THE FIRST SECTION OF THIS PAPER surveys the main developments that have taken place in the international monetary system since the early 1970s. The abandonment of fixed exchange rates and the partial privatization of the creation of international liquidity represent a clear shift to the market and a negation of the postwar idea of a collectively managed system with tight official control over financial markets.
THE FIRST SECTION OF THIS PAPER surveys the main developments that have taken place in the international monetary system since the early 1970s. The abandonment of fixed exchange rates and the partial privatization of the creation of international liquidity represent a clear shift to the market and a negation of the postwar idea of a collectively managed system with tight official control over financial markets.
The second section draws up a provisional balance sheet of the changes introduced during the previous decade and touches upon some of the links between international money and the real economy. It examines the experience of floating exchange rates as well as the effects of short-term volatility and the persistent misalignment of currencies. It then discusses the relationship between floating rates and the autonomy of national monetary policies. The role of international banks in balance of payments financing, the outbreak of the debt crisis, and the heavy adjustment burden imposed on many developing countries are also examined. The emphasis is clearly placed on the growing costs and deficiencies of the new “system.”
Although a major monetary reform exercise a la Bretton Woods is deemed to be politically infeasible and also perhaps counterproductive, a process of gradual adaptation of existing arrangements is advocated in the third section. The objective would be to bring about some form of collective management that corresponds better than the current arrangements to the present level of international financial interdependence. This adaptation is discussed with respect to the management of exchange rates and the coordination of macroeconomic policies as well as the role of the International Monetary Fund in the process of adjustment. In view of the slowness of many Western industrialized countries, and especially the United States, to move along this road, crises in the system may eventually play the role of catalyst for reform.
The New “System”
The international monetary system was radically transformed during the 1970s. The first important turning point came in August 1971 when the U.S. Administration unilaterally decided to end the convertibility of the U.S. dollar into gold, which had been one of the main pillars of the postwar system. This convertibility had, in fact, for some years before 1971 been largely a myth; it was able to survive only so long as the main holders of dollar assets refrained from exercising their formal right to demand convertibility into gold.
The suspension of dollar-gold convertibility led to the de facto establishment of a dollar standard. Despite long periods of weakness of the U.S. currency and the high degree of volatility of exchange rates, invoicing practices in international trade and the asset composition of commercial and central banks have shown remarkably little shift to other national currencies or composite units. Some diversification away from the dollar has taken place, especially toward the deutsche mark and to a lesser extent the yen, establishing the elements of what can be called a multiple currency standard. However, this diversification has been limited, and the dollar still remains by far the most important international unit of account, means of payment, and store of value. The process of diversification was, in fact, reversed during the recent period of strength of the U.S. currency that was at least partly associated with high nominal and real interest rates.
Gold was finally demonetized under the Second Amendment of the Fund’s Articles of Agreement after a long and often acrimonious debate, in which the U.S. and France played as usual the role of protagonists. But gold has not disappeared from the scene. It has remained stored in the vaults of central banks which have been extremely reluctant to use it, except in extremis as collateral, for balance of payments financing. In some respects, gold can be regarded as an asset of last resort.
Fixed exchange rates, the other main pillar of the Bretton Woods System, were abandoned in March 1973, when most of the major currencies were floated against each other. What was presented at the time as a temporary expedient, with governments giving in to market pressures, was finally legalized in Jamaica in 1976 and was later incorporated in the Fund’s Articles of Agreement. Floating was now legal, as was, in fact, any exchange rate system that a member country cared to choose. The legalization of floating was, however, accompanied by a recognition of the need for at least a minimum degree of management of exchange rates and for the joint supervision of the policies pursued by member countries that might directly or indirectly influence exchange rates. This led to the surveillance function being entrusted to the Fund.
Another important qualitative change that took place in the 1970s (but that, unlike the other two changes already mentioned, did not require any rewriting of the rules) was the partial privatization of the creation of international liquidity. This happened through the large-scale financing of balance of payments deficits that followed the 1973 oil price rise. The growth of international credit and capital markets, which developed outside the control of national authorities, had started much earlier. But 1973 was the turning point of a new era of exponential growth. This has had a major effect on international monetary and trade relations. The role of international banking dramatically changed, at least during the second half of the 1970s, the trade-off between adjustment and financing of payments deficits. During the same period it also contributed to the explosion of international liquidity, which became more endogenous.
Although the international monetary system was radically transformed in the 1970s, some observers would still refuse to talk in terms of a breakdown of the postwar order, because of the survival of some important elements that constituted the original Bretton Woods System. Market convertibility remained, and in many industrialized countries it was extended to capital transactions. On the other hand, some form of multilateral management of the System was preserved, although the role played by the Fund and international cooperation in general were inevitably affected by the change of the exchange rate regime and developments in international banking.
With the abandonment of fixed exchange rates and the lack of any clear rules governing the floating system, the Fund lost an important function. The concrete effects of its surveillance role over the exchange rates of the major currencies are not easily discernible. With very limited resources to deal with the recycling problem of oil surpluses, which was mainly taken care of by the commercial banks, the Fund was allowed to play only a limited role in the mid- and late 1970s. In recent years, however, as the international debt crisis developed and private bankers began to get cold feet, the situation has changed once again. More and more countries have been forced to resort to the Fund’s conditional finance. Agreement with the Fund came to be seen increasingly as a precondition for further bank loans to countries trying to cope with the servicing of their external debt. The Fund also played a crucial role in complex debt rescheduling negotiations that involved the governments of debtor and indirectly also of creditor countries and the central banks from both sides, as well as a host of international banks.
With the advent of floating exchange rates, international economic policy coordination was seen by some countries as having lost much of its raison d’être. After all, floating rates were introduced mainly because of their promise to restore the autonomy of national monetary policies. But as the contradiction between international financial interdependence and national monetary sovereignty, irrespective of exchange rate regimes, became increasingly apparent, interest in international coordination of national macroeconomic policies has resurfaced.
The Bretton Woods conference of 1944 had produced a set of basic rules intended to provide the framework for monetary relations among sovereign countries. These rules were a form of written constitution, and the Fund was designed to ensure their day-to-day application. The common rules agreed were neither comprehensive nor inflexible and, as with any written constitution, their interpretation and application were to a large extent a function of the objective needs and the prevailing balance of power in the system itself.
