Lecture 11. The Emergence of the International Monetary System
Recommended post : 【Economic History】 Table of Contents for Economic History
1. Overview
2. The Classical Gold Standard
3. The Bretton Woods System
4. The Post–Bretton Woods System
1. Overview
⑴ The need for an international monetary system : The same reason money is needed in general—i.e., a coincidence of wants.
⑵ National income accounting identity
① Y: National output
② C: Private consumption
③ I: Investment
④ G: Government consumption
⑤ NX: Net exports
⑥ S: National saving
⑦ Current account deficit: When net exports are negative. Because I is large, the economy is borrowing investment funds from abroad.
⑧ Current account surplus: When net exports are positive. Because I is small, the economy is investing abroad.
⑨ (Reference) A current account surplus is not necessarily “good” in all cases.
⑩ Without an international monetary system, domestic investment and domestic saving are identically equal (S = I).
⑶ The trilemma (trilemma) of an open economy : Explains the absolute stability of a regime.
① Choice 1. Exchange rate fixity
○ A fixed exchange rate is advantageous because there is no uncertainty.
○ A fixed exchange rate is disadvantageous because when capital mobility is free, it becomes difficult to conduct monetary policy by adjusting interest rates.
○ A floating exchange rate can be advantageous because it can help resolve a trade deficit.
○ A floating exchange rate is disadvantageous because it involves uncertainty.
○ Today, floating exchange rates are dominant : Floating exchange rates are not as bad as one might think.
② Choice 2. Unlimited capital mobility
③ Choice 3. Monetary policy autonomy
④ The open-economy trilemma : Holds well in an open economy.
○ (Reference) Dilemma: A problem of giving up one of two values.
○ (Reference) Trilemma: A problem of giving up one of three values.
○ Proposed by Obstefeld and Taylor.
○ You can choose only two among exchange rate fixity, unlimited capital mobility, and monetary policy autonomy.
⑷ Commitment, trust, and symmetry : Explain the relative stability of a regime—i.e., how strong the forces for change are.
2. The Classical Gold Standard
⑴ The emergence of the gold standard
① Gold has been used as money since ancient times.
② The gold standard as an institution began with the United Kingdom’s Resumption Act of 1819.
③ Newton’s “great mistake” played a role in Britain’s adoption of the gold standard.○ Newton briefly served as the Master of the Mint in Europe and had to set the mint ratio between gold and silver; he set the price of gold too high.
④ Japan adopted a silver standard after the Meiji Restoration, then acquired a large amount of gold after winning the First Sino–Japanese War and introduced the gold standard.
⑤ Korea naturally adopted the gold standard after coming under Japanese rule in 1905 : At the time, China was still on a silver standard.
⑵ The emergence of the international gold standard
① Britain emerged as an economic powerhouse and drew other countries into Britain’s gold standard.
② From 1865, European countries formed the Latin Monetary Union (LMU), which encouraged the emergence of the international gold standard.
③ From the late 19th century to World War I was the era of the international gold standard.
⑶ The open-economy trilemma
① The gold standard is basically a fixed exchange rate system : If the exchange rate is not constant, allowing gold convertibility enables risk-free arbitrage.
② It fixed the exchange rate and allowed unlimited capital mobility at the cost of sacrificing monetary autonomy.○ Thus, under the gold standard, governments generally took a laissez-faire approach to economic policy.
○ Reason : They believed in the price–specie–flow mechanism proposed by Hume in 1752.
○ Case 1. If gold flows into Britain, the value of Britain’s money rises, and gold flows back out abroad.
○ Case 2. If Britain accumulates a lot of foreign currency, gold flows into Britain, and the money supply and price level restore equilibrium.
⑷ Limitations
① Limitation 1. In practice, sterilization policy occurred frequently : That is, unlimited capital mobility was not actually allowed.
○ Central banks worried more about gold losses than about gold gains.
○ The Bank of England used active interest rate policy to prevent gold losses.
② Limitation 2. Under the gold standard, the scale of credit is limited by the amount of gold, so purchasing power cannot expand elastically.
○ Banks create credit by taking deposits, keeping part as reserves, and lending the rest.
○ This method resolves the liquidity constraint that the gold standard fundamentally has.
③ Limitation 3. The cost of storing gold is quite high.
④ Despite Limitation 1, the gold standard persisted due to commitment, trust, and symmetry.
⑸ Outcome : When monetary policy became important due to political and social change, the international gold standard regime collapsed.
① During World War I, the gold standard was temporarily suspended.
○ Governments financed themselves by expanding the money supply through bond issuance or by printing money.
○ In Germany’s case, money was printed after the war as well to finance reconstruction.
② The United States, which benefited from the wartime boom, returned to the gold standard in 1919.
③ Britain returned to the gold standard in 1925 after the war ended.
④ Excessive obsession with the gold standard caused the Great Depression.○ The U.S. expected that abandoning the gold standard would reduce the dollar’s value.
○ The U.S. and France held 70% of the world’s gold : Other countries could not even issue currency.
○ As holders began converting dollars into gold, dollar liquidity started to decline.
○ Combined with a deflation shock, banks began to fail.
⑤ After the Great Depression began, countries that could not maintain the gold standard abandoned it : The gold standard collapsed in a self-fulfilling way.
