Heilleiner- The Evolution of the monetary and financial system

John Ravenhill chap07.tex V1 - July 30, 2007 5:13 P.M. Page 213

7 The Evolution of the InternationalMonetary and Financial SystemERIC HELLEINER

Chapter Contents

Introduction

The Fate of a Previous Globally Integrated Financial and Monetary Order

The Bretton Woods Order

The Crisis of the Early 1970s

From Floating Exchange Rates to Monetary Unions

The Dollars Declining Global Role?

The Globalization of Financial Markets

Conclusion

Readers Guide

The international monetary and financial system plays a central role in the global

political economy. Since the late nineteenth century, the nature of this system has

undergone several transformations in response to changing political and economic

conditions at both domestic and international levels. The most dramatic change was the

collapse of the integrated pre-1914 international monetary and financial regime during

the inter-war years. The second transformation took place after the Second World War,

when the Bretton Woods order was put in place. Since the early 1970s, another period

of change has been under way as various features of the Bretton Woods order have

unravelled: the gold exchange standard, the adjustable peg exchange-rate regime, the US

dollars global role, and the commitment to capital controls. These various changes have

important political consequences for the key issue of who gets what, when, and how in

the global political economy.


Introduction

It is often said that money makes the world goaround. In this age of globalization, the sayingappears more relevant than ever. Internationalflows of money today dwarf the cross-border tradeof goods. And the influence of these flows seemsonly to be enhanced by their unique speed andglobal reach.

If money is so influential, it is fitting that itshould have a prominent place in the study ofglobal political economy, and scholarly research onthe political economy of international monetaryand financial issues has indeed grown very rapidlyin recent years. While perspectives vary enormouslywithin this literature, scholars working in this fieldshare the belief that the study of money and financemust adopt a wider lens than that adopted by mosteconomists.

Economists are trained to view money and fin-ance primarily as economic phenomena. From theirstandpoint, money serves as a medium of exchange,a unit of account, and a store of value, while financialactivity allocates credit within the economy. Both ofthese functions are critical to large-scale economiclife, since they facilitate commerce, savings, andinvestment.

These descriptions of the economic role of moneyand finance are certainly accurate, but they are alsolimiting. Money and finance, after all, serve manypolitical purposes as well (not to mention socialand cultural ones). In all modern societies, controlover the issuing and management of money andcredit has been a key source of power, and thesubject of intense political struggles. The organiz-ation and functioning of monetary and financialsystems are thus rarely determined by a narroweconomic logic of maximizing efficiency. They alsoreflect various political rationales relating to the

pursuit of power, ideas, and interests (Kirshner2003).

The interrelationship between politics and sys-tems of money and finance is particularly apparentat the international level, where no single politicalauthority exists. What money should be used tofacilitate international economic transactions andhow should it be managed? What should the natureof the relationship between national currencies be?How should credit be created and allocated atthe international level? The answers to these ques-tions have profoundly important implications forpolitics, not just within countries but also betweenthem. It should not surprise us, then, that they pro-voke domestic and international political struggles,often of an intense kind.

This chapter highlights this point by providingan overview of the evolution of the internationalmonetary and financial system since the late nine-teenth century. The first section examines howchanging political circumstances, both internation-ally and domestically, during the inter-war yearsundermined the stability of the globally integratedfinancial and monetary order of the pre-1914 era.The next section describes how a new interna-tional monetary and financial systemthe BrettonWoods orderwas created in 1944 for the post-war period, with a number of distinct features.The following four sections analyse the causes andconsequences of the unravelling of various fea-tures of that order since the early 1970s: the goldexchange standard, the adjustable peg exchange-rate regime, the US dollars prominent global role,and the commitment to capital controls. In the nextchapter, Louis Pauly addresses another feature ofthe contemporary international financial order: itsvulnerability to crises.

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The Fate of a Previous Globally IntegratedFinancial and Monetary Order

Debates about contemporary economic globaliza-tion often note that this trend had an importantprecedent in the late nineteenth and early twentiethcenturies. This is certainly true in the monetary andfinancial sector (see McGrew, Chapter 9, and Hay,Chapter 10 in this volume). Cross-border flows ofmoney increased dramatically in this earlier periodand, according to some criteria, even surpassedthose in the current era in significance for nationaleconomies. Some of these flows involved short-termcapital movements that responded primarily to in-terest rate differentials between financial centresaround the world. Others involved long-term cap-ital exports from the leading European powers tointernational locations. The United Kingdom, inparticular, exported enormous amounts of long-term capital after 1870, sums that were much largeras a percentage of its national income than any cred-itor country is exporting today (James 2001: 12).

These capital flows were facilitated by the emer-gence of an international monetary regime thatwas also highly integrated, indeed much more sothan in the current period. By 1914, the curren-cies of most independent countries and colonizedregions around the world were linked to the samegold standard (see Box 7.1). The result was afixed exchange-rate regime with an almost globalreach. Indeed, some European countries went evenfurther, to create regional monetary unions inwhich the currencies of the member countries couldcirculate in each others territory. Two such unionswere created: the Latin Monetary Union (LMU)in 1865 (involving France, Switzerland, Belgium,and Italy) and the Scandinavian Monetary Union(SMU) in 1873 (involving Sweden and Denmark,plus Norway after 1875). A high-level interna-tional conference was held in 1867 to considerthe possibility of a worldwide monetary union of

The Theory of the Adjustment Process Under the International Gold Standard

In theory, the international gold standard was aself-regulating international monetary order. Externalimbalances would be corrected automatically by do-mestic wage and price adjustments, according toa process famously described by David Hume: thepricespecie flow mechanism. If a country experi-enced a balance of payments deficit, Hume noted,gold exports should depress domestic wages andprices in such a way that the countrys interna-tional competitive positionand thus its trade po-sitionwould be improved. Humes model assumedthat most domestic money was gold coins, but the do-mestic monetary system of most countries on the goldstandard during the late nineteenth and early twen-tieth centuries was dominated by fiduciary money inthe form of bank notes and bank deposits. In this

context, the monetary authority that issued notes andregulated the banking system had to stimulate theautomatic adjustments of the gold standard by fol-lowing proper rules of the game. In the event ofa trade deficit, it was expected to tighten monetaryconditions by curtailing the issue notes of and rais-ing interest rates. The latter was designed not just toinduce deflationary pressures (by increasing the costof borrowing) but also to attract short-term capitalflows to help finance the payments imbalance whilethe underlying macroeconomic adjustment processwas taking place. In practice, however, historians ofthe pre-1914 gold standard note that governmentsdid not follow these rules of the game as closelyand consistently as the theory of the gold standardanticipated (Eichengreen 1985).

BOX 7.1

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this kind. As the scramble for colonies intensifiedafter 1870, many imperial powers often encouragedthe circulation of their currencies in the newlyacquired colonies during this period (Helleiner2003; chs 6, 8). These currency unions and imperialcurrency blocs were designed to make economictransactions within each union or bloc easier toconduct.

The end of globalization

What can we learn from this era in our effortsto understand the political foundations of inter-national money and finance? Perhaps the mostinteresting lesson is that this globally integratedfinancial and monetary order did not last. In thecontemporary period, globalization is sometimessaid to be irreversible. A study of the fate of thisearlier globalization trend, however, reminds us tobe more cautious. In particular, it highlights theimportance of the political basis of internationalmoney and finance.

The first signs of disintegration came duringthe First World War, when cross-border financialflows diminished dramatically and many countriesabandoned the gold standard in favour of float-ing currencies. After the war ended, there was aconcerted effortled by the United Kingdom andthe United Statesto restore the pre-1914 inter-national monetary and financial order, and thisinitiative was initially quite successful. Many coun-tries did restore the gold standard during the 1920s,and international capital flowsboth short-termand long-termalso resumed on a very large scaleby the late 1920s (Pauly 1997; ch. 3).

But this success was short-lived. In the early1930s, a major international financial crisistriggered the collapse of both international lendingand the international gold standard. This devel-opment signalled what Harold James (2001) hascalled the end of globalization. The interna-tional monetary and financial system broke upinto a series of relatively closed currency blocs.

