International Financial Architecture: Part II

This is the second lecture on Understanding the Rise and Fall of the Gold Standard — shortlink: bit.do/azifa2 — we start with a  Summary of First Lecture 

The first lecture discusses the Keynesian theory that the exact level of money in an economy is critically important – too little leads to recessions, while too much leads to inflations. Furthermore, domestic business cycles, and international financial crises are caused by pro-cyclical behavior of current artificial systems of money creation and international trade. Standard macro theories make it impossible to understand the economy because they assert that money is neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that the quantity of money is all important. Standard macro model currently in use throughout the world have no explicit role of money, banks, and credit, even though these factors are of central importance in understanding the world. Once we understand the vital role and function of money within an economy, it becomes possible to understand historical events of the twentieth century – whereas this is impossible using conventional macro theories. The first lecture summarizes how the colonial system came into being, and the monetary arrangement for a hard currency at the core and soft currencies in the periphery. This system of fiat currencies works fine within one system of colonies, where the value of money is decreed by sovereign fiat. For trading between different countries, the gold backed currencies were used. As European countries prospered by exploiting resources throughout the globe within their colonies, inter-European trade increased. The optimal quantity of money required for the domestic economy is not the same as that required for stable international exchange rates. The pro-cyclical money creation which is characteristic of the system creates cycles, and large cycles lead to crises on a routine basis. World War I was partly caused by the breakdown of the colonial trading system due to the end of expansion possibilities after the completion of the conquest of the globe. Efforts to restore the gold standard after World War I failed. The second part of the lecture discusses the post World War I history, with reference to the international financial architecture that emerged in the post-Gold era after World War I.

3100 Word Summary of Second Lecture on Global Financial Architecture

Part 1 of Second Lecture: History of Gold Standard

Colonization and Globalization: Over the nineteenth century, Europe grew rich and prosperous by colonizing the globe; as Edward Said remarks in the introduction to Orientalism, about 85% of the planet was under European control by the beginning of the 20th Century. In the early part of the 19th C, most trade occurred within a colonial system, between center and periphery, on highly unequal terms, with massive advantages accruing to the center. With increasing prosperity, a process of globalization took place, with rapidly increasing trade between the different European powers.

Keynesian Theory: As we noted in part I of this lecture, trade within a colonial system works using money created by sovereign fiat. As Keynes established, exactly the right amount of money is required for an economy to function well. Too little leads to recession, while too much leads to inflation. This makes a gold standard highly unsuitable for managing the needs of the domestic economy. This problem can be partially resolved using fractional reserve banking, which allows the sovereign to print far more notes than the gold which is available as backing for the currency. However, increasing globalization put strain on this system, since sovereign fiat does not extend to foreign countries.

Deficiencies of the Gold Standard: The gold standard is one way to conduct international trade, and this was the method used in Europe. However, this method is highly unsatisfactory, because the objective of keeping exchange rates stable against foreign currencies requires that the reserves backing the currency should be kept at an adequate level to manage surpluses and deficits in trade. When the reserves are fixed in this way, then control of the quantity of money within an economy is lost – the amount of money cannot be expanded to meet the needs of a growing economy, without reducing gold backing and thereby altering exchange rates with foreign currencies.

Pro-cyclical Money Creation: Furthermore, the methods for creating money in capitalist economies, based on fractional reserve, are pro-cyclical. This means that they create lots of money when the economy is booming and restrict creation of money when the economy is in a slump. This is the opposite of what is required – as per Keynesian theory, the rate of growth of money needs to be adjusted to match the potential growth of the economy. In expansions, private credit creation is far above required rate, and the central bank should contract rate of growth of money supply to compensate, and prevent overheating of the economy leading to inflation. In a recession, private credit contracts, and the central bank should expand the rate of money creation to compensate, to prevent recessions. Pro-cyclical money creation has the effect of causing crises and collapses in booms, and prolonging and deepening recessions.

Post WW1 collapse of Gold Standard: War expenses depleted gold stocks of governments, forcing them off the gold standard during WW1. Because of the amazing prosperity of the pre-WW1 period, there was a universal desire to go back to that era – it was believed that this prosperity had been due to globalization, enabled by the Gold Standard. Despite tremendous efforts by nearly all countries, the gold standard could not be restored, for reasons to be discussed later. Here it is worth noting that end of pre-war prosperity was due to the end of possibilities for colonial expansion, which was also one of the reasons for the WW1. Furthermore, inherent instability of the Gold standard, and its defects as a basis for an international trading system, created many tensions which increased as the pre-war globalization increased trade. Thus, post war efforts to re-create gold standard were misguided; what was needed then, and what is needed now, is a better system for creation of money domestically, and a more equitable and efficient system of international trade.

Part II of Second Lecture: Differences in pre and post WW1 monetary experience

The second part of the lecture explains a paper by Barry Eichengreen (2017) “Ragnar Nurkse and the international financial architecture“. This paper analyzes the lessons from book of Ragnar Nurske with the title of “International Currency Experience: Lessons of the Interwar Period: Economic, Financial and Transit Department”. In this brief summary of my lecture, I will list the main points covered in part II of my lecture. The differences analysed by Nurske, and discussed in Eichengreen all revolve around the famous Trilemma of Monetary Policy, so we discuss this first to provide the foundation for the subsequent discussion.