The Bretton Woods System was an integral and indeed absolutely crucial part of the postwar effort, led by the United States, to liberalize international economic relations on a multilateral basis. Yet it was also built on a clear assumption that, as regards monetary affairs, the invisible hand of the market had to be firmly guided by national public authorities and international institutions. Monetary systems in the past had developed in a more spontaneous and gradual way; Bretton Woods, on the contrary, signified a conscious attempt to design a new international system which would remain under collective management.
The developments of the last ten years or so have brought about a clear shift to the market. The new system, and it is probably a question of semantics whether the current set of arrangements can be described as a system, has loose rules regarding exchange rate adjustment, and the creation of international liquidity and reserve assets. It constitutes, therefore, a conscious, or unconscious, negation of the postwar idea of a collectively managed system with a tight official control over markets.
This shift to the market may be seen to a large extent as an inevitable outcome of the increasing complexity of international monetary relations and the growing liberalization of trade and capital movements. But it has also been the result of the inability of the major countries to agree among themselves about new forms of collective management that would take those changes into account. The reform negotiations in the Committee on Reform of the International Monetary Systems and Related Issues (the Committee of Twenty) between 1972 and 1974 showed widely diverging interests among the main participants. And this was, after all, the main cause of failure of these negotiations, with the “oil shock” only delivering the final blow. In fact, many countries saw important advantages in the new “system,” mainly in the form of increased national monetary autonomy. The partial dismantling of the Bretton Woods edifice also reflected the collapse of the postwar ideological consensus that was based on the Keynesian paradigm. The new system, as it gradually emerged, partly by design and partly by default, was as much a reflection of economic reality as it was of a new international political environment characterized by a wide divergence of perceived interests and policies, as well as growing nationalism. The new economic orthodoxy, under the general label of monetarism, provided an intellectual justification for the main changes in the system.
A Provisional Balance Sheet
The emergence of the new international monetary “system” coincided with dramatic changes in the world economic environment. The 1970s marked the end of the postwar economic miracle: growth decelerated rapidly, together with investment ratios and productivity rates, mass unemployment reappeared, and inflation galloped. The era of cheap energy also came to an end, and a very abrupt end indeed as manifested by the first and then the second oil shock. Meanwhile, tension and open conflict in international economic relations escalated while the importance attached to cooperative solutions drastically diminished.
The obvious question arises about the cause and effect relationship between changes in the international monetary system and world economic developments in the 1970s and early 1980s. The question is crucial, but has no generally accepted answer among economists. Triffin (1984), for example, considers the changes that took place in the international monetary system as an important contributor to the economic recession of the past decade. He does, in fact, go even further by arguing that “world-wide recessions as well as inflations have always been linked to the breakdown of the monetary system.” But Triffin seems to be in a minority; most observers tend to concentrate mainly on nonmonetary factors and often treat money just as an epiphenomenon (see Strange, 1985).
Was the new international monetary system the best that could be achieved under the political and economic circumstances, and what were the consequences of the changes introduced in the earlier part of the previous decade? Any general observations about the overall efficiency of the system, partial though they may inevitably be, should be complemented by an analysis of the distributional impact of the changes introduced. Like most other economic situations, this has led to winners and losers. Clearly, the experience of a New York banker should be substantially different from that of an industrial worker in Sao Paulo or a peasant in Sudan. All three have been directly affected by post-1973 developments in the international monetary system. Distributional issues are, after all, the bread and butter of politics, and this is what largely determines changes in the system itself.
Floating exchange rates have been usually presented as the inevitable outcome of growing inflation (itself unrelated to international monetary developments?), and the divergence of economic policies among the main partners. The big balance of payments disequilibria that followed the first oil shock and the need to recycle large amounts of petrodollars have been seen as adding considerably to the inevitability of floating. Under those circumstances, any attempt to stick to the previous system would have created chaos in exchange markets and serious tension between countries, with long periods of misalignment of exchange rates and pressures for trade protectionism resulting. Thus, floating rates could be seen as a damage-limitation exercise, with government policies and the international political and economic environment taken as given. Such a minimalist approach would probably command wide support among policymakers and professional economists.
The “inevitability” or “the best of all possible worlds” argument was not the only one on which floating exchange rates were sold. The prospectus that accompanied them, endorsed by a constantly increasing number of academic and professional economists in the late 1960s and early 1970s, was itself a good example of an aggressive and efficient market strategy—a strategy that should, after all, be expected from exponents of the return-to-the-market theory. The main selling points included the insulation of national economies from external shocks, the restoration of monetary sovereignty in a world of high mobility of international capital, coupled with the inherent stability of floating exchange rates. The evidence so far suggests that this prospectus was, to say the least, misleading. First of all, floating exchange rates have been highly volatile, and overshooting has been a regular phenomenon. We now have new theories and elaborate models to explain both the volatility and “overshooting,” but this may be little comfort to policymakers and traders. The emphasis in those new theories and models is on a process of continuous adjustment to outstanding stocks of several currencies in response to differences in nominal interest rates as well as expectations of exchange rate changes. (See, for example, Williamson, 1985.)
In addition to short-term volatility, the period of floating has been associated with strong and persistent misalignment among the major currencies, as witnessed in recent years by the overvaluation of the dollar. It is true that the concept of misalignment is itself anathema to a pure floater who tends to consider any exchange rate as “correct” since this is the price at which markets clear. But misalignment does have a meaning for those concerned with world trade and the international allocation of resources. Moreover, there is nothing surprising about the persistent misalignment of various currencies in view of the divergence of national economic policies and the multitude of factors influencing exchange rates. Trade-related transactions nowadays represent only a very small percentage of the total transactions conducted in exchange markets.
The development of interbank and futures markets has certainly provided traders with some means of dealing with the uncertainty arising from exchange rate volatility. However, those means are both costly and inadequate. A study undertaken jointly by the Fund and the General Agreement on Tariffs and Trade has expressed serious doubts on the existence of a strong causal link between exchange rate volatility and international trade (see International Monetary Fund, 1984). But such a link may be extremely difficult to isolate. On the other hand, the results obtained in a study of U.S. and German external trade suggest the existence of significant negative effects arising from volatile exchange rates (see Akhtar and Hilton, 1984). Similar results have been obtained for developing countries (see Bautista, 1980, and Rana, 1983).
