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In this article we will discuss about the International monetary system since the end of World war II.
The Bretton Woods System:
During the period preceding World War I almost all the major national currencies were on a system of fixed exchange rates under the international gold standard. This system had to be abandoned during World War I. There were fluctuating exchange rates from the end of the War to 1925.
Efforts were made to return to the gold standard from 1925. But it collapsed with the coming of the Great Depression. Many countries resorted to protectionism and competitive devaluations—with the result that world trade was reduced to almost half. But depression completely disappeared during World War II.
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In July 1944, the allied countries met at Bretton Woods in the USA to avoid the rigidity of the gold standard and the chaos of the 1930s in international trade and finance and to encourage free trade. The new system was the present International Monetary Fund (IMF) which worked out an adjustable peg system.
Under the Bretton Woods system exchange rates between countries were set or pegged in terms of gold or the US dollar at $ 35 per ounce of gold. This related to a fixed exchange rate regime with changes in the exchange within a band or range from 1 per cent above to 1 per cent below the par value. But these adjustments were not available to US which had to maintain the gold value of dollar.
If the exchange rate hit either of the bands, the monetary authorities were obliged to buy or sell dollars against their currencies. Large adjustments could be made where there were “fundamental disequilibrium” (i.e. persistent and large deficits or surpluses) in BOP with the approval of the IMF and other countries. Member countries were forbidden to impose restrictions on payments and trade, except for a transitional period.
They were allowed to hold foreign reserves partly in gold and partly in dollars. These reserves were meant to incur temporary deficits or surpluses by member countries, while keeping their exchange rates stable. In case of a BOP deficit, there was a reserve outflow by selling dollar and reserve inflow in case of a BOP surplus.
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Reserve outflows were a matter of concern under the Bretton Woods system. So the IMF insisted on expenditure reducing policies and devaluation to correct BOP deficit. Temporary BOP deficits were also met by borrowing from the Fund for a period of 3 to 5 years. A country could borrow from the Fund on the basis of the size of its quota with it. The loans made by the IMF were in convertible currencies.
The first 25 per cent of its quota was in gold tranche which was automatic and the remaining under the credit tranches which carried high interest rates. To provide long-term loans the World Bank (or IBRD) was set up in 1946 and subsequently its two affiliates, the International Finance Corporation (IFC in 1956 and International Development Association (IDA), in 1960. For the removal of trade restrictions, the General
Agreement on Tariffs and Trade (GATT) came into force from January 1948. To supplement its resources, the Fund started borrowing from the ten industrialised countries in order to meet the requirements of the international monetary system under General Agreements to Borrow (GAB) from October 1%2.
Further, it created special Drawing Rights (SDRs) is January 1970 to supplement international reserves to meet the liquidity requirements of its members. The Bretton Woods system worked smoothly from 1950s to mid 1960s. During this period world output increased and with the reduction of tariffs under the GATT, world trade also rose.
The Breakdown of the Bretton Woods System:
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The following are the principal causes and sequences of the breakdown of the Bretton Woods system:
1. Built-in Instability:
The Bretton Woods System had a built-in instability that ultimately led to its breakdown. It was an adjustable peg system within plus or minus 1 per cent of the par value of $ 35. In case of fundamental disequilibrium, a country could devalue its currency with the approval of the IMF.
But countries were reluctant to devalue their currencies because they had to export more goods in order to pay for dearer imports from other countries. This led countries to rely on deflation in order to cure BOP deficits through expenditure-reducing monetary-fiscal policies. The UK often restored to deflation such as in 1949, 1957 and 1967.
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2. The Triffin Dilemma:
Since the dollar acted as a medium of exchange, a unit of account and a store of value of the IMF system, every country wanted to increase its reserves of dollar which led to dollar holdings to a greater extent than needed. Consequently, the US gold stock continued to decline and the US balance of payments continued to deteriorate.
Robert Triffin warned in 1960 that the demand for world liquidity was growing faster than the supply because the incremental supply of gold was increasing little. Since the dollar was convertible into gold, the supply of US dollars would be inadequate in relation to the liquidity needs of countries.
This would force the US to abandon its commitment to convert dollars into gold. This is the Triffin Dilemma which actually led to the collapse of the Bretton Woods System in August 1971.
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3. Lack of International Liquidity:
There was a growing lack of international liquidity due to increasing demand for the dollar in world monetary markets. With the expansion of world trade, BOP deficits (and surpluses) of countries increased. This necessitated the supply of gold and of the dollar. But the production of gold in Africa was increasing very little. This led to larger demand and holdings of the dollar.
Countries also wanted to have more dollar holdings because they earned interest. As the supply of dollars was inadequate in relation to the liquidity needs of countries, the US printed more dollars to pay for its deficits which other countries accepted as reserves.
