10 Establishing a Vision for Stabilization and Reform
- James Boughton, and K. Lateef
- Published Date:
- April 1995
Jacques de Larosière’s speech will cover the central points on the issue of the reform of the international monetary system, an issue to which the work and the report of the Bretton Woods Commission have also made most valuable contributions. My own contribution to this exercise, therefore, can be a modest one. I should like to limit it to enumerating some factors of the global setting that are likely to be with us in the foreseeable future and that should be taken into account when thinking about the future role of the Bretton Woods institutions in the international monetary system and in global economics in general.
First, let me start with something self-evident, namely, that compared with our “needs” and aspirations, real resources are and will continue to be in short supply. This will be even more so if and when, in a global perspective, excessive population growth and ecological problems put question marks on traditional strategies for growth and employment. It follows that there should be an optimal mobilization of the resources available and that there should be an optimal use of the mobilized resources.
This leads me to my second point. Experience—costly experience for some of us—shows us that the task of mobilizing and using resources in an optimal way can best be performed by free markets, in a framework of monetary stability. This axiom also holds true of the special aspect for transferring scarce resources internationally, across national frontiers—an aspect of special importance for both developing countries and countries in transition. In other words, official channels for resource transfer, including the multilateral institutions, should encourage and supplement free markets as and when necessary, but not try to replace them. We all know that there are limits to official financing in the international field, no less than in the national context. It is therefore important for the IMF not to try to overplay its role in global financing—or to circumvent the economic and political limitations of the global transfer of real resources by ingenious financial engineering.
Third, any approach to stabilization and reform, and any approach to optimizing resource allocation globally, must take due account of the fact that, in our system, there is a dichotomy of globalized financial markets, on the one hand, and the continuing existence of traditional nation-states, on the other—notwithstanding regional integration and cooperation, as in the European Union. Together with the other factors I mentioned before, this dichotomy is of great relevance to the Fund’s and the World Bank’s role in our system.
I should like to mention only two aspects. First, by nature, nation-states’ policies and priorities can and will often vary in direction and time—notwithstanding our countries’ adherence to common principles, such as free enterprise, price stability, and full employment. Must we not conclude from that—whether we like it or not—that there are limits to what can be accomplished by efforts and arrangements to promote coordination and convergence of national policies and performance internationally?
If this is true of financial policies in general, it seems to be especially true of any attempts at “formalizing” exchange rate arrangements among the major currencies. As we know from experience in the European Monetary System, maintaining formalized exchange rate arrangements is already difficult on a regional basis. It would be all the more difficult on a worldwide basis. In any case, although experience tells us again and again that converging policies and performance with respect to “fundamentals” are a necessary condition for better exchange rate stability, they are unfortunately not always sufficient.
Second, it follows that in the foreseeable future there is no chance of establishing a world central bank, or of turning the IMF into such an institution. We have to realize that we are living and will continue to live in the future in a multipolar world, despite all our efforts at more and better cooperation. To my mind, this means that the chances of making the SDR the principal reserve asset in the international monetary system by substituting SDRs for the present multicurrency reserve system are rather slim.
Finally, if this analysis is correct, I wonder whether there are not some obvious conclusions to be drawn for the future role of our institutions.
First, the center of the purposes of the Fund must be monetary stability as the condition sine qua non for successful cooperation, sustainable liberalization, and integration, growth, and employment. That means there is no way of putting growth and development at the center, because that would not only be in conflict with the Fund’s Articles of Agreement but would also harm the Fund’s genuine role, namely, that of safeguarding an open payments system, balance of payments adjustment, and financial stability as preconditions for growth and employment.
Second, the role of the Fund in global financing should not be misunderstood. In the international as well as in the national field, creating additional liquidity cannot substitute for lacking capital. The Fund should stick to its proven role of providing “help for self-help” to its members in need by assisting them with conditional program lending and thereby catalyzing additional financing from other sources. In short, as the Fund’s Managing Director has said, adjustment is more important than financing. For its part, the World Bank Group, in close cooperation with the regional development banks, should, of course, continue to provide capital for development and structural reform, ensuring its funding primarily on the private markets by maintaining its credit standing.
Third, we should also be realistic about the role of SDRs in the foreseeable future. Given the global framework I have just mentioned, pushing the role of SDRs in our system could be counterproductive and could destabilize rather than strengthen our monetary system. Obviously, there is no long-term global need for supplementing existing reserve assets. It is for these reasons that some members have expressed doubt about whether there is a factual justification for general allocations of SDRs in present circumstances. However, there are good reasons for being in favor of enabling the Fund’s new members to participate fully in the SDR system through a special allocation of SDRs, ensuring the equitable participation of all members in the SDR mechanism.
