THE PERIOD SINCE THE DEMISE OF THE BRETTON WOODS SYSTEM in the early 1970s has been one of structural change, market adaptation, and unprecedented financial innovation in the international financial system. The structure, operation, and institutions of the international system have evolved in a largely unplanned manner and without a clearly defined and agreed official framework—the latter being represented by governments in industrial countries, aid agencies, and multilateral development and financial institutions. Given this lack of structure, the evolution of the international financial system responded to significant changes in the economic and financial environment, and new objectives and behavior patterns of private institutions. In particular, the balance of the roles of the official and private sectors has altered substantially. This has meant, most especially, changes in balance of payments financing arrangements, but also in exchange rate behavior, the provision of international liquidity, and the essentially demand-determined course of international reserves.

THE PERIOD SINCE THE DEMISE OF THE BRETTON WOODS SYSTEM in the early 1970s has been one of structural change, market adaptation, and unprecedented financial innovation in the international financial system. The structure, operation, and institutions of the international system have evolved in a largely unplanned manner and without a clearly defined and agreed official framework—the latter being represented by governments in industrial countries, aid agencies, and multilateral development and financial institutions. Given this lack of structure, the evolution of the international financial system responded to significant changes in the economic and financial environment, and new objectives and behavior patterns of private institutions. In particular, the balance of the roles of the official and private sectors has altered substantially. This has meant, most especially, changes in balance of payments financing arrangements, but also in exchange rate behavior, the provision of international liquidity, and the essentially demand-determined course of international reserves.

This evolution of international monetary arrangements may be captured by three dominant and related themes:

  • Market-related adaptation to major shifts in the economic and financial environment, given no officially agreed and clearly defined “rules of the game.”

  • Structural change in the relative roles of the private and official sectors (a “privatization” of international monetary arrangements).

  • Financial innovation, both in the structure of the system and the particular role and operation of the private sector. Banks especially have responded to a substantially increased demand for international financial intermediation, to changes in the portfolio preferences of its “users,” and to new portfolio preferences and strategies of their own with respect to international business.

Without clearly defined ground rules (perhaps because of their absence), the major changes in the economic and financial environment in the world economy that the international financial system responded to were the following: increases in the size of international payments imbalances (see Stanyer and Whitley, 1981), structural changes in the pattern of world payments, a combination of inflation and recession, the structural aspects of two sharp rises in the price of oil, increased international capital mobility, sometimes volatile exchange rates and interest rates, and substantial changes in the conduct of financial policy in major countries. Since 1972 the market has evolved rather than followed a conscious plan, in the context of an often unstable economic and policy environment combined with an absence of any Grand Design to replace the structured system of Bretton Woods. These changes developed within a basically oligopolistic world political structure, with power more diffused than in the period immediately after 1945.

While in many respects global economic performance deteriorated after 1970, the adaptation of the international financial system was in the main remarkably successful. Notwithstanding the pressures of the economic environment, the international monetary system remains basically liberal. Although problems have emerged in the process of adaptation and financial innovation, it is not clear that in practice a planned new Grand Design would have been a more effective replacement of the old order in the early 1970s. A market response was what was needed at the time, although this is not to argue that official reform measures could not now be usefully considered. These are reviewed in a later section, in the context of problems that have arisen in the course of the adaptation and structural changes that developed after 1972.

It is not intended to consider in any detail in this paper the usual dimensions of analysis of the international monetary system: the exchange rate regime, the structure and determination of international liquidity, the adjustment process, and the management of the system. These are each analyzed in detail by other contributors in other papers, and Tew (1982) offers a concise history of developments in the international monetary system. The objective in this paper is to attempt to identify the nature of the underlying changes or unifying themes in the evolution of the international financial system over the 1970s, to describe the role of financial innovation in this global context, and to establish a general framework for considering why the structure and operation of the system change over time.

Although the study focuses upon the international financial system and monetary arrangements, this of necessity encompasses domestic financial systems. Given the way the system has evolved, it is inappropriate to make a rigid distinction between the evolution of domestic financial systems and international monetary arrangements. This is partly because both have been subject to the same pressures (a rise in the size of financial imbalances, changes in portfolio preferences and so on), but also because financial intermediation became increasingly internationalized during the 1970s (as borrowers and savers had increasing access to global facilities). This trend itself had an impact on the international system. In parallel, private institutions providing national financial intermediation services also absorbed functions hitherto defined as predominantly official. The international role and behavior of banks is included in the discussion because the role of international banking in the international system has substantially increased since the late 1960s. Portfolio decisions by international banks, particularly with respect to the volume and distribution of international lending, have an impact on the international financial system. As in national financial systems, international financial intermediation can influence the balance between adjustment to and financing of payments imbalances, the level of savings and borrowing, and the level of real income at which surpluses are disposed of and deficits financed.

Though much of the discussion concentrates on current account financing, international financial intermediation and the international role of banks encompass a wider set of activities. If the portfolio preferences of domestic agents (both savers and borrowers) in a country can be met more effectively by external than domestic financial markets, international financial intermediation takes place even though there is no net transfer of real resources as a counterpart. The financing of current account deficits is only one part of the process of international financial intermediation. In this context, the interpretation of gross external debt positions may depend upon whether the counterpart is a current account deficit and net absorption of real resources, or external financial assets acquired by domestic savers (Llewellyn, 1986).

The Emergence of a Less Collective System

The central feature in international monetary relations is necessarily the interdependence of national systems. All the significant issues derive from this fact. There was a steady intensification of international financial integration over the 1970s and, for reasons and in forms noted later, the geographical domain of financial integration has been extended as a result of the structural changes in the international monetary system.

Financial integration is the extent to which national financial markets are connected. It relates to: (1) the degree to which transactors seek to maximize portfolio objectives through international diversification; (2) the extent to which they are able to do so; and (3) the efficiency of information transfers. Increased financial integration was a product of simultaneous pressures from several sources: from new technology affecting information and financial markets; from the abolition of exchange controls (where relevant); from a desire for more internationally diversified portfolios by banks and their clients; from the effect of financial innovation on the range of portfolio options available to wealth-holders; and from the international financial intermediation performed by market-dominated financial institutions.

The high degree of financial integration achieved by the financial asset markets and the portfolio behavior of banks during the 1970s have clear implications for the structure and operation of the international financial system. In a financially integrated system (whether global or regional) there are five central issues to be resolved. It is the method of their resolution that distinguishes the nature of the system in particular periods. The first issue is the problem of securing compatible policy targets and the resolution of ex ante inconsistencies. The second question relates to the distribution of power, and particularly to whether monetary arrangements in the system or any sub-system are based upon the hegemony of one dominant partner. The third problem is the extent to which members recognize and adhere to agreed rules of conduct and abide by mutually determined and agreed obligations; in turn, the nature and precision of the rules, and the degree of compulsion in adhering to them, are significant. Fourth are specific issues related to payments adjustments among members and particularly to who adjusts, under what circumstances, and through which mechanisms. Finally, given the overall importance of the monetary aspects of integration, there is the question of the compatibility of the monetary policy of different members of a system and how consistency is ultimately achieved.

In various ways, either explicitly or implicitly, these five issues dominate developments in the international monetary system and the debate over reform. A subsidiary issue, though important at times of strain, is how the international community deals with any conflicts that may arise through the effects of financial integration. An example is the cooperative approach (both between governments and between the official and private sectors) adopted in the early 1980s to the external debt problems of some developing countries.

Given monetary interdependence, conflicts and potential instability within the global monetary system may be minimized through arrangements either for ensuring ex ante consistency among countries or minimizing resistance to equilibrating mechanisms. Five alternative “organizing structures” for the international monetary system may be identified: (1) automatic market mechanisms such as floating exchange rates, non-sterilization of changes in the money supply induced by the balance of payments, reliance on private, market-oriented financial institutions and so on; (2) the (n-1) approach, whereby one country in the system agrees not to have an external target (this implies the hegemony of a dominant country); (3) ex ante policy coordination designed to ensure consistent targets and compatible means of securing them (which implies a bargaining process among members of the integrated group); (4) an agreement to a precise set of policy rules that indicates what is required of policymakers in specified circumstances; or (5) a multilateral approach, whereby some supranational authority indicates (and enforces?) policy measures that have been calculated to ensure consistency and stability in the system. Something along the lines of (5) was implicit in the proposal by the Committee of Twenty (the Committee on Reform of the International Monetary System and Related Issues) in 1974 that the amended Articles of Agreement of the International Monetary Fund should provide for a permanent Council of Governors which would have decision-making powers. In the event, an Interim Committee was established (and still exists), but has no decision-making authority.