Within each bloc, currencies were usually fixedvis-a`-vis each other, and some international lend-ing resumed. But between the blocs, currencieswere often inconvertible and their value fluctuatedconsiderably for much of the decade. Internationalflows of capital between the blocs were also limited,and often regulated tightly by new capital controlregimes.

Hegemonic stability theory

What explains this dramatic change in the nature ofthe international monetary and financial regime? Aprominent explanation within international polit-ical economy (IPE) scholarship has been that thetransformation was related to a change in thedistribution of power among states within the in-ternational monetary and financial arena (see, forexample, Kindleberger 1973). According to thishegemonic stability theory, the pre-1914 interna-tional financial and monetary regime remainedstable as long as it was sustained by British hege-monic leadership. Before the First World War, theUnited Kingdoms currency, sterling, was seen to beas good as gold and it was used around the globeas a world currency. Britain was also the largestcreditor to the world and Londons financial mar-kets held a pre-eminent place in global finance. TheUnited Kingdoms capital exports helped to financeglobal payments imbalances and they were usefullycounter-cyclical; that is, foreign lending expandedwhen the UK entered a recession, thus compensat-ing foreign countries for the decline in sales to theUK. During international financial crises, the Bankof England is also said to have played a leadershiprole in stabilizing markets through lender-of-last-resort activities.

However, after the First World War, the UnitedKingdom lost its ability to perform its leadershiprole in stabilizing the global monetary and financialorder. The United States replaced it as the leadcreditor to the world economy, and the US dollaremerged as the strongest and most trustworthy

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world currency. New York also began to rival Lon-dons position as the key international financialcentre. In these new circumstances, the UnitedStates might have taken on the kind of leadershiprole that the United Kingdom had played beforethe war. But it proved unwilling to do so becauseof isolationist sentiments and domestic politicalconflicts between internationally orientated andmore domestically focused economic interests. Theresulting leadership vacuum is blamed for theinstability and eventual breakdown of the goldstandard and integrated financial order during theinter-war period.

Hegemonic stability theorists criticize several as-pects of US behaviour during the 1920s and early1930s. Its capital exports during the 1920s werepro-cyclical; they expanded rapidly when the USeconomy was booming in the mid-to-late 1920s,but then came to a sudden stop in 1928, just as thegrowth of the US economy was slowing down. Thecollapse of US lending generated balance of pay-ments crises for many foreign countries that hadrelied on US loans to cover their external paymentsdeficits. The United States then exacerbated thesecountries difficulties by raising tariffs against im-ports with the passage of the 1930 SmootHawleyAct. As confidence in international financial mar-kets collapsed in the early 1930s, the USA alsorefused to take on the role of international lender-of-last-resort, or even to cancel the war debts thatwere compounding the crisis.

Changing domestic politicalconditions

This interpretation of the evolution of the inter-national monetary and financial system from thepre-1914 period and into the inter-war period isnot universally accepted (see, for example, Calleo1976; Eichengreen 1992; Simmons 1994). One lineof criticism has been that it overstates the signific-ance of UK leadership in sustaining the pre-1914monetary and financial order. The distribution of

financial and monetary power in that era is said tohave been more pluralistic than hegemonic, withstability being maintained by co-operation betweenleading central banks rather than unilateral UKleadership. Even more important is the argumentthat the transformation of the international finan-cial and monetary system was generated more bya change in the distribution of power within manystates than between them.

According to this latter perspective, the stabilityof the pre-1914 international monetary and finan-cial order was dependent on a very specific domesticpolitical context. In that era, elite-dominated gov-ernments were strongly committed to the classicalliberal idea that domestic monetary and fiscal policyshould be geared to the external goal of maintainingthe convertibility of the national currency into gold.When national currencies came under downwardpressure in response to capital outflows or tradedeficits, monetary and fiscal authorities usually re-sponded by tightening monetary conditions andcutting spending. These moves were designed partlyto induce deflationary pressures, which improvedthe countrys international competitive position,and thus its trade balance. Equally important, theywere aimed at restoring the confidence of financialmarket actors and encouraging short-term capitalinflows (see Box 7.1). Indeed, the very fact thatgovernments were so committed to these policies,and to the maintenance of their currencys peg togold, ensured that short-term capital movementswere highly stabilizing and equilibrating in thisperiod.

The strength of governments commitments tothese policies, however, rested on a particular do-mestic political order. Deflationary pressures couldbe very painful for some domestic groups, particu-larly the poor, whose wages were forced downwards(or who experienced unemployment if wages didnot fall). The poor also often bore the brunt of theburden when government spending was cut. Thesepolicies were politically viable only because manylow-income citizens had little voice in the politicalarena. In most countries, the electoral franchise

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remained narrow before 1914. In many countries,central banks were not even public bodies in thisperiod, and in colonial or peripheral regions, mon-etary authorities were often controlled by foreigninterests.

After the First World War, the domestic politicalorder was transformed in many independent states.The electoral franchise was widened, the power oflabour grew, and there was increasing support formore interventionist economic policies. In this con-text, it was hardly surprising to find new demandsfor monetary and fiscal policies to respond to do-mestic needs rather than to the goal of maintainingexternal convertibility of the currency into gold, andthe confidence of foreign investors. Governmentsbegan to run fiscal deficits, and central banks cameunder new public pressure to gear interest rates toaddress domestic unemployment.

It was these new domestic circumstancesrather than declining UK powerthat many be-lieve played the key role in undermining the stabilityof the integrated international and monetary sys-tem during the inter-war period. As governmentsceased to play by the rules of the game, the self-regulating character of the gold standard beganto break down (see Box 7.1). Short-term interna-tional financial flows also became more volatileand speculative, as investors no longer had con-fidence in governments commitment to maintainfixed rates and balanced budgets. Faced with thesenew domestic pressures, central banks also found itmore difficult to co-operate in ways that promotedinternational monetary and financial stability.

In the context of the international financial crisisof 1931 and the Great Depression, many govern-ments then chose simply to abandon the goldstandard in order to escape its discipline. At thetime, the collapse of international lending and ex-port markets, as well as speculative capital flight,had left many countries with enormous balanceof payments deficits. If they stayed on the goldstandard, these deficits would be addressed by defla-tionary policies designed to press wages and prices

downwards. A depreciation of the national cur-rency provided a quicker, less painful, manner ofadjusting the countrys wages and prices vis-a`-visthose in foreign countries in order to boost exportsand curtail imports.

A floating exchange rate also provided greaterpolicy autonomy to pursue expansionary monet-ary policies that could address pressing domesticeconomic needs. While on the gold standard, agovernment wishing to bolster economic growthby lowering interest rates would experience cap-ital flight and an outflow gold of and would beforced to reverse the policy in order to restorethe stability of the currency. With a floating ex-change rate, the government could simply let theexchange rate depreciate. The exchange rate wouldadjust to the changing level of domestic prices andwages instead of the other way around. This de-preciation would also reinforce the expansionaryintent of the initial policy, since exports would bebolstered and imports discouraged. More generally,it is worth noting that a floating exchange rate wasalso attractive to many governments in the early1930s because it could insulate the country frommonetary instability abroad, particularly from thedeflationary pressures emanating from the USA atthis time.

In addition to abandoning the gold standard,many governments during the 1930s turned tocapital controls to reinforce their national policyautonomy. With this move, they insulated them-selves from the disciplining power of speculativecross-border financial movements. If, for example,a government wanted to bolster domestic economicgrowth by lowering interest rates or engaging in de-ficit spending, it no longer had to worry aboutcapital flight. For this reason, it was natural tofind John Maynard Keynes, the leading advocateof such domestically-orientated, activist macroeco-nomic management, emerge as one of the strongestsupporters of capital controls in the early 1930s.As Keynes put it, let finance be primarily national(Keynes 1933: 758).

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KEY POINTS

In the late nineteenth and early twentieth centuries,a highly integrated global financial and monetaryorder existed. By the early 1930s, it had collapsed,and was replaced by a fragmented order organ-ized around closed economic blocs and floatingexchange rates.

Some believe the reason for the breakdown of thepre-1914 order was the absence of a state actingas a hegemonic leader to perform such roles as the

provision of stable international lending, the main-tenance of an open market for foreign goods, andthe stabilization of financial markets during crises.

Others argue that the pre-1914 order was broughtdown more by a domestic political transformationacross much of the world, associated with expan-sion of the electoral franchise, the growing powerof labour, and the new prominence of supportersof interventionist economic policies.

