I have been asked to give a conducted tour of postwar financial developments in 40 minutes. That gives just 1½ minutes a year. Along the way, I am supposed to cover developments of international financial arrangements; the role of gold and special drawing rights; the problems of adjustments to balance of payments disequilibria; and recent monetary crises in perspective. Perhaps there would not be much more than a minute each for the crises either. In fact, the paradox of recurrent crises—and it is a paradox because crises are supposed to bring things to a head—itself suggests that the conventional labels may not be fully descriptive. Crises are no longer what they were, and that should tell us something about the evolution of the system. There seems a need to step back from the fast-moving stream of events, and in this talk I intend to make a virtue of necessity by going for perspective rather than historical narrative. I shall attempt a broad sweep, which in places will be distinctly impressionistic.
The Problem: Traffic Control Without a City Council
Perhaps the major economic and political fact of the twentieth century has been that national governments have taken—or have been landed with—responsibility for the economic welfare of their citizens. Now some may regard this extension of governmental concern as unfortunate, misguided, or futile—such thoughts have been expressed in this city—but no one doubts that it has happened, and such a basic concept is not easily eradicated. So national authorities acquire active economic policies: and these policies, as well as the underlying developments in national economies, interact between countries. I need not elaborate on such interactions to this audience: they involve trade flows and money flows, which are in turn transmitted to key elements in national economies such as employment and output. The miserable experience of the 1930s has often been taken as a warning example of malign interaction in which each country seeks to slough off its economic troubles onto its neighbors, but all countries lose in the process—a predictable negative sum game. While this experience has sometimes been wrongly interpreted as showing that conscious international cooperation is a sufficient condition of international economic prosperity, which it is not—thus, continued international cooperation in holding up a rigid gold standard in 1931 would have blocked the national measures needed to initiate recovery from the slump—there is little doubt that deliberate international cooperation is a necessary condition of economic prosperity. The ghost of the 1930s—the specter of economic isolationism—has a continued walk-on part on today’s stage. And this is a ghost everyone believes in either because they have seen it or, depending on age, because they have found it in their econometric equations. Even where national policies are expressly designed to protect the national economy from unwelcome outside influences through deliberate measures of insulation, such as adjustment of the exchange rate, an agreed framework of international rules, or code of behavior, will be necessary to ensure that such measures are not frustrated by counteractions taken by other countries.
This is the underlying rationale of the elaborate machinery of international financial cooperation that has been built up since World War II in the Fund and other forums. These institutions and their attendant arrangements are sometimes seen—hopefully as well as fearfully—as instruments to promote an ever-increasing degree of international economic integration, as a kind of advance guard of a world central bank and global economic government. I think this is an unhelpful view toward understanding their real function, at least for the past and for the foreseeable future, which is to provide the working frame for the degree of international integration that currently exists. Seen in this light, international financial machinery is as necessary to protect legitimate national objectives as it is to ease the way toward greater internationalism. By providing an accepted system of traffic control, the machinery allows the several units of the international economy to go their own way, within the limits of the agreed highway code, without the snarl ups and crashes that would be unavoidable without any driving rules at all.
In its ultimate objective of preventing major snarl ups in the international economy, the machinery of international financial control has been pretty successful thus far; the strains and splutterings in the machinery have plagued mainly the controllers themselves. (It is worth remembering that since exchange adjustments invariably involve the monetary authorities in a financial loss, such adjustments have thereby offered private parties an equivalent profit.) Yet the point has now been reached where there is general agreement that a major renovation in the international monetary system is required. The detailed form this is to take lies beyond the subject of this session. My task is to provide the backcloth. The experience of the past years suggests that the main constraints are not so much technical as political. The new and more ambitious system of traffic control must still be consistent with the limited functions appropriate to a traffic management without a City Council.