If there may be doubts about the negative effects of short-term volatility, the consequences of persistent misalignment of exchange rates should be less controversial, although even more difficult to quantify. Such misalignment is associated with additional adjustment costs in tradable goods sectors and is also expected to lead to lower productive investment in these sectors, as well as to less efficient allocation of resources. Long periods of currency overvaluation have been closely associated with strong domestic protectionist pressures and this is clearly true of the United States in recent years. On the other hand, one long-term effect of exchange rate volatility and misalignment is likely to be the reduced importance of prices in international trade and the further strengthening of economic concentration, given the cost of insuring against uncertainty or the ability to spread the associated risks.
In practice, floating exchange rates have not provided governments with an all-powerful and painless medicine for balance of payments adjustment. The J-curve effect of overshooting exchange rates, low elasticities, labor market rigidities, and floating itself have turned the exchange rate into a less effective instrument than had been generally expected. Nor have floating rates eliminated or even significantly reduced the need to hold foreign reserves. And this is for the simple reason that most governments have never practiced clean floating, nor have they believed in the absolute wisdom of the market.
Expectations about more autonomy in national monetary policy had been the main factor behind the adoption of floating exchange rates in the early 1970s. Have these expectations been fulfilled? Floating rates have indeed allowed governments greater flexibility in the conduct of domestic economic policies than the previous system of fixed parities. But the difference seems to be a question of degree rather than kind. Floating rates have not provided and could not provide governments with a convenient escape from the policy dilemmas arising from external shocks or from the constraints imposed on national autonomy by international trade and financial interdependence. Many governments soon abandoned the idea of an independent monetary policy and adopted some form of exchange rate target. The importance of the exchange rate in the determination of national price levels and the international competitiveness of domestic producers has been the crucial factor behind the concern shown by governments for the exchange rate, especially in countries with relatively open economies. Moreover, if it is true that the observed instability in the income velocity of money is associated with shifts in currency portfolios, which would make sense in a world of high capital mobility, then national money supply targets lose much of their meaning (see McKinnon, 1982 and 1984).
It is interesting that despite the advent of generalized floating in March 1973, the “decoupling” of European economies from U.S. interest rates did not take place until about 1979. Only since then, and especially after especially after 1983, did substantial interest rate differentials appear between the two sides of the Atlantic, as the members of the European Monetary System (EMS) tried to resist much of the upward pressure on interest rates emanating from the United States (see Thygesen, 1986, and Micossi and Padoa-Schioppa, 1984). This was achieved at the cost of a substantial depreciation of their currencies vis-à-vis the dollar. Experience seems to suggest that the Europeans had both underestimated their own margin of manoeuver and also exaggerated the costs associated with the dollar depreciation of their currencies.
However, there still exist important structural differences that largely explain the divergence in attitudes over exchange rates and monetary policy between the Americans on the one hand and the countries of the EMS on the other. For the Europeans, the openness of their economies and the rigidity of their labor markets considerably reduce the attraction of floating rates. This is especially true when European economies behave as separate units and not as a unified bloc. For the United States, on the other hand, the international role of the dollar reduces the short-term cost of exchange rate fluctuations, and, coupled with the size and depth of domestic financial markets, it gives U.S. Administrations a degree of flexibility that no other government enjoys.
Until the end of the 1970s, the role played by international banks in the first round of petrodollar recycling was hailed by most people as a big success and another example of the efficiency and flexibility of the market. Intergovernmental cooperation, it was argued, could not have been relied upon to effect such a massive transfer of funds across frontiers so smoothly. And so efficiently, one might add. There were some doubts expressed about the long-term viability of the operation and about its equity, in view of the very limited access of many poor countries to bank finance. But these doubts clearly represented the view of a small minority.
Attitudes have changed rapidly since then, as the international debt crisis broke as a result of a combination of different factors, including the second oil shock, the ensuing deep economic recession in the industrial countries, rapidly falling commodity prices and the skyrocketing of U.S. interest rates. Since then, economists and politicians have rediscovered the problem of confidence in financial markets and the crucial role of the lender of last resort. People have also realized that banks collectively can make very serious mistakes, especially given strong official encouragement, which they certainly received in the United States and in other industrial countries, and given the belief that “countries do not go bankrupt,” which was itself based on a shocking ignorance of history. In recent years, some people in creditor countries have also learned from bitter experience that the market on its own cannot take care of the problem of international debt, if only because of its very high economic cost for society as a whole.
The international debt crisis has brought central banks, governments, and international organizations back to the center of the stage. The main objective from the point of view of creditor countries has been to avoid any formal defaults which would endanger the stability of the international financial system, given the very large accumulation of sovereign debt by the banks. The approach adopted until the time of writing has been on a case-by-case basis and is also essentially short term, although some of the more recent reschedulings may suggest the growing realization of the need for a longer-term solution to the problem. The means employed to deal with the debt crisis have included the provision of finance through the Fund, tied to domestic adjustment measures in the debtor countries; the granting of new, often “involuntary,” loans by the banks under Fund supervision; and the rescheduling, usually on a short-term basis, of the debts.
The approach adopted by the creditor countries and international organizations such as the Fund and the Bank for International Settlements (BIS) has been based on the assumption that the debt crisis is essentially a problem of illiquidity and not insolvency as regards the majority of heavily indebted countries (see Cline, 1983). This, plus the usual desire of creditors to exert maximum leverage and pressure on the debtors, is the main justification for the short-term, case-by-case approach adopted. The costs of this approach as well as the inherent dangers are very obvious (an alternative approach is discussed in Commonwealth Secretariat, 1984). Strong deflationary measures have been forced upon many developing countries in order to attain, often with the aid of extensive import controls, the required surpluses in external trade accounts. These measures have already had a considerable negative effect on present consumption and production levels and also on the future productive capacity of those countries. The medicine offered to indebted countries in the developing world is very bitter, and does not promise to produce quick results. This is especially true if some of the optimistic assumptions regarding economic growth in the industrial countries, international trade and interest rates, on which the success of the therapy lies, do not materialize. Industrial workers and farmers in many developing countries have been asked to pay a heavy price for mistakes previously committed jointly by Western banks and usually unrepresentative governments. (These mistakes have, however, brought considerable gains to the international banking community and to some of the better-off groups of their own societies.) Moreover, prolonged austerity programs in countries where the standard of living for the large majority of the population is already very low contain the seeds of social revolt. Such a development would have major implications, not only for the political system of indebted countries but also for the policy adopted vis-à-vis the creditors. (The Baker plan put forward in October 1985 constitutes itself a recognition of the inadequacy and the inherent dangers of the approach adopted until then.)