The Bretton Woods Order

If an integrated international monetary and finan-cial order was to be rebuilt, it would need to becompatible with the new priority placed on do-mestic policy autonomy. An opportunity to createsuch an order finally arose in the early 1940s, whenUS and UK policy-makers began to plan the organ-ization of the post-war international monetary andfinancial system.

Embedded liberalism

At the time, it was clear that the United States wouldemerge from the war as the dominant economicpower, and US policy-makers were determined toplay a leadership role in building and sustaininga more liberal and multilateral international eco-nomic order than the one that had existed during the1930s. The closed economic blocs and economic in-stability of the previous decade were thought to havecontributed to the great depression and the SecondWorld War. But US policy-makers did not wantto see a return to the classical liberal internationaleconomic order of the pre-1930s period. Instead,they hoped to find a way to reconcile liberal mul-tilateralism with the new domestically orientatedpriorities to combat unemployment and promotesocial welfare that had emerged with the New Deal.

This objective to create what Ruggie (1982) hascalled an embedded liberal international economicorder was shared by Keynes, who had emerged asthe policy-maker in charge of UK planning for thepost-war world economy during the early 1940s. Heworked with his American counterpart, Harry Dex-ter White, to produce the blueprint for the post-warinternational monetary and financial order that wassoon endorsed by forty-four countries at the 1944Bretton Woods conference (Van Dormael 1978;Gardner 1980).

At first sight, the blueprint seemed to signal a re-turn to a pre-1930s world. Signatories to the BrettonWoods agreements agreed to declare a par value oftheir currency in relation to the gold content of theUS dollar in 1944. At the time, the US dollar wasconvertible into gold at a rate of $35 per ounce.By pegging their currencies in this way, countriesappeared to be establishing an international goldstandardor, to be more precise, a gold exchangestandard or gold-dollar standard. And at one level,the objectives underlying the Bretton Woods agree-ments were indeed similar to those of the goldstandard. The Bretton Woods architects sought tore-establish a world of international currency sta-bility. Floating exchange rates were associated withbeggar-thy-neighbour competitive devaluations,

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speculative financial flows, and the general break-down of international economic integration.

A different kind of gold standard

But several other features of the Bretton Woodsagreements made clear that this commitment didnot signal a return to the kind of gold standard ofthe 1920s or the pre-1914 period. First, countrieswere given the option of adjusting their countriespar value whenever their country was in funda-mental disequilibrium. This was to be, in otherwords, a kind of adjustable peg system, in whichcountries could substitute exchange-rate devalu-ations for harsh domestic deflations when theyexperienced sustained balance of payments deficits.Currency realignments of up to 10 per cent fromthe initial parity were to be approved automatically,while larger ones required the permission of thenewly created International Monetary Fund (IMF).Even in the latter case, the priority given to domesticpolicy autonomy was made clear; the Articles of theAgreement of the IMF noted that the Fund shallnot object to a proposed change because of thedomestic social or political policies of the memberproposing the change (Article iv-5).

Second, although countries agreed to make theircurrencies convertible for current account transac-tions (that is, trade payments), they were given theright to control all capital movements. This provi-sion was not intended to stop all private financialflows. Those that were equilibrating and designedfor productive investment were still welcomed. Butthe Bretton Woods architects inserted this provi-sion because they worried about how speculativeand disequilibrating flows could disrupt both stableexchange rates and national political autonomy.Regarding the latter, Keynes and White sought toprotect governments from capital flight that wasinitiated for political reasons or with the goal ofevading domestic taxes or the burdens of sociallegislation (quoted in Helleiner 1994: 34). Capitalcontrols could also enable governments to pursuemacroeconomic planning through an independentinterest rate policy. As Keynes (1980: 149) put it,

In my view the whole management of the domesticeconomy depends upon being free to have the ap-propriate rate of interest without reference to ratesprevailing elsewhere in the world. Capital control isa corollary to this.

The Bretton Woods architects also establishedtwo public international financial institutions: theInternational Bank for Reconstruction and De-velopment (IBRD) (known as the World Bank)and the IMF. At a broad level, these institu-tionsparticularly the IMFwere given the taskof promoting global monetary and financial co-operation. More specifically, they were to assumesome aspects of international lending that hadpreviously been left to private markets. The IBRDwas designed to provide long-term loans for re-construction and development after the war, atask that the private markets were not trusted toperform well. The IMF was to provide short-termloans to help countries finance their temporarybalance of payments deficits, a function that wasdesigned explicitly to reinforce those countriespolicy autonomy and challenge the kind of externaldiscipline that private speculative financial flowsand the gold standard had imposed before the 1930s(see Box 7.2).

For the first decade and a half after the SecondWorld War, the Bretton Woods system, it has beensaid, was in virtual cold storage (Skidelsky 2003:125). It is certainly true that the IMF and IBRDplayed very limited roles during this period, andthat European countries did not make their cur-rencies convertible until 1958 (the Bretton Woodsagreements had allowed for a transition period ofno specified length, during which countries couldkeep currencies inconvertible). At the same time,however, most governments outside the Soviet or-bit were committed to the other principles outlinedat Bretton Woods: namely, the maintenance ofan adjustable-peg exchange-rate regime; the gold-dollar standard; and the control of capital move-ments. Moreover, although the IMF and WorldBank were sidelined, other bodiesparticularlythe US government, but also regional institutionssuch as the European Payments Unionacted in

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How Does the IMF Work?

While the World Bank can borrow from the privatemarkets to fund its lending, the IMFs capacity to lendcomes primarily from the contributions of membergovernments. On joining the IMF, all member gov-ernments pay a quota to the institution that largelyreflects their relative size within the world economy.The amount of money they can borrow from theFund is then determined by their quota size. Quotasalso play a very significant role in determining votingshares within the Fund. All countries are allocated250 basic votes, but the bulk of their voting shareis determined by their quota size. At the time of thefounding of the IMF, basic votes made up 11 percent of total votes, but this figure has fallen to approx-imately 2 per cent at the time of writing because ofthe entrance of new members and quota increases.

Quotas are reviewed at least every five years, andthe relative share of various countries has changedover time in response to these reviews. The US quotashare, for example, has fallen from more than 30

per cent of the total votes in 1944 to roughly 17per cent today, while the shares of countries suchas Japan, Germany, and Saudi Arabia have increasedconsiderably. The most recent adjustment of quotastook place in September 2006, when an agreementwas reached to provide four countries, whose existingshares were particularly out of line with their growingeconomic significance, with quota increases: namely,China, South Korea, Mexico, and Turkey.

The IMF is governed by its Board of Governors,which meets annually. Day-to-day decision-making,however, is delegated to the Executive Board, whichmeets several times a week. The Executive Board star-ted with only twelve executive directors, with the fivelargest country contributors being assigned a singleseat and other members being represented by con-stituency groups. Today, the number of executive dir-ectors has risen to twenty-four and, in addition to thefive largest contributors, single-country constituencieshave been created for Saudi Arabia, China, and Russia.

BOX 7.2

the ways that Keynes and White had hoped theBretton Woods institutions would. Public interna-tional lending was provided for temporary balanceof payments support, as well as for reconstruc-tion and development. United States policy-makersalso promoted embedded liberal ideals when theywere engaged in monetary and financing advis-ory roles around the world (Helleiner 1994; ch. 3;2003; ch. 9).

During the heyday of the Bretton Woods or-der, from the late 1950s until 1971, the IMF andIBRD were assigned a more marginal role in thesystem than Keynes and White had hoped for.

But governments remain committed to the otherkey features of the order. What, then, became ofthe Bretton Woods order? In some respects, itseems to be still alive. Currencies remain convert-ible, and the IMF and IBRD still exist (althoughtheir purpose has been altered, as described below).In the following sections, however, I explore thecauses and consequences of the unravelling of theother features of the Bretton Woods regime sincethe early 1970s: the gold exchange standard; theadjustable-peg exchange-rate system, the US dol-lars prominent global role, and the commitmentto capital controls.

KEY POINTS

The Bretton Woods conference in 1944 created anew international monetary and financial order thatwas inspired by an embedded liberal ideology andbacked by US leadership.

