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Thursday, 11 August 2011

Understanding the International Monetary System

To understand the future we need to consider the past. In the turmoil from the international credit crisis, bank defaults and sharemarket crashes, what does the future hold and how did this international monetary system develop to what it is today?

In this article I will examine the changes in the international monetary system over the last 100 years. I will explain how this system has developed from the days of merchantilism and the international gold standard, to the hybrid system of today. I will explain how these changes came about, why they were considered a good set of rules at that time and why they were eventually superseded by the next order. The possible return to the international gold standard will also be considered. As will the possibility of a world central bank along with a single world currency and finally, I will suggest a new consideration that needs to be examined to ensure the international monetary system is delivering its full potential.

Singer-songwriter Bob Dylan sung—The Times They Are a-Changin'—and so it has been with the international monetary system. Gone are the days when ordering a new vehicle from the Ford factory meant you would wait months, if not years, for it to arrive. You could also choose any colour, so long as it was black. Even then you had to be wealthy and usually apply to the government to be allowed to send domestic currency offshore to pay for that new vehicle. International financial transactions are now conducted with the click of a computer mouse, touch-pad or touch-screen. So, what is this system we call the international monetary system and just how has it evolved? Mark Carney, the Governor of the Bank of Canada gave his perspective in a speech to the Foreign Policy Association in New York City in November 2009. He described it thus: “The international monetary system consists of (i) exchange rate arrangements; (ii) capital flows; and (iii) a collection of institutions, rules, and conventions that govern its operation.”. Barry Eichengreen in his book Globalizing Capital described it as, the glue that binds national economies together. Its role is to lend order and stability to foreign exchange markets, to encourage the elimination of balance-of-payments problems, and to provide access to international credits in the event of disruptive shocks. But before we go any further, let's go back to the beginning and examine the path of the international monetary system since the days of merchantilism, when the monetary system evolved around that precious yellow metal we call gold.

The logic behind merchantilism was that gold and other precious metals symbolised a nation's wealth, and the goal was to encourage exports but discourage imports. Merchantilists assumed that trade was a zero-sum game and therefore, for every winner, there was also a loser. The fallacies of this logic were exposed by David Hume in 1752, with his specie-flow mechanism theory. This theory explained that it was not the amount of gold and silver a country held that was important, it was how many goods and services that could be bought with this gold and silver. So consequently, as gold and silver were amassed there was more currency in circulation (in the form of gold and silver) so this simply led to higher prices, therefore no one was better off. In fact most were probably worse off because that country's exports became far more expensive, so less goods were exported. Trade theory was expanded upon by Adam Smith in 1776 and David Ricardo in 1817, with their theories of absolute advantage and comparative advantage.

The international gold standard was the first major development in the international monetary system and was adopted by major countries from 1876 – 1913. Exchange rates were effectively fixed, because governments agreed to buy and sell gold at a fixed rate. This system of using gold to back national currencies ran quite smoothly until 1914 when World War I began. Problems continued right through until the end of World War II in 1944. These wars interrupted trade and the free movement of gold was suspended. The Great Depression of the 1930's was also a major problem with restrictions on trade causing this world wide depression to continue. At the time, countries were more concerned with their national economies rather than exchange rates and trade.

The next major development in the international monetary system was the Bretton Woods Agreement,1945-1971. Allied countries met and created the International Monetary Fund (IMF) and the World Bank after WWII. Article I stated its purpose as: “to promote international monetary cooperation, to facilitate the expansion and balanced growth of international trade, promote exchange rate stability, and to assist in the establishment of a multilateral system of payments”.

The reserve currency for which all signatories would fix their currency to was the US dollar. This is not surprising, because as Mundell also explained, “Historically, whenever there has been a superpower in the world, the currency of the superpower plays a central role in the international monetary system. This has been as true for the Babylonian shekel, the Persian daric, the Greek tetradrachma, the Macedonian stater, the Roman denarius, the Islamic dinar, the Italian ducat, the Spanish doubloon and the French livre as it has for the more familiar pounds sterling of the 19th century and the dollar of the 20th century.”