In practice, there is never a “pure” system and mechanisms are likely to be a composite of several, with the most powerful participants in parts of an integrated system partially imposing their own objectives. These conclusions apply to the global monetary system and to coalitions within and among any regional blocs or countries in the global system. But there is never one overriding structure and the history of the international monetary system is one of a changing balance of the five alternative pure structures.

At the global level, the Bretton Woods System as it developed was based essentially upon the (n-7) principle (with the passive role played by the United States) but with a high degree of international cooperation; that is, it combined structures (2) and (4) with elements of (5). A comparable option is also available within regional arrangements, and to some extent the Federal Republic of Germany performed a similar role in the mini-snake and in the European Monetary System (EMS). The option is feasible if there is a clearly recognized dominant power in the global or regional system (though this still presupposes that the central country agrees not to have an external target) and if partners are prepared to accept the hegemony of that country, particularly in monetary policy. It was the latter requirement that proved to be a major weakness in the final years of the Bretton Woods System but a strength of the mini-snake arrangement and the EMS. The major potential weakness is the moral hazard confronted by the key country that can largely determine its own policy and targets and in the process impose costs (in the form of unattained targets) on partner countries. With a fixed exchange rate, the rate of growth of the money supply in an integrated group can be determined by the dominant country if, like the United States in the 1960s, it chooses to sterilize the monetary effects of its balance of payments position.

Since different organizing structures may be applied to different parts of the global system, the issue arises whether there is an advantage in creating a dual structure whereby different solutions are adopted for countries within and among regional blocs. The case for a regional approach might be made in terms of there being less formidable problems of ex ante coordination among countries with a comparatively high degree of integration, and where other general political objectives might also be served by policy coordination.

During the 1970s, a series of attempts culminating in the EMS were made within Europe to create a regional subsector of the global monetary system and a different organizing structure with respect to the five central issues outlined. In this and other respects the evolution of the international monetary system over the 1970s produced a hybrid structure which, in turn, became one of the central characteristics of the system. There was a much greater variety of arrangements than under Bretton Woods and the system became less coherent.

The negotiations for reform that began after the demise of Bretton Woods did not produce a universal, coherent Grand Design analogous to that of 1944. The Bretton Woods concept of a Grand Design was eroded during the 1960s under the pressure of market forces, was abandoned in the early 1970s, and was not subsequently replaced by an alternative reform program, although the Committee of Twenty unsuccessfully attempted one.

The initial response to the breakdown of the Bretton Woods System was to produce a Grand Design that would reform international monetary arrangements and avoid the weaknesses that had developed in the previous regime. In practice, none of the major issues and weaknesses highlighted by the Committee of Twenty was subsequently resolved through multilateral agreement. (These issues included the primary role of the U.S. dollar, the liquidity of the U.S. external position, the asymmetrical nature of the exchange rate system, official convertibility arrangements, symmetrical incentives for balance of payments adjustment, the control of international liquidity, and the role of reserve currencies and requirements for asset settlement, together with the potential destabilizing effects of volatile international capital movements.) In effect, a decision was made to live with a “nonsystem” and a set of more or less informal monetary arrangements. (For an analysis of the reasons for the failure of the Committee of Twenty to establish a reformed Grand Design, and the origins of the emergence of the nonsystem, see Williamson, 1977 and 1985.) Throughout the 1970s, there was no common exchange rate system, no clearly defined set of rules for official intervention (though various attempts were made to design and implement certain guidelines), no effective control over the growth of international liquidity, and no clearly specified obligations with respect to balance of payments adjustment. Above all there were no clearly defined rights and obligations of governments in their international monetary relations. The scope for conflict was therefore substantial, particularly in the oligopolistic structure of the world monetary system that emerged. In effect, countries were free to choose their own strategies, though in practice the degree of autonomy was limited.

The 1970s, therefore, had no clear monetary system. It was a period of substantial structural change and financial innovation as the international monetary system was privatized and arrangements became more market oriented and pragmatic. This implied a move toward the first of the alternative structures outlined earlier—an automatic market system was most obviously manifest in exchange rate determination and the role of banks in balance of payments financing. The arrangements were not based upon any central authority or the explicit hegemony of a single dominant power. Nevertheless, the policy after 1973 of “benign neglect” by the U.S. authorities (with only a short interruption during 1978–80) meant in practice that U.S. monetary and fiscal policy were based exclusively upon domestic considerations, and the U.S. had no explicit balance of payments policy or objectives. In this sense, the United States continued to exert a degree of hegemony on the global system as in practice it had under earlier arrangements, though its partners had more ways of responding in the 1970s than they had under the previous pegged exchange rate regime.

The predominant role of the major official monetary institution (the Fund) changed after 1972. In general, the Fund’s power waned during much of the 1970s after the abandonment of the adjustable peg exchange rate regime. The Decision by the Fund on “Guidelines for the Management of Floating Exchange Rates” (Decision No. 4232–(741671)) originally envisaged a positive role for the Fund in surveillance, as did the revised Article IV of its Articles of Agreement. For this to have been an effective role, the Fund would have had to have an influence on members’ general policy. In the event, the Fund has had little role in members’ exchange rate policies. It did make a contribution to the financing of the deficits associated with the 1973 oil price rise (through its Oil Facility), and in the 1980s it took on a more decisive role in lending to developing countries and restructuring external debt positions. The role became something of a partnership with private sector banks which, while the Fund has been regarded as a lender of last resort to deficit countries, even though its interest cost has been substantially below that of the banks, became powerful at times when banks were hesitant to extend new credit. It might even be said that the private institutions have become quasi-official through this partnership as the Fund and central banks have had a role both in debt restructuring negotiations, but also on occasion in inducing banks to provide additional finance.

Several factors undermined the attempt by the Committee of Twenty to reinstate a Grand Design to reform the system. The balance of power in the global system had shifted by the 1970s, with the singular power of the United States considerably less than it was in 1944. Above all, power had become more diffuse, with the concomitant practical problem that it was more difficult to envisage an imposed system or even an agreement based upon a coalition of interests. It was also apparent from the outset that there was no agreement over the approach to be adopted, either in terms of fundamentals or detailed mechanisms and arrangements.

The conflicts were very substantial. Increasingly, the belief began to emerge that a decentralized system based more upon market mechanisms might be more feasible in the environment of greater financial integration in general and international capital mobility in particular. This was reinforced by a strong desire for an ill-defined national “monetary autonomy,” which much theoretical literature of the time suggested would be more easily secured with floating exchange rates. The greater emphasis on control of the money supply, again in the context of increased capital mobility, made floating exchange rates more acceptable. In fact, floating rates have not afforded the degree of monetary insulation and power to monetary policy that some analysis at the time suggested they would. A market system also appeared attractive to the United States, which did not wish its policy actions to be constrained as it believed at times they had been under the Bretton Woods System. Following the experience of the late 1960s, Europe, for its part, would not accept any arrangements implying the explicit hegemony of the United States.

However, an alternative collective system proved difficult to devise. In any event, none was agreed. This had both a negative and positive aspect. On the one hand there was simply no agreement over many of the key issues. On the other hand, there was a positive belief that market mechanisms would cope with the adjustments of the time. So the reform program of the Committee of Twenty, based as it was upon “stable but adjustable par values,” proved infeasible. It misjudged the emerging trends toward a more decentralized approach to international monetary arrangements.

