Chapter X: The international financial system

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Chapter X The international financial system

1. Evolution of the international financial system
2. The gold standard
3. The Bretton-Woods System and the IMF
4. The ECU, the ERM and the euro
5. Nominal anchoring (dollarization, currency
   boards, and managed float)
6. Globalization and stability of the international
   financial system

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Evolution of the international financial system

• Before World War I, the world economy operated
  under the gold standard
• It means that most world currencies were backed
  by, and convertible into gold.
• For currencies whose unit is permanently tied to
  a certain quantity of gold, the gold standard
  represents a fixed-exchange rate regime
• To see how it works we take an example

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Operation of the gold standard (1)

• The exchange rate between the and the is
  effectively fixed at 51 via the common
  denominator gold
• As the appreciates beyond 5 in financial
  markets, an American importer importing goods for
  100 from the UK would have to pay more than 500
• This importer could arbitrage against the
  financial by exchanging 500 for gold,
  shipping it to the UK, and converting it into
  100 at the fixed gold parity

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Operation of the gold standard (2)

• An appreciation of the leads to British gains
  in international reserves, and an equal loss in
  international reserves in the United States
• It entails a commensurate expansion of base money
  in Great Britain, and a contraction of base money
  in the United States
• This must raise the British price level, and
  provoke a deflation in the US
• It causes a depreciation of the against the
  until the former parity is reinstalled

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Price-species-flow mechanism

• Price adjustments under fixed exchange rates work
  through symmetries in the supply of base money
  between two countries
• One country loses international reserves, the
  other gains international reserves
• This mechanism will ultimately entail a
  countervailing adjustment of price levels for
  goods and services in each country
• This price-species-flow mechanism was first
  described by David Hume

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Example The U.S. during the 1870s

• During the Civil War in the US, the gold standard
  had been abandoned and the government had issued
  significant amounts of paper money to finance
  the war
• In the end, this had lead to an almost doubling
  of the price level
• After the war, the US returned to the gold
  standard at the parity that had reigned before.
• This (shock) contraction of the money supply
  caused the depression of 1873-79

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Return to the gold standard after WW I

• After World War I most countries tried to return
  to the gold standard
• International trade was mainly carried out in
  British pounds, French francs, US dollars, all
  (partially) covered by gold
• Payments were made in gold certificates
  (promissory notes denominated in gold), the
  volume of which increased by credit expansion
• The Great Depression caused insolvencies in gold,
  which brought the gold standard to an end

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The Bretton-Woods System

• In 1944, the post-war international economic
  order was conceived in the little town of
  Bretton Woods (New Hampshire)
• The three international institutions created are
• the International Monetary Fund (IMF)
• the Bank for Reconstruction and Development
  (Worldbank)
• the General Agreement on Tariffs and Trade
  (GATT), now World Trade Organization (WTO)

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The Bretton-Woods System

• The international financial system
  (Bretton-Woods System) was based on gold and the
  US dollar
• The parity between the dollar and gold was fixed
  at 35 for an ounce of gold
• The exchange rates of other countries adhering to
  the system were pegged to the dollar
• Discretionary exchange-rate adjustments were
  possible in the case of fundamental
  balance-of-payments disequilibria

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Forex interventions by central banks

• If the domestic currency was undervalued, the
  central bank must sell domestic currency to keep
  the exchange rate fixed (within limits of 1
  percent), but as a result it had to take
  international reserves (US dollars) on board
• If the domestic currency was overvalued, the
  central bank must purchase domestic currency to
  keep the exchange rate fixed, but as a result it
  lost international reserves

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The role of the IMF

• Surplus countries faced a strengthening of their
  currencies (revaluation)
• Deficit countries experienced a weakening
  (devaluation)
• The IMF took (and takes) the role of an
  international lender under certain conditions
• Loans are given to member countries with
  balance-of-payment difficulties
• The IMF has now close to 190 members

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IMF as lender of last resort

• A lender-of-last-resort operation by the IMF is
  a two-edged sword
• central bank lending during a financial crisis
  could stabilize the currency and strengthen
  domestic balance sheets and it could
• fend off speculation and prevent contagion
• But it could also
• arouse fears of inflation spiraling out of
  control, and hence cause a further depreciation
  and it could
• increase moral hazard and adverse selection
  problems and make the crisis worse

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The operation of the system

• As for any fixed-exchange-rate regime, the
  price-species-flow mechanism was also working
  under the BW-system
• However, revaluations and devaluations were
  devices to let out steam and to ease economic
  pressures, and hence to avoid the full price
  adjustment
• This was in particular helpful for deficit
  countries, because internal prices are typically
  rigid downwards (in particular wages), and a
  painful deflation could thus be avoided

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Problems of the BW system

• The US-dollar became an international trading
  and reserve currency, for which the Fed held a
  monopoly
• As more and more dollars would be issued (US gold
  reserves remaining constant), trust in the world
  currency was expected to weaken (Triffin
  Dilemma)
• However, initially there was a shortage of
  international reserves worldwide, although this
  changed later