Although there is clear evidence of irresponsible lending by banks, the size and timing of the international debt crisis of the early 1980s are closely related to the macroeconomic and trade policies pursued by the major industrialized countries. The high interest rates and the stagnation of international trade of the earlier part of this decade cannot be considered exogenous variables in the context of a highly interdependent world economy. The fallacy of the “own house in order” argument and the real cost to the world economy of the lack of effective coordination of national macroeconomic policies became increasingly evident in the 1980s, especially because of the international repercussions of the U.S. policy mix (or mismatch). Even during 1983–84 when the U.S. economy acted as a locomotive pulling the rest of the world out of the recession, the positive effect on the exports of heavily indebted countries was surely at least partly offset by the negative effect of high interest rates. Moreover, the emergence of one of the richest and most capitalized countries in the world as a net external debtor, soon to become the world’s biggest debtor, is not a good sign for the international economy. U.S. policies are singled out for no other reason than their disproportionate influence on the rest of the world. Asymmetries did not disappear under the new “system.” They were accentuated.
As time passed, the costs and deficiencies of the new system have grown, or at least they have become more apparent. There is now some real experience with floating exchange rates and the results fall far short of expectations. The role of private banks in balance of payments financing has not proved to be an unmitigated success, and the stakes are very high indeed. Crude monetarism and mechanical rules have been seen not to work in societies with open and mixed economies and highly complex structures; and the chacun pour soi principle applied to national economic policy has been in open contradiction with the degree of international economic interdependence already reached. If, therefore, the existing arrangements are deemed to-be inadequate, what are the prospects for reform in the foreseeable future?
Prospects for Reform
Dissatisfaction with the new system has eventually led to calls for international monetary reform. References have been made to a new Bretton Woods conference and the subject has appeared in the regular summits of the leading industrialized countries.
Calls for reform are almost invariably based on the premise that money cannot manage itself or, to put it differently, that markets cannot reconcile that which is not deliberately coordinated. It is certainly not a question of black and white. Thus, without denying the scope for measures to improve the functioning of markets, it can be argued that any reform would inevitably involve an attempt to restore some form of collective management and official control in international monetary affairs. It would thus imply at least a partial reversal of the shift to the market evidenced in the 1970s and reflected in the Second Amendment of the Fund’s Articles of Agreement. A few timid steps in this direction were already taken in the first half of the 1980s in response to the international debt crisis.
However, in the present economic and political environment, any attempt to draft a new monetary constitution following the example of the Bretton Woods conference would be politically infeasible and also in some respects counterproductive. The Bretton Woods conference has been described as a meeting of “one and a half countries. Power is now much more dispersed. Although large asymmetries still exist, there are quite a few countries or groups of countries with strong views on particular issues that are ready to exercise their veto power. Despite growing dissatisfaction with the status quo, large differences of attitudes and perceived interests still exist. The calls for international monetary reform have usually come from Paris or from meetings of developing countries; there is still remarkably little interest in a comprehensive monetary reform among the majority of industrialized countries. As for the United States, whose role in this respect is absoutely crucial, the apparent and rather belated conversion of some policymakers to the idea of a new monetary order still needs to be translated into concrete proposals and then, perhaps, official action.
Short of a major breakdown or a dramatic change in the international environment, it is extremely difficult to envisage a new monetary constitution with fairly detailed and comprehensive rules based on a broad consensus reached in an international negotiation. The experience of the Committee of Twenty is hardly encouraging and it may be quite a few years before a new attempt is made in this direction.
Power is not only more dispersed among countries; private institutions have also become important actors in their own right, especially the international banks. National and international official institutions have gradually lost their tight control over financial markets. Thus, international monetary relations may no longer be amenable to simple or rigid rules.
Alexandre Lamfalussy (Assistant General Manager of the BIS) has warned against “succumbing to two opposite temptations”—a return to complete ad hocery or to a world of rigid rules. The road to follow, in his view, “is somewhere in between: rules applied with a pragmatic sense of discretion” (see International Monetary Fund, 1985; a similar approach is advocated by Padoa-Schioppa, 1985). The argument in favor of international cooperation based on more discretion and stronger central institutions has a great deal of appeal in a highly complex multi-country economy. In this perspective, monetary reform would not be the product of a particular international negotiation leading to the adoption of a new set of rules. On the contrary, it could be a gradual process based on developing patterns of cooperation, which would in turn rely on a shared perception of a common interest in collective management.
There are, however, also risks inherent in this approach. Where the rules are vague and collective management relies essentially on joint discretion, concrete decisions may be difficult to take and even more difficult to implement. This is where the role of central institutions becomes crucial in order to avoid inaction, which is a characteristic of ad hoc intergovernmental cooperation. On the other hand, rules are usually a guarantee for the weak against the abuse of power by the strong. Can collective management based on discretion rather than rules be anything more than a euphemism for one-way coordination or for the domination by one or more countries? An indirect and also incomplete answer to this question may be that any attempt to devise rules that do not reflect the balance of power in the system will be doomed to failure.
What would reform or gradual adaptation imply in specific areas of the international monetary system? Exchange rates undoubtedly provide a major focus of attention. In an attempt to reduce the excessive volatility and misalignment of exchange rates in the period of floating, various proposals have been put forward for setting up target zones for the exchange rates of the major currencies. At least in the initial experimental stages, the emphasis would be, however, on relatively wide bands of fluctuation and flexibility.
