Evolution of the International Monetary System

In 1979, after the failure of the snake in the tunnel system, a new system was introduced called the “European Monetary System” (EMS) where the European Currency Unit (ECU) would be defined. Some of the key terms of the agreement were: (1) The ECU, which is composed of a basket of currencies, would prevent any fluctuations above 2.25% in bilateral exchange rates among member countries. (2) A new system called the Exchange Rate System (ERS) would be established which would limit exchange rate variability and prepare grounds for monetary stability in Europe. (3) Credit would be extended to all the members in need.

In the outcome of negotiations, even though no currency was declared the key/anchor currency, the German Deutsche Mark and the German Bundesbank were undeniably lying at the heart of this system. This was mainly because of its relatively strong value compared to other currencies and due to the monetary policies of the bank, which advocated for low-inflation in European economies. Over time, it turned out that the implicit designation of the German currency, as some of the member countries did not welcome the anchor currency.

By the mid-1990s, the EMS had suffered a series of turbulences: (I) primarily with the escalating tension over which member country’s currency would be the anchor currency, (II) the implementation of incompatible economic policies among member countries followed by an increase in violation of the rule of 2.25% in bilateral exchange rates have caused the system to lose its elementary functions. “The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the Euro.”

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

This situation has gradually led to the foundation of a single European currency called the “Euro” (€) after the signing of the Treaty of Maastricht on February 7

, 1992 which made the Euro the only legal tender for the European Community. Some of the most important criteria were: (I) controls on inflation levels (i.e. the inflation level in a given member country should not be more than 1.5% higher than the average of the other three members with the lowest inflation rates). (II) The proportion/ratio of the annual government deficit to gross domestic product (GDP) should not exceed the 3% margin by the end of the preceding fiscal year. (III) “Applicant countries should have joined the exchange-rate mechanism under the European Monetary System (EMS) for two consecutive years and should not have devalued its currency during the period. (IV) The nominal long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.”

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

The purpose of the imposition of the Maastricht criteria was to bring about exchange rate stability to the Euro zone (also known as Optimum Currency Area), which is an economic union of member states that use the Euro as their currency. The benefits of joining the Optimum Currency Area included: (1) A higher economic integration, (2) free-movement of goods and services and factors of production, (3) Common tariff structures on non-members, (4) Economic symmetry and stability, and finally (5) more self-control on monetary policy. In 1998, 11 countries announced the adoption of Euro as their currency and in the following year, Euro was introduced and the European Central Bank was established.

Conclusion

The key foundation stone of the pre-war gold standard era required strict adherence to the rules of the game as currency convertibility was the crucial component for maintaining this regime. The emergence of the classical gold standard system prior to the WWI was accidental. This can be partially attributed to the fact that this regime evolved out in an era where a variety of commodities such as; cattle, wine, jewelry and diamonds were being used and traded for daily transactions instead of paper currency. A further contributing factor to the development of this regime came about with Britain’s accidental acceptance of a de facto gold standard system by the end of the nineteenth century. Britain’s assumption of both financial and commercial leadership has become an attractive alternative and a perfect substitute for silver. In the end, countries who had a desire to trade with Britain have gradually converted to a more popular gold-based system. It was precisely during this era, when an international system of fixed exchange rates came into effect.

Prior to the collapse of the Bretton Woods System in the early 1970s, there was a widespread belief in the international community that the high levels of volatility of capital flows were the root cause of the problem. The reason for this was the lack of tight regulation in international capital flows, which gave rise to a destabilization of national currencies.

In return, this international predicament forced governments to take drastic measures to protect their domestic economies whether by raising tariffs or by increasing import quotas, which is very similar to what they have done during the inter-war period. As a counterattack strategy, those countries that chose to devaluate their currencies would witness their immediate neighbors impose the same strategy of currency devaluation which then would trigger a reactionary war of tariffs and quotas.

In essence, the lessons extracted from the unfortunate economic circumstances of the 1930s have demonstrated that currency instability was the least desired strategy for the establishment of a free international trade. Therefore, it was understood that the restoration of global economic growth presupposed a system that would favor limited international capital flows and a sustainable regime for currency stability.

