An Introduction to the
International Monetary System
INTERNATIONAL BUSINESS ENVIRONMENT
Course numbers STRT 571-44 & -45, Spring 2010, Mod 4
James Raymond Vreeland, School of Foreign Service
Week 4 (Wednesday, 7 April; Monday, 12 April)
Tonight’s schedule
• 6:30-7:30
• 5 minute break
• 7:35-8:35
• 5 minute break
• 8:40-9:40
Plan for tonight:
1.
Why a “trilemma”?
2.
Why were countries able to maintain fixed exchange
rates with high capital mobility in the late 19th century
but not the 20th?
3.
Why did we ever invent an IMF? Do we need Regional
MF’ers?
(e.g., AMF, EMF)
4.
What is the current international monetary system?
5.
What is the future international reserve currency?
1st: A reminder of
The Inconsistent/Unholy
Trinity
Or
“Trilemma”
Free Capital Flow
Inconsistent/Unholy
Trinity
Or
“Trilemma”:
a country can only have 2 out of
3 of these
Fixed Exchange Rate
Sovereign Monetary Policy
Why would you want…
• Free Capital Flow?
– Draw on the savings of the rest of the world
– Investment opportunities abroad
• Fixed Exchange Rate?
– Reduce uncertainty in trade
• Sovereign Monetary Policy?
– Address inflation/unemployment
And now a puzzle…
A puzzle
Degree of
global
capital
mobility
Fixed
exchange
rates
Floating
exchange
rates
+
+
Capital
controls
Open
capital
flows
1944
1971-3
Conclusion:
Cannot maintain (global) fixed
exchange rates in the presence of
high capital mobility…?
A puzzle
*
1870
Degree of
global
capital
mobility
Fixed
exchange
rates
Floating
exchange
rates
+
+
Capital
controls
Open
capital
flows
1944
1971-3
Keynes 1919 quote:
• “The inhabitant of London could order by telephone,
sipping his morning tea in bed, the various products of
the whole earth, in such quantity as he might see fit, and
reasonably expect their early delivery on his doorstep;
he could at the same moment and by the same means
adventure his wealth in the natural resources and new
enterprise of any quarter of the world. He could secure
forthwith, if he wished it, cheap and comfortable means
of transport to any country or climate without passport or
other formality…. He regarded this state of affairs as
normal, certain, and permanent.”
A puzzle:
Why were countries able to maintain fixed exchange
rates with high capital mobility in the late 19th century?
Fixed
exchange
rates
+
Degree of
global
capital
mobility
Open
capital
flows
1870
Interwar period
Fixed
exchange
rates
Floating
exchange
rates
+
+
Capital
controls
Open
capital
flows
1944
1971-3
Why?
Answer: Democracy
Few democracies
Growing #’s of democracies
Fixed
exchange
rates
Degree of
global
capital
mobility
+
Open
capital
flows
1870
Interwar period
Fixed
exchange
rates
Floating
exchange
rates
+
+
Capital
controls
Open
capital
flows
1944
1971-3
Growth of democracy (minimalist definition)
1870 (7):
1884 (8):
1897 (12):
1911 (17):
United States
Norway
Netherlands
Sweden
Canada
1885 (9):
1901 (14):
Portugal
France
United Kingdom
Australia
1912 (18):
Switzerland
1890 (10):
Denmark
Argentina
Greece
Luxemburg
1909 (15):
Orange Free State 1894 (11):
Cuba
New Zealand
Chile
Belgium
(lost OFS – 1902)
Why?
• So, why do fixed exchange rates pose a
problem for democracies in the face of
highly mobile capital?
Pure gold standard
• Country A imports from Country B
• Gold moves from A to B (re-coined/minted)
• Less money in A  lower prices
• More money in B  higher prices
•  Country B imports from Country A
• Balance is restored
With paper money
• Central Banks intervene by adjusting
interest rates
• So gold doesn’t actually flow
• Gold Standard  strict discipline!
What is “discipline”?
• What do “lower prices in Country A”
mean?
• Supply of money down
• More expensive to borrow
• Jobs cut!
• People don’t eat!