Let me say one final word about cooperation and coordination. In view of the dichotomy, mentioned before, of globalized markets and traditional nation-states, stability-oriented cooperation, especially between the major countries, is an absolute necessity. At the same time, this dichotomy puts limits on what can reasonably be expected of cooperation and coordination. We should avoid overstraining this instrument.
Certainly, any formalized or quantified targeting, like any “automaticity,” must be out of the question. If this is true of economic policy coordination in general, it is especially true in the field of exchange rate policy. Let us be realistic: in the foreseeable future, “formalized” exchange rate arrangements between the world’s major currencies are not a viable route to follow.
Jacques de Larosière
Anniversaries—especially institutional ones—give rise to discussions and analyses of past and future. Set up half a century ago, the Bretton Woods institutions are no exception, and over the past few months, many have attempted to review their performance.
This debate is well timed. During the 50 years since the Bretton Woods institutions were created, the economic and financial environment has changed radically, and the international monetary “system” set up at the end of the war has collapsed. Having had the honor to be associated with the fortunes of the Fund for some time, it is a great privilege for me to share with you today a few thoughts on the future of the monetary system. But before looking to the future, let us try to understand how we got where we are today.
How Did the Bretton Woods Monetary System Work?
The Bretton Woods institutions were founded on the following key principle: to establish a multilateral system of economic cooperation to promote free trade and monetary stability and thus foster economic growth. The mechanism created at Bretton Woods for monetary stability relied heavily on two factors that were crucial to the success of the system in the postwar years: on the one hand, a fixed but adjustable exchange rate system anchored to the U.S. dollar; and on the other, a monetary framework in which current account transactions predominated and international capital flows were limited. Let us look more closely for a moment at these two factors.
Regarding the first factor, the United States emerged from the war as the strongest economy. Owing to this unique position of strength, its currency became the anchor of the exchange rate system. The dollar was convertible to gold at a fixed price, and all other currencies were linked to it. No change in parity was allowed except to correct a fundamental disequilibrium and, even then, only after consultation with the IMF. The Fund was the institutional backbone of the Bretton Woods monetary arrangement. Its goal was the promotion of international monetary cooperation, exchange rate stability, and orderly exchange arrangements.
On the second factor, the system set up at Bretton Woods was based on the predominance of current account transactions. This reflected the reality that trade and invisibles made up the bulk of the balance of payments at the time. International capital movements remained of very limited importance because of exchange controls. At Bretton Woods, priority was placed on reducing restrictions on current account transactions, but little was said about the desirability of countries liberalizing capital movements. In fact, a clause in the IMF Articles expressly provided that if capital movements were ever to undermine the fixed exchange rate system, capital controls could be used to avert this danger.
What we must remember is that—unlike today—money had an essentially national characteristic at the time. It was accepted that currencies were for the use of residents. In general, exchange controls forced residents doing business abroad to repatriate funds, ensuring that holdings of a currency by nonresidents were an exception. For example, deposits of French francs by nonresidents in French banks amounted to only F 1.5 billion in 1960; by 1993 this figure had grown to over F 400 billion. National authorities thus enjoyed a large degree of autonomy over their currency. This had been of key importance to Keynes during the Bretton Woods conference. He is on record as telling the House of Lords in May 1944 that “we intend to retain control of our domestic rate of interest, so that we can keep it as low as suits our own purposes, without interference from the ebb and flow of international capital movements or flights of hot money.”
While the two pillars of exchange rate stability and predominance of current account transactions remained in place, supported by the IMF, the postwar international monetary system secured remarkable achievements. It was a time of extraordinary economic growth in much of the world; an unprecedented level of cooperation and stability was achieved; and trade and exchange restrictions were substantially reduced. Many currencies became convertible and world trade grew dramatically: between 1953 and 1963, world trade grew at an average of some 6 percent a year, and between 1963 and 1973, at an average of some 9 percent a year. Those monetary problems that were inevitably encountered were overcome through cooperation and consultation, rather than through restrictions and reprisals.
How Did the System Collapse?
There are two basic reasons for the collapse of the system: first, the currency anchor was derailed; second, the financial and monetary context changed radically.
The success of the par value system based on the dollar depended on the internal stability of the anchor currency and on the quality of macro-economic policy in the United States. The system worked well for two decades. However, the relaxation of fiscal and monetary discipline in the United States in the late 1960s to finance the Viet Nam war and the welfare state had two direct consequences: erosion of the domestic value of the dollar; and, as expectations changed, a growing tendency by holders of dollars to seek refuge in gold and currencies other than the dollar.
