The International Monetary System: Contemporary International Monetary Arrangements

1. The International Monetary System: Contemporary International Monetary Arrangements READING ASSIGNMENT: Oatley – Chapter 11

2. Plan for today • The rise and fall of Bretton Woods • Why fail to address a BoP imbalance under fixed XR – why “beggar-thy-neighbor”? • The Trilemma • France vs. Germany in the 1980s • How to deal with imbalances: fix vs. float • The US $

3. THE RISE AND FALL OF BRETTON WOODSA puzzle Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1971-3 1944 BRETTON WOODS PERIOD

4. Conclusion: Cannot maintain (global) fixed exchange rates in the presence of high capital mobility…?

5. THE RISE AND FALL OF BRETTON WOODSA puzzle Degree of global capital mobility * Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1971-3 1870 1944 BRETTON WOODS PERIOD

6. A puzzle:Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century? Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

7. Why?

8. Answer: Democracy Growing #’s of democracies + LABOR UNIONS! Few democracies Fixed exchange rates + Open capital flows Degree of global capital mobility Fixed exchange rates + Capital controls Floating exchange rates + Open capital flows 1870 Interwar period 1971-3 1944

9. Why? • So, why do fixed exchange rates pose a problem for democracies in the face of highly mobile capital?

10. Pure gold standard • Country A imports from Country B • Gold moves from A to B (re-coined/minted) • Less money in A  lower prices • More money in B  higher prices •  Country B imports from Country A • Balance is restored

11. With paper money • Central Banks intervene by adjusting interest rates • So gold doesn’t actually flow • Gold Standard  strict discipline!

12. What is “discipline”? • What do “lower prices in Country A” mean? • Supply of money down • More expensive to borrow • Jobs cut! • People don’t eat!

13. Under authoritarianism: Let them eat cake Under democracy: Incumbents lose elections People don’t eat

14. Hazard Rate over Time for Democracies (Solid Line) & Dictatorships (Dotted Line) – Time in years

15. Stylized history • Late 19th century: • Mobile capital, authoritarian governments • Interwar years: • Mobile capital + democracy  beggar-thy-neighbor • http://www.youtube.com/watch?v=3_ex0sTsb_I&feature=channel • Bretton Woods (1944-1971/3): • Capital controls + democracy • http://www.youtube.com/watch?v=GVytOtfPZe8 • Post Bretton Woods: • Floating exchange rates • http://www.youtube.com/watch?v=iRzr1QU6K1o

16. What were the goals of Bretton Woods? • Attempted to establish a system of fixed XR in a world where governments were unwilling to sacrifice employment to address imbalances • 4 INNOVATIONS: • Some XR flexibility (fixed-but-adjustable “snake”) • Capital controls • A stabilization fund (held on reserve at the IMF) • The International Monetary Fund – authority over XR changes + conditionality attached to loans

17. Bretton Woods failed for several reasons • IMF lacked true authority over XR – governments did as they saw fit • Governments did not like IMF conditionality • The stabilization fund was never large enough to deal with the potentially massive imbalances that come with growing globalized economic integration • Straws that broke the BW back: • USA: VIETNAM + SOCIAL SPENDING + INTERNATIONAL RESERVE CURRENCY •  SPECULATION that the US cannot maintain the fixed convertibility to gold + the French – regularly demanded American gold from the US for the $’s they accumulated • http://www.youtube.com/watch?v=iRzr1QU6K1o

20. http://www.youtube.com/watch?v=loBe0WXtts8

21. The saga continues… • The story of the contemporary international monetary system is the story about the search for the elusive ideal balance between domestic economic autonomy and exchange rate stability

22. The Unholy Trinity • Fixed Exchange Rate • Autonomy of Monetary Policy • Capital Mobility Mundell-Fleming: Only 2 out of 3 are possible

23. The point of the unholy trinity – you can’t have it all… • “The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe).” • – Paul Krugman http://slate.com/id/36764

24. Free Capital Flow Eurozone countries Switzerland PRC Inconsistent/Unholy Trinity Or “Trilemma”: a country can only have 2 out of 3 of these Fixed Exchange Rate Sovereign Monetary Policy

25. Fixed Exchange Rate Eurozone countries Switzerland PRC The Trilemma Open Capital Flows Sovereign Monetary Policy

26. Fixed Exchange Rate Eurozone countries Switzerland PRC The Trilemma Open Capital Flows Sovereign Monetary Policy

27. The European Monetary System • 1979 • Fixed but adjustable • The Bundesbank (Germany) used monetary policy to keep inflation low, and other countries engaged in foreign exchange market intervention to fix their currencies to the German mark