4. Mistakes in US Policies:
The BOP deficits of the US became steadily worse in the 1960s. To overcome them, the policies adopted by the US government ultimately led to the world crises. Rising US government expenditure in the Vietnam War, the financing of US space programme and the establishment of the “Great Society” (social welfare) programme in the 1960s led to large outflow of dollar from the US.
But the US monetary authority (FED) did not devalue the dollar. Rather, it adopted monetary and fiscal measures to cut its BOP deficit.
5. Destabilising Speculation:
Since countries with “fundamental disequilibrium” in BOP were reluctant to devalue their currencies and also took time to get the approval of the IMF, it provided speculators an opportunity to resort to speculation in dollars. When devaluations were actually made, there were large doses of devaluation than originally anticipated.
This was due to destabilising speculation which made controls over capital flows even through monetary-fiscal measures ineffective. This was the immediate reason for the UK to devalue the pound in 1967.
6. Crisis of Confidence and Collapse:
The immediate cause of the collapse of the Bretton Woods System was the eruption of a crisis of confidence in the US dollar. The pound had been devalued in November 1967. There was no control over the world gold market with the appearance of a separate price in the open market. The immediate cause for the collapse of the Bretton Woods System was the rumour in March 1971 that the US would devalue the dollar.
This led to a huge outflow of capital from the US. On 15 August 1971, the US suspended the conversion of dollars into gold when some small European central banks wanted to convert their dollar reserves into gold at the US. It refused to intervene in the foreign exchange markets to maintain exchange rate stability and imposed a 10% import surcharge.
Thus the main cause of breakdown of the Bretton Woods System was the problems of liquidity, adjustment and confidence. The increase in liquidity (international reserves) was in the form of dollars arising from BOP deficits of the US. But as the US was unable to adjust its deficits and excessive dollars accumulated in foreign countries, there was a crisis of confidence in the dollar and the Bretton Woods System broke-down.
Between 15 August 1971 and the Smithsonian Agreement of 18 December 1971, 48 countries including the United States, Japan and a large number of European countries abandoned fixed exchange rates. The ‘Group of Ten’ industrial countries met at the Smithsonian Institution in Washington on 18-19 December, 1971 and agreed to a new system of stable exchange rate with wider bands.
As a first step towards realignment of major currencies, the US, devalued the dollar by 8 per cent, the Japanese revalued the yen by 17 per cent and the Germans their mark by 14 per cent.
The Smithsonian Agreement widened the margin of fluctuations of the exchange rates to 2.25 per cent above or below the new parities of central rates. It officially devalued the dollar against gold from $ 35 to $ 38 per ounce. In 1973, the band was widened to 4.5 per cent. The Smithsonian Agreement broke down following the devaluation of the US dollar by 10% in February, 1973.
Another development took place in Europe when the EEC countries decided to limit the fluctuation of their currencies relative to each other to a smaller band. This came to be known as “the snake in the tunnel”. Under this arrangement, the EEC currencies were tied together and could fluctuate within narrow limits in relation to one another but could fluctuate in relation to other currencies within the limits set by the band proposals.
The Present International Monetary System:
At the beginning of March 1973 India, Canada, Japan, Switzerland, the UK and several smaller countries had floating exchange rates. However, the “joint float” of the EEC countries continued even after March 1973 and was now called the “snake in the lake”, as there was no band within which the EEC currencies could fluctuate relative to other currencies.
In March, 1979 the European Monetary System (EMS) was formed which created the European Currency Unit (ECU) which is a “basket” currency of a unit of account consisting of the major European currencies. The EMS limits the internal exchange rate movement of the member countries to not more than 2.25 per cent from the “central rates” with the exception of Italy whose lira can fluctuate up to 6 per cent.
In the meantime, the Jamaica Agreement of January 1976 (ratified in April 1978) formalized the regime of floating exchange rates under the auspices of the IMF. A number of factors forced the majority of member countries of the IMF to float their currencies. There were large short-term capital movements and central banks failed to stop speculation in currencies during the regime of adjustable pegs.
The oil crisis in 1973 and the increase in oil prices in 1974 led to the great recession of 1974-75 in the industrial countries of the world. As a result “the dollar went into a rapid decline, which, by late 1978, had such alarming proportions that the United States government finally decided on a policy of massive intervention in order to prevent a further fall in the value of the dollar”.
At last, the system of managed floating exchange rates had come to stay by 1978. By the Second Amendment of the IMF Charter in 1978, the member countries are not expected to maintain and establish par values with gold or dollar. The Fund has no control over the exchange rate adjustment policies of the member countries. But it exercises international “surveillance” of exchange rate policies of its members.
The Second Amendment has reduced the position of gold in the global monetary system in the following ways by:
(a) Abolishing the official price of gold;
(b) Delinking it with the dollar in exchange arrangements;
(c) Eliminating the obligations of the Fund and its members to transfer or receive gold; and
(d) Selling a part of Fund’s gold holdings.
The Second Amendment has also made SDRs as the chief reserve assets of the global monetary system whose value is expressed in currencies and not gold. It is now a unit of account, a currency peg and medium of transactions.
