Chapter X:
The international financial system
A.
B.
C.
D.
E.
F.
Evolution of the international financial system
The gold standard
The Bretton-Woods System and the IMF
The ECU, the ERM and the euro
Nominal anchoring (dollarization, currency
boards, and managed float)
Globalization and stability of the international
financial system
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Evolution of the
international financial system
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Before World War I, the world economy
operated under the gold standard
It means that most world currencies were
backed by, and convertible into gold.
For currencies whose unit is permanently
tied to a certain quantity of gold, the gold
standard represents a fixed-exchange rate
regime
To see how it works we take an example:
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Operation
of the gold standard (1)
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The exchange rate between the $ and the £
is effectively fixed at $5:£1 via the common
denominator gold
As the £ appreciates beyond $5 in financial
markets, an American importer importing goods
for £100 from the UK would have to pay more
than $500
This importer could arbitrage against the
“financial” £ by exchanging $500 for gold,
shipping it to the UK, and converting it into £100
at the fixed gold parity
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Operation
of the gold standard (2)
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An appreciation of the £ leads to British gains in
international reserves, and an equal loss in
international reserves in the United States
It entails a commensurate expansion of base
money in Great Britain, and a contraction of
base money in the United States
This must raise the British price level, and
provoke a deflation in the US
It causes a depreciation of the £ against the $
until the former parity is reinstalled
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“Price-species-flow”
mechanism
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Price adjustments under fixed exchange rates
work through symmetries in the supply
of base money between two countries
One country loses international reserves, the
other gains international reserves
This mechanism will ultimately entail a
countervailing adjustment of price levels
for goods and services in each country
This “price-species-flow” mechanism was first
described by David Hume
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Example:
The U.S. during the 1870s
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During the Civil War in the US, the gold
standard had been abandoned and the
government had issued significant amounts
of paper money to finance the war
In the end, this had lead to an almost doubling
of the price level
After the war, the US returned to the gold
standard at the parity that had reigned before.
This (“shock”) contraction of the money supply
caused the depression of 1873-79
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Return to the gold standard
after WW I
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After World War I most countries tried to return
to the gold standard
International trade was mainly carried out in
British pounds, French francs, US dollars, all
(partially) covered by gold
Payments were made in gold certificates
(promissory notes denominated in gold), the
volume of which increased by credit expansion
The Great Depression caused insolvencies in
gold, which brought the gold standard to an end
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The Bretton-Woods System
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In 1944, the post-war international economic
order was conceived in the little town of Bretton
Woods (New Hampshire)
The three international institutions created are
 the International Monetary Fund (IMF);
 the Bank for Reconstruction and Development
(Worldbank);
 the General Agreement on Tariffs and Trade (GATT),
now World Trade Organization (WTO)
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The Bretton-Woods System
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The international financial system
(Bretton-Woods System) was based on gold
and the US dollar
The parity between the dollar and gold was
fixed at $35 for an ounce of gold
The exchange rates of other countries
adhering to the system were pegged to the
dollar
Discretionary exchange-rate adjustments were
possible in the case of “fundamental balanceof-payments disequilibria”
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Forex interventions
by central banks
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If the domestic currency was undervalued,
the central bank must sell domestic currency to
keep the exchange rate fixed (within limits
of ± 1 percent), but as a result it had to take
international reserves (US dollars) on board
If the domestic currency was overvalued, the
central bank must purchase domestic currency
to keep the exchange rate fixed, but as a result it
lost international reserves
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The role of the IMF
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Surplus countries faced a strengthening of
their currencies (revaluation)
Deficit countries experienced a weakening
(devaluation)
The IMF took (and takes) the role of an
international lender under certain conditions
Loans are given to member countries with
balance-of-payment difficulties
The IMF has now close to 190 members
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IMF as “lender of last resort”
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A “lender-of-last-resort” operation by the IMF is a
two-edged sword:
 central bank lending during a financial crisis could
stabilize the currency and strengthen domestic balance
sheets; and it could
 fend off speculation and prevent contagion
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But it could also
 arouse fears of inflation spiraling out of control, and
hence cause a further depreciation; and it could
 increase moral hazard and adverse selection problems
and make the crisis worse
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The operation of the system
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As for any fixed-exchange-rate regime, the
“price-species-flow” mechanism was also
working under the BW-system
However, revaluations and devaluations were
devices to “let out steam” and to ease economic
pressures, and hence to avoid the full price
adjustment
This was in particular helpful for deficit
countries, because internal prices are typically
rigid downwards (in particular wages), and a
painful deflation could thus be avoided
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Problems of the BW system
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The US-dollar became an international
trading and reserve currency, for which the
Fed held a monopoly
As more and more dollars would be issued
(US gold reserves remaining constant), trust
in the world currency was expected to weaken
(“Triffin Dilemma”)
However, initially there was a shortage of
international reserves worldwide, although this
changed later
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Special Drawing Rights (SDR)
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In order to overcome the apparent shortage of
international reserves in the 1960s, the US and
other key IMF members had allowed the IMF
to issue a paper substitute for gold:
“special drawing rights” (SDRs)
SDRs function as international reserves, but -unlike gold -- they can (within limits) be issued
by the IMF through credit creation
SDRs are only being used for official payments
among central banks
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The end of Bretton Woods
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The Bretton-Woods agreement lasted until 1971,
when it broke down due to institutional and
economic asymmetries
When the US pursued an inflationary policy
during the 1960s and early 1970s, the “lowinflation” Deutsche Mark became an increasingly
attractive speculative asset
Prices for gold in the free market provided
opportunities for arbitrage gains; there were
mounting incentives for currency speculation
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The end of Bretton Woods
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One option of surplus countries would have
been to follow US inflationary policies (and take
on board US dollars without limits!)
