An Introduction to the International Monetary System

INTERNATIONAL BUSINESS ENVIRONMENT Course numbers STRT 571-44 & -45, Spring 2010, Mod 4

James Raymond Vreeland, School of Foreign Service

Week 4 (Wednesday, 7 April; Monday, 12 April)

Tonight’s schedule

• 6:30-7:30

• 5 minute break

• 7:35-8:35

• 5 minute break

• 8:40-9:40

Plan for tonight:

1. Why a “trilemma”?

2. Why were countries able to maintain fixed exchange rates with high capital mobility in the late 19th century but not the 20th?

3. Why did we ever invent an IMF? Do we need Regional MF’ers?

(e.g., AMF, EMF)

4. What is the current international monetary system?

5. What is the future international reserve currency?

1st: A reminder of

The Inconsistent/UnholyTrinity

Or“Trilemma”

Free Capital Flow

Fixed Exchange Rate Sovereign Monetary Policy

Inconsistent/UnholyTrinity

Or“Trilemma”:

a country can only have 2 out of 3 of these

Why would you want…

• Free Capital Flow?– Draw on the savings of the rest of the world– Investment opportunities abroad

• Fixed Exchange Rate?– Reduce uncertainty in trade

• Sovereign Monetary Policy?– Address inflation/unemployment

And now a puzzle…

A puzzle

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

Conclusion:

Cannot maintain (global) fixed exchange rates in the presence of

high capital mobility…?

A puzzle

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870

*

Keynes 1919 quote:

• “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery on his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprise of any quarter of the world. He could secure forthwith, if he wished it, cheap and comfortable means of transport to any country or climate without passport or other formality…. He regarded this state of affairs as normal, certain, and permanent.”

A puzzle:Why were countries able to maintain fixed exchange

rates with high capital mobility in the late 19th century?

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870 Interwar period

Fixed exchange rates

+

Open capital flows

Why?

Answer: Democracy

1944

Degree of global capital mobility

1971-3

Fixed exchange rates

+

Capital controls

Floating exchange rates

+

Open capital flows

1870 Interwar period

Fixed exchange rates

+

Open capital flows

Growing #’s of democraciesFew democracies

Growth of democracy (minimalist definition)

1870 (7): 1884 (8): 1897 (12): 1911 (17):

United States Norway Netherlands Sweden

Canada 1885 (9): 1901 (14): Portugal

France United Kingdom Australia 1912 (18):

Switzerland 1890 (10): Denmark Argentina

Greece Luxemburg 1909 (15):

Orange Free State 1894 (11): Cuba

New Zealand Belgium Chile

(lost OFS – 1902)

Why?

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

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

With paper money

• Central Banks intervene by adjusting interest rates

• So gold doesn’t actually flow

• Gold Standard strict discipline!

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!

People don’t eat

Under authoritarianism:

• Let them eat cake

Under democracy:

• Incumbents lose elections

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

2015105

0.625

0.5

0.375

0.25

Time (years)

Hazard Rate

Time (years)

Hazard Rate

Stylized history• Late 19th century:

– Mobile capital, authoritarian governments

• Interwar years:– Mobile capital + democracy beggar-thy-neighbor

• Bretton Woods (1944-1971/3):– Capital controls + democracy

• Post Bretton Woods:– Floating exchange rates

What was Bretton Woods

And what was the IMF’s role?

5 minute break

What is the IMF?• Like an international “credit union”

• Almost all the countries in the world are members (186?)

• All hold currency on reserve

• The IMF can use these reserves to loan to countries in “crisis”

• Moral Hazard? Conditionality!