In parallel with the weakening of the anchor currency, capital account transactions came to dominate exchange transactions. Capital controls had been considerably relaxed in many countries by the mid-1960s, helping investors to invest in the money markets of their choice. This was further facilitated by the significant technological advances in global information flows. The outcome was that capital transactions increasingly overshadowed current account transactions. This trend has continued: in 1989, global foreign exchange trading was estimated at $650 billion daily, almost forty times the average daily value of world trade. By mid-1992, global foreign exchange trading had grown further—to $880 billion a day.
These factors meant that the whole concept of national currency became less focused. Currencies became international commodities rather than symbols of sovereignty. New actors, such as pension funds and mutual funds, entered the scene, closely followed by new financial instruments. These events served to “internationalize” portfolios and to make currencies more volatile and less geared to their equilibrium price. This internationalization of money had a knock-on effect on national monetary policies. Gone was much of the autonomy engendered by the postwar system, and, contrary to Keynes’s wish, monetary authorities faced increasing problems in securing their desired monetary policy at home as international factors played an increasing role.
Inevitably, the collapse of the two pillars that maintained the system brought about the collapse of the system itself. In 1971 the United States decided to sever the dollar’s link to gold, and then, following a period of devaluation within the fixed exchange rate system, the system broke down.
Search for New Solutions
Since then, the international monetary system has encountered many difficulties, as governments have sought to reconcile the principles upon which the Bretton Woods institutions were founded with the realities of the day.
The Floating Rate System
In the early 1970s, the immediate response after the collapse of the fixed exchange rate system was the adoption of floating exchange rates. That system has been disappointing. It was supposed to fulfill four key functions:
- protect countries from destabilizing short-term capital movements and speculation;
- allow currencies to respond to trade imbalances;
- preserve the freedom of international trade; and
- protect the autonomy of monetary policies.
In fact, the floating exchange rate system has fallen short of fully achieving these objectives.
Today, currency speculation is a huge business, and it has never been more intense. The name of the game for many institutions is to hedge their clients against exchange rate volatility—which is in itself a profitable operation—while themselves contributing to the volatility by taking positions on the markets.
High levels of exchange rate volatility and substantial currency misalignments have become increasingly frequent. I need only cite as good examples the sharp, sustained, and excessive appreciation of the dollar in the early 1980s, the real appreciation of some European currencies before the 1992 European monetary crisis, and the more recent appreciation of the yen. Of course, equilibrium exchange rates are difficult to define. Trade balance, year by year and country by country, is clearly neither desirable nor possible. Long-term capital flows from surplus countries to deficit countries have a crucial role to play in world growth and balance. But the problem is not long-term capital flows nor, to the extent that they are viable, current account imbalances, but rather the high frequency and magnitude of short-term capital flows and the ensuing erratic and distorted movements in the exchange rates of the major currencies.
Furthermore, in the field of monetary policy, national autonomy has been very limited, especially in those countries—mostly the norm today—that are largely open to international trade and finance.
Excessive exchange rate volatility and severe misalignments have had detrimental consequences for the real economy. Even if the gravity of these consequences is open to discussion, the reality of the phenomenon is widely accepted. Not only does business planning become very difficult in situations of high exchange rate volatility, but the costs and restricted horizons of hedging also tend to discourage investment, production, and trade. In addition, investors are reluctant to enter into long-term commitments if exchange rates look “wrong” over an extended period. Smaller companies have suffered relatively more; being less favorably placed to hedge currency exposures than multinationals, many have shied away from the international business arena. Currency misalignments also carry the threat of trade protectionism—a threat that we cannot ignore.
More pervasively, the apparent freedom and ease given to policymakers by the floating exchange rate system no doubt contributed to the laxity of economic policies and the surge of inflation we witnessed in the 1970s. Governments, freed from the sanction of devaluation, often decided to let their currencies slide. The world has not yet finished paying for the consequences of 15 years’ disregard of the external stability of currencies.
With the abandonment of the fixed exchange rate system, the institutional backbone of the postwar international monetary system, namely, the Fund, had to adapt to the new conditions and to redefine its role with regard to the exchange rate system. With the new Article IV, its tool became multilateral surveillance: the Fund was to exercise “firm surveillance” over the exchange rate policies of its members. Certain successes came from this new policy, but also many failures. During some periods, the instability of exchange rates was reduced, especially with the Plaza and Louvre agreements, but, in general, these achievements were limited. We did see the development of closer international cooperation between central banks, which is welcomed. And we have seen a remarkable convergence of mentalities on the need to fight inflation as a condition for sustained growth.
