Economic Policy and Theory - International monetary policy




International monetary policy attracted few economic theorists before the twentieth century. Only when historic mercantilist concern for the accumulation of specie, and the rapid adjustment of interest rates under the gold standard, gave way to greater concern for mass unemployment did it begin to garner much theoretical attention. Before that, few who suffered at the hands of recurring gold outflows and restrictive domestic monetary policy were in any position of influence to either arrest such trends or call for new policies and theory with which to assail or question the prevailing regime. Exchange rates and gold reserves were defended at almost any cost, interest rates moved precipitously to reverse potentially large capital outflows, and investment planning could proceed under the assumption of minimal or virtually nonexistent exchange rate risk. However secure it rendered investment planning, this approach often proved that it would require, above all else, the willingness to sacrifice output in the name of exchange rate stability. As industrialization reconstituted American and European labor markets, this approach also implied recurring episodes of mass unemployment.

Much as it had with international trade theory, the shock of world war and the Great Depression gave great impetus to change. And just as these events compelled economists to rethink the theories that had somehow prevented them from capturing or explaining real world tendencies in international trade, so they forced economists to train their sights anew on questions of international money. The Baring-Argentine financial crisis of 1890 and the U.S. depression of 1890s had also focused much attention on international currency problems, but economic theorists were as yet unequipped to respond directly or forcefully. It was not until the later crises and the even more widespread economic calamity of the 1930s that economic theory began to respond with analyses directed at international monetary policy. It was at this time that the United States, for example—closely following its European counterparts—began to compile international balance of payments accounts, records of its transactions with the rest of the world. It was also at this time that Keynes and others began to urge new ways of conducting international monetary transactions, actively seeking theoretical insights by which changes could be guided and accommodated. "To close the mind to the idea of revolutionary improvements in the control of money and credit," Keynes warned, "is to sow the seeds of the downfall of individualistic capitalism."

To Keynes, the early twentieth century had proven the extent to which nations would resort to currency devaluation as a lever to improve their balance of trade, seldom improving in the process either their own terms of trade or the opportunities inherent in a flourishing and expanding trade network. As balance of payments accounting had become more common, many Western nations had come to believe that unilateral currency devaluation would, in the absence of reciprocal action, improve the terms of trade. It would make a nation's own exports cheaper in terms of foreign currency and would, of course, make imports equally more expensive. It was not uncommon to find, however, the price of imports rising under such an initiative to the point where the aggregate value of imported goods continued to outpace the value of the higher, newly attained level of exports. Abba Lerner, in his 1944 publication The Economics of Control, introduced what eventually came to be called the Marshall-Lerner criterion, a theoretical rule with which one could determine the positive or negative outcome of such a devaluation. Assuming that factors such as supply constraints do not enter into the picture, Lerner showed that if the price elasticity of exports plus the price elasticity of imports is less than 1, then the increased cost of the imports exceeds the value of the growth in exports. Moreover, if a nation began with a large sum of foreign liabilities denominated in foreign currency, devaluation of its own currency might well add terrific sums to its net interest payments. With competitive devaluation added to the mix as a likely outcome, perhaps only after an interval of unilateral manipulation and worsening results, the terms of trade could seldom be rendered any more reliable or propitious. Global trade diminution became an increasingly likely outcome.

With a little prodding from Bertil Ohlin and others, Keynes's theoretical insight here was to recognize that in modern industrial economies, monetary policy would simply have little effect in restoring balance through price deflation. It would regulate external balance, instead, by causing unemployment, lower incomes, and decreased imports. He then seized upon the notion that exchange rate mechanics mattered far less than international liquidity. Though gold, the pound sterling, and the U.S. dollar had all proved somewhat useful in attempts at securing substantial international reserves with which to conduct increasing levels of trade, even the highly regarded British and American currencies remained vulnerable to the deflationist tendencies Keynes so abhorred.