• IMF programs = loans + conditions

• Decisions at the IMF are by majority rule

• Influence over decisions pegged to “economic size”

– MAJOR SHAREHOLDERS– Votes are determined by contributions (“quota”), Quota set by an

85% majority rule– Most other decisions by simple majority rule (CONSENSUS)

Problem• Keynes Plan called for contributions totaling $26 billion

(with $23 billion from the US)

• The White Plan called for only $5 billion (with $2 billion from the US)

• Compromise:– $8.8 billion, with just $2.75 billion from the US

• The US would only provide Marshall Plan assistance to countries that did not seek additional assistance from the IMF

• On the eve of the current crisis:– instead of having reserves approximating half of the value of

global imports, the IMF holds on reserve a total of less than 2 percent of global imports

What were the goals of Bretton Woods?

• Support Fixed XR’s with governments unwilling to sacrifice employment to address imbalances

• 4 INNOVATIONS:

1. Some XR flexibility (fixed-but-adjustable “snake”)

2. Capital controls

3. A stabilization fund (held on reserve at the IMF)

4. The International Monetary Fund – authority over XR changes + conditionality attached to loans

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

Recapping 1st session:

• Normal trade temporary imbalances

• Fixed exchange rates discipline

• Democracy

• IMF to the rescue!... Or not.

Taking a step back…Why is the IMF involved in the developing world?

• Originally designed to help developed countries maintain fixed exchange rates

• “Soften the blow” of adjustment

• Did it ever do that?

• So what did the IMF do?

Was there really a shift?

Figure 1.1: Percentage of countries participating in IMF programs

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

0.40

0.45

0.5019

46

1949

1952

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

Year

Per

cen

t

Western Europe, US and Japan Rest of the world

IMF effect in the developing world has been lackluster

• Why?

– Partial reform?

– Bad policies?

– International politics?

Partial reform?

• Historically, lack of “ownership” & transparency

• Governments push through some reforms but not others

• Protect elite constituents at the expense of labor & the poor

Bad policies?

• Crisis in the developed world? Stimulus!

• Developing world? Contractionary policies:– Raise interest rates, limit credit, cut public

spending, raise taxes, devalue the currency

• Example: – Compare Mexico 1994 & Indonesia 1997

– South Korea spent 13 years under consecutive agreements from 1965 to 1977

– Zaire 14 years straight (1976-1989)

International Politics?

• Sometimes the “major shareholders” use the IMF to pursue foreign policy goals

• Friends get – Big loans – Fewer policy conditions– Or they ignore conditions with impunity

• Loans prop up bad policies and corrupt governments

Bureaucratic story?

• The IMF is like any other bureaucracy

• Tries to make big loans to generate revenue

• Does not care about enforcing conditionality

Evidence of political favoritism

• Top 5 members:

– United States (16.8%)

– Japan (6.0%)

– Germany (5.9%)

– France (4.9%)

– UK (4.9%)

• Other important members:– China (3.7%)– Saudi Arabia (3.2%)– Russia (2.7%)– Belgium? (2.1%)– Canada? (2.88%)– Brazil? (1.4%)– India? (1.9%)– Korea? (1.3%)

UNSC

IMF

IMF/WB project in Ghana

Figure 1: Participation in IMF programsby rotating membership on the UN Security Council

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

Non-members Members

mean=0.26 mean=0.33

std dev.=0.44 std dev.=0.47

(n=7129) (n=477)

UN Security Council Membership Status

% o

f ob

s. p

artic

ipat

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in I

MF

pro

gram

s

Figure 3: Participation in IMF programsby UN Security Council Membership and Region

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0.20

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0.60N

on-

mem

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n=1669 n=95 n=1119 n=47 n=1254 n=100 n=591 n=36 n=814 n=51 n=998 n=108

Africa Asia & S.Pacific

LA & Carib. E. Europe Middle East &N. Africa

IndustrializedCountries

UN Security Council Membership Status and Region

% o

f obs

. par

ticip

atin

g in

IMF

pro

gram

s

Figure 1: Participation in IMF programs by non-permanent UN Security Council Membership over time