In general, however, it must be said that the policy of multilateral surveillance has been found wanting. A number of industrial countries have accumulated substantial fiscal deficits over the past 15–20 years. For example, if we look at the aggregate fiscal deficit for the Group of Seven countries as a percentage of GDP, including social security budgets, this figure has risen steadily from 2.6 percent of GDP in 1980 to a projected 4 percent of GDP in 1994. Many governments have lost control of their fiscal policies, and the succession of budget deficits over the past two decades has resulted in an unprecedented surge of public indebtedness. In the countries of the Group of Seven, the public debt-GDP ratio has increased by more than 30 percentage points since 1974, from 36 percent of GDP in 1974 to 67 percent of GDP in 1993.
The magnitude of the debt accumulated is such that policymakers in a number of countries are today deprived of their normal fiscal margin of maneuver in times of recession. Indeed, even if governments were tempted to have recourse to inflation as a means of taxation or as a way of reducing the real value of their debt, they now realize that this does not work any more: buyers of treasury papers today demand a real interest rate on their investment and are free to obtain it abroad if they wish; and central banks—being increasingly independent—have no choice but to counteract fiscal laxity by restricting monetary policy, thus only adding to the cost of treasury borrowing. Moreover, this mix of lax fiscal policies and tight monetary policies has tended to crowd some productive investment out of the markets and has thus hampered growth. The recent upheavals in the bond markets are connected to the markets’ perception of this high level of public debt.
Finally, the stimulation, within the framework of multilateral surveillance, of Japanese domestic demand in the 1980s through monetary relaxation led to asset inflation (not price inflation) in one of the few countries to have attained a fiscal balance. When it later became necessary to burst the financial bubble, the result was further economic and financial strains.
Did the multilateral surveillance system successfully prevent these excesses? The answer is “no,” and it is because of shortcomings in surveillance that the attempts to stabilize exchange rates had limited success. Although governments gave their word to cooperate and coordinate, domestic pressures often prevented them from delivering. Admonishment without sanction was not enough to make them perform.
What do we see on the horizon? On the one hand, we see an increasing integration of international trade and finance for reasons that pertain as much to social trends and technological development as to deliberate policy by governments; and, on the other, economic and monetary policies still being defined essentially in national terms.
We are all familiar with the dangers and abuses to which this situation has given rise. Unless something is done, international monetary relations will remain volatile and crisis ridden. Certain currencies will remain potentially destabilizing, owing to the size of the economies concerned and the extent to which they are used for foreign exchange transactions. This situation could lead to regional groups trying to defend themselves against the impact of currency fluctuations, which, in turn, could lead to a fragmentation of trade relations. Who could wish for such a situation, a situation so different from the spirit that prevailed, 50 years ago, at Bretton Woods?
Seeing the seriousness of the problem, I believe we must react against it and come up with solutions.
Historically, there have really been only two types of international monetary system: systems based on an anchor currency; and systems based on cooperation and commitment among states to abide by binding rules. Anchor currency systems are typical of periods in which one economic power dominates the international scene. Systems based on binding cooperation, such as the gold standard in the past and European Monetary Union in the future, are systems freely chosen by states that have decided to make their prime objective the external—and thus internal—stability of their currencies.
At the end of the twentieth century, the world has become more integrated, more interdependent, and more “egalitarian” than it was 50 years ago. The phenomenon of a dominant national currency is less common, and the use of reserve and transaction currencies tends to be more widespread. Furthermore, there is wide consensus on the dangers of inflation.
Logically, therefore, the future trend should be toward greater and closer international cooperation. As I have attempted to illustrate, “soft” cooperation based on pressure to emulate is no longer enough, and we must formulate and implement new approaches.
Views differ on whether such cooperation should be more or less ambitious. The more radical schemes have been described many times, and I will touch on them only very briefly. They involve global management of the international monetary system, with a central authority issuing and controlling an international currency. Under this type of system, external use of reserve currencies would be kept within set limits; above those limits, participants would have to settle their balances in the international currency managed by the central authority (asset settlement).
I do not believe that such proposals would be realistic at this juncture. I am afraid that the situation would need to be far more drastic for governments to accept such a far-reaching solution.
I do think, however, that a more formal mechanism of currency cooperation could be established to reduce misalignments and excessively volatile exchange rates. A system that would be suitably flexible while providing direction with exchange rates moving within bands, as described by the Bretton Woods Commission, seems to me to be an interesting possibility for the future.
