Economy, Banking And The Monetary System
Domestic monetary policy frameworks dovetail, and are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the efficient allocation of resources, increased specialization in production based on comparative advantage, and the diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates to shifts in trade and capital flows. Under Bretton Woods, countries pegged their currencies to the dollar at specified parities, which in turn was convertible into gold at the official rate of $35/oz. However this only applied to dollars held by central banks and governments and not by private citizens. The US provided price stability but did not engage in currency intervention – other countries had to intervene to fix their exchange rates against the dollar.
Under these conditions, a policy of fixed exchange rates between different coins would have driven the good or undervalued coins out of circulation through the workings of Gresham’s Law. Instead, the government allowed the local markets to determine not only the exchange rate of the sultani but also the exchange rate for all types of coins, Ottoman and foreign. The government of the country would have to reduce the amount of paper currency, because there could not be more currency in circulation than its gold reserves. With less money floating around, people would have less money to spend and prices would also eventually decrease. As a result, with cheaper goods and services to offer, companies from the country could export more, changing the international trade balance gradually back to being in balance.
Some countries had already abandoned the gold standard before Britain and others were forced to follow, sometimes with a lag. Following a pattern that several countries had already faced when crises hit during the gold standard years, some developing countries had also abandoned convertibility before the United Kingdom, and others soon followed. A few countries retained the gold standard for a few more years, but the most important of them, France, finally abandoned it in 1936. However, this process led to competitive devaluations as well as the use of foreign exchange controls by many countries that hampered the international system of trade and payments. To facilitate trade and avoid competitive devaluations, it was then agreed at Bretton Woods that exchange rates should be normally fixed but could be adjusted ‘to correct a fundamental disequilibrium’ . This concept, like some others in the agreement, was never clearly defined, but its meaning was perhaps self-evident, as reflected in the severity of the balance-of-payments crises faced by specific countries at different times.
The oil shock fuelled the inflationary pressures that had been evident since 1972 and, at the same time, led to the worst downturn of economic activity in the post-Second World War period. Individual developed economies faced great difficulties, particularly the United Kingdom and Italy. Developing countries also slowed down but their growth remained faster (see Figure 1.8). However, some regions and countries faced unprecedented external deficits financed by the recycling of petro-dollars, building up major debt burdens for the first time since the 1920s. New shocks came in the early 1980s, particularly massive global imbalances and a new dollar crisis, as well as a major debt crisis in the developing world, particularly in Latin America; these developments are reviewed in Section 1.5. Fixed exchange rates are “fixed” by the government and not determined by market forces, and only small deviations from this fixed value is possible.
The window of opportunity to change the relevant policy frameworks is closing quickly as global growth is resuming and the cyclical determinants that led to the temporary unwinding of imbalances disappear. In addition, with the two-speed recovery and different cyclical positions, political interests have started to diverge again between the major currency blocs. Greater flexibility in the exchange rates of major emerging economies is in this respect a fundamental precondition for a stable international monetary system. At the same time, macroeconomic policies should avoid the externalisation of domestic imbalances to the global economy. Hence, the restoration of a stable international monetary system based on flexible exchange rates requires a fundamental change in economic mind-set across the global economy, rather sooner than later.
On July 1, 1944, delegates from 44 nations came together in Bretton Woods, New Hampshire, to work out arrangements for a new international monetary and financial order. This meeting occurred just after “D-Day,” where more than 160,000 Allied troops had landed on the beaches of Normandy to battle against the Nazi forces. After a general discussion of the major types and examples of monetary regimes, this chapter considers three important periods of multilateral cooperation, culminating in the Bretton Woods system of fixed exchange rates, which lasted from 1944 to 1971. Under Bretton Woods, the world’s industrialized countries and much of the developing world, save for the Soviet bloc, agreed to fix the values of their currencies to gold and to maintain fixed exchange rates within a narrow band of ±1%. The Bretton Woods countries also committed themselves to the free convertibility of all currencies within the system and to open trading markets.