28. French-German fight in 1981-3 • Mitterand – socialist president – believed German monetary policy was strangling • Expansionist monetary policy (e.g., lowered interest rates) • French inflation began to rise • Called on Germany to lower their interest rates • 18 month stand-off… the French backed down

29. 1988-2002: Monetary Union • 1988: Planning begins • Gradually moved towards fixing their currency XR’s (1999 – “permanently” fixed) • Jan 2002: The Euro! • Why union? • High degree of economic openness across Europe  • Sacrificed monetary autonomy for XR stability

30. To fix or to float?

31. Trade & international capital flows lead to imbalances How do governments deal with these imbalances? • Fixed exchange rate  sacrifice monetary policy OR: • Floating exchange rate uncertainty Trade-off between • exchange rate stability versus • domestic price stability with monetary policy autonomy

32. Why are there imbalances? • These days, foreign exchange markets conduct between $1 trillion and $1.5 trillion worth of business… PER DAY!! •  Exchange rate volatility! •  Exchange rate misalignments

33. Consequences of XR volatility? • Uncertainty hurts international transactions? • Suppose you work on a profit margin of 5%-9% and the XR changes 5% between the time you ship an export and the time it arrives… • But businesses can purchase options to buy a foreign currency 30, 60, or 90 days in the future at today’s XR, thereby insuring themselves against short-term XR volatility • Nevertheless, a reduction in investment is one possible consequence of currency misalignments

34. Fixed XR • A kind of commitment • To avoid SPECULATATION governments try to make a credible commitment to a fixed XR • If the commitment is not credible, speculation can be disastrous • Argentine Currency Board (1991-2002) • Pegged the Argentine peso to the U.S. dollar in an attempt to eliminate hyperinflation • Credibility? Required legislative vote to change the value of the currency (public discussion undermines the point of a devaluation!) • But deficit spending ultimately undermined confidence • And tied hands prevented the government from acting • Run on the currency in 2002  disaster!!

35. Free Capital Flow USA PRC Inconsistent/Unholy Trinity Or “Trilemma”: a country can only have 2 out of 3 of these Fixed Exchange Rate Sovereign Monetary Policy

36. Why is the US dollar special?

37. Overvaluation of the Dollar • International reserve currency • Early 1980s: Reagan’s fiscal expansion – cut taxes, increased spending  • Current account deficit  • Increased interest rates and capital inflows (from, e.g., Japan) • Value of the dollar goes up! • Plaza Accord (fall 1985): G5 agreed to reduce the value of the dollar against the yen & mark by 10-12% – sell dollars if it appeared the value was going to increase • By early 1987, dollar had depreciated 40%

38. Similar situation today • US twin deficits: fiscal & current account • Japan, Europe, China, current account surpluses  • Finance the American deficit • US absorbs about 6% of the world’s savings • US international investment position: • foreign-owned assets in 2007: $17.8 trillion • US residents’ foreign assets in 2007: $15.4 trillion • international investment position: –$2.4 trillion

39. What’s the worry? • Catastrophe! • Doubts about the solvency of American financial institutions & American assets • Foreign lenders reluctant to continue to accumulate dollar-denominated assets • Trigger massive sales of current holdings? • http://www.youtube.com/watch?v=qu2uJWSZkck

40. Hope? • Cooperation amongst G5? • (G5??? p255... China?) • US needs to reduce its budget deficit • Countries with surpluses need to expand demand in their own countries • Macroeconomic coordination along these lines would reduce American imports & expand consumption in surplus countries • Cooperation could also guide a gradual decline of the $, rather than a fast catastrophic drop • Problem for China: adjustment moving from the US market to the domestic market would create economic dislocation, winners & losers…  political instability? • This is a reality that the Chinese government must deal with and therefore the American government must also! • But a catastrophic drop would hurt the export-oriented sectors of all countries with current account surpluses with the US!

41. Take aways • Democracy  Fall of the gold standard • Fall of Bretton Woods replaced with floating XR • The Trilemma • France vs. Germany in the 1980s • Floating XR allows for flexibility in monetary policy • China-US problem – we have incompatible solutions to our trilemmas

42. Thank you

43. Source: http://www.fas.org/sgp/crs/row/RS22860.pdf