The Evolution of the International Financial System

1
The Evolution of the International Financial
System

• Experience is the name we give to past mistakes,
  reform that which we give to future ones.
• (Henry Wallach, 1972)

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The Goals of This Chapter

• Present the history of the international
  financial system that existed before todays
  mixture of floating, fixed, and manipulated
  exchange rates.
• Use the historical examples to illustrate how the
  trilemma was dealt with and how well each system
  promoted human welfare.
• Show why financial orders tend to change when
  changing economic, social, and political
  conditions cause policy makers to address the
  trilemma differently.
• Enable students to better judge the pros and
  cons of the different financial orders.

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Time Line of International Financial Orders
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The Rules of the Game

• The set of rules and other formal and informal
  incentives under which a financial system
  operates is called an order.
• An international monetary order is sometimes
  referred to in the international finance
  literature as the rules of the game, a term
  reportedly coined by John Maynard Keynes.
• A monetary order is to a monetary system somewhat
  like a constitution is to a political system.

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Judging Past International Financial Systems

• 1. How fast did economies grow and raise
  standards of living?
• 2. How fast did international trade and
  investment expand?
• 3. How compatible was the order with sound
  monetary policies and price stability?
• 4. How well were outside economic shocks
  dissipated and negative consequences to
  employment and inflation avoided?
• 5. How much flexibility did individual countries
  have in setting policies aimed at specific
  national economic objectives?
• 6. How were the benefits and costs of operating
  under the order spread across the different
  countries that adhered to the system?
• 7. Was the system was largely self-regulating or
  did it require costly institutional guidance and
  frequent policy adjustments by individual
  countries?

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Report Card

• The textbook evaluates each international
  financial order according to seven criteria.
• A report card covering each of the criteria will
  be used to summarize the conclusions, with a P
  awarded for success and a Ðfor failures.
• Sometimes it will be necessary to leave a grade
  undetermined with a ? when conflicting evidence
  makes it difficult to pass judgment.
• Students are encouraged to reach their own
  conclusions and apply their own evaluations.

• Economic growth
• Globalization
• Price stability
• Output stability
• Policy flexibility
• Mutually beneficial
• Self-regulating

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The Order of the Gold Standard

• Under the Gold Standard, the order effectively
  followed by national government required that
  they
• Fix an official gold price or parity for the
  national currency in terms of a fraction of an
  ounce of pure gold
• Permit the free conversion of gold into domestic
  money and domestic money into gold at the parity
  price in unlimited amounts and without question
• Eliminate all restrictions on foreign exchange
  transactions and allow the import and export of
  gold.

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The Order of the Gold Standard

• A gold standard has a serious weakness, which is
  that revenue-hungry governments are tempted to
  issue more paper currency than they can back with
  the gold stored in their vaults.
• Suspicious holders of paper money could then
  panic and start a run on gold, in which case
  the government would have to suspend
  convertibility of paper money into gold and
  effectively leave the gold standard.
• The Gold Standard was an order built on the faith
  that paper money and bank accounts could always
  be converted to pure gold at any time without
  restrictions.

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The Order of the Gold Standard

• To enhance faith in the system, several other
  rules of the game had to be respected by
  governments
• Back domestic coin and currency fully with gold
  reserves, and link the growth of domestic money
  to the availability of reserves.
• Effectively allow the domestic price level to be
  determined by the worldwide supply and demand for
  gold.
• If the central bank must serve as a lender of
  last resort in the case of short-term credit
  crises in the domestic banking sector, always
  charge interest rates well above market.

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The Gold Standard and Exchange Rates

• Fixed gold parities, free convertibility, and
  credible economic policies meant that exchange
  rates remained fixed.
• For example, the British government set the
  pounds for gold parity rate at 4.24 pounds per
  one ounce of gold, and the U.S. government set
  its parity at the rate of 20.67 per ounce of
  gold.
• These two parities defined the exchange rate to
  be 4.24 pounds per 20.67 dollars, or 1.00
  4.87.

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The Gold Standard and Exchange Rates

• The free export and import of gold was an
  important rule of the game.
• The potential movement of gold along with free
  convertibility kept exchange rates within a
  narrow band of the fixed exchange rate defined by
  the cost of shipping gold (gold points).

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The Gold Standard and Exchange Rates

• For example, if the supply of foreign exchange
  increases from S to S, without the gold standard
  rules, e would fall to 4.00.
• Demanders of dollars will not buy dollars at e
  4.00 they will instead buy gold at the official
  price of 4.24 per ounce, ship it to the U.S.,
  and exchange it at 20.67 per ounce.
• This effectively gives them 4.87 for every
  pound, minus the expense of shipping the gold.

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Humes Specie-Flow Mechanism

• The specie flow mechanism and was first described
  as far back as 1752 by David Hume, before the
  establishment of the gold standard.
• Humes reasoning was used to argue that the gold
  standard was self-correcting.
• If a trade deficit caused gold to flow out of a
  country, its money supply would fall and prices
  would decline, thus restoring international
  competitiveness without changing the exchange
  rate.
• Similarly, a trade surplus would cause gold to
  flow into the country, increasing the money
  supply, and eventually reducing exports and
  increasing imports.