Trilemma of Monetary Policy: Eichengreen (1999), in his book, titled “Globalizing Capital: A History of the International Monetary System” stated that countries can have only TWO out of THREE things:

  1. Democratic Political System
  2. Pegged/Stable Exchange Rates
  3. International Capital Mobility

A democratic political system means that we cannot use monetary policy to stabilize the exchange rate at expense of the domestic economy. The voters will not accept this. If use monetary policy for supporting the domestic economy, then our ratio of money to gold reserves will vary, since we will change the money supply according to the needs of the economy. This means that our exchange rates will fluctuate, since the gold backing of our currency fluctuates. When the gold content of our currency goes up, people will buy our appreciating currency, and they will sell our currency when the gold content goes down. If we want to have stable exchange rates, and an independent monetary policy, then we have to prevent people from being able to buy and sell our currency. This means imposing capital controls – putting restrictions on the convertibility of our currency to gold or to any other foreign currency. With capital controls, we can ensure the first two goals, by sacrificing the third one. However, if we want to allow free flows of capital, than if we fix exchange rates, we will lose control of domestic money supply and be unable to use monetary policy for managing domestic economy. Alternatively, if we retain control of the money supply, we will have to let the exchange rate adjust flexibly as the demand and supply of our currency changes. This is the trilemma.

Pre-War Central Bank Behavior: In the pre-WW1 era, high finance was enormously influential in dictating the structure of the global economy. Since free flow of financial capital was central to their interests, it was taken for granted as the central pillar of a global economy. As the trilemma tells us, once we accept free flows of capital, Central Banks must choose between fixed and stable exchange rates, or a monetary policy which suits the needs of the domestic economy. Again the power and political influence of financial capital dictated a preference for stable exchange rate, which was exceedingly useful to the wealthy and powerful financial elites. The needs of the domestic economy were sacrificed to stable exchange rates and free flows of capital. This was possible to do because a globalization and a booming economy meant that the population did not suffer very much – the conflict between the needs of the domestic economy and the needs of globalization was not very strong. However, the picture changed in the post war period.

Post-WW1 CB Behavior: European economies were ruined by WW1 over 1914-18, while the US economy was ruined by the Great Depression of 1929. In the post-war era, the priority of rebuilding the domestic economy was tremendously high, while the priorities of maintaining stable exchange rates was relatively low. In addition, gold reserves of the central banks had been substantially depleted, so that maintaining a gold standard at pre-war levels was impossible. The Central Banks faced a dilemma: massive investments were required to re-build war-torn economies, but money was not available for doing so. This is where Keynesian theory was helpful: Keynes argued that deficit financing would provide the required funds without having the feared inflationary effects, because the economy was in a slump. The change in Central Bank behaviour to manage money supplies in accordance with the needs of the domestic economy, rather than the needs of maintaining a stable exchange rate, had a tremendous impact on the global financial system. The argument of Nurske is that these changes were all harmful and negative, created instability, and eventually led to the breakdown of the efforts to restore the gold standard.

De-Stabilizing Capital Flows: Large BoP deficits weakened a currency, since excess stock would be held by foreigners. In the prewar era, CBs could be counted upon to take measures to strengthen the currency by raising interest rates, since stable exchange rates was the highest priority. Realizing this, financial speculators would purchase weak currencies, anticipating that CBs would act to strengthen them. This led to stabilizing capital flows, which acted to restore equilibrium. In the postwar era, CBs would often allow the currency to depreciate, rather than harm the domestic economy by raising interest rates to strengthen the currency. Thus, a weakening currency signalled a possible devaluation in the future, rather than a defence of the weak currency by the Central Bank. Anticipating devaluation, financiers would rush to sell the weak currency, thereby further weakening it. This led to de-stabilizing capital flows in the postwar era, the opposite of the prewar era. The only way to handle these problems was to impose capital controls, and restrictions on trade, and these were often used, especially by the weaker economies.

Immobilization of Reserves: Whereas the prewar system was centered around the pound sterling, the post war financial system, was multipolar. The dollar was emerging to prominence, but the franc, deutschmark and other hard currencies were also used as reserve currencies by the central banks. This created some instability since financiers would jump around from one currency to another in search of highest returns. The multipolar system also created pro-cyclical global liquidity, intensifying business cycles and leads to crises and slumps. This was because in booming times, all currencies were acceptable as reserve, leading to expansion of global monetary stock. In slumps, CBs would move out of weakening currencies into strong currencies or gold, thereby lowering global liquidity when the opposite, counter-cyclical policy was required to fight against the slump. Reserves of strong currencies and gold were required to protect the currency against devaluations in bad times. Paradoxically, countries with reserves could not use them for this purpose in times of need. This is because using reserves to protect the currency was taken as a sign of weakness, and would lead to de-stabilizing capital flows, as speculators would move out of the currency and further weaken it.