As these arrangements evolved, formal international monetary cooperation deteriorated, or at least became less extensive. During the 1950s and 1960s the Fund had “managed” the fixed exchange rate system while the Organization for Economic Cooperation and Development (OECD) provided a mechanism for an element of coordination in macroeconomic policies. With the exception of the 1978 Bonn Summit Meeting, which in principle established a “locomotive” approach to expansion, there has been little, if any, coordination of policy. This was not due to any shortage of institutional mechanisms that share information on macroeconomic policies; this, however, falls short of an overt ex ante coordination of policy measures. The institutions include the Economic Policy Committee and Working Party No. 3 of the OECD, the Interim Committee of the Fund, ten annual economic summits since 1975, the Group of Five, the Group of Ten, the Executive Board of the Fund, monthly meetings of central bank governors at the Bank for International Settlements (BIS), and several committees within the European Economic Community. The Fund’s Interim Committee was established in 1974 and over the decade became an integral element in the Fund’s policymaking machinery (see de Vries, 1985). Its origin lay in the failure of the Committee of Twenty to agree upon a reform. The Interim Committee has a wide brief and meets twice each year when Ministers discuss current issues of relevance to the international financial system, the world economic outlook, and the conduct of economic policy.

The reasons for the general decline in international monetary cooperation are more fundamental than the absence of institutional mechanisms and are associated in part with the reasons why a Grand Design to reform the system was not feasible at the outset. First, there had developed in certain powerful countries a doctrinal commitment to market mechanisms and a belief in the merits of minimizing government intervention. Second, overt cooperation became more problematic in the absence of explicit rules of the game in the new decentralized arrangements. There developed a degree of pessimism over the efficacy of coordinated action given the greater international capital mobility. In addition, there was less consensus among governments about the central role of monetary policy in particular and the solutions to economic problems in general. This produced differences in view as to what concerted action would be appropriate. The alleged independence conferred by floating exchange rates was also influential in inducing a belief that explicit coordination was redundant as the market would reconcile any conflicts. Above all, the United States was, in general, unsympathetic to formal coordination and to framing policy with a view to international considerations, most especially exchange rate policy. This also emerged in the 1980s over policy affecting the budget deficit and the level of interest rates. In this last respect, and in the context of mounting international pressure, the U.S. authorities have consistently denied the alleged link between the budget deficit and the level of U.S. interest rates. (This is also consistent with its denial of the authority of others to make judgments about the conduct of domestic U.S. policy.)

In practice, therefore, while the machinery has existed for the exchange of information, there has been little evidence of explicit coordination of monetary policy. Indeed, the problems likely to be encountered in ex ante coordination are formidable. First, there would almost inevitably be protracted negotiations over the standard to aim at resulting from a conflict of interest between, for instance, high and low inflation countries. Second, the technical problem of calculating for each member the rate of growth of the money supply and the fiscal stance, for instance, that are consistent with the agreed objective would also be formidable. Effective coordination also requires a recognition that cooperation is a less costly and more certain method of securing targets than no cooperation, which in turn presupposes no attempts are made to impose national targets on unwilling partners in the coordinating exercise. As implied in Meade’s original analysis (Meade, 1951), if national targets are not consistent and each country believes it is sufficiently powerful to impose its will, ex ante coordination is unlikely to be adopted. Conflicts can also arise over the distribution among countries of the net policy changes required to secure collective targets. Above all, it implies a recognition that pooled sovereignty confers greater benefits than the exercise of unfettered individual sovereignty, given that the latter frequently means that chosen objectives may be frustrated by the actions of others also pursuing sovereignty in the conduct of policy.

But the emergence of a less formal cooperative system has not produced a state of anarchy or even of overt national insularity in economic and monetary affairs. While there have been some protectionist moves in the world trading system, these have so far been limited, though the recession in the 1980s induced protectionist moves of a specific, ad hoc rather than general nature. In the financial sphere, two major countries (the United States and the United Kingdom), abolished capital and exchange controls, and Japan has made modest progress toward liberalizing its capital account mechanisms. Nor have countries in general adopted overly aggressive exchange rate policies. International cooperation has also been explicit in two major areas: in dealing with the international debt problems that surfaced in 1982, and in the prudential regulation of international banking. International monetary arrangements, however, are still based more upon decentralized than cooperative principles than, for instance, they were in the 1960s.

The Privatization of the System

Some of the major structural changes in the international financial system since 1972 have been in mechanisms for balance of payments financing, particularly for developing countries. Combined with larger balance of payments deficits, there were substantial shifts in the pattern of financing the deficits of developing countries, which were increasingly met through borrowing as nondebt forms of financing (aid and autonomous capital inflows) declined in relative importance. The privatization of international financial intermediation and the enhanced role of banks were a powerful trend throughout the 1970s; the proportion of debt incurred against banks rose sharply as the private sector displaced the traditional official sector in balance of payments financing. At the same time, international bank lending tended to shift from private to public sector borrowers, from long-term to short-term assets, from fixed to floating interest rates, and from trade-related and project-related credit to balance of payments financing. The implications of these structural changes are considered in a later section.

The changes in the form of international financial intermediation are central to the structural shifts in the system as a whole. The role of financial intermediation (whether national or international) is essentially five fold: (1) to provide mechanisms for the disposal of savings or financial surpluses and the financing of investment or financial deficits; (2) to bridge different portfolio preferences of surplus and deficit agents; (3) to allocate funds to the most efficient users; (4) to enable risks to be diversified and transferred from ultimate savers; and (5) to allow changes to be made in the structure of portfolios. Financial intermediation operates across space, time, and agents. In turn, such intermediation has an impact on the real economy as its efficiency may influence both the volume of savings and investment and the allocation of investible funds among competing claims. In the process, intermediation determines the ease of transfer of real resources among agents (effectively from ultimate savers to ultimate borrowers) and over time, and has an important impact upon the pressures in a system between the financing of and adjustment to financial imbalances.

In this sense, the international financial system performs globally what national financial systems execute domestically. It provides a payments mechanism, offers facilities for borrowing funds and disposing of surpluses, creates different types of financial assets and liabilities and intermediates among the various portfolio preferences of different agents. As with domestic financial systems, a two-fold distinction is made between market and nonmarket forms of financial intermediation and between private and official channels. While private mechanisms are presumed to be exclusively market oriented, public mechanisms are not invariably nonmarket.

A major, though by no means exclusive, function of international financial intermediation involves the financing of the net international transfer of real resources implied by current account imbalances. The major current account imbalances in the period after 1972 were the fluctuating surpluses of the Organization of Petroleum Exporting Countries (OPEC), the Federal Republic of Germany, and Japan, and the substantial deficits of non-oil developing countries and the United States. The structure of these payments imbalances changed markedly after 1980. In the period between 1980–82 and 1983–84 an OPEC surplus of $152 billion was transformed into a deficit of $24 billion; the deficit of the non-oil developing countries was reduced by $173 billion to $106 billion and a group of small industrial countries had their deficit cut from $56 billion to less than $5 billion.

But one of the most significant structural changes for international financial intermediation occurred among major industrial countries, as the United States moved from an $8 billion surplus to a $102 billion deficit, and the combined surplus of Germany and Japan rose from $7 billion to $70 billion. Given the nature of the financial markets involved, this also meant that international financial intermediation switched from banks toward transactions in financial assets as nonresidents purchased U.S. assets traded in active secondary markets, which is not an option in the financing of developing countries. This was also consistent with the new portfolio preferences of banks, which were seeking to moderate their international exposure in the mid-1980s. In this sense, the geographical location of financial imbalances influenced the form of international financial intermediation. It has already been noted that the ease of financing in large part determines the pressure for balance of payments adjustment. The much reduced collective deficit of developing countries between 1980–82 and 1983–84 was associated largely with financing constraints in the context of revised portfolio objectives of banks. In effect, there was a resultant requirement for nonbank forms of financial intermediation and this materialized with the current account deficit of the United States and financing through asset market transactions.