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Report CardThe Gold Standard

• 1. Economic growth P
• 2. Globalization P
• 3. Price stability P
• 4. Output stability Ð
• 5. Policy flexibility Ð
• 6. Mutually beneficial ?
• 7. Self-regulating ?

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Figure 14.2The Trilemma and the Gold Standard
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Returning to the Gold Standard under Changed
Circumstances After World War I

• Inflation during the war years meant that
  countries would have to deflate if they were to
  return to the gold standard under the old gold
  parities.
• John Maynard Keynes argued that the tight
  monetary policies required to restore the real
  value of gold relative to the worlds money
  supplies cost too much in terms of unemployment,
  falling investment, and lost output.
• He suggested that countries forget trying to
  return to the gold standard under the old gold
  parities and that they should set new parities
  and simply seek to maintain price stability at
  the higher price levels instead of trying to
  deflate prices.

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Returning to the Gold Standard under Changed
Circumstances After World War I

• A strong case can be made that the deflationary
  policies of the 1920s, driven by the desire to
  return to the gold standard under the traditional
  gold parities, caused the Great Depression.
• According to Nobel-laureate Robert Mundell
• Had the price of gold been raised in the late
  1920's, or, alternatively, had the major central
  banks pursued policies of price stability
  instead of adhering to the gold standard, there
  would have been no Great Depression, no Nazi
  revolution, and no World War II.
• Policy makers would design a very different
  financial order after World War II.

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Report CardThe Inter-War Period

• 1. Economic growth Ð
• 2. Globalization Ð
• 3. Price stability Ð
• 4. Output stability Ð
• 5. Policy flexibility Ð
• 6. Mutually beneficial Ð
• 7. Self-regulating Ð

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The Extraordinary Bretton Woods Conference

• In July of 1944, while the Second World War was
  still raging, the economic policy makers from the
  allied countries met in the U.S. to establish the
  order that would guide the post-World War II
  international system.
• The motivation for the Bretton Woods Conference
  was to reverse the trend toward economic
  isolation and growth-retarding economic policies
  during the inter-war years.
• The purpose of the Bretton Woods conference was
  to design a world economic order that would
  minimize economic conflict, encourage sound
  macroeconomic policies to generate growth and
  employment in all economies, and restore the flow
  of goods and investments between countries.

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The Bretton Woods Order

• 1. Countries other than the U.S. intervene in the
  foreign exchange market to keep their exchange
  rate within 1 of the dollar peg.
• 2. The U.S. does not intervene in the foreign
  exchange markets, but will convert dollars to
  gold at 35/oz. for foreign central banks.
• 3. The International Monetary Fund (IMF) serves
  as the central bankers central bank, providing
  liquidity to intervene in the foreign exchange
  markets.
• 4. Pegs should be adjusted in the exceptional
  circumstances of a fundamental disequilibrium
  otherwise adjust domestic monetary policies to
  keep the exchange rate fixed.
• 5. The U.S. and its large economy effectively
  anchors the world price level with its monetary
  policy.
• 6. Currency should be freely convertible for
  current account transactions.

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Devaluation? Depreciation?Whats the Difference?

• The term depreciation (appreciation) refers to a
  decline (rise) in value of a currency relative to
  other currencies under a regime of floating
  exchange rates.
• The term devaluation (revaluation) refers to an
  intentional one-time lowering (raising) of the
  fixed value of a currency under a fixed exchange
  rate arrangement.

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Figure 14.7The Trilemma and the Bretton Woods
System
Early Bretton Woods 1944-1958
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Report Card Bretton Woods

• 1. Economic growth P
• 2. Globalization P
• 3. Price stability ?
• 4. Output stability ?
• 5. Policy flexibility Ð
• 6. Mutually beneficial ?
• 7. Self-regulating Ð

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Figure 14.8The Trilemma The Post-Bretton Woods
Float
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Report Card Post-1973 Floating Rates

• 1. Economic growth ?
• 2. Globalization P
• 3. Price stability Ð
• 4. Output stability Ð
• 5. Policy flexibility P
• 6. Mutually beneficial ?
• 7. Self-regulating P

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Figure 14.10The Real Effective Exchange Rate of
the U.S. Dollar 1973-2000
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Establishing a European Monetary Union

• At a meeting in Madrid in December of 1995, the
  European Union, jus having expanded to 15
  members, reconfirmed its intent to create a
  single currency.
• The new currency was to be called the euro and
  denoted by the symbol i.
• European governments agreed to a three-step
  procedure for moving toward a single currency.
• Most importantly, a set of specific economic
  goals were set, and these goals would have to be
  met by a country before it could become part of
  the single currency area.
• At the start of 2002, the euro became the
  currency of Austria, Belgium, Finland, France,
  Germany, Greece, Ireland, Italy, Luxemburg, the
  Netherlands, Portugal, and Spain.

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The 5 Criteria for Joining the Euro

• 1. The currencys exchange rate must have
  remained within a tight band for two years.
• 2. Inflation must be less than 1.5 percent above
  the average inflation rate of the three European
  countries with the lowest inflation.
• 3. Interest rates on openly-traded government
  bonds must be less than 2 percentage points above
  the average rates for the three European
  countries with the lowest rates.
• 4. The government budget deficit must be less
  than 3 percent of GDP.
• 5. Total government debt must be less than 60
  percent of GDP.

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Figure 14.11Summary of 1870-2003 Financial Orders