rates (ii) the assumption of a supervisory role by the monetary policy which would be responsible for keeping the money supply under control (i.e. self-imposed discipline on monetary policy (iii) The occurrence of a change in a country’s balance of payments is more likely under the fixed exchange rate system. However, it can be controlled by devaluation (one-time change).

Conversely, some of the costs that were associated with the system of fixed exchange rates included the following deficiencies: (a) First, under this system, monetary policy would not completely be independent. For instance, in the event of a severe recession, when a large increase in money supply is needed, fixed exchange rate regime would not allow it. (b) Second, monetary policy is most tempted to break the rule of not allowing the money supply to grow excessively. An example would be the “systemic risk” of irresponsible monetary policy. It is better to have a flexible exchange rate system, which would show the consequences of changes in the money supply on a daily basis.

On the other hand, those countries that were running independent monetary policies with floating exchange rates have selected to use some key currencies such the U.S. dollar ($), Euro (€), Japanese Yen (?) and also what is called the Special Drawing Rights (SDRs).

The SDRs were created during the Bretton Woods system in 1969 as an alternative to the strongest currencies to support the fixed exchange rates regime (only to be issued by the IMF). The SDRs are basically an international reserve asset that was put to use under the guidance of the IMF when two of the major currencies: the gold and the U.S. dollar, fell short of achieving their intended objectives of underpinning the expansion of international trade and encouraging financial flows between the member countries.

The SDRs are generally allocated in proportion to the contributions of the members to the IMF. If a member country wants to contribute more than the required amount, then the IMF would issue SDRs to this member. The value of SDR is currently expressed in a basket of four currencies as opposed to the past where it was represented solely by the U.S. dollar. Today these are: the U.S. dollar, the Japanese Yen, pound sterling and the Euro. The use of the SDRs may vary depending on the need trading arrangements. For instance, if the U.S. government had a desire to export certain goods or a service from Japan and was reluctant to make a payment in U.S. dollars, the transaction can be made with the usage of SDRs since both countries are participating members of the IMF.

In brief, it is possible to argue that the post-1973 period was largely marked by three crucial turning points, which have shaped much of the historical structure of the international monetary system. The first significant event was the advent of the “European Currency Snake” (also referred to as the snake in the tunnel), the second was the eruption of the “Great Debate” between fixed exchange rates and floating exchange rates, and the third event encompasses the dynamic changes in the monetary policies of the U.S. Federal Reserve.

By the mid-1970s, a globalization trend emerged that simultaneously promoted free trade and the elimination of capital controls (i.e. reduction of barriers to trade). This trend, in essence, came into being with the ongoing development in the areas of telecommunications, information technologies, as well as with the rapid structural improvements in the financial markets.

The liberalization of exchange rates during this period has revived unpleasant memories of the post-WWI era where floating exchange rates have largely caused massive hyperinflation. “Europe, not the United States or Japan, was where floating currencies had been associated with hyperinflation in the 1920s. Europe was where the devaluations of the 1930 had most corroded good economic relations.” (Eichengreen, 2008, pg. 150)

Many European countries with the breakdown of the Bretton Woods system were reluctant to go back to a system of floating exchange rates. Therefore, in an attempt to devise a single currency band among European countries, the concept of the “snake in the tunnel” was introduced. This monetary policy was supposed to limit fluctuations among various European currencies and peg all the European Economic Community (EEC) currency bands to one another. The so-called snake provided a window of opportunity for the European currencies to trade with each other, especially with the Smithsonian agreement setting bands of above or below +/– 2.25% for maintaining the exchange rates, which allowed European currencies to fluctuate in relation to their individual rate against the U.S. dollar. However, the snake in the tunnel fell apart in 1973 with the free-floating of the U.S. dollar as a result of the quadrupling oil prices (i.e. oil shock of 1973) and with several other currencies simultaneously joining and abandoning it.