In practice, any form of joint management of exchange rates would require the participation of the United States, the EMS countries as a bloc, and Japan. It would, therefore, be strictly an affair of a small group of industrialized countries. This should, ceteris paribus, increase the chances of agreement and effective cooperation in a context in which specific rules can only be of limited use. Such an arrangement would require that all the parties concerned adopt exchange rate targets. And this should be translated into a responsibility to intervene in exchange markets in order to smooth out short-term fluctuations and, even more important, to coordinate their monetary and fiscal policies. This coordination could be either explicit or implicit, as for example suggested by McKinnon (1984), through the adoption of an exchange rate target in the conduct of monetary policy. In this respect, the Fund could also play an important role; hence the need to give more substance to the surveillance function entrusted to that institution.
The above would make a radical departure from the pattern established during the last decade. Apart from any doubts that may exist about the theoretical basis or the practical feasibility of specific proposals, the crucial question is whether the countries concerned would be prepared to accept the responsibilities and the constraints involved. The joint management of exchange rates would call for a shift in U.S. attitudes much more dramatic than anything required from the Europeans or the Japanese.
The United States has hardly ever accepted an external constraint on the conduct of its economic policies. The “own house in order” argument and the advocacy of floating rates to restore the independence of national monetary policies have, not surprisingly, found much support in the United States. Moreover, the federal system and the division of powers between the executive and the legislative branches would always constitute a major obstacle against any attempt to achieve a coordination of policies with other countries.
Growing protectionist pressures and the import leakage effects on the economy arising from the constantly increasing penetration of the domestic markets by imports, which in turn has been closely related to the long overvaluation of the dollar, finally acted as a catalyst for the U.S. Administration to rediscover the virtues of intervention and international cooperation in the macroeconomic field. A change of attitudes could also have been precipitated (or perhaps could be reinforced in the future) by a large and rapid depreciation of the dollar, because of the inflationary impact of such a depreciation and the negative effects on the international role of the U.S. currency. The “closed-economy” syndrome from which much of the American political establishment has been suffering may now be going through a process of radical transformation in view of its obvious divorce from reality.
With no major international currency of their own and with more open and highly interdependent economies, most of the Western European countries have, albeit slowly and reluctantly, accepted the constraints on national monetary autonomy. This has been the foundation stone of the EMS. The lack of any serious progress in international cooperation could eventually be a strong incentive for further financial integration at the regional level as a way of reducing Europe’s disproportionate financial dependence on the United States. One crucial step in this direction would be the strengthening of the international role of the European Currency Unit (ECU) for both commercial and financial transactions. The creation of a real multiple currency standard, which would also involve a greater role for the yen, might act eventually as a catalyst for closer and more effective cooperation among the U.S., Europe, and Japan. Greater symmetry would make international economic policy coordination more attractive to the U.S. and less one sided for the others.
There is, however, at least one other alternative to a modified exchange rate arrangement that tries to achieve flexibility with a greater degree of stability of exchange markets. If policy coordination proves to be impossible, there may be attempts to reduce interdependence through controls or a tax imposed on international capital transactions. Proposals to this effect have been made in recent years in Europe and they are likely to resurface in the future. Doubts about the practical feasibility of such proposals may in the end delay or prevent their application much more than any reservations about their intrinsic desirability.
It is no longer possible to discuss international monetary reform without reference to the problem of accumulated sovereign debt. The outbreak of the crisis in 1982 eventually brought both national and international official institutions back into the picture. Any long-term solution, the desirability or inevitability of which may eventually be accepted by governments in industrial countries, is likely to strengthen this new cooperative relationship that has developed between the private and the official banking sector, with the Fund being asked to play the role of coordinator. Official regulation of the international activities of commercial banks and the question of the lender of last resort are likely to be major issues in the next few years. The extension of the existing framework of regulations applying to Eurocurrency markets and more active supervision may be the price that private banks will have to pay for the provision of a safety net by the central banks and for the cost paid by the taxpayer as part of a long-term solution of the accumulated debt problem.
The exponential growth of international banking in the 1970s may indeed prove to have been an historical aberration, with the signs of a return to a much slower long-term trend becoming increasingly evident. The partial shift back to more traditional forms of balance of payments financing immediately raises the question of the adequacy of the Fund’s resources. The choice between adjustment and financing of balance of payments deficits can never be a purely technical question nor can there be any specific rules designed to deal with the problem. The choice will continue to be a political one, at least as regards sources of official liquidity, and therefore political decisions will need to be taken mainly about the level of the Fund’s resources as well as the conditions applying to their use. Expectations about future balance of payments deficits in the developing world suggest that there is a real danger of a serious shortage of Fund liquidity in the next few years which, unless corrected, could have major implications for the management of the debt problem, economic growth in Third World countries (not to mention the stability of their political systems), and international trade. There have recently been signs of a more positive approach being adopted on this subject by the governments of industrialized countries.
The developments of the 1970s and early 1980s have accentuated the asymmetry in the relationship between the Fund and its member countries. While the influence exercised by the Fund over the economic policies of many developing countries has considerably increased, its influence over the policies of most industrialized countries has virtually disappeared. Access to bank finance is a crucial factor, and this has added significantly to the old asymmetry between surplus and deficit countries or even between reserve currency centers and other mortals.
The important asymmetry in the international distribution of the burden of adjustment and the role that the Fund plays in it will remain a major issue in the foreseeable future. Will the Fund be able to exercise any control over the policies pursued by surplus countries or reserve currency centers? On the other hand, apart from the danger of illiquidity, there are a number of basic questions that arise regarding the Fund’s policy toward countries seeking access to balance of payments finance. These questions revolve around the issue of conditionality and refer more specifically to the effectiveness of Fund-supported adjustment programs in the past, the flexibility of the Fund in its approach to different countries as well as its political sensitivity (see Killick, 1984a and 1984b). Moreover, as the number of countries subject to the Fund’s adjustment programs increases, so will the need for the Fund to take a more global view of world economic developments in the formulation of such programs. The asymmetry in the international process of adjustment carries with it the risk of a strong deflationary bias for the world economy.