○ It was expected that if the gold standard were abandoned, money could not be converted into gold, and thus the money’s value would fall further.
○ As moves to convert into gold increased, the gold standard kept shrinking.
○ When Britain abandoned the gold standard in 1931, other countries began to follow.
⑥ After abandoning the gold standard, economies began to recover quickly from the Great Depression.
○ Rapid devaluation freed them from the shackles of an overvalued currency.
⑦ When the U.S. abandoned the gold standard in 1933, the dollar’s value did not fall.
○ In other words, it was effectively allowing a floating exchange rate in 1933.
○ Because uncertainty disappeared.
⑧ France abandoned the gold standard relatively late, in 1936.
○ If France had abandoned it earlier, it might have overtaken the British economy.
○ Persson argues that if France had abandoned the gold standard earlier, the Popular Front would not have taken power.
○ Reason France abandoned it late : It pursued sterilization policy and held a lot of gold.
3. The Bretton Woods System
⑴ The emergence of the Bretton Woods system
① In July 1944, 44 countries signed the IMF Articles of Agreement at Bretton Woods in the United States.
② The dollar was fixed to the price of gold : 35 dollars per ounce.
③ All currencies were fixed in value against the dollar : With N − 1 exchange rates given.
⑵ The open-economy trilemma
① It fixed currencies to the U.S. dollar and allowed monetary policy, at the cost of restricting capital mobility.
⑶ Demise : It lacked commitment, credibility, and symmetry.
① Lack of commitment
○ Although capital mobility was restricted, speculators could circumvent it.
② Lack of credibility
○ In the 1960s, the U.S. Democratic administrations ran budget deficits and pursued expansionary monetary policy, causing the dollar to become overvalued.
○ Mainly due to expanded welfare spending and the Vietnam War.
○ In 1971, the dollar was devalued against gold, and in 1973 gold convertibility was abandoned.
○ At the time, the guarantee of the dollar’s value had so little credible basis that it was said to rest on “faith in God.”
③ Lack of symmetry
○ Countries other than the United States were not issuers of the key currency, so they could not freely conduct monetary policy.
○ Even very wealthy countries could conduct monetary policy only within a limited scope.
○ As a result, the risk of a fundamentally self-fulfilling currency crisis always existed.
④ When it became impossible to suppress capital mobility due to the growth of world trade and other pressures, the Bretton Woods system collapsed.
4. The Post–Bretton Woods System
⑴ The open-economy trilemma
① A regime that abandoned fixed exchange rates and accepted floating exchange rates.
② It allows unlimited capital mobility and free monetary policy.
③ Some countries still peg their currencies, but a worldwide fixed exchange rate system is a thing of the past.
⑵ Optimum Currency Area (OCA) theory : Proposed in the 1960s by Robert Mundell and others.
① Economies of scale in currency : Using a single currency produces the same effect as a fixed exchange rate.
○ If the same currency is used, there is no risk from exchange rate fluctuations and no transaction fees.
○ The economy can be stabilized with a single monetary policy : Tighten policy when overheated, or inject money to support recovery.
② Diseconomies of scale in currency
○ Economic shocks are asymmetric, and political preferences differ across countries.
○ A single monetary policy may strongly conflict with the needs of a particular region or country.
○ Therefore, it is difficult for countries to survive in a fixed exchange rate system whose members are highly diverse.
③ A currency union can succeed only if members meet conditions within an appropriate geographic scope.
○ That geographic scope is called the criterion for an optimum currency area.
○ That is, geographic conditions under which business cycles propagate so that members are inevitably exposed to the same cycle.
⑶ Overcoming asymmetry in a currency union
① First criterion : Proposed by Robert Mundell
○ The importance of labor mobility
○ If factor mobility is free, equilibrium is restored without exchange rate or price changes.
② Second criterion : Proposed by Peter Kenen
○ Production diversification and similar trade structures
○ Economic shocks would have only limited impact and could help reduce asymmetry.
③ Third criterion : Proposed by Robert McKinnon
○ Trade openness among countries
○ With the law of one price prevalent, the real exchange rate will equalize whether or not a country participates in the currency union.
⑷ The emergence of the Eurozone
① Adoption of a currency union : As an extreme form of fixed exchange rates, exchange rates are abolished together.
② Endogenous hypothesis : Predicts that once a currency union is formed, the movement of labor, goods, and capital becomes smoother, transforming the region into an optimum currency area.
③ The European sovereign debt crisis following the 2007–2008 U.S. financial crisis revealed that Europe had not become an optimum currency area.○ Rather, it created many regions that were inevitably more exposed to fiscal crises.
○ PIIGS (Portugal, Italy, Ireland, Greece, Spain) are in a poor state because they lack borrowing capacity, so there would be no default.
○ But because they borrow and spend using the Eurozone’s credit, a crisis occurs.
④ The European Union can be exited (e.g., Brexit), but the Eurozone cannot be exited : It is designed that way.
○ If countries such as Greece had monetary sovereignty, they could reduce the value of their own currency to overcome a crisis.
○ Example : During the IMF crisis, Korea lowered the exchange rate to around 800 won per 1 U.S. dollar.
○ Exiting the Eurozone would require enduring an enormous financial shock, and there is effectively no country that can withstand it.
○ Paul Krugman predicted this from the time the Eurozone was created.
Posted: 2020.07.23 21:59