It should be stressed, however, that a mechanism of this kind could work only if the participating states undertook to reinforce their macro-economic policies and to cooperate closely with their partners. This was highlighted in the Treaty on European Union, which stresses the importance of precise and measurable economic convergence criteria as a pre-condition for fixed exchange rates and monetary union.
Thus, the quality of the economic policies of the main players in the world economy is the first requirement for greater exchange rate stability. Central elements of this are the progressive reduction of fiscal deficits and public debt burdens. As the recently published Bretton Woods Commission report concluded: “the major industrial country governments should take two successive steps: first, strengthen their macroeconomic policies, and achieve greater economic convergence; and second, establish a more formal system of coordination to support these policy improvements and avoid excessive exchange rate misalignments and volatility.” I fully concur with its conclusion. This implies a set of objective rules by which all must agree to abide. But we must realize that the main players involved will de facto impose on themselves such rules only if they are truly committed to them politically. They will commit to them politically only if they are sure that it is in their own self-interest to do so. Furthermore, the domestic pressures to which they may be subjected will require governments not only to have strength of purpose but also to obtain the agreement of the main political groups. Without such a commitment, the market will start making its own guesses and presumptions; speculation could then even be intensified by the existence of bands, thereby undermining the necessary foundation for further coordination.
Role of the Fund
The Fund has a vital mandate to be the global monetary authority. It should be fully empowered once again to fulfill this role. Of course, I do not envisage returning to the IMF of the postwar years. Circumstances today have radically changed. Indeed, it is precisely because circumstances have changed so much that the Fund must revitalize and adapt its oversight function. To stabilize the system through greater cooperation, as I have suggested, countries will need to observe certain rules of the game. I believe the Fund should be the institution responsible for enforcing such rules. Essentially, this would mean two things: first, the Fund would have to ensure that the convergence criteria and rules pertaining to macroeconomic fiscal coordination between countries are respected by all; and second, once exchange rate bands are introduced, the Fund should be the agent responsible for their surveillance. But let me reiterate that political commitment will be the key to success. The Fund’s shareholders—especially the major ones—must be willing to strengthen the Fund’s monetary role and commit themselves to binding rules for this scenario to become reality.
In parallel to an enhanced role in monetary surveillance, what the Fund can achieve and has achieved in the area of conditional lending to restore balance of payments equilibrium should not be forgotten. If anything, this role should also be strengthened and the Fund given the necessary resources. The Fund’s conditional lending throughout the period of floating exchange rates—and particularly since the foreign debt crisis—has greatly helped developing countries achieve macroeconomic stability, reduce debt overhangs, restore growth, and thus strengthen the international financial system. The experience of Latin America is eloquent in this respect. Now the challenge has turned to the transitional economies of Eastern Europe and the former Soviet Union, and much still needs to be done there. The IMF must continue to play a vital role in this area.
The volatility, speculation, and misalignments that have shaken the international monetary system in recent years must not be allowed to continue. Governments must recognize that it is in their best interests to take concerted action, both at home and internationally, to regain international monetary stability. Of course, the international monetary system is the reflection of the present and at the same time a product of the past. Such systems evolve with people and time. It would be difficult to imagine a totally new system emerging today. What we must do is learn, adapt, and evolve. As Fred Bergsten put it, “the overriding lesson [of the postwar years] is that systemic stability cannot be taken for granted. It must be nurtured and constantly renewed.”
The problem we face is not so much with the technical difficulties of a new system, it is the acceptance by countries—especially the larger industrial countries—of the notion that they must adopt national policies that aim to attain a better international balance.
Strength of purpose alone, however, will not guarantee success in achieving effective international coordination and discipline. Indeed, systemic coordination and stability will also inevitably require a broadly accepted “oversight institution” with sufficient authority to sustain the rules of the game. It is undeniable that the professionalism, independence, and expertise of the Fund offer the attributes to be the natural source of authority; the difficult issue is enforcement. The challenge ahead is the design of, and commitment to, the incentive and sanction framework required to ensure that member countries abide by the rules.
Concluding Remarks: Hans Tietmeyer
Jacques de Larosière has given us a brilliant analysis, and he is absolutely right in stressing, on the one hand, the need for national policies that strive for stability both nationally and internationally and, on the other, the important role the Fund has to play in surveillance.
Cooperation is important and will be even more important in the future. Whether there is a chance to move into a more formal system or into a more formal cooperation is really an important question that has to be discussed further.