0%

10%

20%

30%

40%

50%

Non-members

Members Other years 4 yearsbefore

3 yearsbefore

2 yearsbefore

1 year before 1st yearmember

2nd yearmember

1 year after 2 years after

mean=0.28 mean=0.34 mean=0.28 mean=0.28 mean=0.31 mean=0.33 mean=0.32 mean=0.35 mean=0.34 mean=0.30 mean=0.28

st.dev.=0.45 st.dev.=0.48 st.dev.=0.45 st.dev.=0.45 st.dev.=0.46 st.dev.=0.47 st.dev.=0.47 st.dev.=0.48 st.dev.=0.48 st.dev.=0.46 st.dev.=0.45

(n=6684) (n=462) (n=5405) (n=178) (n=196) (n=215) (n=236) (n=236) (n=225) (n=234) (n=221)

UN Security Council Membership Status

% o

f ob

s. p

arti

cipa

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in I

MF

pro

gram

s

The horizontal line shows the average IMF participation rate across our entire sample. The dots reflect the results where only low and lower-middle income countries are included.

So, how might programs hurt?

• Sometimes partial reform

• Sometimes bad policy advice

• Sometimes good policy advice but ignored

• Note: sometimes things work out!– Willing governments develop good policies

with the IMF and follow through

IMF web page…http://www.imf.org/external/np/sec/memdir/eds.htm

http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)

Asian Monetary Fund Proposal?• Going back to the aftermath of the US/IMF

bailout of Mexico in 1995

• Japanese policy-thinkers/makers begin thinking about an “Asian Monetary Organization” ($20 billion)

• Why? – Believed that the US would not act as vigorously in

the event of a crisis in Asia

• Then: East Asian Financial Crisis

• http://www.xtimeline.com/timeline/Asian-Financial-Crisis

Aug 1997

• Japan facilitates bilateral commitments towards the IMF rescue package for THAILAND

• Japan commits $4 billion out of the $17.2 billion package (as much as the IMF’s contribution)

• US – conspicuously absent!

“Asian sense of solidarity”

AMF vision

• $100 billion

• 10 members:– Australia, China, Hong Kong, Indonesia,

Japan, Malaysia, Philippines, Singapore, South Korea, Thailand

– NOT the United States– Secretary of State Summers to MOF official

Sakakibara:– “I thought you were my friend!”

US argument

• Moral hazard – postpone adjustment

• Duplication– Add little to the pre-existing IMF system

US enticements

• Offer Asian countries increased IMF quotas– What does this get them?– More votes… and more rights to borrow (more

larger loans)

• New arrangements to borrow

• CHINA: was lobbied regarding “Japanese hegemony”

• Why did Japan propose the AMF?

• Why did the US and the IMF oppose?

• Why did China oppose?

Donors are CONCERNED ABOUT MORAL HAZARD moral hazard if:

• Economic & political ties to the crisis country are weak

• Use the crisis as an OPPORTUNITY:– Extract concessions from the crisis country

(force it to open up to trade and investment)

• Use the crisis country as an example to deter future “moral hazard”

• Economic ties with the crisis-country are dense

• Political interests are at stake

• Domestic conditions are conducive to providing funds abroad– Investors, creditors

• This approach will provide a quick recovery of the crisis economy

• This approach benefits creditors!

• Moral hazard costs are borne over the long run by the entire international community

Donor States will prefer rapid liquidity provision if:

Why did Japan (not US or EU)lean towards liquidity provision in the East Asian Crisis?

25% of Japanese lending to all developing countries went to Thailand!

ADB: US and Japa have the same shares

Japan vs. US

• Japan – largest foreign investor in Thailand

• US & Japan – same share of overall trade

• But Japan ran a surplus, the US a deficit

• Slowdown in Thailand hurts Japanese exports

• Regarding bank exposure, FDI, & trade, the same goes for Japan’s relationship with the rest of East Asia

Flashback to Tequila crisis (1994)!