Current account deficits are sustainable if surplus countries are able to transfer excess savings overseas via autonomous long-term overseas investment or if financial intermediation mechanisms are available. If there is a constraint on either, ex ante deficits have to be adjusted. The supply of international financial intermediation services increased over the 1970s. OPEC financial systems were not sufficiently developed to facilitate the smooth transfer abroad of excess savings in the form of autonomous long-term capital flows, and neither were domestic bond and credit markets sufficiently developed to provide deficit countries with efficient financial intermediation mechanisms. To a lesser extent, this was also true of the Federal Republic of Germany and Japan. This meant that, if planned payments imbalances and the net transfer of real resources were to be sustained, external financial intermediation mechanisms were required—which in practice meant the U.S. banking system, the Eurocurrency markets and the domestic banking systems of a few industrial countries. Through these mechanisms a further feature of the international financial system of the 1970s evolved, as the source of capital was different from the location of the financial intermediaries. Albeit in different ways, the United States continued to perform an international banking role and in a more literal sense than the interpretation given in some analyses of the U.S. balance of payments problem of the 1960s. While for much of the period since 1972 the United States has had a current account deficit and net absorption of real resources, the domestic financial system in general, and U.S. banks in particular, performed a substantial international financial intermediation role.

Changes in the form of international financial intermediation, which were central to a general structural change in the international system over the 1970s, were the result of four broad pressures: (1) changes in the demand for financial intermediation services; (2) the evolution of the portfolio preferences of borrowers and lenders; (3) changes in the relative efficiency and supply of different intermediation mechanisms; and (4) shifts in the portfolio behavior of the suppliers of financial intermediation services.

The demand for international financial intermediation rose substantially in the 1970s with the absolute size of global financial imbalances. The demand for more reserves added to financing requirements, as developing countries’ reserves rose in each year except 1975, though their real value declined and the ratio of reserves to imports fell to 15 percent in 1983 from 26 percent in 1978 and 32 percent in 1973.

In many developing countries, internal factors such as the evolution of large-scale investment projects and budget deficits in an environment of domestic financial constraints also increased the demand for international finance. The apparently high real rates of return on capital projects, coupled with negative real rates of interest for much of the 1970s, also induced an increase in demand for external finance over the decade.

The real resource costs of balance of payments adjustment, determined in part by economic circumstances in industrial countries, also affect the demand for finance. To the extent that the general economic conjuncture of the 1970s was perceived as increasing the real cost of adjustment, this would have increased the demand for international financial intermediation. But circumstances producing a rise in the cost of adjustment (such as a deterioration in a country’s terms of trade) may also adversely affect access to international finance to the extent that it impairs the credit standing of the country. The net effect of the higher real costs of adjustment on the demand for financial services was therefore ambiguous as the impact on the demand of individual borrowers varied and could have been offsetting.

The portfolio preferences of both surplus and deficit countries are relevant in determining the forms of international financial intermediation. The portfolio preferences of OPEC have been analyzed in detail elsewhere (Amuzegar, 1983). A bias against nondebt instruments among lenders was based upon a strong liquidity preference, the implicit risk involved in equity investment, a lack of management skills, and the attractive yields that were available on short-term bank deposits. Banks were a convenient intermediary and had the general advantage of being able to meet the conflicting maturity preferences of depositors and borrowers through maturity transformation. OPEC depositors could also gain the implicit advantages of a diversified portfolio by sharing in the wide asset structure of banks and in the benefit of their economies of scale in such services as risk assessment. To the extent that there is an assumed lender of last resort to banks which does not exist to ultimate borrowers, the risk of holding bank deposits is reduced, which acts as an implicit subsidy to financial intermediation by banks (Swoboda, 1983).

Borrowing countries, by contrast, had a strong demand for long-term finance. But the terms of different financing options were also relevant. One particular example of the importance of terms was the experience with the type of conditionality provisions imposed by the Fund. While the Fund’s lending capacity was increased over the 1970s (albeit by a considerably smaller amount than the size of financial imbalances), for much of the decade the Fund was underloaned while countries were borrowing heavily from banks at considerably higher rates of interest. There seemed to be a strong preference to avoid Fund conditionality provisions, particularly when the amounts that could be drawn from the Fund were small compared with some countries’ access to private facilities. In effect, the increased supply of private financial intermediation mechanisms was perceived as reducing the pressure for adjustment.

Given the expected rate of return on capital, the assumed negative real rate of interest on borrowed funds, and the perception of low debt-to-GDP ratios, several developing countries also sought to make stock adjustments by increasing the volume of external debt, both absolutely and relative to income. (GDP stands for gross domestic product.) Some borrowing countries developed a deliberate strategy of becoming less dependent on official aid, direct investment, and other official sector financing, and attempted to develop a high standard of creditworthiness with financial markets.

On the demand side, the portfolio preferences of deficit sectors are determined partly by the availability of different sources of funding and their cost. One of the factors behind the strong demand for bank financing over the 1970s was the slow growth of alternative financing options (such as aid, direct investment flows, and the lending capacity of development institutions) relative to the sharp rise in the total external financing requirement.

A key factor in the growth of financial intermediation has been the flexibility of banks and their record of financial innovation, which was considerable and unprecedented during a decade of structural change. Financial innovation (in national and international markets) is partly a reflection of rising wealth that creates a demand for an increased variety of financial assets, and partly of changes in the market environment that alter the portfolio requirements both of financial institutions and their customers. Financial innovation is the process whereby financial institutions create instruments and markets to meet the portfolio requirements of depositors and borrowers in a way that is consistent with the institution’s own objectives and constraints. Banks were prepared to meet the maturity requirements of borrowers, while at the same time offering short-term deposits, through developing new loan mechanisms (roll-over credits) and pricing formulae (floating rate loans)—though the latter passed the risk to the borrower rather than being absorbed by the intermediary. This is considered further in a later section.

The relative efficiency of different forms of financial intermediation may be powerfully influenced by the regulatory environment. The growth of Eurocurrency markets is associated in part with the competitive advantage conferred by the “tax” effect of reserve requirements imposed on banks’ domestic liabilities, a tax which increases with the level of interest rates. It might also be thought that, as there is a lender of last resort to banks, intermediation through banks entails less risk to depositors than the alternative of securities markets. Many of the institutional changes and innovations in the international financial system were induced in part by changes in official regulations. One of the most powerful examples during the 1970s was the abolition of U.S. capital controls, which induced U.S. banks to make a substantial stock adjustment toward the acquisition of external assets.

Banks are not passive agents, but have balance-sheet objectives and act to secure them. Subject to official regulations, banks have a choice over the total size of the balance sheet, over the sources of funds, and the geographical structure of assets. The evidence indicates that, during the 1970s, one of the major portfolio adjustments in banking was a general shift of objectives toward balance sheet growth rather than the immediate rate of return on assets or other measures of profitability. This was evident in the domestic business of banks in many industrial countries, most notably the United States and the United Kingdom, and was associated in part with a general trend toward deregulation in the financial sector, and the more intense competitive environment of several financial centers. International business became one way of satisfying this general objective. International lending became part of a general and simultaneous process of balance sheet growth and portfolio diversification, and in turn had a significant impact on the international monetary system. In this sense, there was an increased supply of international financial intermediation services. But the strategic objectives and portfolio behavior of banks changed during the early 1980s as they began to feel increasingly limited by capital and exposure constraints. The volume of international bank lending declined sharply after 1982 in particular and banks sought, amongst other things, to develop off-balance-sheet business.

The factors inducing the structural change in international financial intermediation, and the expansion of bank lending to developing countries in the 1970s (see Dennis, 1983, for a statistical analysis of international bank lending), can be summarized as follows: (1) the substantial increase in the absolute size of international financial imbalances, which were in part due to oil price rises; (2) the failure of the supply of traditional finance to expand in line with the size of financial deficits; (3) the discernible shift in portfolio preferences by both deficit and surplus sectors toward intermediation by banks; (4) the change in the portfolio preferences and strategies of banks as the development of international business and lending became part of their strategic objectives; and (5) the constant financial innovation that made international lending operations increasingly attractive and feasible on terms that enabled the banks to meet the different portfolio requirements of their depositors and borrowers. In addition, the regulatory climate was conducive to the expansion of financial services, especially, but not exclusively, in certain offshore financial centers.