This opens up unlimited seignorage gains for the
issuer of the reserve currency, the US
The other option was to revalue
For countries that use the dollar as a reserve
instrument, their relative wealth position is tied to
the exchange rate of international reserves
A revaluation of the DM implies a devaluation of
the acquired claims in US dollars
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Forex market
and monetary policy
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Moreover, an appreciation of the currency
entails an increase in export prices for
foreigners, and a fall of import prices at home
This could trigger higher unemployment
“Because surplus countries were not willing
to revise their exchange rates upward,
adjustment .. did not take place and the BW
System collapsed in 1971.” (F. Mishkin)
“The ability to conduct monetary policy is easier
when a country’s currency is a reserve currency”
(F. Mishkin)
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The ECU and the ERM
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The ECU was a weighted average of the
currencies of all (initially 9, then 12) member
states of the (now) European Union
The ERM (“exchange-rate mechanism”) was an
arrangement that compelled governments to
keep the exchange rate of their currencies within
predetermined corridors (± 2.25% or ± 6%)
relative to the ECU rate
Participation in the ERM was voluntary
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The composition of the ECU
(1989)
Luxemburg (0,30%)
France (18,99%)
Germany (30,08%)
Ireland (1,10%)
UK (12,99%)
Italy (10,14%)
Netherlands (9,40%)
Portugal (0,80%)
Spain (5,30%)
Denmark (2,50%)
Belgium (7,60%)
Greece (0,80%)
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The exchange-rate
mechanism (ERM)
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The national currency is fixed to the ECU
A variation of the exchange rate within the predefined “corridor” is allowable
Once the exchange rate tends toward the
margins of the “corridor”, the central bank is
encouraged to intervene (“infra-marginal
interventions”)
Once the exchange rate moves out of the
“corridor”, a central bank intervention is
mandatory to bring it back into the “corridor”
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International monetary
policy coordination
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There were two (failed) attempts to coordinate exchangerate policies to stabilize the US dollar in the 1980s:
the “Plaza” and the “Louvre” accords
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Capital controls
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Capital controls (particularly those on outflows)
are typically rejected by economist
Controls on capital inflows receive some support
and have also been used rather successfully in
some countries (Chile and Colombia)
Reason: Capital inflows can cause an excessive
lending boom, … entailing a painful reversal
But controls of capital inflows could also block
funds for economic development. It calls for
differential treatment according to maturity
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The international policy focus
is now on …
.. improving
banking regulation and
supervision, and on
greater transparency.
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The role of a nominal anchor
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Adherence to a nominal anchor forces
a monetary authority to conduct “disciplined”
monetary policy
A priori publicized self-binding rules
 imply a strong auto-commitment;
 can relieve from short-term political pressures;
 contribute to the predictability of policy and hence
stabilize economic behavior;
 foster confidence building in monetary authorities
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The time-consistency problem
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Economic behavior is influenced by what
economic agents expect monetary authorities
to do in the future
If expectations were to remain unchanged there
is the temptation to abuse this fact by attempting
to boost the economy through discretionary
expansionary monetary policy
If expectations will incorporate the expected
outcome of such a policy, output will not be
higher, but inflation will!
A monetary anchor acts as self-binding rule
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Exchange-rate targeting
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Exchange-rate targeting has a long history,
including the fixing of the exchange rate to the
price of gold
Exchange-rate targeting has clear advantages
 it links the price of traded goods to that found in the
anchor country; this might contain inflation;
 time-inconsistent monetary becomes less of an
option; this stabilizes price expectations;
 it is a simple and transparent rule (“franc fort”)
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Exchange-rate targeting has been widely used
in Europe and world-wide
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Disadvantages
of exchange-rate targeting
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Exchange-rate targeting might be create serious
problems because
 the country tying its currency to that of an anchor
currency can no longer respond to shocks to its own
economy;
 there could also be shocks applying to the anchor
country; these are fully transmitted (the case of
Germany after unification);
 if the anchor country opts for inflation, countries with
pegged currencies will “import inflation”
 it may present opportunities of a one-way bet for
speculators (crisis of the EMS of September 1992)
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The 1992 ERM crisis:
the UK and France
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The UK did devalue
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France did not!
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The “cost” of pegging
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The UK had higher
growth and less
unemployment
But its inflation rate
increased
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France had lower
growth and more
unemployment
But its inflation rate
was lower
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Exchange-rate targeting:
For whom?