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Special Drawing Rights (SDR)

• In order to overcome the apparent shortage of
  international reserves in the 1960s, the US and
  other key IMF members had allowed the IMF to
  issue a paper substitute for gold special
  drawing rights (SDRs)
• SDRs function as international reserves, but --
  unlike gold -- they can (within limits) be issued
  by the IMF through credit creation
• SDRs are only being used for official payments
  among central banks

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The end of Bretton Woods

• The Bretton-Woods agreement lasted until 1971,
  when it broke down due to institutional and
  economic asymmetries
• When the US pursued an inflationary policy during
  the 1960s and early 1970s, the low-inflation
  Deutsche Mark became an increasingly attractive
  speculative asset
• Prices for gold in the free market provided
  opportunities for arbitrage gains there were
  mounting incentives for currency speculation

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The end of Bretton Woods

• One option of surplus countries would have been
  to follow US inflationary policies (and take on
  board US dollars without limits!)
• This opens up unlimited seignorage gains for the
  issuer of the reserve currency, the US
• The other option was to revalue
• For countries that use the dollar as a reserve
  instrument, their relative wealth position is
  tied to the exchange rate of international
  reserves
• A revaluation of the DM implies a devaluation of
  the acquired claims in US dollars

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Forex market and monetary policy

• Moreover, an appreciation of the currency entails
  an increase in export prices for foreigners, and
  a fall of import prices at home
• This could trigger higher unemployment
• Because surplus countries were not willing to
  revise their exchange rates upward, adjustment ..
  did not take place and the BW System collapsed in
  1971. (F. Mishkin)
• The ability to conduct monetary policy is easier
  when a countrys currency is a reserve currency
  (F. Mishkin)

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The ECU and the ERM

• The ECU was a weighted average of the currencies
  of all (initially 9, then 12) member states of
  the (now) European Union
• The ERM (exchange-rate mechanism) was an
  arrangement that compelled governments to keep
  the exchange rate of their currencies within
  predetermined corridors ( 2.25 or 6)
  relative to the ECU rate
• Participation in the ERM was voluntary

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The composition of the ECU (1989)
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The exchange-rate mechanism (ERM)

• The national currency is fixed to the ECU
• A variation of the exchange rate within the
  pre-defined corridor is allowable
• Once the exchange rate tends toward the margins
  of the corridor, the central bank is encouraged
  to intervene (infra-marginal interventions)
• Once the exchange rate moves out of the
  corridor, a central bank intervention is
  mandatory to bring it back into the corridor

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International monetary policy coordination

• There were two (failed) attempts to coordinate
  exchange-rate policies to stabilize the US dollar
  in the 1980s the Plaza and the Louvre
  accords

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Capital controls

• Capital controls (particularly those on outflows)
  are typically rejected by economist
• Controls on capital inflows receive some support
  and have also been used rather successfully in
  some countries (Chile and Colombia)
• Reason Capital inflows can cause an excessive
  lending boom, entailing a painful reversal
• But controls of capital inflows could also block
  funds for economic development. It calls for
  differential treatment according to maturity

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The international policy focus is now on

• .. improving banking regulation and
  supervision, and on greater transparency.

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The role of a nominal anchor

• Adherence to a nominal anchor forces a monetary
  authority to conduct disciplined monetary
  policy
• A priori publicized self-binding rules
• imply a strong auto-commitment
• can relieve from short-term political pressures
• contribute to the predictability of policy and
  hence stabilize economic behavior
• foster confidence building in monetary authorities

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The time-consistency problem

• Economic behavior is influenced by what economic
  agents expect monetary authorities to do in the
  future
• If expectations were to remain unchanged there is
  the temptation to abuse this fact by attempting
  to boost the economy through discretionary
  expansionary monetary policy
• If expectations will incorporate the expected
  outcome of such a policy, output will not be
  higher, but inflation will!
• A monetary anchor acts as self-binding rule

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Exchange-rate targeting

• Exchange-rate targeting has a long history,
  including the fixing of the exchange rate to the
  price of gold
• Exchange-rate targeting has clear advantages
• it links the price of traded goods to that found
  in the anchor country this might contain
  inflation
• time-inconsistent monetary becomes less of an
  option this stabilizes price expectations
• it is a simple and transparent rule (franc
  fort)
• Exchange-rate targeting has been widely used in
  Europe and world-wide

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Disadvantages of exchange-rate targeting

• Exchange-rate targeting might be create serious
  problems because
• the country tying its currency to that of an
  anchor currency can no longer respond to shocks
  to its own economy
• there could also be shocks applying to the anchor
  country these are fully transmitted (the case of
  Germany after unification)
• if the anchor country opts for inflation,
  countries with pegged currencies will import
  inflation
• it may present opportunities of a one-way bet for
  speculators (crisis of the EMS of September 1992)

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The 1992 ERM crisis the UK and France

• The UK did devalue

• France did not!