The interaction of these pressures produced a decade of unprecedented expansion in international banking, and a structural change in the form of international financial intermediation occurred as new forms emerged to meet the increased balance of payments deficits. These new forms were additional to, and not a replacement for, traditional facilities (such as the Fund and the World Bank). The structural change in financing occurred at the margin as the supply of traditional financing mechanisms did not keep pace with the rise in financial imbalances, while the new portfolio management of banks was consistent with the greater demand for financial intermediation services. In the process, the enhanced role of banks had a major impact on the international monetary system by changing the balance of pressures between adjustment and financing. This was a factor in the substantial growth of international liquidity and contributed to the financing of a major international transfer of real resources (Llewellyn, 1984). By the 1980s it had also, however, created external debt problems for a significant number of countries.

Combining some of the strands, one interpretation of the 1970s is that both developing country borrowers and banks were making once-for-all stock adjustments. The argument was that some countries had substantial potential for capital formation beyond the capacity of domestic savings to meet it, and a stock adjustment to greater external debt was considered appropriate. At the same time, banks in major centers had concentrated portfolios based on domestic assets. It is therefore likely that the sharp rise in international lending during the 1970s represents the combination of a finite, though substantial, stock adjustment toward a more diversified and larger stock of external debt by developing country borrowers, and a strategy by banks to diversify the structure of their assets. The adjustment might be expected to be completed by the end of the decade so the growth of international bank lending, due to this pressure, would be expected to slacken in the 1980s.

The international financial system evolved in the context of a changed economic and financial environment, and without a Grand Design to replace the Bretton Woods System, through a process of privatization. Financial institutions and markets, while also developing their own new portfolio objectives, responded to the new environment and induced a significant shift in the balance of roles between the official and private sectors. In several important areas within international monetary arrangements (the provision of liquidity, the financing of the transfer of real resources, and balance of payments financing), the private international banking sector substantially increased its role, both absolutely and relative to the traditional official sector (of governments, central banks, and official multinational development and financing organizations).

There has never been a rigid demarcation between national financial arrangements and the international financial system; domestic institutions and markets have always performed international functions, so the distinction is one of degree. But for most of the postwar period up to around 1970, it was reasonably clear. Net balance of payments positions were settled largely independently of national banking and financial systems while banks were engaged predominantly in domestic financial intermediation and the financing of international trade transactions of domestic clients. International financial intermediation and the financing of international payments imbalances took place predominantly through official arrangements.

During the 1960s, the main form of financing the current account deficits of developing countries was a combination of official and semiofficial grants and concessionary loans, plus private direct investment inflows. The main form of bank financing was self-liquidating trade credit. Financing was predominantly nonmarket and public sector. Several related changes in the financing of developing countries’ current account deficits then emerged over the 1970s: from nondebt to debt forms; from equity (direct investment) to bank financing; from nonmarket to market mechanisms; from official to private sources; and from concessionary to nonconcessionary forms.

The evolution of international banking over the 1970s meant that this sector became an integral part of the international monetary system. It shifted the balance of pressures between adjustment to and financing of payments imbalances toward the latter. In the process, the international banking sector contributed to a substantial transfer of real resources to developing countries. To the extent that this international financial intermediation allocated world savings to where rates of return were highest, it also contributed to world economic growth.

The shift from balance of payments adjustment toward financing has three dimensions. To the extent that it is easier to finance deficits, there is correspondingly less pressure to adjust. Whether this is beneficial depends upon whether the previous balance of pressures between adjustment and financing was optimal and continued to be appropriate in the new economic and financial environment of the 1970s. The second dimension is that the change in the balance of pressures had a distributional effect by increasing the financing potential of those countries with ready access to bank finance. Not only did the greater financial intermediation of banks alter the global balance between financing and adjustment, but it also altered the inter-country balance. Third, there is a time element in the balance between adjustment and financing; debt servicing requires appropriate adjustment, though the pressure to adjust depends in part upon the use made of borrowed funds and the rate of return on capital in the borrowing country.

A further implication of the increased role of international banking is that the significance of the adequacy or otherwise of international liquidity, which was a central feature in the debate about international monetary arrangements in the 1960s, became less clearly defined. As the access of some countries to borrowing facilities expanded, their need for “owned liquidity” or reserves declined. Liquid liabilities displaced the need for liquid assets for these countries. At the same time, the proportion of owned reserves held with private sector institutions grew steadily over the decade. The role of owned reserves and the demand for asset holdings have both changed as a result of the structural changes in the international financial system and the access that some countries have to credit markets. Dooley, in his contribution to this volume, also notes that, for these reasons, reserves play a more important role in the policies of countries that do not have access to private credit markets.

A less sanguine view of international banking is that its larger role has not been unambiguously beneficial in the world economy, for two main reasons. First, by providing financial intermediation services to oil importers and exporters, international banking validated the rise in the price of oil. Had oil-importing countries been unable to finance their deficits, the price of oil would probably have been reduced earlier. Second, international banking and the ease of financing delayed necessary balance of payments adjustment. In some cases, the ease of access to foreign savings even reduced domestic saving and induced expenditure on uneconomic investment projects.

Financial Integration

The distinction between market and nonmarket financial intermediation has implications for the nature and extent of international financial integration. In a market system, profit-maximizing institutions compete for funds and seek to make loans to maximize the risk-adjusted rate of return on total assets. The supply and terms of financial intermediation services are determined by supply and demand conditions in the global market for loanable funds. The components of these markets are not rigidly segmented and all participants are influenced by the same set of factors. By way of contrast, in the nonmarket sector: (1) the allocation of funds need not be determined by reference to rates of return or profit maximization; (2) the supply of funds to the “intermediary” (such as an aid-giving government) need not be determined by market terms; and (3) the supply of financial intermediation services need not be dependent upon market considerations. The process implies that new lending by public financial intermediation mechanisms is based on taxation receipts. But public intermediation may not imply new lending as, for instance, when public sector agencies absorb existing international debt positions from private sector banks.

A corollary of the shift toward market-related balance of payments financing is that more countries have become financially integrated in the world economy. Financial integration among highly developed market-oriented industrialized countries is well established. They may be termed the “integrated group.” In essence, financial integration derives from arbitrage in active and efficient money, foreign exchange, and securities markets. Financial integration among the developed economies occurs predominantly through secondary trading in existing financial assets and the disposition of existing portfolios.

International financial integration as applied to developing countries requires a different mechanism because of their lack of active and efficient financial markets. Developing countries become financially integrated with the financial markets of the developed group, predominantly through the credit activities of the international banking sector (which, in turn, is integrated within the major national and related international financial markets). While the form and extent of financial integration between the two groups of countries may be different from integration within the developed economies themselves, the international banking sector is an integrating force.

The extent to which developing countries have access to the international banking sector varies considerably. At the end of 1983 only 13 developing countries had liabilities to banks that exceeded $5 billion, and these represented 60 percent of total outstanding bank claims against all developing countries. As banks became more important in international financial intermediation during the 1970s, market mechanisms became more central for some developing countries. The portfolio behavior of banks that provide international intermediation services is clearly affected by the implications of international financial integration in the integrated countries. This implies that those developing countries with access to banks are also affected by the implications of international financial integration in the developed group. The enhanced role of international banking has had the effect of integrating a group of developing countries into a previously more exclusive domain. Even if only a limited number of transactors (either depositors or borrowers) have access to the international banking sector, domestic credit markets and financial conditions in those countries will reflect conditions that exist in the already integrated group.

This means that the stance of fiscal and monetary policy in the integrated countries affects developing countries through an influence on market conditions in the international banking sector. In particular, interest rates in the financial markets of developed countries have implications for developing countries—both because they affect the terms on which funds are made available, and their debt-servicing liabilities. It also implies that, as official regulations or their abolition in developed economies (U.S. capital controls in 1974) affect the provision of financing to foreign borrowers, the access of developing countries to world savings can be influenced by the regulatory regime in the integrated group. Overall, financial and real shocks are transmitted to developing countries through their impact on the portfolio behavior of market-based financial institutions.