This system was seen as a tool to create a stable world monetary system, which made international balance of payment settlements much easier as well as world trade. Unfortunately the system started to fall apart in the 1960's when US President, Lyndon Johnson, started to fund his “Great Society” programme, which produced large deficits and created balance of payments problems. A number of external shocks then brought about a lack of confidence in the US dollar, which markets started to sell off. Then in 1971 US President, Richard Nixon, suspended official purchases or sales of gold. In 1973 the US dollar came under attack for being over-valued and many countries allowed their exchange rates to float against it, because it had become unsustainable for central banks to prop up their currencies due to a lack of large quantities of international reserves. Currencies were then traded on foreign exchange markets,which encouraged the free flow of money which has also opened up trade. Given current circumstance surrounding the US, it is unlikely this will continue for much longer without a dramatic economic turnaround in the US.

The IMF is an intrinsic part of the international monetary system and helps keep it stable. It is controlled by the governments of its member countries and represented through a Board of Governors. The Governor for each member country is usually the Minister of Finance or sometimes the Central Bank Governor. The IMF loans emergency funds money to countries that have found themselves in financial difficulties. This is often due to poor economic management or a financial crisis outside of their control although at present these problems have mostly been self inflicted. In order to qualify for these loans the country needs to meet certain criteria as stated from time to time by the IMF. The IMF is funded through quotas based on the size of the national economy. Surveillance and reporting of world capital markets has become a large part of the activities of the IMF. In many ways it might be considered a watchdog and now also considered as a lender of last resort. The IMF has also grown from the 44 states from the Bretton Woods days to now incorporate 187.

The World Bank was instituted at Bretton Woods at the same time as the IMF. The World Bank website states, “Our mission is to fight poverty with passion and professionalism for lasting results and to help people help themselves and their environment by providing resources, sharing knowledge, building capacity and forging partnerships in the public and private sectors.” The World Bank is made up of two unique development institutions. The International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA). The IBRD aims to reduce poverty in middle-income and creditworthy poorer countries, while IDA focuses on the world's poorest countries. These organisations provide low-interest loans, interest-free credits and grants to developing countries for a wide array of purposes that include investments in education, health, public administration, infrastructure, financial and private sector development, agriculture and environmental and natural resource management. The IMF and the World Bank do have their critics, Joseph Stiglitz, a renowned economist, Nobel Laureate, Chairman of Bill Clinton's Council of Economic Advisor's and World Bank Chief Economist stated, “The IMF prescribed outmoded, inappropriate, if 'standard' solutions, without considering the effect on the people in the countries told to follow these policies.”

An interesting development in the international monetary system has been the creation of the European Union and the Euro currency. In 1957, the Treaty of Rome was signed by Belgium, France, Germany, Italy, Luxembourg and the Netherlands forming what was to be known as the European Economic Community. This group had grown out of the 1951 Treaty of Paris that formed the European Steel and Coal Community, which was designed to help reconstruct the European economy after World War II had destroyed it. Today, this group has expanded into twenty-seven member countries and is now known as the European Union. In January 2002 a new currency called the Euro came into use in the European Union. The United Kingdom and Denmark chose to opt-out of the Euro and still use their own currency alongside the Euro.

The monetary union that was created is nothing new. Previous examples are the Latin monetary union, comprising France, Belgium, Switzerland, Italy and Greece, which existed from 1865 until 1927. The Scandinavian monetary union of Sweden, Denmark and Norway lasted from 1873 until 1924. The German Zollverein, which was a customs union between German principalities in 1834, is often held up as the most successful example. It produced a central bank, the Reichsbank, and a single currency, the Reichsmark, in 1875.

The concept of an EMU is to integrate independent states and their economies to help them achieve economic efficiencies, break down barriers that exist between the states and strengthen their resolve to any external shocks. By doing this, custom tariffs can be removed, free trade can flourish, goods - capital - labour will have free movement, and a single currency with a centralised and harmonized fiscal and economic policy will promote currency stability, growth and economic power for the region. For the EU this is controlled by the European Central Bank. The EU has had its problems ever since, with several countries needing expensive bail-outs. The EU has had its benefits however. Not the least being the opening up of trade and the removal of trade barriers between all members. Inflation has been stabilised and the likelihood of wars in the region has been dramatically reduced. Although the value of the Euro has continued to drop against the US dollar since first launched, it has acted as a major world currency and an alternative reserve currency to the US dollar. The jury is still out on its continuance and benefits to the international monetary system.

