Putting the ‘system’ in the international monetary system

Michael Bordo, Angela Redish 20 June 2013

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The Eurozone and Bretton Woods are prime examples of planned international monetary arrangements designed in each case to deal with the perceived flaws of earlier more ‘spontaneous order systems ‘based on domestic monetary institutions (Gallarotti 1995).

  • In the case of Bretton Woods the widespread belief that the Great Depression and World War II were precipitated by the collapse of the gold exchange standard, and the fear of the perceived chaos of floating exchange rates, led to the case for a failsafe man-made creation.
  • In the case of the Eurozone, the political case for European integration to prevent a recurrence of the European conflicts of the twentieth century, the attempt to avoid the perils of floating for the Common Agricultural Policy, and to fix the mistakes of earlier systems – the Snake in the Tunnel and the European Monetary System.

In this context, our recent paper takes the long view and examines the evolution of the international monetary system (Bordo and Redish 2013). It looks from the regime of ‘spontaneous order’ in the early nineteenth specie standard, to the classical gold standard 1880-1914 as well as the gold exchange standard 1924-1931 and the Bretton Woods System 1944 to 1971. We end with the Eurozone. This transformation occurred within deep evolving political fundamentals including the rise of democracy, nationalism, fascism, communism and two world wars.

The evolution of the international monetary system

The pre 1850 specie standard was based on a simple rule that each country would choose to follow – to define their currency in terms of a fixed weight of silver, gold or both. In the British case, the silver content of sterling was not changed from 1666 to 1816 when the country shifted from silver to the gold standard. The gold content of the pound did not change from 1717 to 1931. The consequence of each nation fixing the prices of their currencies in terms of precious metals was a system of fixed exchange rates and an international monetary system that emerged spontaneously. There was no explicit international cooperation or coordination of policies in the era although central banks on occasion provided liquidity assistance to their counterparts during financial crises (Bordo and Schwartz 1999).

In the face of tumultuous political events in the 1870s – the defeat of France by Prussia in 1871 and massive silver discoveries in the 1860s – the European countries shifted away from bimetallism to a monometallic gold standard by 1878. Within this context the Latin Monetary Union was formed by France and other continental countries in an, eventually fruitless, attempt to preserve bimetallism by standardising the basic silver franc across countries. While the classical gold standard was a spontaneous order system and its success was driven by market forces that provided adjustment to international shocks, many economists have followed Keynes in arguing that the Bank of England acted as a conductor for the international financial orchestra.

The first world war wrecked the classical gold standard and led to postwar attempts to restore it and avoid the chaos of another spontaneous order system – floating exchange rates – as well as to modify it to take account of major changes in the post war order – a gold shortage, and the near-universal creation of central banks to conduct domestic monetary policy and manage the external accounts. The Brussels (1920) and Genoa (1922) conferences created the gold exchange standard which had several fatal flaws. The key weakness was the decision to impede the operation of the classical price specie flow-adjustment mechanism which had forced adjustments to deal with global imbalances. This followed Britain’s decision to return to gold convertibility in 1931 at an overvalued pound, France’s return to convertibility at a greatly overvalued franc and gold sterilisation policies followed by France and the US (Irwin 2012). The collapse of the gold exchange standard led to attempts at multilateral and bilateral cooperation such as the 1933 World Monetary and Financial Conference which failed, and the Tripartite agreement of 1936, which collapsed in 1939. The interwar system degenerated into currency blocs, bilateral agreements, exchange controls and high tariffs.

Bretton Woods

The planning that led to the Bretton Woods agreement in 1944 attempted to avoid these pitfalls. The compromise between the US and the UK kept gold convertibility for the US and created an adjustable peg in terms of dollars for the other members. Members protected by capital controls could engage in domestic stabilisation policy to maintain internal balance. The IMF, established as an international credit union, was to provide temporary credit to members undergoing a current-account deficit.

The Bretton Woods System evolved into a gold dollar standard similar to the preceding gold exchange standard. It was not a ‘spontaneous order’; its operation depended on the man-made rules of the IMF articles. The Bretton Woods System had similar flaws to the gold exchange standard, especially the failure of members to follow the gold standard adjustment mechanism and the systemic Triffin Dilemma in which the US as reserve-currency centre provided dollar reserves to the rest of the world by running balance-of-payments deficits. As outstanding dollar balances increased relative to US gold reserves, the threat of a run on the bank would increase, forcing the US to abandon its fixed gold dollar peg or else pursue tight money and starve the world of liquidity. The fully convertible Bretton Woods system functioned for a number of years but beginning in the late 1960s, in the face of inflationary US monetary policy it became a slow moving train wreck until President Nixon closed the gold window in August 1971, ending the system.