Governments joining this order committed them-selves to currency convertibility for current account

payments; a gold-dollar standard; an adjustable-peg exchange-rate regime, an acceptance of capitalcontrols, and support for the IMF and World Bank.

Many of the features of the Bretton Woods orderwere in place between 1945 and 1958, but thisorder reached its heyday between 1958 and 1971.

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The Crisis of the Early 1970s

The breakdown of the goldexchange standard

The Bretton Woods system is usually said to havebegun to collapse during the early 1970s, when boththe gold exchange standard and the adjustable-pegexchange-rate system broke down. The former wasbrought to a swift end in August 1971, when theUnited States suddenly suspended the convertibilityof the US dollar into gold. Since other currencieshad been tied to gold only via the US dollar, thismove signalled the end of golds role as a standardfor other currencies as well. This breakdown hadin fact been predicted as far back as 1960, whenRobert Triffin (1960) had highlighted the inherentinstability of the dollar-gold standard. In a systemwhere the dollar was the central reserve currency,he argued that international liquidity could be ex-panded only when the United States provided theworld with more dollars by running a balance ofpayments deficit. But the more it did so, the moreit risked undermining confidence in the dollarsconvertibility into gold.

One potential solution to the Triffin paradoxwas to create a new international currency whosesupply would not be tied to the balance of pay-ments condition of any one country. Keynes hadin fact proposed such a currencywhich he calledbancorduring the negotiations leading up tothe Bretton Woods conference. In 1965, the UnitedStates began to support the idea that the IMF couldissue such a currency as a means of supplementingthe dollars role as a reserve currency, and SpecialDrawing Rights (SDR) were finally created for thispurpose in 1969. The SDR was not a currency thatindividuals could use; it could be used only by na-tional monetary authorities as a reserve asset forsettling inter-country payments imbalances (andsubject to certain conditions). Despite its poten-tial, IMF members have never been willing to issue

significant quantities of SDR to enable this currencyto play much of a role in the global monetary system.

During the 1960s, and in particular after the mid-1960s, Triffins predictions were increasingly borneout. US currency abroad did grow considerably lar-ger than the amount of gold the US governmentheld to back it up. In one sense, the situation was be-neficial to the United States: the country was able tofinance growing external deficits associated with theVietnam War and its domestic Great Society pro-gramme (which produced rising imports) simplyby printing dollars. Indeed, the United States wasdoing much more than providing the world withextra international liquidity by the late 1960s; it wasactively exporting inflation by flooding the worldwith dollars. In another sense, however, the countrywas becoming increasingly vulnerable to a confid-ence crisis. If all holders of dollars suddenly decidedto demand their convertibility into gold, the USAwould not be able to meet the demand. Anothercost to the USA was the fact that the dollars fixedvalue in gold was undermining the internationalcompetitiveness of US-based firms. If other coun-tries had been willing to revalue their currencies,this competitiveness problem could have been ad-dressed, but foreign governments resisted adjustingthe value of their currencies in this way.

A crisis of confidence in the dollars convert-ibility into gold was initially postponed whensome key foreign alliesnotably Germany and Ja-panagreed not to convert their reserves into gold(sometimes as part of an explicit trade-off for USsecurity protection: Zimmerman 2002). But othercountries that were critical of US foreign policyin this periodFrance in particularrefused toadopt this practice, seeing it as a reinforcementof American hegemony (Kirshner 1995: 192203).Private speculators also increasingly targeted theUS dollar, especially after sterling was devaluedin 1967. When speculative pressures against the

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dollar reached a peak in 1971, the United States wasforced to make a decision: it could either cut backthe printing of dollars, or simply end the currencysconvertibility into gold.

The US decision to take the latter course reflec-ted its desire to free itself from the constraint onits policies that gold convertibility imposed (Gowa1983). In the eyes of many observers, this decisionalso signalled an end to the kind of benevolenthegemonic leadership US policy-makers had prac-tised in the international monetary and financialrealm since the 1940s. Some attributed this changein US policy to the fact that the United Stateswas losing its hegemonic status in the interna-tional monetary and financial realm. From thisperspective, the breakdown of the gold exchangestandard provided further evidence to support thehegemonic stability theory that a stable integratedinternational monetary and financial order requiresa hegemonic power. Others, however, suggestedthat US hegemonic power remained substantial inworld money and finance, but what had changedwas the United States interest in leadership. Facedwith new domestic and international priorities, USpolicy-makers chose to exploit their position as thedominant power in this realm of the global eco-nomy to serve these ends. To support the thesis thatthe United States remained an important globalmonetary power, scholars pointed to the fact thatthe US dollar remained the unchallenged dominantworld currency after 1971 (for example, Strange1986; Calleo 1976)a point to which we shallreturn below.

The collapse of the adjustable-pegexchange-rate regime

The second feature of the Bretton Woods mon-etary order that broke down in the early 1970swas the adjustable-peg system. This developmenttook place in 1973, when governments allowed theworlds major currencies to float in value vis-a`-visone other. The new floating exchange-rate systemwas formalized in 1976, when the IMFs Articlesof Agreement were amended to legalize floating

exchange rates, and to declare that each countrynow had the responsibility for determining the parvalue of its currency.

The end of the adjustable-peg system wastriggered partly by the growing size of speculat-ive international financial flowsa phenomenonexplained in a later sectionwhich complicatedgovernments efforts to defend their currency pegs.Equally important, however, was the fact that in-fluential policy-makers began to re-evaluate themerits of floating exchange rates. We have alreadyseen how the Bretton Woods architects took a verynegative view of the experience of floating exchangerates before the Second World War. Indeed, thedrawbacks of floating exchange rates were deemedto be so obvious that there had been very few seriousdefences of them at the time. By the early 1970s,however, floating exchange rates had attracted anumber of prominent advocates, particularly in theUnited States (Odell 1982).

These advocates argued that floating exchangerates could play a very useful role in facilitatingsmooth adjustments to external imbalances in aworld where governments were no longer will-ing to accept the discipline of the gold standard.Under the Bretton Woods system, the idea of us-ing exchange-rate changes for this purpose had, ofcourse, already been endorsed; governments couldadjust their currencys peg when the country was infundamental disequilibrium. But, in practice, gov-ernments had been reluctant to make these changesbecause exchange-rate adjustments often generatedpolitical controversy, both at home and abroad.Governments usually made these adjustments onlywhen large-scale speculative financial movementsleft them no option. The result had been a ratherrigid and crisis-prone exchange-rate system, inwhich countries often resorted instead to inter-national economic controls, particularly on capitalflows, to address imbalances. A floating exchange-rate system would allow external imbalances to beaddressed more smoothly and continuously, andwithout so much resort to controls.

It was also argued that floating exchange rates hadunfairly been given a bad name during the 1930s.

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Advocates argued that floating exchange rates neednot necessarily be associated with either competit-ive devaluations or with a retreat from internationaleconomic integration, as they had been in the1930s. Their role in encouraging destabilizing spec-ulative financial flows during the 1930s was also

questioned. Financial movements in that decade,it was argued, had been volatile, not because offloating exchange rates but because they were re-sponding properly to the highly unstable underlyingeconomic conditions of the time (for example,Friedman 1953).

KEY POINTS

The initial signs of the unravelling of the BrettonWoods system are usually dated to the early1970s, when the gold exchange standard and theadjustable-peg exchange-rate system collapsed.

In 1971, the United States ended the gold convert-ibility of its currency, and, by extension, that of allother currencies. The US decision reflected its de-sire to free itself from the growing constraint on itspolicies that gold convertibility was imposing.

The adjustable-peg exchange-rate regime ofBretton Woods was replaced in 1973 by a systemof floating exchange rates between the currenciesof the leading economic powers. The change wascaused by heightened capital mobility and by areconsideration of the merits of floating exchangerates among leading policy-makers, particularly inthe United States.

From Floating Exchange Rates to Monetary Unions

Has the floating exchange-rate system performedin the ways that its advocates had hoped? Theproponents of floating exchange rates were cer-tainly correct that this exchange rate regime hasnot discouraged the growth of international tradeand investment to any significant degree. Indeed,by enabling governments to avoid using trade re-strictions and capital controls, floating exchangerates may have helped to accelerate internationaleconomic integration. Floating exchange rates haveundoubtedly also often played an important partin facilitating adjustments to international eco-nomic imbalances. But critics have argued thattheir useful role in this respect should not be over-stated.

