International Monetary System

Author: Bhaskar Chitraju
International Monetary System

In my opinion, the modern international monetary system began with the dissolution of the gold standard and the adoption of Bretton Woods System. Prior to 1914, gold was the underlying instrument through which international trade occurred. Historically gold and silver were seen as valuable commodities which had perceived intrinsic values. Since accumulation of gold was seen as increase in wealth, it was only fitting that countries saw gold as an instrument through which to conduct international trade. Since constant carrying of gold to conduct financial transactions were inconvenient, countries pegged their currencies to gold, which allowed the holders of a currency to convert it or exchange it for its face value in gold. Gold standard allowed companies to engage in international commerce more efficiently as it allowed corporations to readily convert their local currencies to foreign currencies. For example, a company in United States wishing to open a factory in Great Britain could convert U.S. dollars to gold and then use the gold proceeds to buy British pound sterling or it could trade US dollars for an equivalent value of British pounds.

The advent of First World War, forced many European Nations to increase spending to finance the war. Since the currencies were pegged to gold, any increase in monetary supply would have to be backed by gold. Since gold is a rare and a valuable commodity with a finite supply, any large increase in runaway printing of money would have to be backed by gold - which wasn't possible. Countries like Britain suspended the convertibility of their currency to gold. Now without being restricted by gold standard, Britain and other European nations printed money in large amounts to finance the war which caused increase inflation. After the war concluded, Britain brought back gold standard but to prewar time prices. The inflation severely depreciated the real market value of sterling pound compared to gold. Since the pound sterling was not allowed to depreciate to its true market value, British goods priced themselves out of competition which further increased unemployment rate. In my opinion the high inflation rate (unrealistically high asset pricing which led to stock market crash), unemployment rate, and loss of confidence among investors and people (currency not being able to converted to gold), caused people to panic which led to bank runs and eventually caused the Great Depression. Countries began to abandon the gold standard as they were no longer able to back their currencies with gold, thereby leading to collapse of international monetary system.

The failure of gold standard led 44 nations to meet in New Hampshire in 1944 and implement a new system that would bring back faith to the international monetary system and allow for greater commerce among nations. The new system was called Bretton Woods System under which the US dollar would be the only currency that would be convertible to gold, and other currencies would fix the value of their currencies in terms of gold, and decided how their currencies would be priced against the U.S. dollar. For example, France could decide that 70 Francs were equal to 1 ounce of gold, which was in turn equal to 35 US dollars. So, a Frenchman wishing to convert his francs to gold could exchange his 70 francs for 35 USD, and then demand the US government to provide him with 1 ounce of gold. I believe the US dollar was chosen to be the only currency to be convertible to gold because it was the country that came out strongest economically after World War II, thus positioning its currency as the stable currency through which international business could be conducted. Since the Bretton Woods system institutionalized the use of U.S. dollar as the only currency that could be converted to gold, the US dollar became the de-facto world currency or a reserve currency. In addition to the establishment of a fixed exchange rate system, the Bretton Woods conference also led to the creation of International Monetary Fund and International Bank of Reconstruction and Development (also known as World Bank).

Bretton Woods System worked well until late 1960s when the US government increased spending to finance Vietnam War and welfare programs. As in World War I, the increased spending caused increased inflation which in turn caused downward pressure on US dollar. The increased spending stimulated the economy, and people began to spend more, which resulted in increased imports in addition to high inflation. For the first time since 1945, U.S. showed a trade deficit in 1971, and caused investors and speculators to believe that the U.S. currency would have to be devalued against other currencies. Since the US currency was fixed with gold and real value of US dollar was perceived to be lower than its exchange rate, countries demanded gold instead of US dollars. This caused gold outflow and a perception that US would no longer able to back its currency by gold. German Bundesbank (Central Bank) for example attempted to shore up US dollar by purchasing the currency but gave up due to repeated speculative attacks and "floated" its currency against the dollar. Separately, a higher US dollar also meant that the US wouldn't be able to maintain its competitiveness which would further widen the trade deficits. The US government under Nixon imposed a 10% import tax which effective nullified any possible advantages other countries could derive through incorrect dollar pricings. This forced other nations to agree to devaluation of the US dollar, and the eventual signing of Smithsonian agreement in New York which disbanded the fixed exchange rate system. The Smithsonian agreement was signed in1971 by the Group of 10 (United States, United Kingdom, Switzerland, Sweden, Netherlands, Japan, Italy, Germany, France, Canada, and Belgium). Smithsonian agreement led to appreciation of the currencies of Group of 10 in relation to US dollar.

With fixed exchange system disbanded, IMF members met to reform the international monetary system and agreed to allow floating of currencies. In addition to floating of currencies, gold was abandoned as a reserve asset. This effectively allowed currencies to trade according to economic conditions and supply and demand. The disbanding of gold standard and the floatation of monetary system let to fiat money, where currency didn't derive its value from a commodity but rather through its perceived value. The immediate result of this was that countries were completely free to set up their monetary policy, who were earlier restricted as they were forced to maintain their parity in a fixed exchange rate system.

After the floating of currencies against US dollar, the USD derived its value from the strengths of the US economy which increased due to strong economic growth and heavy inflows of cash (FDI and Portfolio Investments) from abroad as investors believed that the US had a better investment climate than Europe. Along with already established use of US currency as the de-facto reserve, and the decreased supply of USD led to appreciating of its value. The appreciating of US dollar made US uncompetitive and led to increased calls for protectionism. This caused the Group of 5 (Great Britain, Japan, West Germany, France, and US) to meet in Plaza Hotel in New York and to devalue the USD in a phased manner. One of the increased reasons for the protectionism was that the Japanese goods were making huge inroads in the American market, and putting American industries at a competitive disadvantage. What I am surprised is that fact that Japan agreed to appreciation of its currency even though such an increase would have jeopardized its economy by putting its export oriented industries in peril.