As developing countries become more dependent upon banks for international financial intermediation services in general and for balance of payments financing in particular, they become increasingly affected by the portfolio behavior of these market-dominated banks. Banks operate simultaneously in a multitude of domestic and external money markets and complex arbitrage operations limit the extent to which monetary and financial conditions can differ among different markets. In turn, and to the extent that some borrowers in developing countries have access to the international banking sector, their borrowing terms and their domestic market conditions can be influenced by financial conditions within the integrated group of countries. The effect of greater dependence on bank finance has been to make the terms and availability of balance of payments financing, and the balance of pressures between adjustment and financing, largely dependent upon bank portfolio behavior, the terms on which they in turn secure funds, and the banks’ judgments about creditworthiness, both absolutely and relative to competing claims.

Implications of Structural Change

The central theme of this paper has been that international financial arrangements underwent several structural changes during the 1970s and early 1980s in the absence of any clearly defined and ordered official system. The mechanism for capital transfers, a major component of the international financial system, evolved in this context in response to powerful forces related both to the strong demand from developing countries for finance, and to changes in the objectives, preferences, and constraints of financial institutions and their markets (both public and private). It does not necessarily follow that the overall system has been entirely suitable for the financing needs of developing countries. (A general survey of particular problems associated with balance of payments financing via banks can be found in Smith and Cuddington, 1985.)

The structural changes evident during the 1970s may be assessed in terms of: (1) the flexibility of the system; (2) the stability of financing flows; (3) the appropriateness, or otherwise, of the structure of financing (particularly the implied structure of external debt and the lack of equity finance); and (4) the emergence of a new dimension to the confidence problem. Were the Committee of Twenty to be convened now, a major agenda item would be the mechanism for capital transfers (which would feature more centrally than it did in the early 1970s) and the implications for the international monetary system of the external debt of developing countries. These issues reflect the way the international monetary system adapted during the 1970s.

In global terms, the system demonstrated a high degree of flexibility during the decade; it showed a capacity to innovate in response to changes in the economic and financial environment and, specifically, to the evolving demands of developing countries. The size of financial imbalances rose faster than the supply of traditional finance to developing countries. While banks had their own portfolio reasons for increasing their international operations, and there was a deliberate shift in portfolio preferences by both deficit and surplus sectors toward bank intermediation, the banks nevertheless responded flexibly. Official flows overall were slow to adjust, although some components (lending by the Fund and the multilateral development banks, for instance) were more flexible. Equity flows and direct investment proved to be inflexible, and even bank finance was not always provided at just the right juncture. But while the system as a whole proved to be flexible, it is another question whether, when banks are more constrained, the system will continue to be responsive to changing circumstances.

The stability of the capital transfer system can be judged by its ability to maintain uninterrupted funding to capital importing countries—suggesting a low propensity to provide both excessive and too meager funds at different junctures. Stability should imply, for instance, an absence of the “herd instinct” among the institutions participating in the system and, ideally, access to financing that is independent of particular sources with volatile supply because of market or institutional changes. In a flexible system, alternative forms of financial intermediation should emerge as supply constraints develop in particular channels, so that the total supply of financing is less volatile than particular sources. Stability in the flow of financing is important in maintaining reasonably stable national economic conditions by contributing to an even net absorption of real resources and avoiding the necessity of sudden and unduly severe balance of payments adjustments.

In general during the 1970s official financing flows and direct investment exhibited fairly steady, albeit slow, growth. Banks, in contrast, sometimes showed a tendency to lend excessively large volumes of funds to a narrow range of developing countries or particular countries. At other times they suddenly withdrew their lending altogether from specific countries. This behavior was marked, for instance, in 1982 and 1983 when banks substantially reduced their lending to heavily indebted Latin American countries which, in turn, forced immediate, substantial, and costly adjustment.

On the question of the appropriate structure of financing, this should ideally provide a reasonably wide and diversified spectrum of financial instruments so that risk dispersion, maturity transformation, and currency diversification can be accomplished at minimum cost. The form of financing should also be appropriate to the particular financing requirement (whether for short-term trade financing, high risk investment, or long-term projects). The concept of an appropriate structure is pertinent to the stability of the system in that a heavy dependence on a single type of financial instrument or set of similar financial instruments can make a borrower vulnerable for two reasons: the terms may change unpredictably, and the total supply may be subject to discontinuities.

For some developing countries, particularly the higher income and fast growth groups, the financial system that evolved over the 1970s offered a fairly wide range of financing options. But a clear deficiency has been the marked shortage of long maturity finance to match the gestation periods of development projects. This represents a form of market failure at the international level. Individual developing countries have little access to the long-term fixed interest bond markets (though the market is important to them through the intermediation of the World Bank which is a major issuer on the finest terms), and the flow of equity finance has been weak. This trend in equity investment is itself a structural weakness in the capital transfer process and international system. Equity finance should be a suitable means of financing capital transfers when the rate of return on a project is uncertain. It represents the ultimate form of risk capital. To a country it has the advantage that the servicing is made only to the extent that the project is successful and yields an appropriate rate of return, though holders of equity may still incur a transfer risk. Frequently, when this criterion is met there is no corresponding net outward financial transfer as profits are reinvested.

When considering the structure of external financing for developing countries over the 1970s, two clear trends emerged as a product of the increased role of bank financing: the ratio of floating rate to fixed rate financing rose, and the gearing ratio increased as the volume of debt-creating finance rose relative to total financing. A rising gearing ratio combined with floating interest rate debt inevitably enhances a country’s vulnerability to external shocks.

A substantial proportion of bank financing is based upon medium-term maturities priced at adjustable short-term interest rates. This necessarily increases the degree of uncertainty over the future flow of servicing costs. It means, in particular, that the stance of fiscal and monetary policy in industrialized countries affects developing countries to the extent that it influences market conditions in the international banking sector. In particular, interest rates in the financial markets of developed countries have implications for developing countries both because they affect the terms on which funds are made available and their debt-servicing liabilities. The pricing of loans on the basis of short-term interest rates also means that one of the central functions of a financial system (the effective transfer of risk) is not efficiently served as interest rate risks are passed exclusively to borrowers rather than shared between them and the banks or depositors (though the asset or default risk is still incurred by the banks). Interest rate risk is shifted effectively only through default.

The real rate of interest is beyond the control of both borrowing countries and the governments of countries where nominal interest rates in the international financial system are determined. With floating rate loans, movements in either nominal rates or the rate of inflation may invalidate the assumptions about the expected real rate of interest relative to the expected rate of return on projects and make vulnerable projects that were initially viable. They also alter the expected net transfer of real resources through time, as a rise in interest rates implies a transfer to the lender (through debt servicing) earlier than originally planned. Floating rate finance may also impose debt-servicing requirements that have a perverse relationship with a country’s capacity to pay (Lessard, 1984). This became a particular problem in the early 1980s as the real dollar interest rate moved to unprecedentedly high levels while in the early and mid-1970s, when many loans were contracted, real rates of interest had been negative for some considerable time. Combined with slow growth in external markets in some industrial countries, the second major rise in the price of oil, and deteriorating terms of trade coupled with some protectionist moves in a few industrial countries, this produced serious debt-servicing problems for heavily indebted countries in the early 1980s.

A particular technique—swaps—has been developed in some domestic financial systems of industrial countries. Swaps provide fixed rate finance to borrowers who would not normally be able to issue fixed rate paper on acceptable terms. In effect, two borrowers with access to markets on different terms (that reflect their different comparative advantages) agree to swap liabilities on mutually advantageous terms. The issuer of a long-term fixed rate bond exchanges its obligation with a borrower securing funds on a floating rate basis, with the gain in exploiting comparative advantage being split between the two on mutually acceptable terms. But this technique has not been developed in the international market, though the World Bank has engaged in swap transactions. If it were to be developed, it could alleviate a structural weakness in the system of capital transfers to developing countries. In addition to swaps across maturities and between fixed and floating rate finance, swaps have also been developed across currencies. This enables borrowers to change the currency composition of their external liabilities (see Bock and Wallich, 1984).