Some have echoed the argument made in the1930s, that floating exchange rates have encourageddestabilizing speculative financial flows because ofthe uncertain international monetary environmentthey create. These flows, in turn, are said to generate

further volatility and misalignments in currencyvalues. One of the best-known advocates of thisview is Susan Strange (1986), who suggests thatfloating exchange rates have encouraged a kind ofcasino capitalism, in which speculators have comeincreasingly to dominate foreign exchange markets.From her standpoint, the consequences have beendevastating:

The great difference between an ordinary casinowhich you can go into or stay away from, and the globalcasino of high finance, is that in the latter all of usare involuntarily engaged in the days play. A currency

change can halve the value of a farmers crop before

he harvests it, or drive an exporter out of business . . .

From school-leavers to pensioners, what goes on in the

casino in the office blocks of the big financial centres

is apt to have sudden, unpredictable and avoidable

consequences for individual lives. The financial casino

has everyone playing the game of Snakes and Ladders

(Strange, 1986: 2).

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It is certainly true that currency trading hasgrown very dramatically since the early 1970s; thesize of daily foreign exchange trading increasedfrom $15 billion in 1973 to almost $1,900 billionby 2004 (Gilpin 2001: 261; BIS 2005). The latterfigure dwarfs the size of trading that would be ne-cessary simply to service regular international tradeand investment flows. As cross-border financialflows have grown dramatically, it is also accuratethat exchange rates have sometimes been subject toconsiderable short-term volatility and longer-termmisalignments. In these circumstances, a floatingexchange rate has often been the source of, ratherthan the means of adjusting to, external economicimbalances.

International exchange-ratemanagement: the Plaza to theLouvre

One of the more dramatic episodes of a long-term misalignment involved the appreciation of theUS dollar in the early-to-mid-1980s. This currencymovement was not responding to a US currentaccount surplus; indeed, the country experienceda growing current account deficit at the time. In-stead, the dollars appreciation was caused by verylarge inflows of foreign capital, attracted by thecountrys high interest rates and rapid economicexpansion after 1982. The appreciation proved tobe very disruptive; it exacerbated the US currentaccount deficit and generated widespread protec-tionist sentiments within the USA by 19845.

This episode led the USA and other major indus-trial countries to consider briefly a move back to-wards more managed exchange rates. In September1985, the G5 (the United States, the United King-dom, the Federal Republic of Germany, France, andJapan) signed the Plaza Accord which committedthese countries to work together to encourage theUS dollar to depreciate against the currencies of itsmajor trading partners. After the dollar had fallen al-most 50 per cent vis-a`-vis the yen and Deutschmarkby February 1987, they then announced the Louvre

Accord, which established target ranges for themajor currencies to be reached through closer mac-roeconomic policy co-ordination (Henning 1987;Funabashi 1988; Webb 1995).

This enthusiasm for a more managed exchange-rate system between the worlds major currenciesproved to be short-lived. The three leading eco-nomic powersthe United States, Germany, andJapanwere not prepared to accept the kinds ofserious constraints on their macroeconomic policyautonomy that were required to make such a sys-tem effective. Many policy-makers in Germany andJapan also argued that the US interest in mac-roeconomic policy co-ordination seemed designedprimarily to reduce its own external deficit by en-couraging changes in macroeconomic policy abroadrather than at home. This complaint had beenheard once before, during the late 1970s, whenthe US policy-makers last pressed Germany andJapan to co-ordinate macroeconomic policies. Inboth instances, US policy-makers sought to ad-dress their countrys external payments deficit bypressing Germany and Japan to revalue their cur-rencies and pursue more expansionary domesticeconomic policies. These moves would enable theUnited States to curtail its deficit without a domesticcontraction by boosting US exports.

United States pressure in these two cases was ap-plied not just through formal negotiations but alsoinformally by talking down the dollar. The latterencouraged financial traders to speculate againstthe dollar, leaving the German and Japanese gov-ernments with two options. They could defend theUS currency through dollar purchases, thereby pre-serving the competitiveness of domestic industryvis-a`-vis the important US market as well as thevalue of their dollar-denominated assets. In the end,however, these purchases would probably producethe other result that the USA wanted: an expandingdomestic monetary supply in Japan and Germanycaused by the increased purchase of dollars. Altern-atively, if they accepted the dollars depreciation,pressure for domestic expansionary policies wouldstill come from another sourcedomestic industryand labour that was hurt by the countrys loss of

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competitiveness vis-a`-vis the United States. The ef-fectiveness of this dollar weapon rested on the USdollars key currency status and the fact that theUS market remained such an important one forJapanese and German businesses in this period. Itwas a strategy that met with some success for theUSA in both instances, although it also left the USAvulnerable to a crisis of confidence in the dollar atsome key moments.

The IMF and exchange ratemanagement

Arguments for exchange rate management amongthe leading powers have emerged at other moments,most recently vis-a`-vis Chinas large trade surpluses.In this most recent episode, US policy-makers, inparticular, have pressed the IMF to take a more as-sertive stance in pressing the Chinese governmentto allow its currency to appreciate. These demandshave generated new interest in the IMFs mandatein this area.

When it was created in 1944, one of the centralpurposes of the Fund was to oversee its adjustable-peg exchange rate regime. When that regime brokedown in the early 1970s, many questioned the IMFsfuture. The outbreak of the international debt crisisin the early 1980s soon gave the Fund a new lifeas an institution focused on crisis managementvis-a`-vis poorer countries (see Pauly, Chapter 8 inthis volume). But the Fund was also reborn fora second time after the early 1970s. In an effortto maintain some semblance of multilateral rulesover the new floating exchange rate system, theIMF was given a new mandate in 1976underArticle iv in the Second Amendment to its Articlesof Agreementto exercise firm surveillance overthe exchange rate policies of members (quoted inPauly 1997: 105).

The IMFs surveillance activities have since be-come an important part of its overall operations.With individual member governments, the Fundengages in Article iv consultations in which it of-fers advice about various aspects of their economic

policies. It has also moved recently to boost itssurveillance role beyond the bilateral context bycreating multilateral consultations in which sys-tematically important countries can have a forum todiscuss and debate specific issues of global economicsignificance.

The first such multilateral consultationinvolving China, the Euro area, Japan, the USA,and Saudi Arabiawas announced in 2006 with afocus on global imbalances. Some have hoped thatthis kind of initiative might allow the IMF to takean active role in reinvigorating the kind of multilat-eral exchange rate management that characterizedthe Plaza to Louvre period. With its near universalmembership, the IMF may be better suited thanother bodies, such as the G7 or OECD, to launchthis kind of initiative.

But sceptics argue that the IMFs ability toinfluence the decision-making of these powerfulgovernments is likely to be very limited. Even in thebilateral context, the Funds advice has generallyhad a significant impact only when backed up bythe promise of loans. None of these governmentsis a borrower from the Fund. Without the financialcarrots of its loans, the IMFs power is limited andeach of these governments faces enormous incent-ives to maintain control over exchange rates, giventheir significance to national economic life.

The creation of the euro

Although efforts to stabilize the relationshipbetween the values of the worlds major curren-cies have been limited since the early 1970s, somegovernments have moved to create stable monet-ary relations in smaller regional contexts. The mostelaborate initiative of this kind has taken placein Europe. At the time of the breakdown of theBretton Woods exchange-rate system, a number ofthe countries of the European Community (EC)attempted to stabilize exchange rates among them-selves. These initial efforts were followed by thecreation of the European Monetary System in 1979,which established a kind of mini-Bretton Woods

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adjustable-peg regime in which capital controlswere still widely used and financial support wasprovided to protect each countrys currency pegvis-a`-vis other European currencies. Then, withthe Maastricht Treaty in 1991, most members ofEuropean Union went one step further to committo a full monetary union: this was created in 1999.

The long-standing resistance of many Europeangovernments to floating exchange rates withinEurope has been driven partly by worries thatexchange-rate volatility and misalignments woulddisrupt their efforts to build a closer economic com-munity. Exchange-rate instability was deemed to bedisruptive not only to private commerce but also tothe complicated system of regional public paymentswithin the Europeans Community Common Ag-ricultural Policy. But why go so far as to abandonnational currencies altogether by 1999?