Bretton Woods and the Triffin Dilemma As the end of World War II approached, Keynes and many of his American counterparts began planning for the postwar period. The Bretton Woods conference of 1944 convened with a sharp focus on both the monetary fragility of the interwar period and the theoretical prescriptions of Keynes and his growing legion of American disciples. The conference proved successful in reorienting the world's economic exchange system away from the constraints of the gold standard. Exchange rates were fixed and pegged, and could be adjusted within limits only during periods of "fundamental disequilibrium." Because Keynes and the head of the U.S. delegation, Treasury assistant Harry Dexter White, hoped to insulate government domestic policies from the misdeeds of currency speculators, Bretton Woods called for explicit capital controls. It also created the International Monetary Fund (IMF), an organization designed to provide a cushion of international reserves to nations caught in a persistent current account deficit. The IMF would also serve as the final arbiter of fundamental disequilibrium.

In the end, however, Keynes's preoccupation with international currency reserves gave way to the overriding American concern for exchange rate stability. His proposal for an International Clearing Union, under which international liquidity could be expanded without reliance upon a single currency, never came to pass, mostly due to widespread fears that it would prove to have an inherent inflationary bias. It included provisions for bank "credits," extended to surplus states, and an artificial bookkeeping currency he called a "bancor," to maintain exchange rate stability. Overdraft provisions (up to $26 billion initially for member states) were proposed as well, to prevent contractionary domestic policy measures or competitive devaluations undertaken in the defense of embattled currencies. The IMF, however, acknowledging part of Keynes's theoretical contribution, did arrange for lending quotas (based mostly on the relative value of recent trading levels). In theory, these might have been utilized for both reconstruction and investment, and like the Clearing Union, could become a means to increased international liquidity. Unprecedented inflation in the immediate postwar years, however, altered the real value of IMF quotas to the point that short-term currency stabilization proved to be the only feasible activity. And since the Bretton Woods system came to be anchored upon the U.S. dollar (pegged to gold at $35 per ounce) rather than any type of new reserve asset, international liquidity would also depend in large measure upon worldwide confidence in a currency destined to wind up in a precarious overhang or glut position. Indeed, generous Marshall Plan assistance, combined with larger than anticipated Cold War military outlays, quickly transformed a dollar shortage expected to last for some time into a dollar glut. By about 1953 the dollar gap or shortage had disappeared.

Although the modest U.S. payments deficits of the mid-1950s represented little more than a sensible response to varying levels of worldwide savings and investment requirements, Yale economist Robert Triffin noted that the dollar's unique position in the fixed exchange rate Bretton Woods system posed a fundamental dilemma. As the anchor of the system and the chief reserve asset, the flow of dollars into foreign accounts would necessarily outpace the flow of other currencies into American hands. Yet, despite the salutary effect such reserves would have on international trade in general, Triffin speculated that confidence in the dollar as a store of value would decrease as its numbers and its role as a reserve asset increased. Dollar accumulations overseas would engender an increasingly risky situation governed by a self-fulfilling prophecy. The implication of this dilemma was that international liquidity depended upon either a return to the Keynesian approach and a new independent reserve asset, or an end to fixed exchange rates pegged to the dollar value of gold.

Although the Lyndon Johnson administration tried to move in the direction of the former option, by introducing special drawing rights (informally, "paper gold") into IMF operations, they failed to catch on as a source of genuine, dayto-day international liquidity. Previously, John Kennedy's undersecretary of the Treasury for International Monetary Affairs, Robert Roosa, had arranged for a series of mostly stopgap measures designed to ease the dollar overhang and stanch the attendant gold outflow. Negotiated offsets (purchase of U.S. goods by nations receiving U.S. military aid), swap arrangements (U.S. agreement to exchange U.S.-held foreign currencies for dollars at a future date to protect foreign banks otherwise reluctant to hold large sums of dollars), and the December 1961 "General Arrangements to Borrow" (a large, short-term borrowing arrangement that gave Great Britain and the United States additional IMF resources to avert a speculative currency crisis) were among the measures employed by Roosa and his successor in the Johnson administration, Frederick Deming. Afterward, the only remaining questions concerned the way in which the world would manage the departure from the Bretton Woods system and the nature of the floating exchange rate system certain to take its place. The end came quite abruptly after a decade of patchwork revisions, holding operations, and stopgap measures. President Nixon's decision of 15 August 1971, to end the guaranteed conversion of U.S. dollars into gold at $35 per ounce, announced after a series of Camp David meetings with top-level economic advisers, effectively ended the Bretton Woods international monetary regime.