With the emergence of external debt problems in some developing countries in the early 1980s, a new dimension to the confidence problem emerged. Following the rise in external indebtedness and the consequent exposure of banks, a certain parallel can be drawn between the position as it was beginning to be perceived in the early 1980s and the confidence problem as identified two decades earlier by Triffin (1960). The original confidence problem emerged with respect to a characteristic of the gold exchange standard, in that the world’s emerging liquidity needs could not be met by new gold supplies and, hence, there was a requirement for a U.S. balance of payments deficit. The problem identified by Triffin centered on the ability of a single rich country to meet the external obligations denominated in its own currency owed to central banks. While formally the U.S. authorities maintained a fixed dollar price of gold, the problem emerged when doubts were cast on the U.S. Government’s ability to maintain convertibility of the dollar following years of steadily rising external liabilities in the context of a fixed gold stock.

The new confidence problem is different in that it centers upon the ability of several, comparatively poorer, countries to service debt rather than the capacity of a single wealthy country. The debt is also owed to banks rather than central banks. With respect to the terms, in the 1980s version, the debt implied the foreign exchange risk being taken by the borrower, whereas lenders (holders of dollar reserves) sustained the exchange rate risk in the late 1960s and early 1970s. In addition, in the earlier case the debt-servicing costs were determined domestically, while in the later situation interest rates were determined externally. On the other hand, the cases are similar in that in both, debt arose through nonadjustment to payments imbalances, both involved external debt denominated in dollars, and both focused upon debt carrying floating interest rates.

The official response to the debt-servicing difficulties that emerged in the early 1980s involved a new role for the Fund in collaboration with governments and banks. In the case-by-case approach adopted, debt was restructured, countries agreed to a Fund adjustment program, and banks agreed to provide new funds, albeit on a limited basis. Whether the piecemeal approach will prove sustainable is an issue to be determined. This approach contrasts radically with the experience of the 1930s when international financing was conducted predominantly through securities markets. Debt rescheduling in the 1980s was conducted in the context of Fund stabilization programs, whereas debt problems encountered in the 1930s produced defaults on a large scale. This changes the allocation of risks; banks are more protected in the 1980s than were bond holders in the 1930s, partly because of their more pivotal position in the financial system, but also because official institutional mechanisms (such as the Fund) are available in the 1980s. The response to the debt problems represents a case of official cooperation in the context of strains in the international financial system.

The parallel with the original confidence problem of the late 1960s is yet more focused with the emergence in the mid-1980s of a substantial external debt position of the United States denominated in its own currency and again associated with an overvalued dollar. This, in turn, began to induce a more protectionist attitude in some quarters in the United States in the context of the employment consequences of what, on any form of purchasing power parity criteria, had become a substantially overvalued currency. In 1984, for instance, both U.S. Houses of Congress held hearings on the feasibility of an import surcharge not dissimilar to that proposed in 1971.

The United States currently has substantial internal and external financial imbalances which, as a proportion of gross national product, substantially exceed those of the late 1960s and early 1970s. The U.S. current account deficit was around $100 billion in 1984 (higher than the largest recorded aggregate deficit of all developing countries) and is projected to be higher in 1985. The continued rise in the value of the U.S. dollar against other currencies up to 1984 was associated with substantial capital inflows into the United States associated with high interest rates, the perceived strength of the U.S. economy, and reinforcing expectations. With the Federal Republic of Germany and Japan recording substantial current account surpluses, the new structure of international financial intermediation implied the transfer of excess savings of two industrial countries to a third.

The essentially passive international monetary role adopted by the United States was, by the mid-1980s, creating the potential for the accumulation of massive external debt on a more substantial scale than that of individual developing countries. In the process, the country with one of the highest per capita income levels was absorbing real resources from the rest of the world (albeit predominantly from a few other industrial countries). The projected increase in external debt for 1986 would make the U.S. a net debtor country with net interest payments abroad.

The trends of the early 1980s imply that a new confidence problem could become a central issue in the second half of the decade as a result of the external debt position of both the United States and developing countries. It is uncertain how sustainable current trends with respect to the U.S. external position will prove to be in the face of a substantial and continuing current account deficit, net absorption of real resources, and an overvalued currency. Unlike that of developing countries, the U.S. deficit was being financed with “lenders” taking the exchange rate risk. If the proportion of U.S. dollars held in international portfolios were to peak and begin to decline, substantial adjustment would be required of the United States which, if it were not made through protectionism, would imply a substantial exchange rate or income adjustment (see Llewellyn, 1986). The parallel with the trends prior to the breakdown of Bretton Woods is marked. The role of U.S. policy is also common to both phases of the dollar confidence problem. In the late 1960s, it was the expansionary monetary policy of the U.S. that, in a fixed exchange rate regime, implied the accumulation of dollar balances in Europe and Japan and the emergence of an overvalued dollar. In the 1980s, the mechanism producing an overvalued dollar was different in that it was a combination of a large budget deficit with a comparatively tight monetary policy stance that induced substantial capital inflows, with the large current account deficit reflecting the consequent overvalued exchange rate.

With respect to arrangements for the possible confidence problem of developing countries, two central issues are the stability of the current external debt position and bank exposure, and arrangements for the future financing of projected external deficits. The pace of international bank lending slowed markedly after 1981. Longer-run problems of exposure, capital constraints, and debt servicing became increasingly apparent in the early 1980s. Certain political events, but notably the debt-servicing problems, reinforced these longer-run considerations. A two-fold adjustment was made after 1981: the banks gave a lower priority to total external asset growth, and within the total a preference emerged for claims against developed countries.

The portfolio position and constraints of banks vary according to their nationality but, in general, their behavior has changed markedly. A major portfolio adjustment toward external assets was made in the 1970s, and considerations of portfolio balance suggest a more modest trend in the growth of external assets. Perceptions of risk in international lending and risk aversion increased in the early 1980s. In addition, the international exposure of banks in relation both to capital and total balance sheet positions became an issue of concern, most notably in the United States, and banks began to face a capital constraint. The capital position was aggravated by requirements to make balance sheet adjustments to reflect the experience with both domestic and external debt. At the same time official regulators in many countries have issued more strict capital requirements on banks.

The financing requirement of developing countries is likely to remain substantial in spite of their current lower deficits. Faced with a substantial financing requirement, but a more constrained banking system, the future flexibility of the international financial system will be tested. The options are reasonably clear: (1) attract more nondebt flows, most especially of equity capital through, inter alia, encouraging direct investment; (2) facilitate alternative nonbank debt financing by, for example, easing the access of developing countries to international bond markets; (3) alleviate the banks’ balance sheet constraint by, for instance, various forms of loan insurance schemes or official guarantees to developing country debt (a move has been made in this direction by the inception of the World Bank’s Multilateral Insurance Guarantee Agency); and (4) stimulate financial innovation (such as swaps, or secondary markets in bank credit) to produce either off-balance sheet business, or higher lending through widening of the range of potential lenders and investors, by alleviating constraints on banks or by reducing the risk of debt problems encountered by borrowing countries. These four options are considered further in Llewellyn (1986). A final option, (5), is to reverse the structural shift of the 1970s in international financial markets by increasing the absolute and relative role of the official sector. The ultimate alternative to these five options is to force more substantial balance of payments adjustment on developing countries in the absence of any feasible pressure that can be applied to surplus countries. The key issue becomes the level of real income and output at which such adjustment can in practice be made.

Future Reform

The issues concerned with the future reform of the international monetary system are considered by Tsoukalis in this volume and were being discussed by the mid-1980s. In both the U.S. Congress and the British Parliament, hearings were held on various aspects of the operation of international monetary arrangements. In 1982, at the Summit meeting in Versailles, France attempted to place international monetary reform firmly on the active agenda. In 1983 the Group of Ten established a working party to consider various aspects of reform and the group was scheduled to report by late 1985. During 1985 even the United States seemed at times to be more prepared to consider aspects of reform.

Concern with the operation of international monetary arrangements had, by 1985, focused upon four main related issues: (1) the operation of floating exchange rates; (2) the overvaluation of the U.S. dollar; (3) symptoms of lack of coordination of macroeconomic policy and the role of the Fund in international surveillance; and (4) the international debt position.

