International monetary reform: a modest proposal

Business Economics, July, 1996 by Thomas A. Synott, III

For many years, the United States has spent more abroad than it has earned through exports of goods and services. This has offset the deflationary bias of the international monetary system and provided it with liquidity, as Figure 1 shows.

This situation seems bound to change in the years ahead. If the Congressional initiative to put the federal deficit on a declining path succeeds, the U.S. current account deficit is likely to contract significantly. Otherwise, the dollar will rapidly lose its special status as a reserve currency. In either case, the world will need a new source of global liquidity. In addition, the rapid growth of private international capital flows is creating a need for additional international liquidity.

Moreover, the world economy is undergoing some major structural changes. Globalization of markets is encouraging a shift from mass production in one country to specialized but still large-scale production in many countries. This process would be more efficient and less disruptive if greater stability existed in the exchange rates of the three major currencies. Macroeconomic considerations argue for greater stability as well. Nearly all industrialized countries are tightening their fiscal policies, and to maintain adequate economic growth, they need to be able to pursue easier monetary polices without the fear of provoking an exchange rate crisis. This requires greater coordination of monetary policies in the key currency countries.

The time has come, therefore, to consider some reforms to the present system to make it more supportive of global economic growth and less subject to financial accidents or policy errors in one particular country. The specific reforms I have in mind are based on the following general principles:

1. more orderly growth in international liquidity;

2. greater symmetry between deficit and surplus countries;

3. more involvement by the International Monetary Fund (IMF) in developments in major countries; and

4. the introduction of greater multilateralism in official settlements.

FROM BRETTON WOODS TO MEXICO

Born out of the ashes of the economic devastation of both war and world depression, the IMF played an important role in the enormous expansion of international trade that took place during its first twenty-five years of existence. Together with the Marshall Plan, the World Bank and the European Payments Union, it contributed both to the rebuilding of war-shattered economies and to the establishment of an international monetary system based on cooperation.

When the fixed-exchange rate system came to an end in 1973, many people thought the IMF's role, as guardian of that system, was over as well. However, it proved to be a very helpful vehicle for organizing the industrialized world's response to the financial impact of the two oil shocks (in 1973 and 1979) and the Latin American debt crisis of 1982. Then, during the next decade, the IMF played a major role in promoting sound economic growth in the developing world by tying financial assistance to structural reforms (as suggested by IMF experts).

Two years ago, the need for the IMF was questioned in the light of the growth in international capital markets, but the Mexican peso crisis showed again that it has an important role to play.

The Bretton Woods Era - 1944-73

When the International Monetary Fund was established in July 1944 at the Bretton Woods Conference, the participants were, above all, seeking to prevent the mutually destructive currency devaluations and trade restrictions that so afflicted the world economy in the 1930s. As stated in Article I of the Fund's Articles of Agreement, its main purposes (in abbreviated form) were:

To promote international monetary cooperation through a permanent institution which provides the machinery for consultation and collaboration on international monetary problems. . . . To facilitate the expansion of international trade. . . To promote exchange stability, and to avoid competitive exchange depreciation.

The core of the exchange rate system was the definition of the members' currencies at a fixed parity with respect to the U.S. dollar (the dollar being defined in terms of $35 per ounce of gold) and the commitment by the United States to redeem dollars from foreign central banks for gold.

In operation, the IMF was more like a warehouse than a bank. Member countries paid in an initial subscription or quota in gold and their own currency based on their economic weight. When, afterwards, a country needed a particular currency to settle a payments imbalance with another country, it purchased that currency from the Fund, paying with its own currency. When the Fund's holdings of a particular currency exceeded a certain amount, that country was no longer permitted to purchase other currencies and had to accept various conditions in order to obtain other forms of credit from the Fund. These "borrowings" were repaid by the country repurchasing the excess holdings of its currency with "real money." In addition to gold those currencies that were scarce or "understocked" in the fund were the only forms of real money. For the first ten years (the Fund began operations in 1947), the only scarce currency was the U.S. dollar.