One answer is that the adjustable peg system ofthe EMS became unsustainable after European gov-ernments committed themselves to abolish capitalcontrols in 1988. The latter decision left Europeancurrency pegs vulnerable to increasingly powerful

speculative financial flows, a fact demonstratedvividly in the 19923 European currency crisis.At that moment, European governments faced animportant choice. If they sought to preserve finan-cial liberalization and exchange-rate stability, theywould have to give up their commitment to do-mestic monetary policy autonomy. Open macroe-conomic theory teaches us that it is not possible toachieve all three of these objectives simultaneously(see Box 7.3). If they agreed to abandon monetarypolicy autonomy within this impossible trinity,a logical next step was simply to create a monet-ary union that eliminated the possibility of futureintra-regional exchange-rate crises altogether.

This choice was also made easier by the grow-ing prominence of neo-liberal thought withinEuropean monetary policy-making circles (Mc-Namara 1998). Neo-liberals were disillusioned withthe kinds of activist national monetary policies thatbecame popular in the age of embedded liberalism.This sentiment emerged partly out of experiences ofinflation, and partly from the rational expectationsrevolution in the discipline of economics. The

The Impossible Trinity of Open Macroeconomics

Economists have pointed out that national govern-ments face an inevitable trade-off between the threepolicy goals of exchange-rate stability, national mon-etary policy autonomy, and capital mobility. It is onlyever possible for governments to realize two of thesegoals at the same time. If, for example, a nationalgovernment wants to preserve capital mobility and afixed exchange rate, it must abandon an independ-ent monetary policy. The reason is straightforward.An independent expansionary monetary policy in anenvironment of capital mobility will trigger capitaloutflowsand downward pressure on the nationalcurrencyas domestic interest rates fall. In this con-text, it will be possible to maintain the fixed exchangerate only by pushing interest rates back up andthereby abandoning the initial monetary policy goal.If, however, the government chooses to maintain theexpansionary policy, it will need either to introduce

capital controls or to embrace a floating exchangerate, thereby sacrificing one of the other goals withinthe impossible trinity.

Historically, during the era of the gold standard,governments embraced fixed exchange rates andcapital mobility, while abandoning national monet-ary policy autonomy. During the Bretton Woods or-der, national policy autonomy and fixed (althoughadjustable) exchange rates were prioritized, whilecapital mobility was deemed to be less important.Since the early 1970s, the leading powers have sac-rificed a global regime of fixed exchange rates inorder to prioritize capital mobility and preserve adegree of monetary policy autonomy. Many govern-ments within this system, however, have embracedfixed rates at the regional or bilateral level by us-ing capital controls or by abandoning national policyautonomy.

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latter undermined a key idea that had sustainedsupport for activist monetary policies: the Keyne-sian notion that there was a long-term trade-offbetween inflation and unemployment. By high-lighting how experiences of inflation over timemay encourage people to adjust their expectations,this new economic analysis suggested that activ-ist monetary management could simply producestagflationthat is, a combination of high un-employment and high inflation. The appearance ofstagflation during the 1970s seemed to vindicatethis view. If people began to anticipate higher andhigher levels of inflation, this analysis suggestedthat they would adjust their wage demands andpricing decisions accordingly, creating an upwardinflationary spiral. To break these inflationary ex-pectations, authorities would have to re-establishtheir credibility and reputation for producing stablemoney by a strong commitment to price stability.The perceived need for this kind of credibility andreputation has also been reinforced by the discip-lining power of international capital markets (see,for example, Andrews and Willett 1997).

Neo-liberal monetary thinking played an im-portant role in generating support for EuropeanMonetary Union (EMU). By eliminating a keymacroeconomic rationale for wanting a nationalcurrency in the first place (that is, the commit-ment to activist national monetary management),it made policy-makers less resistant to the ideaof abandoning these monetary structures. Indeed,many policy-makers saw the currency union as abetter way to achieve price stability than by main-taining a national currency, because the unionappeared to allow them to import the Germancentral banks anti-inflationary monetary policy.Like the German Bundesbank, the new Europeancentral bank was given a strict mandate to pursueprice stability as its primary goal. In addition, someneo-liberals have applauded the fact that EMU, byeliminating the possibility of national devaluations,might encourage greater price and wage flexibilitywithin national economies as workers and firms areforced to confront the impact of external economicshocks in a more direct fashion.

Because of this basis of support for EMU, manyon the political left have been wary of the project.They worry that it might produce domestic de-regulation, cutbacks to the welfare state, and newconstraints on states abilities to address unemploy-ment and other social and economic problems. Theresultant costs, they suggest, will be borne dispro-portionately by vulnerable groups such as the poorand women (Gill 1998; B. Young 2002). Interest-ingly, however, there have also been many socialdemocrats and unions across Europegroups usu-ally less friendly to neo-liberal thinkingwho havebeen supportive of the drive to monetary union(Josselin 2001; Notermans 2001). Because it canprotect a country from speculative currency at-tacks, some have seen EMU as creating a morestable macroeconomic environment in which pro-gressive supply-side reforms could be undertaken topromote equity, growth, and employment. In somecountries, adopting the euro has also been seen as away to lower domestic interest rates by reducing riskpremiums that the markets were imposing, a resultthat has actually improved governments budget-ary positions and prevented cuts to the welfarestate. Some social democrats and unions have alsohoped that EMU might eventually help to dilutethe monetary influence of the neo-liberal Bundes-bank across Europe, and encourage co-ordinatedEU-wide expansionary fiscal policies. In addition,some social democrats and unions have seen EMUas an opportunity to reinvigorate national cor-poratist social pacts in which co-operative wagebargaining, employment friendly taxation schemes,and other social protection measures can assumea key role in the process of adjusting to externaleconomic shocks.

The EMU project also had a broader politicalmeaning. In addition to challenging US power (seebelow), the creation of the euro has been seen asan important symbol of the process of fosteringever-closer European co-operation. Many analystsalso argue that the decision to create the eurowas linked to a broader political deal betweenGermany and other European countries at thetime of the Maastricht Treaty. Many European

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countriesespecially Francehad become in-creasingly frustrated by the domination of theEuropean monetary system by the German Bundes-bank, and they pressed for EMU as a way todilute its influence. Germany is said to have ac-cepted EMU when it came to be seen as a trade-offfor European (and especially French) support forGerman reunification in 1989 (see, for example,Kaltenthaler 1998).

Currency unions elsewhere?

The European experiment in creating a currencyunion has triggered talk of a similar move in someother regions. Is this likely to happen? Econom-ists try to help address this question by analysingwhether each region resembles an optimum cur-rency area (see Box 7.4). In practice, though, thiskind of economic analysis has had little predict-ive power in the European context, or elsewhere.One of the longest-standing monetary unions in theworld is the CFA franc zone involving many formerFrench colonies in west and central Africa, and itsmember countries do not come close to resem-bling an optimum currency area. Like EMU, thatmonetary union was formed and has been sustained

by certain political conditions. Particularly import-ant in that case have been the power and politicalinterests of France in the colonial and post-colonialcontext (Stasavage 2003).

Another region where interest in monetary unionhas grown is the Americas. Beginning in 1999, manypolicy-makers in that region began to debate theidea of creating a currency union that would bebased on the US dollar. Two countriesEcuadorand El Salvadorwent beyond talk to action andintroduced the US dollar as their national currency,in 2000 and 2001, respectively. The new interestin dollarization across Latin America is partly aproduct of the ascendancy of neo-liberal monetaryideas there. As in Europe, many neo-liberals in theregion see the abandonment of the national cur-rency as a way of importing price stability; in thiscase, from the US Federal Reserve. Advocates ofdollarization have also argued that it will help toinsulate countries from speculative financial flows,and will attract stable long-term foreign investment.

The dollarization debate also emerges from acontext where many Latin-American countries haveexperienced a kind of informal, partial dollarizationsince the 1970s. Local residents have often turned tothe US dollar as a store of value, a unit of account,

Monetary Unions and the Theory of Optimum Currency Areas

The theory of optimum currency areas was first de-veloped by the Nobel-prize-winning economist RobertMundell (1961) to evaluate the pros and cons offorming a monetary union among a selected group ofcountries. While assuming the union will produce mi-croeconomic benefits in the form of lower transactioncosts for cross-border commerce, the theory focusesits analytical attention on the potential macroeco-nomic costs associated with abandoning the exchangerate as a tool of macroeconomic adjustment. If thesecosts are low, the region is said to approximate moreclosely an optimum currency area that should beencouraged to create a monetary union.