The Plaza agreement was successful in devaluing the US currency and reduced the US trade deficit. After the desired USD rate was reached, the G-5 met again in Louvre and agreed to halt the further decline of the USD and maintain the exchange rate at those levels by buying and selling the currency - essentially managing the float or dirty float.

Fixed exchange rate system has numerous benefits associated with it, and in my opinion the biggest beneficiary of this system would be corporations who don't have to worry about currency risk. Fixed exchange system would allow corporations to only concern themselves with activities that would increase their core competencies and not engage significant amount of resources planning for currency risk management. For example if Ford were interested in building a factory in India, it would have to spend significant amount of resources considering possible consequences of abrupt rise in Indian rupee over the course of next 5 years, and how it would affect the profitability of the company. If the primary reason for investing in a Greenfield project in India was to derive benefits due to lower costs, any appreciation in Indian rupee value would seriously jeopardize Ford's future plans. If a fixed exchange rate were to be in place, Ford would be able to accurately carry out capital budgeting plans and plan its investments accordingly without having to face any surprises.

Another advantage of a fixed exchange rate system is that there is a limited amount of money in circulation; this would prevent countries from manipulating their currencies to derive political benefits or spend money in grandiose projects that might not be very beneficial to the nation. For example, a government in a certain country might try to have its central bank lower its interest rates before elections to appease its populace and thereby retaining power. In other case, a nation might implement large scale national projects that might have seemingly no benefit or encourage private corporations to engage in large scale infrastructure building by borrowing money that would not have been possible had fixed exchange rate system was in place. These large scale borrowings could increase inflationary pressures including hyperinflation, unrealistically high asset pricing which could lead to bubbles, possible default on loans if the currency suddenly depreciated significantly, and if currency does depreciate it could lead to bank closures, financial crisis, and recession.

A fixed exchange rate system would also reduce speculation which I believe partly led to the Asian financial crisis in 1997 and Mexican currency crisis of 1995. Speculation in a floatation system I believe leads to self-fulfilled prophecies, which can be avoided in fixed exchange rate system. For example, the Mexican currency crisis could have possibly been avoided had speculation not driven peso value by 40%. Due to increased public and private sector debt, and the country's ballooning trade deficit, speculators bet that Mexico would be forced to revalue its currency currently pegged against the USD. Investors starting dumping pesos, and speculators started attacking the currency by shorting it, which further drove peso down. If it wasn't for the intervention by the IMF and the US government, peso would have been under free fall; thereby fulfilling speculators belief that peso would have been devalued.

I do not see merits in an entirely freely floating exchange system. I believe the key benefits of a freely floating exchange are readily available in a managed float. Floating exchange rates allow countries to set interest rates and take control of the monetary policy of their country and utilize it in a way that would suit their economic conditions. If there is an increased inflation, countries would be able to increase the interest rates and adjust the flow of the currency circulating thereby bringing inflation down. Any change in value of the currency would be immediately reflected in foreign exchange market thereby freeing up resources that would have instead been utilized to meet exchange rate parity.

Although, I believe the fixed exchange system has its many benefits, the managed floating system (the dirty float) is probably the best system for the modern financial system. Countries can "customize" their monetary policy in response to economic conditions affecting their country. For example, in a fixed control system, countries have less control over their monetary policies. If South Korea is going through a recession, it wouldn't be able to engage in large scale public projects that could possibly stimulate the economy as it would have only a limited supply of currency in circulation (if the currency was back by gold). In a floating exchange system, South Korea could theoretically print large amounts of money to fund infrastructure projects without having to worry about maintain a parity with foreign currencies or have enough gold in its reserves to back expanded monetary supply. Even though there are risks associated with managed floating currency, including, inflation, speculation, manipulation by governments to make their exports competitive, or to appease their citizens to win political favors, the advantages associated with being able to freely engage in a monetary policy in a floating exchange system outweighs the risks and benefits of fixed exchange system.

As mentioned numerous times earlier, large financial crisis were created and later resolved through the intervention of national governments and international institutions. The pricing of gold in relation to British pound sterling, inflationary pressures causing downward pressure on USD, and the involvement of IMF in Asian Financial Crisis and the Mexican Currency Crisis are all examples where financial institutions benefitted the international monetary system or forced it into disarray. I do believe governments and financial institutions like IMF need to be involved in maintaining a stable financial system. The unregulated financial industry which caused a meltdown of global financial industry is an example of the need for the involvement of government in regulating financial industry and the monetary system at large. Although I believe countries should manage currencies, I do not believe national governments should engage in manipulating their currencies to maintain competitive advantage through foreign exchange pricing discrepancy. Although managing of the currency is acceptable to maintain a stable system that should not extend to maintaining of the currency at artificially lower prices. IMF or other supra-national financial institution needs to be created that could punish the offending nation or have a similar system to WTO, where if a country implements an unfair tariff or subsidy, WTO would allow the complainant to retaliate against the offending nation. A similar system could be implemented in the financial system to stop countries from manipulating their currencies. Looking forward, any reforms to the international monetary system must also involve increased participation of emerging economies, especially in the decision making of the World Bank and the International Monetary Fund.