This discussion inevitably raises sensitive questions regarding the political control of the Fund and, more generally, the distribution of power in the management of the international monetary system. The Fund’s policies in the 1970s and early 1980s, as well as changes in the rules of the game and their interpretation, have essentially reflected the perceived interests and attitudes of a small group of industrialized countries, with the United States still occupying a dominant position. Some of the important decisions regarding the revision of the Articles of Agreement and the management of international monetary relations were in fact taken at summit meetings of the heads of government of the five, and later seven, leading industrialized countries of the West, or by the Group of Ten. This was no different from the pattern established in the 1960s. What is interesting, although, with the benefit of hindsight, not very surprising, is how little effect the accumulation of large oil surpluses has had on the relative influence of the new creditors in the management of the system. Making Saudi Arabia a permanent member of the Executive Board of the Fund was hardly commensurate with the financial power, albeit circumscribed by other economic and political factors, of the new creditors. This balance of power may indeed be an adequate reflection of international political realities. Yet, it will remain a serious source of friction in North-South relations.
Proposals for an effective control of official international liquidity have always been associated with the introduction of an SDR standard or a standard based on some other internationally created reserve asset. The development of a de facto dollar standard in the 1970s, coupled with the timid appearance of a few other national currencies as international reserve assets, was contrary to the opinion expressed by a large majority both of professional economists and of policymakers in the context of the Committee of Twenty in favor of moving gradually to a system based on the SDR.
Thousands of pages have been written about the inefficacy and the arbitrariness of the dollar standard or any other monetary system based on one national currency. The fledgling multiple currency standard that emerged during the 1970s may have provided an answer, albeit a highly inadequate one, to the problem of asymmetry arising from the right of seigniorage, by extending this “exorbitant privilege” of the reserve-currency country to a few others besides the United States. Meanwhile, however, this development has added a new source of instability to the system, which is likely to increase during a new period of dollar weakness as holders of the U.S. currency try to diversify their portfolios. Major crises of the U.S. currency have in the past led to a revival of the Substitution Account, which was subsequently dropped once the dollar had recovered its strength. Judging from the attitudes of major dollar holders and the views prevailing at the time of writing in Washington, such a resuscitation is unlikely when the next crisis comes about.
Official opinion seems to have become increasingly reconciled to the multiple currency standard as the one likely to prevail in the foreseeable future (see Group of Thirty, 1982a and 1982b). This reconciliation (or resignation) to a system which is generally considered to be inherently unstable is closely associated with the belief about the political infeasibility of an SDR standard. Such a standard would entail, among other things, turning the Fund into a world central bank. We are clearly very far from such supranational solutions; a shift to an SDR standard, if it ever materializes, is bound to be a very slow and gradual process. It is characteristic that in a recently published article Cooper argues that a radical reform of the international monetary system, which would include many of the changes discussed here, should be a target for the twenty-first century (see Cooper, 1984).
Here, the experience of the European Community may be of some relevance. The EMS has often been presented as an example of successful cooperation among sovereign countries intended to ensure some degree of exchange rate stability. However, despite its undeniable success, the EMS and the history of European monetary cooperation in general also show the enormous difficulties that exist in establishing an effective system of international collective management. After all, the countries in the Community have very similar political and economic structures, a high degree of economic interdependence, a long history of close cooperation, and common institutions. The EMS, as it stands at present, falls far short of the degree of cooperation assumed in some of the reform proposals referring to the international monetary system. If the Europeans are so reluctant to develop the ECU into a real international currency, why should we be more optimistic about the SDR? If the European Monetary Fund still remains a plate on a door in Luxembourg, why should the Fund be expected to assume some of the functions of a world central bank? Last but not least, if convergence of economic policies is such a slow and arduous process inside the Community, why should we expect the world’s dominant and relatively insular economy to accept any external constraints in the conduct of its economic policies?
It may indeed be true that a comprehensive reform of the international monetary system would be counterproductive in the present economic and political context. However, the central thesis of this paper has been that important changes are needed to deal with specific problems such as the volatility and misalignment of exchange rates, the large asymmetry in the distribution of the burden of adjustment, and the danger of a new international debt crisis. The gradual process of reform or adaptation of existing arrangements advocated above would be a search for a form of collective management that best corresponds to the degree of international financial interdependence already reached. The main developments in the international monetary system during the 1970s were a negation of this link between collective management and international interdependence. More recently, the pendulum has started moving in the opposite direction. The question is whether the movement will be fast enough to avoid the outbreak of new crises and the growth of the forces of nationalism and disintegration. This will essentially depend on the degree of convergence of attitudes and policies of the major countries, where the real power lies, and their willingness to give up or merge some part of their national sovereignty in terms of economic policy.
The adaptation of existing international monetary arrangements could be precipitated by at least three important events, and these could happen sooner rather than later. In September 1985 the fear of protectionism and the size of international trade imbalances finally led to concerted action undertaken by the Group of Five countries to bring about a realignment of the exchange rates of major currencies. Changes in the macroeconomic policies of the countries concerned and a more genuine acceptance of the need for international coordination may eventually follow, if public statements and exchange rate intervention prove too feeble an instrument to bring about a large but controlled decline in the dollar. The second event, closely related to the first, would be a set of measures adopted by the countries in the European Community to strengthen their collective “monetary personality” and reduce their financial dependence on the dollar. Short of global reforms, a series of regional arrangements with the EMS playing the role of pioneer could provide a second-best solution. The third event would be a new international debt crisis. As is well known, crises are often the most effective means of concentrating the minds of busy politicians.
Tsoukalis has given in his paper an excellent review of the main developments that have taken place in the international monetary system since the early 1970s. There is little that one can disagree with in his diagnosis of the issues that led to the collapse of the Bretton Woods System and his analysis of the arrangements that have since evolved in its place.
The Bretton Woods System was the intellectual and political response of the international community to the interwar international experience with currencies. The system of par values, the dollar exchange standard, the effort to provide temporary balance of payments assistance to avoid deflationary adjustment of internal economies—or in the words of the Articles, to avoid resort to “measures destructive of national and international prosperity”—were all aspects of this. The major contribution of the Bretton Woods System was its recognition that international money could not manage itself and needed an element of consultation and cooperation, if not supervision, to maintain international monetary order.