To evaluate how significant these costs are in eachregional context, the theory examines a number of

criteria. If selected countries experience similarexternal shocks, for example, the theory notes thatthey are more likely to be good candidates for mon-etary union, since they will each have less of a needfor an independent exchange rate. Even if they exper-ience asymmetric shocks, the macroeconomic costsof abandoning national exchange rates may still below if wages and price are very flexible within eachcountry, if labour is highly mobile between coun-tries, or if there are mechanisms for transferringfiscal payments among the countries. Each of theseconditions would enable adjustments to be madeto external shocks in the absence of an exchangerate.

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and even a medium of exchange, as a way to insulatethemselves from domestic monetary and politicaluncertainty. The option has been made easier by thebroader liberalization and deregulation of Latin-American financial systems in this period. Sinceinformal dollarization has already eroded nationalmonetary sovereignty considerably, it has lessenedresistance to the idea of formal dollarization.

Formal dollarization also has many opponents inLatin America. Critics highlight that countries thatdollarize are giving up key toolsdomestic mon-etary policy and the exchange ratewith whichtheir governments can manage their domestic eco-nomies. The potential costs, they argue, have beenwell highlighted in Argentinas recent experience.Between 1991 and 2001, Argentina managed its na-tional currency on a currency board basis, whichtied the value of the currency tightly to the US dollar.When the country began to experience growing cur-rent account deficits after the mid-1990s, the onlyway it could correct the problemwhile retainingthis monetary regimewas to undergo a costlydeflation. This deflation produced high unemploy-ment and dramatic cuts to government spending,and contributed to the countrys massive financialcrisis of 20012.

Critics also point out that, while European coun-tries are joining a monetary union in which they

have some say, the adoption of the US dollarwould leave Latin-American countries as monetarydependencies. United States, policy-makers havebegun to debate what kind of support they mightprovide to countries that adopt the US dollar, andtheir answer to date has been very little. Theyhave made it clear that dollarized countries wouldnot be offered any role in the decision-making ofthe US Federal Reserve, and that Fed officials haveno intention of taking the concerns of dollarizedcountries into account when they set US monetarypolicy. United States, policy-makers are not evenwilling to consider providing lender-of-last-resortsupport to institutions in dollarized countries. Theonly support they have discussed seriously is thesharing of the seigniorage revenue that the UnitedStates would earn from the dollars circulation inLatin-American countries that formally dollarize(see Box 7.5). Even this idea, however, was not ableto pick up enough support to be endorsed by USCongress or US financial officials when it was de-bated in 19992000. As Cohen (2002) puts it, USpolicy-makers seem to prefer a policy of passiveneutrality on the question of dollarization in LatinAmerica. In his view, the only scenario in which USpolicy-makers might become much more support-ive is if the euro began to pose a serious challengeto the dollars international position.

What is Seigniorage?

Seigniorage is usually defined as the differencebetween the nominal value of money and its costof production. This difference is a kind of profitfor the issuer of money. In medieval Europe, thissource of revenue was often very important for rul-ing authorities. They could earn it either openly byadding a seigniorage charge (above the normal mintcharge that offset the cost of minting) when produ-cing metallic coin, or more secretly by debasing theircoin through a reduction of its weight or its fineness(by increasing the proportion of non-precious alloy).If the surreptitious strategy were to be detected by

the public, its effectiveness would be undermined,as people would either not accept the coins or ac-cept them only at a discount. In more modern times,metallic coins no longer dominate the monetary sys-tem, and governments now earn seigniorage alsothrough the issuing of paper currency as well asindirectly through their regulation of the creation ofbank deposit money. National monetary authoritiesearn seigniorage not just from the use of the moneythey issue by citizens within their borders; the in-ternational use of their currency will augment theseigniorage revenue they earn even further.

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KEY POINTS

Floating exchange rates have performed an im-portant role in facilitating balance of paymentsadjustments, but critics argue that they have alsobeen subject to short-term volatility and longer-term misalignments.

Efforts to stabilize the relationship between thevalues of the worlds major currencies have beenlimited since the early 1970s, but initiatives to cre-ate more stable regional monetary relations have

been more common, particularly in Europe, wherea monetary union was introduced in 1999.

Some of the same factors that prompted the de-cision to create a European monetary union havetriggered proposals for monetary unions elsewhere,most notably in the Americas. But a dollar-basedmonetary union in the Americas is not likely unlessthe United States becomes more supportive of theidea.

The Dollars Declining Global Role?

Cohens (2002) observation raises the question ofthe US dollars future role as a world currency.When US policy-makers ended the dollars con-vertibility into gold in 1971, some predicted thatUS currencys role as the dominant world cur-rency would be challenged, since the dollar wasno longer as good as gold. In fact, the dollarscentral global role has endured. It has continuedto be the currency of choice for denominating in-ternational trade across most of the world, andhas remained the most common currency held bymany governments in foreign exchange reserves.In the private international financial markets thathave grown dramatically in recent years (for reasonsexplained below), the US dollar has also been usedmore than any other currency as a store of valueand for denominating transactions since the early1970s (Cohen 1998; ch. 5). The US dollar has evenbeen used to an increasing degree by market actorswithin many countriesnot just in Latin Americabut elsewhere tooas a unit of account, a store ofvalue, and even a medium of exchange since the1980s (Cohen 1998).

In some respects, the US dollars enduring cent-ral global position is a product of inertia. Thereare many network externalities that reinforce thecontinued use of existing currencies, both within

countries and at the international level, even whenthose currencies demonstrate considerable instabil-ity (Cohen 1998). Some foreign governments havealso continued to hold their reserves in US dollarsand denominated their international trade in dol-lars because of their broader political ties withthe USA (see, for example, Gilpin 1987; Spiro1999). Perhaps most important in explaining thedollars enduring global role, however, has beenthe fact that US financial markets, particularlythe short-term markets, have remained amongthe most liquid, large and deep in the world.This has made the holding and use of US dol-lars particularly attractive to private actors andforeign governments. The two other leading eco-nomiesJapan and West Germanyhave notcultivated liquid deregulated short-term moneymarkets that rivalled those of the USA, in which yen-denominated or Deutschmark-denominated assetscould be held.

Emerging challenges to the dollarsdominant position

Only very recently has the dollars position as thedominant world currency begun to be challengedseriously. One challenge has come from the creation

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of the euro in Europe. Some European policy-makers have supported the euros creation forthis reason: they have seen it as a tool to bol-ster Europes power in the global political economy(Henning 1998: 563565). In outlining the officialrationale for monetary union in its One Market,One Money report, the European Commission(1990: 194, 191), for example, praised how theeuro would bring greater symmetry to the globalmonetary order, and force the United States to be-come more conscious of the limits of independentpolicy-making.

What kind of a challenge will the euro pose tothe US dollar? In 1990, the European Commission(1990: 182) predicted that the euro would be a par-ticularly attractive international currency becauseit would be backed by a conservative central bankdedicated to price stability, and because it wouldbe able to be held in unified European money mar-kets that would be the largest in the world. Atthe time of writing, however, the euros challengeto the dollar has proved to be less significant thanthis prediction. One reason has been that Europeanfinancial markets remain highly decentralized and,in the words of Fred Bergsten (1997: 88), there isno central government borrower like the US Treas-ury to provide a fulcrum for the market. Cohen(2003) also argues that the euros international useis held back by uncertainties regarding the gov-ernance structure, and thus the broader politicalcredibility of the whole initiative.

The European Commission (1990: 183) noteda second way in which the euros creation mightthreaten the dollar. It observed that, with no moreintra-EC foreign exchange intervention necessary,an estimated $230 billion of the total $400 billionof foreign exchange reserves of EC member stateswould no longer be needed, the majority of whichwas held in dollars. If these excess reserves weresuddenly sold, Pauly (1992: 108) has predicted, theresult would be destabilizing in the extreme forthe dollar. Again, however, European governmentshave so far shown little interest in provoking thiskind of monetary confrontation with the UnitedStates.