Floats, "Dirty Floats," and the Tobin Tax While floating exchange rates theoretically promised greater scope for expansionary domestic policies—part of Keynes's hope for the Bretton Woods blueprint—large, speculative movements in currency value and rapid, unsettling episodes of capital flight remained distinct possibilities. Indeed, financial transactions soon dwarfed those in goods and services in the post–Bretton Woods era; potentially large and rapid movements became all the more likely. But the demand for reserves did diminish along with the adoption of floating exchange rates, and increased capital mobility opened up the potential for other, more varied types of reserves in general. Nations also adapted, instinctively, by accepting floating exchange rates but with currency management intact. Few currencies were ever allowed to float freely, and instead central bankers most often practiced a "dirty float"; large swings were to be checked by rapid central bank buying and selling in currency markets. This is why Barry Eichengreen has suggested that the Mexican peso crisis of 1994–1995 was "the last financial crisis of the nineteenth century," resembling in a fundamental way the Baring crisis of 1890. In both cases, central bankers rallied around the system by rallying around a besieged currency (and, coincidentally, a Latin American nation).

With ample room for speculation and capital flight, however, theorists have more recently come to question the stability of the prevailing system. Currencies have likely become more volatile, capital flight has become an increasing malady, and trade has lost ground to multinational production due to the increasing currency market volatility. It is in this context that economists have debated the potential for capital controls and, as James Tobin often described it, the means by which policymakers might potentially throw a little "sand in the gears," reducing volatility in the process. Chief among the theoretical contributions or policy proposals here is the international currency transactions tax, or "Tobin tax." Proposed initially by the Yale economist James Tobin, such a tax would be small (typically proposed at 0.1 percent) and placed upon all international currency transactions. Theoretical debate on the Tobin tax has thus far focused upon the potential for offsetting effects. Would a transactions tax decrease volatility by increasing the costs to speculators, or would it increase volatility by reducing the total number of transactions, producing "thinner," more vulnerable markets in the process? Because it would not distinguish between speculative transactions and those conducted on behalf of trade, would the transactions tax reduce levels of trade as it reduced speculation, or would it increase trade by reducing currency market volatility? If introduced, could the tax be applied widely enough (that is, fairly and equitably) by wedding it to the policies of developed nations, or would it be difficult to enforce uniformly, and therefore conducive to avoidance and resulting misallocation?

Although free trade remains a contentious political idea, economists have increasingly devoted their attention to the related problems of capital flows, currency speculation, and international monetary instability. And though many economists predicted at the time that the end of fixed exchange rates would give nations the freedom to create fiscal and monetary policies of their own choosing (unencumbered by exchange rate parity concerns), few remained as sanguine by the end of the twentieth century. Introducing foreign trade and capital movements into a closed economy model, Robert Mundell described in the 1960s and 1970s how a floating exchange rate regime would, by connecting government fiscal stimulus with higher interest rates, capital inflows, and currency appreciation, automatically render fiscal stimulus ineffective. The currency appreciation, he argued, would lower net exports to the point where any fiscal stimulus that gave rise to them in the first place would be completely eliminated. Despite its less suitable conformity to large, as opposed to small, open markets, the apparent lack of correlation between government deficits and interest rates, and the numerous real world examples of currency appreciation tied to comparatively low interest rates, Mundell's pessimistic appraisal of modern fiscal policy remains the dominant analysis for floating exchange rate regimes.

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