People don’t eat
Under authoritarianism:
• Let them eat cake
Under democracy:
• Incumbents lose elections
Hazard Rate over Time for
Democracies (Solid Line) & Dictatorships (Dotted Line) – Time in years
Hazard Rate
0.625
0.5
0.375
0.25
5
10
15
20
T ime (years)
Stylized history
• Late 19th century:
– Mobile capital, authoritarian governments
• Interwar years:
– Mobile capital + democracy  beggar-thy-neighbor
• Bretton Woods (1944-1971/3):
– Capital controls + democracy
• Post Bretton Woods:
– Floating exchange rates
What was Bretton Woods
And what was the IMF’s role?
5 minute break
What is the IMF?
• Like an international “credit union”
• Almost all the countries in the world are members (186?)
• All hold currency on reserve
• The IMF can use these reserves to loan to countries in
“crisis”
• Moral Hazard?  Conditionality!
• IMF programs = loans + conditions
• Decisions at the IMF are by majority rule
• Influence over decisions pegged to “economic size”
– MAJOR SHAREHOLDERS
– Votes are determined by contributions (“quota”), Quota set by an
85% majority rule
– Most other decisions by simple majority rule (CONSENSUS)
Problem
• Keynes Plan called for contributions totaling $26 billion
(with $23 billion from the US)
• The White Plan called for only $5 billion (with $2 billion
from the US)
• Compromise:
– $8.8 billion, with just $2.75 billion from the US
• The US would only provide Marshall Plan assistance to
countries that did not seek additional assistance from the
IMF
• On the eve of the current crisis:
– instead of having reserves approximating half of the value of
global imports, the IMF holds on reserve a total of less than 2
percent of global imports
What were the goals of Bretton Woods?
•
Support Fixed XR’s with governments unwilling
to sacrifice employment to address imbalances
•
4 INNOVATIONS:
1. Some XR flexibility (fixed-but-adjustable “snake”)
2. Capital controls
3. A stabilization fund (held on reserve at the IMF)
4. The International Monetary Fund – authority over
XR changes + conditionality attached to loans
Bretton Woods failed for several reasons
• IMF lacked true authority over XR – governments did as
they saw fit
• Governments did not like IMF conditionality
• The stabilization fund was never large enough to deal
with the potentially massive imbalances that come with
growing globalized economic integration
• Straws that broke the BW back:
– USA: VIETNAM + SOCIAL SPENDING + INTERNATIONAL
RESERVE CURRENCY
–  SPECULATION that the US cannot maintain the fixed
convertibility to gold + the French – regularly demanded
American gold from the US for the $’s they accumulated
• http://www.youtube.com/watch?v=iRzr1QU6K1o
Recapping 1st session:
• Normal trade  temporary imbalances
• Fixed exchange rates  discipline
• Democracy
• IMF to the rescue!... Or not.
Taking a step back…
Why is the IMF involved in the developing world?
• Originally designed to help developed
countries maintain fixed exchange rates
• “Soften the blow” of adjustment
• Did it ever do that?
• So what did the IMF do?
Was there really a shift?
Figure 1.1: Percentage of countries participating in IMF programs
0.50
0.45
0.40
0.30
0.25
0.20
0.15
0.10
0.05
Year
Western Europe, US and Japan
Rest of the world
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
0.00
1946
Percent
0.35
IMF effect in the developing world
has been lackluster
• Why?
– Partial reform?
– Bad policies?
– International politics?
Partial reform?
• Historically, lack of “ownership” &
transparency
• Governments push through some reforms
but not others
• Protect elite constituents at the expense of
labor & the poor
Bad policies?
• Crisis in the developed world? Stimulus!
• Developing world? Contractionary policies:
– Raise interest rates, limit credit, cut public
spending, raise taxes, devalue the currency
• Example:
– Compare Mexico 1994 & Indonesia 1997
– South Korea spent 13 years under consecutive
agreements from 1965 to 1977
– Zaire 14 years straight (1976-1989)
International Politics?
• Sometimes the “major shareholders” use
the IMF to pursue foreign policy goals
• Friends get
– Big loans
– Fewer policy conditions
– Or they ignore conditions with impunity
• Loans prop up bad policies and corrupt
governments
Bureaucratic story?