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Industrialized countries might have more to lose
by exchange-rate targeting than to win
In some industrialized countries the central
banks is subject to political pressure
In this case exchange-rate targeting may prove
to be beneficial
It also encourages economic integration
Contrary to industrialized countries, emerging
market countries may not lose much by giving
up an independent monetary policy, but it leaves
them open to speculative attacks
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Can speculation be averted?
The currency-board approach:
 One approach is to back the domestic currency
by 100% by a foreign currency (euros, dollars)
 It means
 the money supply can only expand when international
reserves of a country increase.
 a strong commitment of monetary policy, which may
therefore work instantly in controlling inflation.
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Currency boards are however not immune
against speculation
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Currency boards: Examples
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Recent examples of currency boards include
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Hong Kong (1983)
Argentina (1991)
Estonia (1992) and Lithuania (1994)
Bulgaria (1997)
Bosnia and Herzegovina (1998)
Argentina had to abandon the scheme in
December 2001 -- with painful social and
economic repercussions
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The CFA-zone
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The CFA franc is the common currency of
14 countries in West and Central Africa,
12 of which are former French colonies
The CFA franc has been pegged to the French
franc since 1948. Only one devaluation has
occurred during the history of the currency peg
(January 1994)
The French Treasury has the sole responsibility
for guaranteeing convertibility of CFA francs into
euros, without any monetary policy implication
for the ECB
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Can speculation be averted?
Dollarization:
 Another approach is to abandon a national
currency altogether and to adopt a foreign
currency (e.g. US dollars) instead
 It means
 a euro or dollar remains a euro or dollar, whether
inside or outside the respective currency area.
 that the country adopting a foreign currency loses
potential income through seignorage.
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However a reversal to a domestic currency
always remains an option
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“Dollarization”:
Examples of countries
Andorra
East Timor
Ecuador
El Salvador
Kirib ati
Kosovo
Liechtenstein
Marshall Island s
Micronesia
Montenegro
Monaco
Nauru
Palau
Panama
San Marino
Tuvalu
Vatican City
euro (formerly French franc, Spanish peseta), own coins
U.S. dollar
U.S. dollar
U.S. dollar
Australian dollar, own coins
euro
Swiss franc
U.S. dollar
U.S. dollar
euro (partly "DM-ized" since 1999)
euro (formerly French franc)
Australian dollar
U.S. dollar
U.S. dollar, own balboa coins
euro (formerly Italian lir a), own coins
Australian dollar, own coins
euro (formerly Italian lir a), own coins
1278
2000
2000
2001
1943
1999
1921
1944
1944
2002
1865
1914
1944
1904
1897
1892
1929
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“Dollarization”: Exits
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Even dollarization does not guarantee a
permanent monetary anchoring
There is need to a continuing inflow of foreign
denominated capital to satisfy domestic
demand for money
This puts severe strains on the economy
There is a large number of exits from a
currency zone during recent years:
 Numerous exits from the ruble zone after the
breakdown of the Soviet Union
 the secession of Slovakia from Czechoslovakia
 the breakdown of Yugoslavia
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Foreign exchange
arrangements
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Inflation targeting
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A number of countries has adopted inflation targeting
following the lead of New Zealand (1990)
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Canada (from 1991)
the UK (from 1992)
Australia (1994)
Brazil (1995)
In 1990 the Reserve Bank of NZ became fully
independent and was committed to the sole objective of
price stability
The governor of the central bank is held accountable for
achieving a predefined inflation goal
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Inflation targeting: strategy
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The strategy consists of
 publicly announcing a medium-term numerical target
for inflation that is well defined;
 committing the central bank to price stability as the
primary (if not sole) policy goal;
 an information strategy that includes several
indicators, not just monetary aggregates
 increased communication with the public to render
monetary policy more transparent; and
 an increased accountability of the central bank for
attaining its inflation target.
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Inflation targeting:
advantages
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Inflation targeting
 enables the central bank to focus on domestic policy
objectives, but a stable relationship between money
and the price level is not critical for its success;
 is highly transparent and easily understood;
 increases the accountability of the central bank
because of a numerical target as a benchmark;
 seems to ameliorate the effects of inflationary shocks
(introduction of a GST in Canada; exit of the British
pound from the ERM in 1992). There was a one-time
price adjustment, but no spiraling up of inflation.
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Inflation targeting:
disadvantages
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Inflation targeting is not without problems
because
 inflation cannot be controlled directly and
policy outcomes occur only with a time lag;
 therefore the policy cannot send immediate
signals to economic agents;
 may be too rigid and limit the policy discretion
to respond to unforeseen events;
 it will even out inflation, but might increase
output fluctuations
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The two pillar strategy
of the ECB
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The strategy of the ECB appears to reconcile
monetary targeting with inflation targeting by
scrutinizing both monetary growth and a bundle
of economic indicators to assess the mediumterm impact on the HICP
Contrary to the NZ approach, the ECB may be
criticized as being less responsive to public
demands for information
Less transparency goes hand in hand with less
accountability
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Reading 10-1: “Wrestling for influence”,
The Economist, July 3rd, 2008
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That’s it !
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Thank you for attending
this course
I hope you enjoyed it
All the best for you private
and professional future,
and …
… good luck for the final
exam !
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