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The cost of pegging

• The UK had higher growth and less unemployment
• But its inflation rate increased

• France had lower growth and more unemployment
• But its inflation rate was lower

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Exchange-rate targeting For whom?

• Industrialized countries might have more to lose
  by exchange-rate targeting than to win
• In some industrialized countries the central
  banks is subject to political pressure
• In this case exchange-rate targeting may prove to
  be beneficial
• It also encourages economic integration
• Contrary to industrialized countries, emerging
  market countries may not lose much by giving up
  an independent monetary policy, but it leaves
  them open to speculative attacks

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Can speculation be averted?

• The currency-board approach
• One approach is to back the domestic currency by
  100 by a foreign currency (euros, dollars)
• It means
• the money supply can only expand when
  international reserves of a country increase.
• a strong commitment of monetary policy, which may
  therefore work instantly in controlling
  inflation.
• Currency boards are however not immune against
  speculation

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Currency boards Examples

• Recent examples of currency boards include
• Hong Kong (1983)
• Argentina (1991)
• Estonia (1992) and Lithuania (1994)
• Bulgaria (1997)
• Bosnia and Herzegovina (1998)
• Argentina had to abandon the scheme in December
  2001 -- with painful social and economic
  repercussions

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The CFA-zone

• The CFA franc is the common currency of 14
  countries in West and Central Africa, 12 of
  which are former French colonies
• The CFA franc has been pegged to the French franc
  since 1948. Only one devaluation has occurred
  during the history of the currency peg (January
  1994)
• The French Treasury has the sole responsibility
  for guaranteeing convertibility of CFA francs
  into euros, without any monetary policy
  implication for the ECB

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Can speculation be averted?

• Dollarization
• Another approach is to abandon a national
  currency altogether and to adopt a foreign
  currency (e.g. US dollars) instead
• It means
• a euro or dollar remains a euro or dollar,
  whether inside or outside the respective currency
  area.
• that the country adopting a foreign currency
  loses potential income through seignorage.
• However a reversal to a domestic currency always
  remains an option

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Dollarization Examples of countries
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Dollarization Exits

• Even dollarization does not guarantee a permanent
  monetary anchoring
• There is need to a continuing inflow of foreign
  denominated capital to satisfy domestic demand
  for money
• This puts severe strains on the economy
• There is a large number of exits from a currency
  zone during recent years
• Numerous exits from the ruble zone after the
  breakdown of the Soviet Union
• the secession of Slovakia from Czechoslovakia
• the breakdown of Yugoslavia

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Foreign exchange arrangements
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Inflation targeting

• A number of countries has adopted inflation
  targeting following the lead of New Zealand
  (1990)
• Canada (from 1991)
• the UK (from 1992)
• Australia (1994)
• Brazil (1995)
• In 1990 the Reserve Bank of NZ became fully
  independent and was committed to the sole
  objective of price stability
• The governor of the central bank is held
  accountable for achieving a predefined inflation
  goal

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Inflation targeting strategy

• The strategy consists of
• publicly announcing a medium-term numerical
  target for inflation that is well defined
• committing the central bank to price stability as
  the primary (if not sole) policy goal
• an information strategy that includes several
  indicators, not just monetary aggregates
• increased communication with the public to render
  monetary policy more transparent and
• an increased accountability of the central bank
  for attaining its inflation target.

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Inflation targeting advantages

• Inflation targeting
• enables the central bank to focus on domestic
  policy objectives, but a stable relationship
  between money and the price level is not critical
  for its success
• is highly transparent and easily understood
• increases the accountability of the central bank
  because of a numerical target as a benchmark
• seems to ameliorate the effects of inflationary
  shocks (introduction of a GST in Canada exit of
  the British pound from the ERM in 1992). There
  was a one-time price adjustment, but no spiraling
  up of inflation.

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Inflation targeting disadvantages

• Inflation targeting is not without problems
  because
• inflation cannot be controlled directly and
  policy outcomes occur only with a time lag
• therefore the policy cannot send immediate
  signals to economic agents
• may be too rigid and limit the policy discretion
  to respond to unforeseen events
• it will even out inflation, but might increase
  output fluctuations

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The two pillar strategy of the ECB

• The strategy of the ECB appears to reconcile
  monetary targeting with inflation targeting by
  scrutinizing both monetary growth and a bundle of
  economic indicators to assess the medium-term
  impact on the HICP
• Contrary to the NZ approach, the ECB may be
  criticized as being less responsive to public
  demands for information
• Less transparency goes hand in hand with less
  accountability

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• Reading 10-1 Wrestling for influence, The
  Economist, July 3rd, 2008

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Thats it !

• Thank you for attending this course
• I hope you enjoyed it
• All the best for you private and professional
  future, and
• good luck for the final exam !

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