Management of Global Liquidity: Just as the right amount of money is required by domestic economy, so there is a right amount of liquidity required for the needs of global trade. However, there is no mechanism or institution to manage global liquidity. Even though the IMF was created for this purpose, it was never successful in achieving this goal. As already noted, in absence of a mechanism, global liquidity moved in a pro-cyclical manner, which exacerbated global business cycles, creates crises and bust with regularity. There are a number of mechanisms which can be used to manage global liquidity in a cooperative manner, which is essential. However, by default, competitive devaluations were used to increase liquidity, which actually caused damage to all, being a lose-lose proposition all around. These are referred to as beggar-thy-neighbor policies, because they seek to improve domestic economy at the expense of others, eventually causing damage to all. For instance, after the Great Depression, the US imposed the Smoot-Hawley tariffs and isolated its economy to manage domestic concerns. This maneuver created a shortage of dollars in the global economy, which needed extra liquidity at this time. Reduced global liquidity caused harm to all, including the US, leading to a prolonged and severe depression. The main point here is that each country on its own cannot manage global liquidity, and a cooperative and institutionalized mechanism for achieving this is needed, even today.

Part III: Bretton Woods and Beyond

The Gold Exchange Standard: The factors discussed above (and many others not covered) created a dangerously unstable global financial system in the post-WW1 era, which made it impossible to go back to the prewar gold standard, even though a massive effort was made by all countries to do so. Once this was realized, the Bretton-Woods agreement was made to create a new system, this time based on a gold exchange standard, which would create stable exchange rates required for trade. Gold exchange means that only Central Banks were authorized to ask for conversions of foreign currencies to gold, so that gold would only be a means to rectify imbalances in trade, but not in general use as backing for a currency. In practice, since the dollar was widely considered as soundly backed by gold, CBs would often use dollars rather than gold as reserves – using dollars and US Govt Bonds allowed earning interest, while meeting the reserve requirement of gold. The gold exchange standard reduced the requirements for holding gold by Central Banks, but it also weakened the link between the currency and the value of gold. The market price of gold deviated significantly and substantially from the official price at which CBs traded currencies for each other, and for gold. This system could function only if trade surpluses and deficits were not too large relative to the size of the domestic economy. The IMF was designed to monitor this system, supply it with necessary liquidity in the form of SDRs, and ensure stable exchange rates using a variety of mechanisms at its disposal. However, IMF did not have the political power required to enforce rules, and could not provide the effective controls needs to manage the global economy.

The Nixon Shock: As massive Dollar expenditures on the Vietnam War created a glut of dollars on the world market, it became impossible for the US to honor the Bretton-Woods requirements of encashing surplus dollars for gold. In 1971, Nixon unilaterally terminated Bretton-Woods by announcing that the US would no longer cash dollars for gold held by other Central Banks. Since then the world has drifted without any explicitly designed global financial architecture. Many efforts were made to create a new post-Bretton Woods architecture, but these efforts failed – for one account, see “The Failure of World Monetary Reform, 1971-74” by John Williamson. As a result, the current system of floating exchange rates has emerged without any conscious effort to create a suitable design which solves the problems of balancing the needs of global trade and the needs of domestic economies.

Future Prospects: One of the reasons that global financial architecture has been allowed to drift is that the default is enormously favourable to the sole world power, the USA. In the current system, the dollar is equivalent to gold. Thus the US can print gold and buy up real resources from around the world. No other currency has the same strength. Many other more symmetric and equitable systems have been designed, but have been effectively blocked by the US, since they would reduce US monetary power. The Euro was created to counteract the US hegemony in the monetary arena. Similarly, with the emergence of China as a leading global power, the Renmimbi is also acquiring importance. The most likely prospect for the future is a tripolar currency system with USD, Euro, and Renmimbi playing important roles as reserve currencies. With the decline of US hegemony, and the rise of alternative financial centers, it will become imperative to create a new design for global financial architecture. We need to have greater understanding of the system in order to shape the emerging future, which will not resemble the past. From the Pakistani point of view, a forward looking program of research into different types of creative possibilities for de-linking the Rupee from the dollar would be of great important right now. More generally, a system for managing global liquidity and handling international trade equitably with respect to adjustments in exchange rates, and Balance of Payments is the need of the hour. These lectures have attempted to provide the necessary background required to think about the design of a suitable financial architecture. It is important to note that these lectures cover the period upto the 1970’s. In the 1980’s and beyond, financial de-regulation has changed the basis of the global economy from industrial capitalism to financial capitalism. This new economic system has its own distinct features which require separate examination. These must be taken into account in designing a suitable financial architecture for the future. We hope to provide this analysis in a later work.

POSTSCRIPT: A more detailed summary — 6800 words, describes many of the issues discussed briefly above in greater detail. 6800SumIFA2 . Slides for the video lecture provide an outline of points discussed in the lecture, and can be downloaded from:

https://1drv.ms/p/s!AqUg6YsQpPb1gbExznsJYb8jp_VKLw

For more lessons in Macro, see Mini-Course on Macroeconomics

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