The Hybrid International Monetary System we now have has evolved since the Bretton Woods agreement fell apart in 1973 and now appears to have been broken into two blocs. Most advanced nations have floating exchange rates, but a larger number of emerging and less developed countries have opted to peg their currencies to currencies like the US dollar or the Euro. China, for example, originally fixed the renminbi to the US dollar but now fixes it against a basket of currencies. However, since the collapse of Argentina’s currency that was pegged to the US dollar, many are doubting that this is a feasible option. Others that moved from soft pegs to floats have been highly managed, but doubts must also be maintained about these actions as the same theory about the gold standard failing still applies in this situation. Small countries like New Zealand, have little power in their exchange rate interventions, because they do not have unlimited funds. Many speculators hold far more reserves in their investment funds and a country like New Zealand could never compete with them in exchange wars. According to a study by Eichengreen & Razo-Garcia, in the next two decades 30% of countries will have pegs, 30% will have floats, and 40% will have intermediate regimes. Compared to the current situation this shows that intermediate arrangements will have declined further, but only modestly.

In 2008 the world faced an international credit crisis, which threatened the international monetary system and continues to this day. This began with the collapse of investment banks like Lehman Brothers. This mostly came about due to sub-prime loans to people who could not afford to pay them back and consequently defaulted as property values plummeted. The world is still recovering and we know it is over yet. The credit crisis that has ensued has raised many issues that effect the international monetary system. In some ways this is not too different to the wave of crisis that swept through East Asian economies, Russia, Argentina, Brazil, and Turkey during the 1990s. They have made the world focus on financial mechanisms, governance, transparency and the threats that economic bubbles pose. It has also made world powers realise just how economically integrated the world has become. Due to the credit crisis, some commentators like US Congressman Dr. Ron Paul have called for a return to the gold standard.

Returning to the gold standard would appear highly unlikely. Nothing has changed in the world to expect that what happened back in the days of the original gold standard would not happen again. Gold in itself has very little intrinsic value or real use, just like fiat currency. Talk of a world currency is not new either. Harry Dexter White, the chief international economist at the U.S. Treasury from 1942 – 1944, floated the idea of a world currency he called the unitas. World renown British economist, John Maynard Keynes, floated the idea of a world currency he called the bancor. Neither took off at the time because there was an advantage for the country whose currency was the reserve currency, not having to balance their balance of payments. Although a world currency, by whatever name, may encourage world trade even more, and also remove uncertainties of currency fluctuation, the problems of a lack of fiscal responsibility and discipline that are currently affecting the EU will also haunt a world currency. There also needs to be competition between currencies, for as surely as communism failed due to lack of competition, so too would a single world currency. The major problems that need addressing by world powers are transparency in our financial institutions, public expenditure, deficits and limiting quantitative easing, all of which are the core of monetary stability and the international monetary system.

One issue rarely considered by economists or Reserve Bank Governors, is the cost of creating new money when it enters the financial system (not to be confused with quantitative easing). The money supply of a country usually needs to expand as the amount of goods and services in a country expands, so that there is enough money to purchase these good and services. This is a fine balancing act, too much money in circulation leads to inflation, but too little also leads to deflation, as was experienced during the Great Depression. However, as this money comes into circulation through government open market operations and consequently the money multiplier effect of the banking system, it enters society as an interest bearing debt. This cost has a compounding effect and must certainly create an unnecessary cost to society. If more money is required to keep the wheels of our monetary system greased, then perhaps governments need to find a way to inject this money into society without this cost? An empirical study into this cost would be an interesting exercise and perhaps an eye opener for future Ministers of Finance and Reserve Bank Governors. Perhaps the lead needs to be taken by a small country like New Zealand, to show the rest of the world how systems can be improved?