Overall, floating rates have not worked as efficiently as many analysts predicted they would. Exchange rates have frequently been volatile, and there is substantial evidence of short-run overshooting of longer-run equilibrium values. There is a dearth of speculators prepared to take a longer-term view on equilibrium exchange rates which, in itself, introduces unwarranted volatility that can have adverse economic and trading effects. It is also apparent that, in practice, floating rates have not conferred a high degree of policy independence. They have not enabled governments to pursue domestic objectives exclusively while ignoring external considerations (Maynard, 1978). Neither is it reasonable to suppose that floating rates could totally insulate economies from external disturbances (Bryant, 1980).

Part of the observed volatility of floating exchange rates is associated with the short-run dominance of exchange markets by transactions in financial assets. This is to be expected, given that markets in financial assets are well organized, information is disseminated and absorbed quickly, speculative gains can be made rapidly, and, in general, transaction costs are low. It also means that expectations have a powerful impact on exchange rates and tend to further accentuate volatility, not because speculators are irrational or perverse, but because they respond quickly to “news” that may have its final impact only in the long run. One of the features of the exchange markets during the 1970s was that for major countries, financial, as opposed to trade, transactions became increasingly dominant. Increasingly, current account positions were determined by the exchange rate effect of financial and capital account transactions. A distinction should be made between volatility and misalignment. The evidence suggests that the former is not a particularly serious problem, given that there are markets through which the uncertainty associated with volatile spot rates can be removed. Long periods of misalignment producing, for instance, sustained and substantial current account imbalances are more serious and became an issue of concern to governments in the 1980s.

By the mid-1980s, a general reappraisal of the regime of floating exchange rates was being made, though there was no serious official argument that the system would, or could, be substantially modified. The debate was centering upon the viability of various forms of official, and perhaps coordinated, market intervention to moderate fluctuations and to prevent serious misalignment. A consensus was emerging that sterilized intervention was not effective in influencing the exchange rate, but that there was a role for nonsterilized intervention.

This issue was given particular focus by movements in the U.S. dollar and the substantial current account deficit of the United States, associated with the strong rise in the real effective exchange rate of the currency. (The associated external debt position of the United States was noted earlier.) The parallel with the position in the late 1960s and early 1970s was powerful. In both periods, concern focused upon the overvaluation of the dollar which had, in the earlier period, induced President Nixon to suspend the convertibility of the dollar and threaten an import surcharge. This was one of the major proximate causes of the final abandonment of the Bretton Woods arrangements. The issue has arisen as to whether a “dollar crisis” might again be a spur to monetary reform, since the position of the dollar was once again the focus of concern about the durability of current monetary arrangements, and that both periods followed phases of benign neglect by the U.S. authorities. In the 1970s, the U.S. authorities were concerned at trends in the balance of payments, but believed there were few adjustments they themselves could take. In particular, given the central position of the dollar in the international monetary system, they felt powerless to alter the exchange rate. The threat of an import surcharge in 1971 was designed to force other countries to engineer the required devaluation of the dollar.

This, in turn, was linked to the third issue of concern noted earlier. Analysis suggested that the overvaluation of the dollar was associated with the fiscal-monetary policy mix of the United States—its large budget deficit and tight monetary policy. The United States came under pressure to reduce its deficit to help lower interest rates (both domestically and elsewhere) and hence correct the overvaluation of the dollar. One concern raised was that, given that the United States had provided a major stimulus to economic expansion in other countries, partly through its fiscal policy, a significant cut in its budget deficit would impose a deflationary bias in the world economy. The United States itself was pressing for a more expansionary stance, particularly with respect to fiscal policy, in Europe and Japan to avoid a significant net deflationary bias. The issue of policy coordination surfaced once again, though the European and Japanese governments were not sympathetic, partly for reasons indicated earlier.

The question of the external debt position of developing countries was never far from the surface in public discussion in the early 1980s, and this came to be related to the other issues under discussion. While the debt problems that arose in 1982 had been handled in a series of piecemeal renegotiations, there remained the question of the durability of the arrangements and their longer-run acceptability given the cost that renegotiations had imposed on some of the debtor countries. A link with the other issues also existed; while lower U.S. interest rates would ease the debt-servicing commitments of debtor countries, if this were to be engineered via a lower U.S. budget deficit and consequential moderation in the pace of U.S. economic expansion it was not clear that debtor countries would be net gainers.

These considerations were the focus of concern, particularly in 1984 and 1985. While reform was being considered for the same reasons as noted earlier, there was no expectation of any new Grand Design, with only France seeming to be in favor of a new international monetary conference. Nevertheless, the issue was alive for the first time in many years. The 1985 Summit Conference gave some support to an enhanced role for the Fund in the surveillance of the policy stance of developed countries. To put it no higher, signs were emerging that governments might be edging toward arrangements that would imply somewhat more managed international monetary arrangements than implied in the ethos of the 1970s.


Susan Strange

As an introductory overview of recent change and innovation in the international monetary system, Llewellyn’s paper covers a great deal of ground in a small compass and offers many good points of departure for discussion. Its main weakness, to my mind, is that it leaves too much of the political blood and guts, the who-wins and who-loses, out of the story. It suffers from an inhibition, prompted perhaps by a wish to avoid partisanship, against critical judgment. This leaves the reader under the impression that whatever has happened was somehow predetermined and inevitable. Thus, there is something of a mismatch between his main theme of the shift from the 1960s’ system dominated by governments to the 1980s’ system dominated by markets and private operators, and the admission that the United States, though it was responding exclusively to domestic considerations, nevertheless continued to exert a degree of hegemony on the global system as in practice it had under earlier arrangements.

The emphasis Llewellyn gives to the role of banks and the importance of their financial innovations in determining the strengths and weaknesses of the system is very proper—though he fails to stress sufficiently (in my view) the profit motive behind their operations and the substantial benefits derived from them. The big banks—perhaps for the first time in history—have made profits out of an inflationary boom and, with a few exceptions, have made even greater profits from the rescheduling necessitated by a deflationary slump. Curiously, Llewellyn’s sharp appreciation of the private side of the authority-market nexus is not reflected in his opening list of five major issues (p. 18). This leaves out the important issue of who controls the creation of credit. In any monetary system this must be a crucial political question. It is especially so in a global system such as ours in which capital has become so transnationally mobile. For it is the lack of control and the abuse of authority which is surely primarily responsible for the “marked shortage of long maturity finance to match the gestation periods of development projects” (p. 36), which he correctly identifies as a major deficiency of the system.

Though Llewellyn is too polite to say so, the economic experts come out of his survey of change as poor prophets—wrongly predicting greater stability under a floating exchange rate system (International Monetary Fund, 1984), and wrongly forecasting the emergence of trade blocs and progressively shrinking world trade as a consequence of some tendencies to protectionism (Nowzad, 1978; Strange, 1985; GATT, 1984). This suggests to me that the Fund’s preference for recruiting narrowly qualified economic technicians is in urgent need of revision. For they are not only apt to be mistaken in judgment, they are also naively prone to assume that when politicians adopt the experts’ cherished ideas or pet nostrums, they have been convinced by the objective logic of the argument. The truth is more often that the politicians are shrewdly making use of such ideas to legitimize policies that best suit domestic electoral or foreign policy ends. This is why some caution should be exercised in approaching such technically beguiling “solutions” as the coordination of monetary policy (referred to on p. 18) between major national economies. In recent history this has already proved in practice either to be totally impractical in view of the political implications or else to mean that the United States is free to do as it pleases while the Germans and the Japanese do as the United States tells them. To a political realist like myself, there is no reason to think that it would mean anything else in the future—unless, of course, united and determined efforts were to be made by the whole European Community to bargain more effectively with the United States.


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Mr. Llewellyn is Professor of Money and Banking and Head of the Department of Economics at Loughborough University in the United Kingdom. He would like to record his gratitude for very helpful comments on an earlier draft by David Folkerts-Landau, Colm Kearney, Pen Kent, Bahram Nowzad, Susan Strange, Chris Taylor, Brian Tew, and John Williamson. The usual disclaimer is entered.