As for the grand monetary experiment conducted by the members of the European Union, there needs to be an increased level of willingness to forego a certain degree national sovereignty to create and further advance the dream of a full-fledged European Economic Integration. The initial steps for the formation of a complete monetary union were taken with the creation of a single common currency called the Euro. However, what is now a feasible economic goal for Europe stands as a difficult objective to be achieved for other regional monetary unions around the world such Latin America, the Middle East, Africa and East Asia as there is less willingness to comprise national sovereignty instead of a stronger monetary union.

WORKS CITED

Braga de Macedo, Jorge, Eichengreen Barry, & Reis Haime. (1996). “Currency Convertibility: The Gold Standard and Beyond” Published by Routledge. 11 New Fetter Lane, London EC4P 4EE.

Eichengreen, Barry. (2008). “Globalizing Capital: A History of the International Monetary System” By Princeton University Press. Published by Princeton University Press, 41 William Street, Princeton, New Jersey. (Second Edition)

Keynes, J.M. (1980). “The Collected Writings of John Maynard Keynes” Vol. 25 Activities 1940-1944: Shaping the Postwar World, The Clearing Union: MacMillan.

Kindleberger, P. Charles, (1993). “A Financial History of Western Europe” Published by Oxford

University Press, Inc., 200 Madioson Avenue, New York, New York. (Second Edition)

Simmons, C. Edward. (1936). “The Elasticity of the Federal Reserve Note”The American

Economic Review Vol. 26, No. 4 (December) pp. 683-690 (http://www.jstor.org/stable/1807996 (http://www.jstor.org/stable/1807996))

Polanyi, P. Karl. (1944). “The Great Transformation” Printed in the United States of America.

By the Ferris Printing Company, New York.

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

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

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

BIBLIOGRAPHY

Barry Eichengreen: is John L. Simpson Professor of Economics and Professor of Political Science, University of California at Berkeley, Research Associate of the National Bureau of Economic Research, and Research Fellow of the Center for Economic Policy Research.

Charles Poor Kindleberger: was a historical economist and author of over 30 books. His 1978 book Manias, Panics, and Crashes, about speculative stock market bubbles, was reprinted in 2000 after the dot-com bubble. He is well known for hegemonic stability theory. Kindleberger during the course of his life worked for several American institutions, such as the Federal Reserve Bank of New York (1936–1939), the Bank of International Settlements in Switzerland (1939–1940), and the Board of Governors of the Federal Reserve System (1940–1942). Kindleberger was a leading architect of the Marshall Plan.[1] In 1945-1947 he served at the Department of State (Acting Director, Office of Economic Security Policy), and shortly (1947–1948) as counselor for the European Recovery Program.

Edward C Simmons: was an Assistant Professor of Economics at the University Michigan who later became a Professor of Economics at Duke University.

Jaime Reis: is Professor of Economic History at the European University Institute in Florence on leave as Senior Research Fellow at the Institute of Social Sciences of the University of Lisbon.

John Maynard Keynes: was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments. He greatly refined earlier work on the causes of business cycles, and advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions. His ideas are the basis for the school of thought known as Keynesian economics, as well as its various offshoots. Keynes was also a civil servant, a director of the Bank of England, a patron of the arts and an art collector, a part of the Bloomsbury Group of intellectuals, an advisor to several charitable trusts, a writer, a private investor, and a farmer.

Jorge Braga de Macedo: Professor of Economics, at the Nova University in Lisbon, Research Associate of the National Bureau of Economic Research and Research Associate of the National Bureau of Economic Research and Research Fellow of the Center for Economic Policy Research. As Portugal’s Minister of Finance, he was a signatory of the Maastricht Treaty and chaired ECOFIN Council from January to June 1992. After leaving the Cabinet in December 1993 he chaired the Committee for European Affairs of the Portuguese Parliament until October 1995.

Karl Paul Polanyi: was a Hungarian intellectual known for his opposition to traditional economic thought and his influential book “The Great Transformation.” Polanyi is remembered today as the originator of substantivism, a cultural approach to economics, which emphasized the way economies are embedded in society and culture. Polanyi's approach to the ancient economies has been applied to a variety of cases, such as Pre-Columbian America and ancient Mesopotamia, although some scholars have denied its utility to the study of ancient societies in general. His book The Great Transformation also became a model for historical sociology. His theories eventually became the foundation for the economic democracy movement. His daughter Kari Polanyi-Levitt is Emerita Professor of Economics at McGill University, Montreal.