Kevthefarmer said...

The World Bank website states, “Our mission is to fight poverty with passion and professionalism for lasting results and to help people help themselves and their environment by providing resources, sharing knowledge, building capacity and forging partnerships in the public and private sectors".
Whatever purpose, benign or otherwise, the World Bank and IMF were created for, de facto they exist to facilitate penetration of capital from advanced economies that are more saturated into undeveloped economies that are unsaturated and where therefore capital is likely to produce higher yields. World Bank loans are largely made to provide infrastructure, ultimately at the expense of the host country, to facilitate the penetration of foreign capital.

This mostly came about due to sub-prime loans to people who could not afford to pay them back and consequently defaulted as property values plummeted./
Of course by far the largest part of the banks exposure here was in mortgage-backed and other derivatives that had little value other than what traders were prepared to pay each other for them in order to mutually inflate the worth of their respective businesses thus achieving the huge executive salaries for which they are now notorious. The sub-prime mortgage fiasco, although serious, mainly created a crisis of confidence in the worth of the banks. The resulting baleouts were a tragedy that resulted in the global sovereign debt crisis and should never have happened. The solution? Take all the institutions into administration, wipe out all their "liars assets" and rebate to the taxpayer all the funds that were injected to fill the gap between fantasy and reality.

for as surely as communism failed due to lack of competition,
This is a value judgement on the merits of competition. Surely, competition acts as a great market regulator, but it does not predicate the success or failure of a social system. Communism failed because of the burden of external pressure from opposed global forces and lack of internal democracy that was a response to the same burden. Lenin predicted it would fail under these circumstances, he could not have predicted that it would take sixty agonising years to die.

Money-it enters society as an interest bearing debt. This cost has a compounding effect and must certainly create an unnecessary cost to society. If more money is required to keep the wheels of our monetary system greased, then perhaps governments need to find a way to inject this money into society without this cost? An empirical study into this cost would be an interesting exercise and perhaps an eye opener for future Ministers of Finance and Reserve Bank Governors. Perhaps the lead needs to be taken by a small country like New Zealand, to show the rest of the world how systems can be improved?
This is the most important thing you have ever said, Steve, and is the key to unravelling the whole economic mess. Only sovereign entities have the right to create legal tender on behalf of society so why are private institutions allowed to create E-money. it is nothing short of legalised forgery.
See this British website for more details how this might happen.

Steve Baron said...

Kev, your last comment is the biggest misnomer Social Creditors and monetary reformers. Private institutions (banks) do not create money as such. It is the 'banking system' itself that creates the money you talk about.

Let me quote Prof. Gregory Mankiw from his economics textbook 'Principles of Macroeconomics' (5th ed. p.347), which explains this phenomenon, in my view, very well.

"Thus, when banks hold only a fraction of deposits in reserve, banks create money. At first, this creation of money by fractional-reserve banking may seem too good to be true because it appears that the bank has created money out of thin air. To make this creation of money seem less miraculous, note that when First National Bank loans out some of its reserves and creates money, it does not create any wealth. Loans from First National give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. In other words, as a bank creates the asset of money, it also creates a corresponding liability for its borrowers. At the end of this money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before."

These comments are not to say the banking system does not have problems, which I highlighted in my last paragraph, but you need to understand the difference Kev, otherwise your solutions might not fix the real problem. There may even indeed be unintended consequences that make the situation worse.

Kevthefarmer said...

This is apologist semantics. The fact that money loaned has a corresponding liability to pay makes not a jot of difference to the fact that the money supply is increased "liquidity" as you say. Unless the economy grows by the same amount as the money increases then the money is debased. Also, the liability to pay includes a liability to pay interest, which has to come from money not yet created. the only way to service this is more loans/debt so on ad infinitum. Can't work forever.

Steve Baron said...

Well I don't agree with you Kev. Your thrust is that 'banks' are the problem and that they are unscrupulous in some way, and I do not believe that to be the case. So therefore the semantics here are very important and your argument needs to be more focused, perhaps more along the lines as I have suggested and for which you agreed.

