In the wake of the global financial crisis, uncomfortable exchange-rate adjustments along with large capital flows are straining international economic co-operation. The policy proposals are many, whether in the form of capital controls, guidelines for current account balances, or most recently a return to the gold standard.
Robert Zoellick, the President of the World Bank, suggested a platform of proposals for consideration by the G20 that would be pro-growth and maintain an open trade regime with exchange rate co-ordination (Zoellick 2010). Gold, he suggested, could play the role of a reference point for major exchange rates in a reformed and co-operative international monetary system. This suggestion merits rigorous discussion.
That the gold standard is a rules-based system with a clear limit on the discretion of central banks is a considerable plus. The lesson of the 20th century is clear on this point. The rules-based systems of the early and late 20th century delivered monetary stability, the discretion in the middle, inflation (Mundell 2000). But not all rules are equal, and we have to ask whether the gold standard is a sensible rule? It is not. The gold standard limits monetary expansion to the rate at which the country’s gold stock expands. While this ensures stability of the price level over time, it does so at the cost of relinquishing the ability to respond to local conditions with monetary policy.
This is almost surely not what Mr Zoellick has in mind; it is likely that he is contemplating something like the Bretton Woods system, where exchange rates were tied together and ultimately to gold via the dollar. Meanwhile monetary independence was achieved by extensive capital controls, but at the cost of losing the very monetary stability that the gold standard was supposed to bring. The modern period of explicit and implicit inflation targeting has already lasted much longer than the ill-fated Bretton Woods system, which proved internally unstable despite the explicit attempt to design stability at the international level (Rose 2006). Indeed, it lasted for less than 13 years after the European currencies became convertible in 1959.
Not only was the Bretton-Woods system ultimately unstable, it also did not deliver the exchange rate stability that is often associated with it. Carmen Reinhart and Kenneth Rogoff (2004) showed how important and different de facto exchange rates were over this period, and how similar the volatility of these de facto rates were during the Bretton Woods period when compared with the period since its collapse. When the de jure nominal exchange rate cannot adjust, the de facto exchange rate and local prices have to adjust to allow real exchange rate adjustments over time. These internal and parallel market adjustments can be highly disruptive and led to a number of large revaluations of nominal exchange rates under Bretton Woods (Rose 2006).
The exchange component of the Bretton Woods system is hardly likely to prove more stable now than before its collapse. But Mr Zoellick may well be contemplating the associated capital controls as a policy lever to that end. There is lately much support for a policymaker contemplating a return to capital controls, after decades of progressive liberalisation of international trade and investment. It is the rising volume of international investments that are reflected in the large current-account balances we observe, and their causes are many and complex (Eichengreen 2005).
One cause is demographic; another is the different opportunities of investment in rapidly developing economies compared with industrialised economies, yet another the differential savings behaviour of households internationally, and finally, differences in fiscal policies, with some governments large dis-savers, such as the US.
Among this list of causes, it is fiscal policy that is the most obviously policy relevant cause of the capital flows reflected in current account balances. Resurrecting Bretton Woods will no more improve fiscal discipline now than it did during the 1960s. While monetary and exchange-rate policies cannot solve underlying fiscal imbalances, attempting to do so can make matters worse for both monetary and fiscal policy in the future as Sargent and Wallace showed many years ago (Sargent and Wallace 1981).
We support Mr Zoellick’s drive for pro-growth policies and the priority to maintain an open international trade system, but see little scope for the gold standard to contribute to those ends, even if watered down in a new Bretton Woods agreement. Indeed, such attempts may themselves be destabilising.
Eichengreen, B (2005), “The blind men and the elephant. Kyoto”, Prepared for the Tokyo Club Foundation’s Macroeconomic Research Conference on the Future of International Capital Flows, Kyoto, 21-22 November.
Mundell, RA (2000), “A Reconsideration of the Twentieth Century”, American Economic Review, 90(3):327-340.
Reinhart, C and K Rogoff (2004), “The modern history of exchange rate arrangements: a reinterpretation”, Quarterly Journal of Economics, 119(February):1-48.
Rose, AK (2006), “A stable international monetary system emerges: inflation targeting is Bretton Woods, reversed”, Journal of International Money and Finance, 26:663-681.
Sargent, TJ and N Wallace (1981), "Some Unpleasant Monetarist Arithmetic", Federal Reserve Bank of Minneapolis Quarterly Review, 5(3):1-17.
Zoellick, R (2010), “The G20 must look beyond Bretton Woods”, Financial Times, 8 November.