Much has happened to undermine the System in the last fifteen years. Many of the central elements of the Bretton Woods System have disappeared. The par value system is dead, as is the dollar exchange standard, and the regime of floating rates has not helped to evolve a stable monetary system and has led to considerable volatility in exchange rates and misalignment of currencies. The failure to develop the SDR has left unfulfilled another major role conceived for the International Monetary Fund—the provision of international liquidity according to the perceived needs of the international economy. Nor has the Fund been able to prevent monetary maelstroms or the pursuit of national economic policies without regard to their international consequences; indeed the floating rate system may have encouraged the independent pursuit of national economic policies. The growth of the Euromarkets and privatization of capital flows has added another major element of uncertainty and instability.
Altogether, it is clear that the Fund is not functioning as it was originally conceived. One is inclined to accept Tsoukalis’ interpretation that the events of the last few years mark a retreat from the concept of collective management of the international monetary system that was the raison d’être of the Fund. Of course, there is nothing wrong with any institution evolving with the times but the evolution of the Fund, at least given its central and original objectives as stated at Bretton Woods, has been an evolution toward irrelevance.
The universe of Bretton Woods consisted of the major industrial countries. There were hardly any developing countries represented at Bretton Woods and the arrangements that were put in place had relevance largely to the problems of industrial countries and their interrelationships. Today the overwhelming proportion of the Fund’s membership is developing countries. Barring a few notable exceptions, such as the United Kingdom and Italy, practically all the major credit transactions of the Fund in the last fifteen years have been with the developing countries. After the debt crisis that erupted in the autumn of 1982, the Fund, as Tsoukalis points out, acquired a new role and has become central to the management of international debt crises and more important than ever in disciplining developing member countries, to the point of becoming almost an arbiter of their economic destinies. The asymmetry arising out of its lack of adequate influence with regard to the major industrial countries (who still are the main actors on the international monetary stage) and its perceived incapacity to influence their policies impinging on the international economy on the one hand, and, on the other, its growing authority and power over the developing countries, are central factors in the contemporary international economic scene. The system as conceived at Bretton Woods, however, envisaged for the Fund a role even with regard to the major industrial countries.
Tsoukalis’ analysis is largely confined to the discussion of the floating rate system and the question of harmonizing the policies of the major industrial countries to avoid the type of currency misalignments and other distortions that we have been witnessing. His suggestions for moving toward target zones (for real effective exchange rates, I presume) with wide bands are in the right direction, though if the bands are very wide we may be buying flexibility at the cost of instability and misalignments. Target zones would, of course, provide signals for domestic policy management if exchange rates are not to vary widely from what Williamson calls “fundamental equilibrium.” His plea for more effective coordination of fiscal and monetary policies of the major countries is also a familiar theme and should be linked to the target zone approach, as should his suggestion regarding a greater role for and a more symmetric application of Fund surveillance. I will have something to say on the last aspect later, but let me now address what I regard as the major weakness of the existing international arrangements in relation to the developing countries.
The Purposes of the Fund’s Articles of Agreement do indeed include as one of its primary objectives “the development of productive resources of all members.” It is interesting to record that the Indian delegation to Bretton Woods had submitted alternative amendments, such as “to assist in the fuller utilization of the resources of economically backward countries” or that the Fund should pay “due regard to the needs of economically backward countries.” These amendments were, needless to say, defeated with, I believe, Ecuador being the only other country to support them. This shows how the developing countries’ problems went by default at Bretton Woods as the obsession with avoiding the mistakes of the interwar period left no room for an appreciation of the structural problems that developing countries would have to face with their balances of payments in the future. In this sense, the absence of any special consideration for the problems of the developing countries in the original Bretton Woods System must be regarded as a congenital defect of the Fund. Such a defect becomes all the more striking in view of the contemporary situation, when virtually all the financial operations of the Fund have been with the developing countries.
The inadequacy of the international monetary arrangements for handling the special problems of developing countries can be viewed in several ways. To begin with the Fund itself, a major weakness is the inadequate level of its quotas. We know how difficult it was to put in place even the modest 47.5 percent increase in quotas under the Eighth Review in 1983, and perhaps even this might not have taken place had the debt crisis not erupted in 1982. Even after the Eighth Review, the Fund’s resources are clearly inadequate in relation to the current level of international trade and payments. Nor, despite the considerable rhetoric surrounding its institution, has the SDR proved to be an even modest source for the augmentation of unconditional international liquidity.
The inadequate expansion of the Fund’s resources has coincided with, and is not unrelated to, a hardening of its conditionality. The use of the Fund’s resources to tide over balance of payments difficulties had its rationale in providing an alternative to deflationary adjustment of national economies. Yet the conditionality that now applies to upper credit tranche drawings has such an emphasis on demand management provisions and follows such a narrow monetary approach that countries are forced to accept deflationary discipline. This is all the more inappropriate given the structural characteristics of developing economies, which both make them more vulnerable than other economies to the vicissitudes of international monetary turbulence and trade disruption and less able to adjust. This reference to the structural problems of developing countries is not intended to suggest that the Fund should have a role in development finance, although one could argue that given the fungibility of funds, the distinction is not that significant and that the revolving character of Fund credit is not necessarily synonymous with short-term accommodation. I do, however, wish to point out that structural adjustment requires financial support over the medium term. The extended Fund facility (EFF) and the earlier Trust Fund for low-income countries were a welcome and positive recognition that the Fund has a role to play in alleviating the perceived structural problems of developing countries. It is a matter for regret, however, that the Trust Fund has been the victim of infant mortality and that the EFF is not operating in the manner and to the extent that was expected. The prescription of deflationary adjustment in a period of global recession has led the Fund to adopt policies that have the effect of aggravating international recession when one would more justifiably expect the institution to play an anticyclical role.
The structural vulnerability of developing countries to exogenous shocks has been demonstrated most graphically in the period following the second oil price increase. The severe deterioration in the terms of trade of the oil importing countries, the global recession that led to shrinking markets and declining export commodity prices, growing protectionist sentiments and, coinciding with these elements of basic deterioration, the decline, in real terms, of international development assistance, have all exposed the weaknesses of developing countries and their inability to withstand externally induced shocks. The debt crisis, whose immediate provocation could be traced to the sharp upswing in interest rates as a result of excessive reliance on monetary policy by, most prominently, the United States is another telling example of this. It is not that the internal policies of the developing countries have always been right. No one holds a brief for a country’s right to mismanage its internal economy and to expect the international community to come to its assistance to offset the impact. There have doubtless been cases of internal mismanagement. But the point is that the severity of the problems that have recently affected the developing countries have been many times compounded by influences over which they have had little control.