• The IMF is like any other bureaucracy
• Tries to make big loans to generate revenue
• Does not care about enforcing conditionality
Evidence of political favoritism
• Top 5 members:
– United States (16.8%)
– Japan (6.0%)
– Germany (5.9%)
– France (4.9%)
– UK (4.9%)
• Other important
members:
–
–
–
–
–
–
–
–
China (3.7%)
Saudi Arabia (3.2%)
Russia (2.7%)
Belgium? (2.1%)
Canada? (2.88%)
Brazil? (1.4%)
India? (1.9%)
Korea? (1.3%)
UNSC
IMF/WB project in Ghana
IMF
% of obs. participating in IMF programs
Figure 1: Participation in IMF programs
by rotating membership on the UN Security Council
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
Non-members
Members
mean=0.26
mean=0.33
std dev.=0.44
std dev.=0.47
(n=7129)
(n=477)
UN Security Council Membership Status
0.60
0.50
0.40
0.30
0.20
0.10
n=1669 n=95 n=1119 n=47 n=1254 n=100 n=591
Africa
Asia & S.
Pacific
LA & Carib.
n=36 n=814
E. Europe
Member
Nonmember
Member
Nonmember
Member
Nonmember
Member
Nonmember
Member
Nonmember
Member
0.00
Nonmember
% of obs. participating in IMF programs
Figure 3: Participation in IMF programs
by UN Security Council Membership and Region
n=51 n=998 n=108
Middle East & Industrialized
N. Africa
Countries
UN Security Council Membership Status and Region
Figure 1: Participation in IMF programs by non-permanent UN Security Council Membership
over time
% of obs. participating in IMF programs
50%
40%
30%
20%
10%
0%
Nonmembers
Members
Other years
4 years
before
3 years
before
2 years
before
1 year before
1st year
member
2nd year
member
mean=0.28
mean=0.34
mean=0.28
mean=0.28
mean=0.31
mean=0.33
mean=0.32
mean=0.35
mean=0.34
1 year after 2 years after
mean=0.30
mean=0.28
st.dev.=0.45 st.dev.=0.48 st.dev.=0.45 st.dev.=0.45 st.dev.=0.46 st.dev.=0.47 st.dev.=0.47 st.dev.=0.48 st.dev.=0.48 st.dev.=0.46 st.dev.=0.45
(n=6684)
(n=462)
(n=5405)
(n=178)
(n=196)
(n=215)
(n=236)
(n=236)
(n=225)
(n=234)
(n=221)
UN Security Council Membership Status
The horizontal line shows the average IMF participation rate across our entire sample. The dots reflect the results where only low and lower-middle income countries are included.
So, how might programs hurt?
• Sometimes partial reform
• Sometimes bad policy advice
• Sometimes good policy advice but ignored
• Note: sometimes things work out!
– Willing governments develop good policies
with the IMF and follow through
IMF web page…
http://www.imf.org/external/np/sec/memdir/eds.htm
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(PPP)
Asian Monetary Fund Proposal?
• Going back to the aftermath of the US/IMF
bailout of Mexico in 1995
• Japanese policy-thinkers/makers begin thinking
about an “Asian Monetary Organization” ($20
billion)
• Why?
– Believed that the US would not act as vigorously in
the event of a crisis in Asia
• Then: East Asian Financial Crisis
• http://www.xtimeline.com/timeline/AsianFinancial-Crisis
Aug 1997
• Japan facilitates bilateral commitments
towards the IMF rescue package for
THAILAND
• Japan commits $4 billion out of the $17.2
billion package (as much as the IMF’s
contribution)
• US – conspicuously absent!
•  “Asian sense of solidarity”
AMF vision
• $100 billion
• 10 members:
– Australia, China, Hong Kong, Indonesia,
Japan, Malaysia, Philippines, Singapore,
South Korea, Thailand
– NOT the United States
– Secretary of State Summers to MOF official
Sakakibara:
– “I thought you were my friend!”
US argument
• Moral hazard
–
– postpone adjustment
• Duplication
– Add little to the pre-existing IMF system
US enticements
• Offer Asian countries increased IMF
quotas
– What does this get them?
– More votes… and more rights to borrow
(more larger loans)
• New arrangements to borrow
• CHINA: was lobbied regarding “Japanese
hegemony”
• Why did Japan propose the AMF?
• Why did the US and the IMF oppose?
• Why did China oppose?
Donors are CONCERNED ABOUT
MORAL HAZARD moral hazard if:
• Economic & political ties to the crisis
country are weak
• Use the crisis as an OPPORTUNITY:
– Extract concessions from the crisis country
(force it to open up to trade and investment)
• Use the crisis country as an example to
deter future “moral hazard”
Donor States will prefer rapid liquidity provision if:
• Economic ties with the crisis-country are dense
• Political interests are at stake
• Domestic conditions are conducive to providing
funds abroad
– Investors, creditors
• This approach will provide a quick recovery of the
crisis economy
• This approach benefits creditors!