This is the particular challenge for international financial management, as exerted by national authorities in their collective capacity, and through international institutions. The frequent comparison with the smoothness of integration in the private sector—e.g., in foreign exchange markets and multinational corporations—is misapplied: because these can “free ride” national responsibilities exerted by governments. If the private operators make a mess, governments are expected to mop it up. Again, the view may be held that in so doing, governments only make things worse: but such a view sweeps away or wishes away the problem, and so it cannot be a part of the solution. This perspective is worth keeping in mind because it rules out certain solutions that might otherwise be attractive and that figure prominently in academic discussion, viz.:
(a) Freely floating rates based on commitments by national governments not to intervene. This assumes away that part of the problem concerned with reconciling national policies, policies which may require governments to reserve the right to intervene in fluctuations in a price so central to their economies as the exchange rate. This rules out the simple system of freely floating rates; it does not rule out fluctuation within margins or according to other criteria, but such systems need deliberate specification, and cannot offer the attractive simplicity and automaticity of clean floating.
(b) Also ruled out is a highly managed international system involving centralization of major powers to international authority (e.g., International Exchange Equalization Account). This assumes away that part of the problem of “traffic management without City Council.” The fact that countries are willing to abide by agreed rules of the road does not mean they are willing to embark on a compulsory guided tour. There is a clear contrast here between what is being attempted on a global basis and the schemes for regional monetary integration, e.g., in the European Economic Community, which do have as a central purpose the promotion of economic integration and harmonization, either as objectives in their own right or as a means to political integration.
The Run Up: Bretton Woods I, 1944-71
It is more than institutional reverence that has for many years sent every discussion of international monetary reform back to the launching pad of Bretton Woods. Bretton Woods, and the work that preceded it, was a conceptual tour de force, in some respects a generation ahead of its time. The problem was seen, the paradigm was established, and the right questions were asked. The Keynes plan is only now being fully appreciated, particularly in its pioneering integration of the provision of liquidity with pressure for adjustment, based on its insight into the international economy as a closed system in which creditors had either to lend or to curtail their surpluses.
The Fund system that emerged from Bretton Woods was on far less ambitious lines, though the vision still showed through. Moreover, while the technical virtues of the Keynes plan are clear enough in retrospect, so also is its political prematurity. The postwar world was not a world of equal partners—still less a dual monarchy as London still hopefully supposed. The system was dollar centered in fact, within a formal multilateral frame.
Ensuing frictions reflected the changing balance of economic power in the world, and delays in adapting to such changes. There was a slowness on the part of Britain to acknowledge the decline in sterling’s world role; this helped exacerbate a serious and for many years persistent adjustment problem, and contributed to a view of the system as requiring rigid exchange rates. The more general shift in the balance between the United States and other countries, particularly continental Europe and Japan, was also inadequately recognized by the parties concerned; or rather, each tended to recognize the aspect that suited it.
By the early 1960s, the shifts in underlying economic and financial strengths provided the basis—and the need—for a true multilateral system. But at this stage, sufficient pressure had not yet been built up to force through the major shifts in political attitudes and in institutional arrangements necessary to bring in a balanced international system. A decade of controlled monetary crisis was necessary first. This is regrettable but not too surprising. As Dr. Johnson might have put it, nothing so concentrates a finance minister’s mind as the knowledge that his currency is going to be devalued in a fortnight. Indeed, it is not certain that we have sufficient steam up even now.
An Evolutionary View
On an optimistic, evolutionary view, therefore, we have been proceeding by fits and starts, and by way of some stops, toward a more balanced international monetary system. Perhaps, as is the way of all evolution, the driving force has been negative as much as positive—the incapacity of the old arrangements to bear their previous load. The significance of the events of August 15 last was to make this incapacity, so to say, “official.” This cleared the way for what had earlier been excluded from official action—system building on a comprehensive front, an approach that is necessary if proper account is to be taken of the key inter-linkages between the various elements in the system.
In the remaining part of this talk I will try to provide a perspective for this task by looking at the evolution of the past 25 years in terms of some major functional components of the international monetary system —gold, reserve currencies, special drawing rights, and the exchange rate mechanism. Obviously in the time available, I cannot attempt any comprehensive treatment of these subjects, but will rather try and bring out what seems to me the key aspects in their development.