After the collapse of Bretton Woods and several attempts to revise it, the international monetary system returned to ‘spontaneous order’ based on floating exchange rates. The major countries learned to operate in the non-system of floating exchange rates just as they had learned to operate under the classical gold standard. It took the Great Inflation of the 1970s to instil the lesson of the importance of adhering to stable and predictable monetary rules.

European Monetary Union

One major effort to construct a Bretton Woods-like managed system was the development of the European Monetary Union. The idea for European integration emerged after World War II. Policymakers strongly believed that economic integration would permanently end the problem of European wars. An endemic aversion to floating by France and the problems that it would create for the Common Agricultural Policy of the European Economic Community led to several attempts by the Europeans to reconstitute a Bretton Woods-like system (with widened bands and periodic realignments amongst the members), i.e. the Snake and the Tunnel System of the 1970s, and the European Monetary system in the 1980s (James 2012). Neither of these systems avoided periodic currency crises as had occurred under Bretton Woods,  reflecting the failure of the adjustment mechanism between Germany (and other hard currency countries) and the rest.

The Maastricht Treaty of 1992 was designed to eliminate the currency-crisis problem by instituting the permanently fixed exchange rates of a monetary union, and a single central bank, but without a fiscal union or a centralised bank supervision authority (Bordo and James 2010). It was believed that the members would maintain fiscal discipline and that the monetary union would endogenously lead to greater real integration and convergence of productivity differentials.

The plan seemed to work in the environment of rapid global growth in the 2000s. Subsequently, following the Financial Crisis of 2007-08 and the Great Recession, serious growth differentials and fiscal strains have emerged. A series of sovereign-debt and banking crises since 2010 have raised doubts about the durability of the latest man-made international monetary system.

The lessons from history

The history of the international monetary system has been from the ‘spontaneous order’ specie standard of the early nineteenth century, to the slightly more managed gold standard, to the even more managed gold exchange standard, to the man-made Bretton Woods system and its successors in Europe. Bretton Woods collapsed in the early 1970s and has been succeeded by the Managed Floating non-system. Although there have been periodic attempts at policy coordination, the present float has evolved to look a lot like the classical gold standard. The key to the gold standard’s success was the credible adherence to the convertibility of national currencies into gold. The key to the success of managed floating is the credible adherence by central banks to a credible low inflation target.

The Eurozone has several of the elements of the man-made Bretton Woods system, i.e. the failure of the adjustment mechanism between Germany (and others) and the peripheral countries; the lack of liquidity in the periphery; and the threat to confidence in the euro from the high costs of Germany bailing out the defaulting periphery. Its current crisis has considerable resonance to what happened to earlier attempts to create an artificial international monetary system. It will be interesting to see how and whether the Eurozone will surmount its difficulties and how long the Eurozone system will survive.

References

Bordo, M D and H James (2010), “A Long-Term Perspective on the Euro.” In M Buti, S Deroose, V Gaspar and J Nogueira Martins (eds) The Euro, The First Decade,  New York: Cambridge University Press

Bordo, M. D. and A. Redish (2013), “Putting the ‘System’ in the International Monetary System” NBER Working Paper 19026.

Bordo, M D and A Schwartz (1999) “ Under What Circumstances, Past and Present, Have International Rescues of Countries in Financial Distress Been Successful?” Journal of International Money and Finance Vol 18. No.4 August pp 683-708.

Gallarotti, G (1995), Anatomy of an international monetary regime: the classical gold standard, 1880-1914, New York: Oxford University Press.

Irwin, D (2012) “The French Gold Sink and the Great Deflation” Cato Papers in Public Policy.

James, H (2012) Making the European Monetary Union: The Role of the Committee of Central Bank Governors and the Origins of the European Central Bank, Cambridge: Harvard University Press.

Steil, B (2012) The Battle of Bretton Woods, Princeton; Princeton University Press

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Topics:  Economic history Macroeconomic policy

Tags:  eurozone, monetary policy, Bretton Woods

Professor of Economics, Rutgers University

Professor of Economics, University of British Columbia