• Moral hazard costs are borne over the long run by
the entire international community
Why did Japan (not US or EU)
lean towards liquidity provision in the East Asian Crisis?
25% of Japanese lending to all developing countries went to Thailand!
ADB: US and
Japa have the
same shares
Japan vs. US
• Japan – largest foreign investor in Thailand
• US & Japan – same share of overall trade
• But Japan ran a surplus, the US a deficit
• Slowdown in Thailand  hurts Japanese
exports
• Regarding bank exposure, FDI, & trade, the
same goes for Japan’s relationship with the rest
of East Asia
Flashback to Tequila crisis (1994)!
• US bank lending & economic ties to
Mexico far exceeded Japan’s
• US leaned towards liquidity provision
• Put together massive bailout package: $50
billion
• Japan provided no liquidity!!!
Japan’s position at the IMF re:
Indonesia
• Japan opposed major structural reforms
(eliminate national projects, reduce
subsidies, restructure financial structure)
• Japan supported a loan package to
stabilize the exchange rate
• IMF ignored Japan
Flash-forward: March 2010
Chiang Mai Initiative
• A multilateral currency swap arrangement
• Members: Association of Southeast Asian Nations (ASEAN), China
(including Hong Kong), Japan, and South Korea
• ASEAN members: http://www.aseansec.org/74.htm
• Foreign exchange reserves pool of US$120 billion
• Set to launch in March 2010
The ASEAN flag
• The initiative began as a series of **bilateral** swap arrangements after
the ASEAN + 3 countries met in May 2000 in Chiang Mai, Thailand
• Why did they meet?
– An annual meeting of the Asian Development Bank
–
http://english.people.com.cn/english/200005/07/eng20000507_40281.html
What about an EMF??
5 minute break
The saga continues…
• The story of the contemporary
international monetary system is the story
about the search for the elusive ideal
balance between domestic economic
autonomy and exchange rate stability
Free Capital Flow
Inconsistent/Unholy
Trinity
Or
“Trilemma”:
a country can only have 2 out of
3 of these
Fixed Exchange Rate
Sovereign Monetary Policy
The point of the unholy trinity – you can’t have it all…
• “The point is that you can't have it all: A country must
pick two out of three. It can fix its exchange rate without
emasculating its central bank, but only by maintaining
controls on capital flows (like China today); it can leave
capital movement free but retain monetary autonomy,
but only by letting the exchange rate fluctuate (like
Britain--or Canada); or it can choose to leave capital free
and stabilize the currency, but only by abandoning any
ability to adjust interest rates to fight inflation or
recession (like Argentina today, or for that matter most of
Europe).”
• – Paul Krugman http://slate.com/id/36764
Trade & international capital flows
lead to imbalances
•
How do governments deal with these
imbalances?
Avoid them? (Capital controls?)
Fixed exchange rate  sacrifice monetary policy
OR:
Floating exchange rate
•
Trade-off between exchange rate stability – or
– domestic price stability with monetary policy
autonomy
Why are there imbalances?
• These days, foreign exchange markets
conduct between $1 trillion and $1.5 trillion
worth of business… PER…???
– Per year?
– Per month?
– Per day?
– Per hour?
•  Exchange rate volatility!
•  Exchange rate misalignments
Consequences of XR volatility?
• Uncertainty hurts international transactions?
• Suppose you work on a profit margin of 5%-9%
and the XR changes 5% between the time you
ship an export and the time it arrives…
• But businesses can purchase options to buy a
foreign currency 30, 60, or 90 days in the future
at today’s XR, thereby insuring themselves
against short-term XR volatility
• Nevertheless, a reduction in investment is one
possible consequence of currency
misalignments
Fixed XR
• A kind of commitment
• To avoid SPECULATATION governments try to make a
credible commitment to a fixed XR
• If the commitment is not credible, speculation can be
disastrous
• Argentine Currency Board (1991-2002)
– Pegged the Argentine peso to the U.S. dollar in an attempt to
eliminate hyperinflation
– Credibility? Required legislative vote to change the value of the
currency (public discussion undermines the point of a devaluation!)
– But deficit spending ultimately undermined confidence
– And tied hands prevented the government from acting
– Run on the currency in 2002  disaster!!