• US bank lending & economic ties to Mexico far exceeded Japan’s

• US leaned towards liquidity provision

• Put together massive bailout package: $50 billion

• Japan provided no liquidity!!!

Japan’s position at the IMF re: Indonesia

• Japan opposed major structural reforms (eliminate national projects, reduce subsidies, restructure financial structure)

• Japan supported a loan package to stabilize the exchange rate

• IMF ignored Japan

Flash-forward: March 2010Chiang Mai Initiative

• A multilateral currency swap arrangement

• Members: Association of Southeast Asian Nations (ASEAN), China (including Hong Kong), Japan, and South Korea

• ASEAN members: http://www.aseansec.org/74.htm

• Foreign exchange reserves pool of US$120 billion

• Set to launch in March 2010

• The initiative began as a series of **bilateral** swap arrangements after the ASEAN + 3 countries met in May 2000 in Chiang Mai, Thailand

• Why did they meet?– An annual meeting of the Asian Development Bank– http://english.people.com.cn/english/200005/07/eng20000507_40281.html

The ASEAN flag

What about an EMF??

5 minute break

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

Free Capital Flow

Fixed Exchange Rate Sovereign Monetary Policy

Inconsistent/UnholyTrinity

Or“Trilemma”:

a country can only have 2 out of 3 of these

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

Trade & international capital flows lead to imbalances

• How do governments deal with these imbalances?

Avoid them? (Capital controls?)

Fixed exchange rate sacrifice monetary policy

OR:

Floating exchange rate

• Trade-off between exchange rate stability – or – domestic price stability with monetary policy autonomy

Why are there imbalances?

• These days, foreign exchange markets conduct between $1 trillion and $1.5 trillion worth of business… PER…???– Per year?– Per month?– Per day?– Per hour?

Exchange rate volatility! Exchange rate misalignments

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

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!!

The Euro

• The ultimate commitment

• So, if it’s credible, will it overtake the dollar as the international reserve currency?

Euro-Zone• Austria (1999)• Belgium (1999)• Cyprus (2008)• Finland (1999)• France (1999)• Germany (1999)• Greece (2001)• Ireland (1999)• Italy (1999)• Luxembourg (1999)• Malta (2008)• Netherlands (1999)• Portugal (1999)• Slovakia (2009)• Slovenia (2007)• Spain (1999)

• EU members not using the Euro:– United Kingdom– Poland– Sweden– Denmark– Czech Rep Nov 2009 set to

join??– Bulgaria– Estonia– Hungary– Latvia– Lithuania– Romania

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

French-German fight in 1981-3

• Mitterrand – 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

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

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%

Similar situation today

• US current account deficit

• 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

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?

Hope??1. US needs to reduce its budget deficit

2. 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!

Is the Euro an alternative?

• Coordination game

• Present distribution of reserve currencies:– Dollar: ~60%– Euro: ~30%– Pound: ~3%– Yen: ~5%

• SDR?

Be careful what you wish for…

• Benefits of international reserve currency– finance fiscal deficits– enhance international prestige– debt denoted in your own currency

• Costs of international reserve currency– Monetary policy autonomy is hindered - vast

quantities of your currency held abroad– Overvaluation leads to uncompetitive

export-oriented/import-competing sectors

Obstacles

• A focal point: The more people who use an international currency, the more effective it is (increasing returns to scale)

• No equivalent to the US treasury bill @ the EU level

• Leadership – who bails you out?

– US track record v. EU (…Greece?)

What can China do?

• Gradual appreciation?– A one-way road to “hot money” and a scary bubble

• A one-off revaluation?– Catastrophic economic dislocation– Politically possible given the export-oriented sector

strength?

• Status quo?

Status quo

• US “shock absorber”:– Floating exchange rate

• China opts for:– restrictions on capital flows

• How can the dollar adjust if China fixes to it?

• This is the current monetary system…

• And it’s doomed

Thank youWE ARE GLOBAL GEORGETOWN!