The present international monetary system of floating exchange rates is not one of free flexible exchange rates but of “managed floating”. It has rarely operated without government intervention. Periodic intervention by governments has led the system to be called a “managed” or “dirty” floating system.
In 1977, when the intervention was very heavy, it was characterised as a “filthy” float. When Governments do not intervene, it is a “clean” float. But the possibilities of a clean float are very remote. Thus a system of managed floating exchange rates is evolving where the central banks are trying to control fluctuations of exchange rates around some “normal” rates even though the Second Amendment of the Fund makes no mention of normal rates.
“The present international monetary system has also evolved in a number of important ways, including new allocation of SDRs, increased nations’ quota in the IMF, renewal of the General Agreements to Borrow (GAB), the abolishment of the official gold price, and the formation of the European Monetary System (EMS) and the Euro Currency.”
The US is the major country which has been influencing the global monetary system. It has permitted the dollar to float in relation to other currencies with occasional interventions when the dollar has reached extreme highs or lows.
When the dollar was extremely high (appreciating), the G-5 (US, UK, Germany, Japan and France) agreed to intervene to bring the dollar down by the Plaza Accord in September 1985. Subsequently, the dollar depreciated substantially i.e. by more than 50% relative to the yen.
By early 1987, the dollar had become undervalued and by the Louvre Accord, the G-7 countries (G-5 plus Canada and Italy) agreed to cooperate in keeping their exchange rates around their current levels at that time. “The Louvre Accord was successful in stabilising exchange rates for the rest of the year. Since then there seems to have been a consensus that exchange rates should be broadly stabilized, but there is little overt cooperation among countries.”
Its Problems:
The present international monetary system is faced with excessive fluctuations and large disequilibria in exchange rates. Often countries, both developed and developing, have been faced with either excessive appreciation or depreciation of their currencies in relation to the dollar which continues to dominate the world monetary system.
Reforms in International Monetary System:
Economists have suggested a number of measures in order to avoid the excessive fluctuations and large disequilibria in exchange rates for reforming the international monetary system.
1. Coordination and Cooperation of Policies:
A few economists, and McKinnon in particular, suggested international co-operation and co-ordination of policies among the leading developed countries for exchange rate stability. According to McKinnon, the US, Germany and Japan should have the optimal degree of exchange rate stability by fixing the exchange rates among their currencies at the equilibrium level based on the purchasing power parity. Thus they would co-ordinate their monetary policies for exchange rate stability.
2. Improving Global Liquidity:
The reform package of the present world monetary system should improve global liquidity. As a first step, both developed and developing countries having BOP deficit and surplus should take steps to reduce a persistent imbalance through exchange rate changes via internal policy measures.
Second, they should also cooperate in curbing large flows of “hot money” that destabilise their currencies. Third, they should be willing to settle their BOP imbalances through SDRs rather than through gold or dollar as reserve assets. Fourth, there should be increasing flow of resources to the developing countries.
3. Leaning against the Wind:
To reduce the fluctuations in exchange rates, the IMF Guidelines for the Management of Floating Exchange Rates, 1974 suggested the idea of leaning against the wind. It means that the central banks of developed and developing countries should intervene to reduce short-term fluctuations in exchange rates but leave the long-term fluctuations to be adjusted by the market forces.
4. Richard Cooper suggests a global central bank with a global currency which should be a global lender of the last resort to developing countries.
5. Jaffrey Sachs proposes the creation of an international bankruptcy court for developing countries which should deal with countries having large external debt.
6. George Soros opines that the IMF should set ceilings for external finance for each developing country beyond which access to private capital need not be insured. But there should be mandatory insurance by an international credit insurance corporation.
7. Economists also suggest the establishment of a fund by developed countries which should provide guarantee to private loans by corporations and banks for lending to developing countries.
8. The developed countries should adopt appropriate measures to overcome price fluctuations in the primary products of developing countries through the creation of international buffer stocks, commodity agreements, compensatory financing, etc. These are necessary to control fluctuations in their exchange rates.
9. Paul Krugman suggests reintroduction of capital controls as a “least bad response” to an international crisis which developed in the Asian Tigers’ Countries.
10. Objective Indicators:
To iron out exchange rate fluctuations, the IMF Interim Committee suggested the adoption of such objective indicators as inflation-unemployment, growth of money supply, growth of GNP, fiscal balance, balance of trade and international reserves. The variations in these indicators require the adoption of restrictive monetary-fiscal measures to bring stability in exchange rates by both developed and developing countries.
Conclusion:
The various suggestions to reform the present monetary system are closely inter-linked. But there is lack of unanimity over the various proposals among the nations. Given the differences of opinion between the developing and developed countries and among the developed countries themselves, there is no hope that any concrete proposal to reform the global monetary system would be acceptable to nations. So the present system of managed floating exchange rate is likely to stay on.
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