The Euro
• The ultimate commitment
• So, if it’s credible, will it overtake the dollar
as the international reserve currency?
Euro-Zone
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Austria (1999)
Belgium (1999)
Cyprus (2008)
Finland (1999)
France (1999)
Germany (1999)
Greece (2001)
Ireland (1999)
Italy (1999)
Luxembourg (1999)
Malta (2008)
Netherlands (1999)
Portugal (1999)
Slovakia (2009)
Slovenia (2007)
Spain (1999)
•
EU members not using the Euro:
– United Kingdom
– Poland
– Sweden
– Denmark
– Czech Rep  Nov 2009 set to
join??
– Bulgaria
– Estonia
– Hungary
– Latvia
– Lithuania
– Romania
The European Monetary System
• 1979
• Fixed but adjustable
• The Bundesbank (Germany) used
monetary policy to keep inflation low, and
other countries engaged in foreign
exchange market intervention to fix their
currencies to the German mark
French-German fight in 1981-3
• Mitterrand – socialist president – believed
German monetary policy was strangling
• Expansionist monetary policy (e.g., lowered
interest rates)
• French inflation began to rise
• Called on Germany to lower their interest rates
• 18 month stand-off… the French backed down
1988-2002: Monetary Union
• 1988: Planning begins
• Gradually moved towards fixing their currency
XR’s (1999 – “permanently” fixed)
• Jan 2002: The Euro!
• Why union?
• High degree of economic openness across
Europe 
• Sacrificed monetary autonomy for XR stability
Overvaluation of the Dollar
• International reserve currency
• Early 1980s: Reagan’s fiscal expansion – cut taxes,
increased spending 
• Current account deficit 
• Increased interest rates and capital inflows (from, e.g.,
Japan)
• Value of the dollar goes up!
• Plaza Accord (fall 1985): G5 agreed to reduce the value
of the dollar against the yen & mark by 10-12% – sell
dollars if it appeared the value was going to increase
• By early 1987, dollar had depreciated 40%
Similar situation today
• US current account deficit
• Japan, Europe, China, current account
surpluses 
• Finance the American deficit
– US absorbs about 6% of the world’s savings
• US international investment position:
– foreign-owned assets in 2007: $17.8 trillion
– US residents’ foreign assets in 2007: $15.4 trillion
– international investment position: –$2.4 trillion
Worry?
• Catastrophe!
• Doubts about the solvency of American
financial institutions & American assets
• Foreign lenders reluctant to continue to
accumulate dollar-denominated assets
• Trigger massive sales of current
holdings?
Hope??
1. US needs to reduce its budget deficit
2. Countries with surpluses need to expand demand in their own
countries
•
Macroeconomic coordination along these lines would reduce American
imports & expand consumption in surplus countries
•
Cooperation could also guide a gradual decline of the $, rather than a
fast catastrophic drop
•
Problem for China: adjustment moving from the US market to the
domestic market would create economic dislocation, winners &
losers…  political instability?
•
This is a reality that the Chinese government must deal with and
therefore the American government must also!
•
But a catastrophic drop would hurt the export-oriented sectors of all
countries with current account surpluses with the US!
Is the Euro an alternative?
• Coordination game
• Present distribution of reserve currencies:
– Dollar: ~60%
– Euro: ~30%
– Pound: ~3%
– Yen: ~5%
• SDR?
Be careful what you wish for…
• Benefits of international reserve currency
– finance fiscal deficits
– enhance international prestige
– debt denoted in your own currency
• Costs of international reserve currency
– Monetary policy autonomy is hindered - vast
quantities of your currency held abroad
– Overvaluation leads to uncompetitive exportoriented/import-competing sectors
Obstacles
• A focal point: The more people who use an
international currency, the more effective it is
(increasing returns to scale)
• No equivalent to the US treasury bill @ the EU level
• Leadership – who bails you out?
– US track record v. EU (…Greece?)
What can China do?
• Gradual appreciation?
– A one-way road to “hot money” and a scary bubble
• A one-off revaluation?
– Catastrophic economic dislocation
– Politically possible given the export-oriented sector
strength?
• Status quo?
Status quo
• US “shock absorber”:
– Floating exchange rate
• China opts for:
– restrictions on capital flows
• How can the dollar adjust if China fixes to it?
• This is the current monetary system…
• And it’s doomed
Thank you
WE ARE GLOBAL GEORGETOWN!