More generally, it is also worth noting that thecreation of a common European central bank mightencourage Europe to present a more unified voicein international monetary politics. European Unioncountries could, for example, unify their votingstances in the IMF, where they already hold a largercollective voting share than the United States.

The other challenge to the dollars role comesfrom Japan, where policy-makers have recentlybecome much more interested in promoting theinternational use of the yen, especially in the EastAsian region (Grimes 2003). Despite Japans emer-gence as the worlds leading creditor in the 1980s,the yen was used very little at the internationallevel throughout that decade. Even the Japanesethemselves relied heavily on the US dollar in theirinternational transactions in both trade and fin-ance. Indeed, the bulk of their assets held abroadremained in this foreign currency, a quite unpre-cedented and vulnerable situation for the worldslargest creditor.

The East Asian financial crisis of 19978 en-couraged many Japanese policy-makers to wantto promote the yens international role, especiallyin the East Asian region, where Japans trade andinvestment was growing rapidly. The crisis high-lighted Japans limited financial power in the region,and East Asias reliance on the US dollar. To cul-tivate the yens international role, the Japanesegovernment has begun to pursue various initiat-ives such as fostering a more attractive short-termmoney market in Japan and encouraging the growthof yen-denominated lending from Japan.

The internationalization of the yen, however, hasbeen held back by problems in the Japanese finan-cial system, and by resistance from countries suchas China to the idea of Japanese regional monetaryleadership (Katada 2002). In the face of this latterresistance, some officials in Japan and elsewhere inthe region have begun to suggest that East Asianmonetary co-operation might be fostered more ef-fectively on the basis not of the yen but of an AsianCurrency Unit (ACU). Modelled on the EuropeanCurrency Unit (ECU) that was a precursor to theeuro, the ACU could reduce the influence of the

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dollar by acting as a unit of exchange whose valuewas determined by the weighed average of a bas-ket of the regions currencies. Although the financeministers of ASEAN, China, South Korea, and Ja-pan agreed to research the idea at a May 2006meeting, the prospect of this initiative leading to afully-fledged East Asian monetary union any timesoon is considered remote by most observers.

Consequences of the dollarsdeclining role?

If the dollars dominant global position is in factchallenged in the coming years, what will be theconsequences? To begin with, the United Stateswill lose some benefits it has derived from thecurrencys status. In addition to the internationalprestige that comes from issuing a dominant worldcurrency, the US dollars use abroad has producedextra seigniorage revenue for the US government,as noted above (see Box 7.5 on page 000). The pre-eminence of the dollar as a world currency has alsoenhanced the USAs ability to finance its externaldeficits. In addition, we have seen already how ithas helped to persuade foreign governments to helpcorrect these US deficits by adjusting their macroe-conomic policies. The USA may thus feel its policyautonomy more constrained as the dollars globalrole diminishes.

The erosion of the dollars central global po-sition will also have consequences for the worldas a whole. In particular, it raises the question ofwhether the international monetary system will be

more or less stable without a dominant monetarypower. Drawing on the inter-war experience, somehave predicted that increasing global monetary in-stability lies ahead. But others have suggested theopposite. David Calleo (1987; ch. 8) has long arguedthat a world monetary order based on more plural-istic or balance of power principles may be morelikely to produce stability over time than one basedon hegemony. A hegemonic power, in his view, isinevitably tempted to exploit its dominant positionover time to serve its own interests rather than theinterests of the stability of the system. Interestingly,European Commission president, Jacques Delors,advanced a similar argument in defending the EMUin 1993; in his words, the creation of the euro wouldmake the EU strong enough to force the UnitedStates and Japan to play by rules which would en-sure much greater monetary stability around theworld (quoted in Henning 1998: 565).

KEY POINTS

The US dollar continued to be a dominant globalcurrency after it ceased to be convertible intogold in 1971. This was in large part a result ofthe unique attractiveness of US financial markets.

Recently, the US dollars global role is begin-ning to be challenged by the euro and the yen,although these challenges should not be over-stated.

These challenges will impose new constraints onUS policy-making, but their wider systemic im-plications for global monetary stability are hardto predict.

The Globalization of Financial Markets

The final feature of the Bretton Woods regime thathas broken down since the early 1970s involves atrend that has already been mentioned a number oftimes: the globalization of private financial markets.

Recall that the Bretton Woods architects endorsedan international financial order in which govern-ments could control cross-border private financialflows, and public international institutions would

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be assigned a key role in allocating short-term andlong-term credit at the international level. Today,this world appears to be turned upside down.Enormous sums of private capital flow around theworld quite freely on a twenty-four-hour basis. Andthe size of these flows dwarfs the lending activitiesof the IMF and World Bank (whose loans havebecome focused exclusively on poor countries).

Explaining financial globalization

How did we get from there to here? The growth ofthe global telecommunication networks has enabledmoney to be moved around the world much moreeasily than in the past. A number of market devel-opments have also been significant. The dramaticexpansion of international trade and multinationalcorporate activity from the 1960s onwards, forexample, generated some of the growing demandfor private international financial services. The 1973oil price rise also provided a big boost to the global-ization of finance, when private banks took on therole of recycling the new wealth of oil-producingcountries. Private actors were also encouraged todiversify their assets internationally by the in-creasingly volatile currency environment after thebreakdown of the Bretton Woods exchange-ratesystem in the early 1970s. The risks and costs ofinternational financial activity were also loweredthroughout this period by various market innov-ations such as the creation of currency futures,options, and swaps.

In addition to these technological and market de-velopments, the globalization of finance has been aproduct of political choices and state decisions (Hel-leiner 1994). In particular, it has been encouragedby the fact that states liberalized the tight capitalcontrols they employed in the early post-war years.The first step in this direction took place when theBritish government encouraged the growth of theeuro-market in London during the 1960s. In thisfinancial market, the British government allowedinternational financial activity in foreign curren-ciesprimarily US dollars in the early yearsto

be conducted on an unregulated basis. After themid-1970s, the globalization of finance was encour-aged further when many governments dismantledtheir capital control regimes, which had been inplace throughout the post-war period. The UnitedStates and United Kingdom led the way, abolishingtheir national capital controls in 1974 and 1979,respectively. They were soon followed by other ad-vanced industrial countries. Indeed, by the 1990s, analmost fully liberal pattern of financial relations hademerged among advanced industrial states, givingmarket actors a degree of freedom in cross-borderfinancial activity unparalleled since the 1920s.

Poorer countries have generally been less will-ing to abolish capital controls altogether. But anincreasing number have done so, and others haveliberalized their existing controls in various ways inthis period. Many small poorer statesparticularlyin the Caribbeanhave also played a central rolein fostering financial globalization by offering theirterritories as a regulation-free environment for in-ternational financial activity. Places such as theCayman Islands have emerged as very significantinternational banking centres in the world (Palan2003).

Why have states largely abandoned the restrict-ive Bretton Woods financial regime? The growinginfluence of neo-liberal ideology among financialpolicy-makers played a part. As we saw in the lastsection, neo-liberals were less sympathetic to theBretton Woods idea that national policy autonomyneeded to be protected. Where Keynes and Whitehad endorsed the use of capital controls for thispurpose, many neo-liberals have applauded the factthat international financial markets might imposean external discipline on governments pursuingpolicies that were not sound from a neo-liberalstandpoint. Neo-liberals have also criticized therole that capital controls might play in interferingwith market freedoms and preventing the efficientallocation of capital internationally.

The liberalization of capital controls has alsobeen seen by some policy-makers as a kind of com-petitive strategy to attract mobile financial businessand capital to their national territory (Cerny 1994).

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The British support for the euro markets and theirdecision to abolish capital controls in 1979 wereboth designed to help rebuild Londons status as aleading international financial centre in this way.The US support for financial liberalization (bothat home and abroad) was also designed to bolsterNew Yorks international financial position as wellas to attract foreign capital to the uniquely deepand liquid US financial markets in ways that couldhelp finance US trade and budget deficits. Thesmaller, offshore financial centres have also seenthe hosting of an international financial centre asa development strategy that could provide employ-ment and some limited government revenue (fromsuch things as licenses

Heilleiner- The Evolution of the monetary and financial system

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