The role of gold at Bretton Woods was very carefully hedged. Thus, in the Fund Articles, gold was given a distinctly limited role. And while gold could be regarded as the linchpin of the international monetary system, at least in the formal arrangements as they existed until August 15, the central role of gold rested on the unilateral undertaking of the United States to freely buy and sell gold in transactions with monetary authorities, an obligation that was consistent with—but that was not required by—the Articles of the Fund. The position of gold in the Articles is in fact consistent with the gradual reduction in the effective role of gold that has occurred in the past 25 years—or perhaps one should say in the past 60 years. This role has in effect been gradually reducing to the function of numeraire or standard of value.
Was this evolution inevitable? In the long term I have little doubt that it was, essentially because the virtues of gold as the key element in the monetary standard lay in the automaticity inherent in that standard; but this automaticity in turn was bound to conflict with the management of national economies, as well as with nonmanaged by-products such as secular inflation. An attempt to reconcile these conflicts by adhering to a gold standard subject to periodic management of the gold price would in fact involve a very different system. It would involve new problems of instability between gold and currencies. It would also involve particular sensitivity to the management decisions made at discontinuous intervals by the country or agency that had effective control of the gold price. The experience of gold price setting in Washington in 1933–34, so graphically recorded by the diarists, gave a well-advertised warning of where—and how—the crucial decisions on the gold price were likely to be made. Thus, preservation of the dominant role of gold, on the terms on which this would be practicable in a world of managed economies, would offer countries at large neither the automaticity nor the autonomy which were the main elements in gold’s traditional attraction as a monetary standard. This distinction has not always been understood.
It is intriguing to speculate on what would have been the effects on this evolution of the role of gold of a major increase in the international gold price in the earlier postwar years, before or soon after the U. S. dollar first came under any kind of pressure against either gold or other currencies. Such a move would almost certainly have had the effect of extending the period of U. S. hegemony over the international monetary system, and thereby of postponing the transition problems associated with a move to a more truly multilateral system. The effective dollar standard would have been given an additional lease of life. But this lease would not have been indefinite, and would not necessarily have been very long; nor might it have been particularly peaceful. A dollar-centered system, even on a firm gold base, might still have appeared inconsistent or incompatible with the broader diffusion of economic power around the world. In any case, this option was passed up in the period—say, until 1963—in which it was effectively open.
Reserve Currencies and SDRs
Growth in monetary reserves through the postwar period as a whole has been essentially dependent on accumulations of national reserve currencies, and above all the U. S. dollar. The potential dangers inherent in this process began to be pointed out by Triffin and a growing band of other critics from the late 1950s. The most dramatic danger proclaimed by the Cassandras— that accumulations of claims- on reserve centers would inevitably erode confidence in the ability of the reserve centers to maintain convertibility at the existing par, and would therefore lead to a run on the bank and a collapse of the system a la 1931—was successfully averted. The world’s monetary authorities responded to these forewarnings by erecting an impressive array of defensive mechanisms. The specifics of these mechanisms mattered less than the intent that lay behind them, which was simply to do what was necessary to avert a breakdown. In these terms, the arrangements were strikingly successful. But they had the disadvantage that collapse of the system could be averted only by what appeared as, and really was, open-ended finance of the United States as the reserve center of the system.
Thus, in the mid-1960s, it became evident that first, the world’s reserve needs could not be fulfilled wholly or even in part by gold, and secondly, that to the extent that they were fulfilled by additional accumulations of reserve currencies, this would now require specific commitments and restraints on the part of the major countries, involving something like a formal dollar standard. This appeared much less attractive to countries than their earlier accumulations of dollars without commitment and on their own judgment.
Rejection of both gold and reserve currencies as the basis of future reserve growth led naturally—which is not to say easily—to creation of special drawing rights. The key negotiations took place between March and August 1967. SDRs were seen as the main vehicle of future reserve growth, though coexisting as a supplement to existing reserves in the form of gold and reserve currencies. The SDR facility was activated for the first time at the beginning of 1970, and in technical terms has been an outstanding success—a success that deserves to be noted, given the skepticism that had been displayed in a number of circles about the willingness of monetary authorities to accept and deal in a synthetic unit of this kind.