If the debt crisis has triggered a renewed and expanded role of the Fund it is, I suggest, at least as much due to the apprehensions in the major countries about the fragility of the international banking system and the implications of this fragility for the global financial system as for the particular circumstances of the debtor countries. The Fund has played a major role in keeping up the flow of commercial bank credit and has interposed itself between the beleaguered debtor countries and the bewildered banking system. In the process it has enjoined a regimen of austerity on the countries seeking its seal of approval. Unfortunately, this adjustment has taken the form of a severe curtailment of investment expenditures, cuts in wages and income, and a compression of imports. While in the short run there has been a turn-around in the external accounts of the major debtor countries, this has come about in a manner that does not appear to be sustainable as it could contain a potential for instability. Several African countries, for instance, have been affected by problems of debt servicing in the context of poor export earnings and an increase in essential imports such as food. A prescription of strict fiscal and monetary discipline with its emphasis on curtailing fiscal deficits has further retarded their growth efforts, as a good part of the investment in developing countries is in the nontradable infrastructural sectors.
It is not that an adjustment program is necessarily antithetical to growth. The Indian experience with its Fund-supported program between 1981 and 1984 is a refreshing contrast to the general pattern. Here was a case in which growth was not sacrificed at the altar of adjustment. The initial current account deficit and fiscal deficit in India were fairly low in relation to gross domestic product, at around 2.2 percent and 3.5 percent, respectively. The extent of adjustment that was necessary was smaller than in many other program countries; furthermore the adjustment itself took the form of accelerated investment in import saving sectors such as petroleum and the like. The Fund-supported program, therefore, did not call for a large reduction in the fiscal deficit and envisaged a gradual improvement in the current account. The program also benefited from India’s early approach to the Fund and the case shows perhaps the possibilities of a positive Fund response when it is approached by a country at an early stage of its payment problems when the situation has not become out of hand. There is no reason why there should not be more examples of this type.
While the Fund has thus become an important influence on the policies of developing countries that turn to it, it has failed to exercise even the modicum of influence over the strong countries with strong payments positions. Adjustment is not, as Killick points out, a unilateral process, and beyond its well-meaning remonstrations to the surplus countries for reciprocal action, the Fund has had little influence on them because it can impose no effective sanctions. The founding fathers had envisaged the need for such sanctions by inserting the Scarce Currency Clause. One is not arguing for that Clause now but the point about giving the Fund some such power needs to be explored in the interest of a more symmetrical adjustment process. Rules and sanctions would protect the weak members against the pursuit of policies by the strong that evidence disregard of their international implications, as is happening now. The developing countries would welcome a stronger Fund in this sense.
To return to Tsoukalis’ paper, I would like to express my disagreement with his observation that it is economically undesirable, in spite of the perceived inadequacies of the present system, to have a major monetary reform exercise. Tsoukalis has the view that it is both economically undesirable and politically infeasible. I believe the gradual adaptation of existing arrangements that he has pleaded for would only be a continuation of what has been happening in the last several years when we have been moving from one monetary crisis to another. In fact, the positive adaptation that seemed to take place in the 1970s has now given way to a retrogression in the manner in which the Fund has been dealing with developing countries. The period following the first oil shock witnessed a responsive reaction from the Fund and a widening of its various facilities. That was the period which marked the institution of the EFF and enlargement of the compensatory financing facility, the institution of the Trust Fund and of the supplementary financing facilities. On the other hand, in the face of the much more severe shock to the external payments of developing countries in the post-second-oil-price-increase period, there has been little evidence of such a positive response. The Trust Fund has ceased to exist. The supplementary financing facilities are not operative, there has not been much recourse to the EFF, while the facilities under the compensatory financing facility are also being constrained. The enlarged access policy is becoming a misnomer as the Fund reduced the access limits as a multiple of quotas following the enhancement of quotas under the Eighth Review. This type of reduction in access limits following an enhancement of quotas was not undertaken before and as a result nearly all low-income countries whose quota increase is less than the average will find that the absolute level of potential access to the Fund to be less now than before the quota increase.
The debt crisis has exposed the fragility of the system and I do not see how it could be argued that a major structural reform of the Fund arrangement is not desirable at the present moment on economic grounds. Indeed we need to arrest the retreat from international cooperation. Yet one could appreciate the point that the political feasibility of such a major reform is not dear. The need for a reform of the Fund arrangements should go beyond the objective of coordinated management of the internal and external economic policies of the major industrial countries and take into account the situations of the developing countries if international economic as distinct from financial interdependence is to have any meaning. A comprehensive reform rather than ad hoc or piecemeal efforts should restore, in Tsoukalis’ phrase, the idea of “collective efficient management” of international money and should be concerned with the related problems of international liquidity, symmetrical adjustment, greater order in exchange rates, and coordinated regulation of the international banking system.
That the politics of reform are difficult cannot be denied, but the question is whether we should wait for a crisis in the system to act as a catalyst for reform, as Tsoukalis seems to suggest, or whether we should anticipate developments, as did those that gathered at Bretton Woods, and initiate action on a reform of the arrangements to take into account the problems of the 1980s and beyond. The proposal for discussion of some of the structural issues at the forthcoming Interim and Development Committee meetings is in the nature of a diversionary tactic. Given the composition of the Committees and the weighted voting pattern that governs changes in policies and amendments to the Articles of the Fund, one cannot expect anything worthwhile from such a discussion. It is in this context that the developing countries have been asking for a new international monetary conference with universal participation and with a development focus.
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Dr. Tsoukalis is a Fellow of St. Antony’s College, Oxford and Director of Economic Studies at the College of Europe in Bruges, Belgium. The author is grateful to all participants at the IMF/ODI seminar at Cumberland Lodge and especially to Mr. Narasimham, who acted as discussant for his paper, for their extremely helpful comments. This paper is a modified version of a chapter in Tsoukalis, 1985.