Kevthefarmer said...

This distinction between "the banks" and "the banking system" might be regarded by some as nitpicking but I do appreciate that there is a subtle difference. However, I would suggest that your belief that they are "not- unscrupulous in some way" leaves you in a very lonely minority.

You will note that at the end of my first comment I used the term "legalised forgery". Well of course this is an oxymoron- if it's legal' then its not forgery, but the point I had to make is that that an asset that should accrue to the crown- the "seignorage" or right of first use of money created, in fact accrues to the bank. This is legal, but its not right. All the time we were living within the growth paradigm, this situation was tolerable because economic growth was more or less able to keep up with the new money created. Tolerable, though probably not desirable in my view because unbridled growth has accellerated resource depletion and the associated ills of profligate consumption so that the inevitable decline occasioned by resource depletion has to be dealt with from a much higher level of lifestyle expectation than would otherwise be the case. "The higher they climb, the harder they fall". Of course, as economic growth was seen as the be-all and end-all of a countries performance in the "grand game" of international finance the banking deregulation of the Reagan-Thatcher-Douglas era was effected precisely to create that high level of growth, and leading inexorably to it's unintended consequences in 2008.

Are the banks unscrupulous? again this is a question of semantics. Given that the objective of any incorporated business is to maximise the profit to it's shareholders then scrupulousness doesn't even come into it. The issue is "do they act legally?". Failing evidence to the contrary we have to answer "yes they do". This then raises the question "do they operate in a way that is compatible with the interest of society at-large?" then the answer must be a resounding "no they don't". It's very difficult for most people to understand that we live in an era of paradigm shift and that we need to rapidly move to an economic model that can cope with a steady state or planned descent style economy. There is a lot of bunkum talked about "decoupling economic growth from the neeed for growth in resource use" but you can't get away from the fact that there is a 97% correlation between economic activity and fossil fuel use, and that the most hard-to-substitute fuel of all,-oil, is at its peak plateau since 2005 and other resources like copper and phosphate are in a similiar situation. This is the paradigm shift.

If you were to ask the question "are the banks' senior executives unscrupulous", then the answer would have to be an unequivocal "yes- they are". Bank deregulation handed them the opportunity to create a tool in the form of "complex financial instruments" that they have used to increase the "on paper" profits of the business on which executive remuneration is based (see para 2 of my first comment in this thread). OK, the executives' first duty is to maximise the return on the shareholders' capital- not to do so constitutes a "feduciary misfeasance" or some such thing, but that has to be tempered with not engaging in "risky behaviour" with the shareholders' capital, which is exactly what they did. Greed and the thrill of risk-taking got the better of them and the one thing that made them think they would get away with it was the idea that the banks are "too big to fail" so far the feeble-mindedness and complicity of the political class has indicated that their gamble paid off -for the time being.

Kevthefarmer said...

When a company engaged in socially necessary work goes bankrupt there is a procedure for dealing with the issue without the lights going out, the taps running dry or, for that matter, the banks locking their safes and bolting their doors- this is called "administration" and this is what should happen to banks that fail.

Take the institution into administration, for the first one or two this would probably involve "dawn raid" type operations but after that I expect they would enter into the arrangement volountarily.

Ensure the security and integrity of private and legitimate business customers accounts so that the "real economy" can continue to function more or less normally.

Unravel the web of real and bogus assets, this would most likely be undertaken by the banks own management and staff under direction of the administrator.

Wipe out all their "liars assets" and rebate to the taxpayer all the funds that were injected to fill the gap between fantasy and reality.

Impose a banking regime as detailed in the link I left at the end of my first comment.

Sue the executives for misfeasance regarding the excessive risk-taking engaged in that precipitated the downfall of the institution. These people have become multi-billionaires by their wrongdoing so a good recovery of funds should be obtainable.

Charge the administration costs to the institution. As the process is likely to be very lengthy and costly, these will probably be high.

Likely there would be no value remaining to hand back to the shareholders. If so, sell the "new" bank to recoup some costs, or run it as a public trust.