But the wider objective of the introduction of SDRs —of bringing a degree of collective control to the international reserve system and avoiding the instabilities inherent in undue growth of reserve currency holdings —was overwhelmed by the dollar explosion which resulted from the surfacing and then exaggeration of the underlying deficit in the U. S. balance of payments. The U. S. decisions of August 15, 1971, and specifically the suspension of the formal convertibility of the dollar into gold, have made the international system still more dependent on development of SDRs, which may now have to move into the center of the reserve system. This would imply that the United States and other existing reserve centers would finance their deficits—but would also receive finance for their surpluses —in essentially the same way as other countries, that is to say, in reserve assets and negotiated credits rather than through accumulations and redemptions of liabilities expressed in their own currencies. But it is clear that the United States will be able to undertake the same commitments for financing their imbalances as other countries only to the extent that it enjoys the same facilities for removing imbalances, or for preventing them from occurring. Thus, the future reserve system and the convertibility system are closely connected with future arrangements for international payments adjustment, particularly as concerns exchange rates.
To secure a smoothly functioning mechanism for adjustment of exchange rates will be perhaps the most difficult aspect of the reform exercise. In this area, the lessons of past experience point less clearly than in the case of reserve evolution to the shape of the future, so that the field is perhaps more open. A major concern of the Articles of the Fund was to provide safeguards against competitive devaluations of the interwar variety: the provisions in the Articles on exchange adjustment therefore specify, in effect, when countries may not adjust their parities, but not when they should. As in other aspects, these limitations have not prevented the exercise of international initiative on an informal basis. This occurred already in the U. S.-led pressure for European devaluations in 1949—when the doctrine of equal responsibility for exchange adjustment by the surplus country had not made sufficient ground to suggest that an administratively simpler solution could have been revaluation of the dollar. In the 1950s and until the later 1960s, the role of exchange adjustment among the larger economies was reduced by the willingness and ability of the United States to see its surplus run down, and then its deficit run up, and by a corresponding disinclination for many years on the part of the United Kingdom to undertake exchange adjustment.
Today all countries have active exchange rate policies, in the sense of being concerned to keep their exchange rate roughly in line with their international competitiveness. Since an exchange rate between two currencies is a reciprocal, currency A over currency B, this involves an operational problem of international reconciliation. Country A and Country B cannot both have full freedom of action, by the nature of the exchange rate relationship. This interdependence was brought out prominently in the exchange rate negotiations that culminated in the Smithsonian Museum on the Saturday before Christmas. Difficult and prolonged as that negotiation was, its completion was an encouraging sign that the necessary reconciliation can be achieved on a cooperative basis. But obviously a less highly charged basis for exchange adjustment is desirable as part of a working system. I fortunately do not have time to enter into the specifics that such arrangements might take, but will end by suggesting three broad requirements that the exchange system of the future will probably have to meet. These requirements are connected with the underlying political constraints on the international monetary system which I referred to at the beginning of my talk.
(1) The arrangements cannot deprive national authorities of instruments they need or think they need to fulfill their domestic responsibilities; official intervention to limit fluctuations in market exchange rates is among those instruments.
(2) It follows from the first limitation that the arrangements will comprise some form of limited exchange flexibility. This requires decisions on the way in which exchange fluctuations are to be regulated, which in turn requires international agreement on the circumstances in which national authorities can take action to adjust their exchange rates, and on how they can do so without clashing with their partner countries.
(3) The fact that “all players are now playing”—that we do not have a passive nth country any more —may now make it necessary for the rules of the game to be specified somewhat more precisely than formerly; and these rules or codes may have to be cast in a more positive frame, indicating when exchange adjustment is internationally necessary, and not only when it is inappropriate or inadmissible. There is also a general desire that payments imbalances should not be permitted to build up to the large proportions that have been responsible for recent disruptions; this also suggests that the collective watch over exchange rates should take on a more positive role.
In principle, this collective watch could take a variety of forms. At one extreme, it could rely heavily on market influences, as in crawling peg proposals under which parities would respond—and would have to respond—automatically to some average of past market rates. At another extreme, the collective criteria for parities could be the result of purely administrative judgments. Whatever choice is made between these approaches—or more realistically, between the various possible blends between them—it seems likely that safeguards against disruptive exchange rate action will have to be extended from protection against unjustified changes to protection against the unjustified status quo.