Isard: Globalization and the International Financial System

Isard, P. 2005. Globalization and the international financial system. Cambridge New York.

Ch. 2: The Evolution of the International Monetary System

"At the core of the international financial system is a set of official institutions and arrangements that govern payments between nations and exchange rates among currencies--a core referred to as the international monetary system" (13).

This system promotes stable exchanges of currencies, which is seen to expand international trade, which is then seen as driving economic growth and improved living standards.

The policy trilemma was explored explicitly by Mundell and Flemming in papers written in the early 1960s, but also must have been at least tacitly held by the framers of the IMF in the 1940s: the system was designed to achieve fixed exchange rates, domestic monetary and fiscal autonomy and constrained capital mobility.

The Gold Standard system that existed from 1870-WWI was based on convertibility of currency to gold reserves. This system suffered crises, which were mitigated in part through the cooperation of major players in the monetary system. "As these episodes suggest, preservation of the international gold standard regime required the core countries of the system not only to cooperate to help each other in times of crisis but also to accommodate over time the growing and somewhat volatile demand for gold in countries on the periphery of the system, including the United States...A second factor that contributed importantly to the credibility and longevity of the gold standard regime was a social and political environment in which it was feasible for national monetary authorities to give the maintenance of currency convertibility precedence over other possible goals of economic policy" (17).

After WWI, and a temporary stoppage of currency convertibility, countries began to return to the gold standard. First the US, and then other European countries pegged their currencies to gold and established currency exchanges, etc. The US left in 1933.

Then, after 1929, a global depression took hold, with production falling by a full 26%. "At least seven countries left the gold standard between 1929 and August 1931" (24).

During WWII, there were very tight exchange pegs.

At the end of WWII, the Bretton Woods institutions were formed, with an eye towards bridging the divide between those who ardently supported free trade agendas, and those who believed in full employment and government spending. "The outcome was a managed multilateral system that left individual countries with considerable autonomy to pursue domestic economic policy objectives but subjected their exchange rate practices and international trade and payments restrictions to international agreement" (28).

"Through period adjustments of exchange rates pegs and a resort to capital controls, the Bretton Woods system survived for a quarter century. The demise came after internationally mobile private capital had grown substantially in both volume and agility, thereby becoming a major force that was difficult to control" (30).

"The policy-oriented literature of the 1960s characterized the prevailing international monetary system as incapable of simultaneously resolving the problems of liquidity, adjustment, and confidence. With the production of new gold being inadequate to meet the increasing demand for official international reserves in a growing world economy, and with gold and reserve currencies comprising the principal reserve assets in the international monetary system, the liquidity problem could be solved, or so it was perceived, in only two ways: by continuing to increase the liabilities of the reserve-currency countries, especially those of the United States, or by raising the purchasing power of gold. This choice presented what was known as the Triffin dilemma. The first solution would lead to a persistent balance of payments deficit for the United States on an official settlements basis, which many economists viewed as an adjustment problem. The second solution, moreover, would create a confidence problem, undermining faith in the reserve system. In particular, an increase in the official dollar price of gold...could induce attempts by foreign governments to convert their dollar reserve holdings into gold and would also induce speculative investments in gold by private market participants. This would rapidly drain the gold reserves of the United States and destroy the ability of the US authorities to defend any fixed gold parity for the dollar" (32-3).

In order to solve this conundrum, special drawing rights (SDRs) were created. This was a new asset held by the IMF in reserve.

The Euro-Dollar market was created. These were dollars held in banks primarily in Britain. This eventually led to speculation on the dollar that caused Nixon to suspend convertibility in 1971. By 1973 the international monetary system had moved to a floating exchange rate system.

In the 70s, the countries of Europe moved towards creating a monetary union.

The remainder of the chapter deals with the different kinds of forms that monetary systems and policies can take in the post-Bretton Woods system, as well as the implications of moving to fiat money and relatively floating exchange rates.

Gould: Money Talks

Gould, Erica R. (2003). "Money Talks: Supplementary Financiers and International Monetary Fund Conditionality". International Organization, 57(03), 551-586.

This article examines IMF conditionality. The IMF was originally created to monitor and offer short-term loans to support and stabilize the international exchange rate regime. In 1952, it started to place conditionalities with their loans, things that countries had to do in order to meet the requirements of the loan. Gould would like to examine why conditionalities are the way that they are. What factors and variables have contributed to their current state of being.

She argues that, “…Fund conditionality is influenced by the private and official financiers who supplement the Fund’s loan to borrowers” (552). These supplementary financiers are the agents who provide additional capital to countries when they are going through a short-term liquidity problem. These financiers can be grouped into three categories: creditor states, private financial institutions (PFIs) and multilateral organizations. Gould focuses on PFIs.

She then examines the historical arguments for IO influence. She looks at liberal theory and generalizes that IOs help, “…facilitate mutually beneficial exchange between international actors” (554). IOs are seen as being Pareto improving because they change the incentive structure between states. Much previous literature on this subject has focused on the state-as-an-actor assumption. Looking at PFIs provides a different perspective.

“Supplementary financiers and the IMF are locked in a mutually dependent relationship. The Fund depends on supplementary financiers to help ensure the success of its loan programs and its future bargaining leverage with borrowers. In turn, supplementary financiers depend on the Fund to help facilitate their financing transactions and make borrowers’ commitments more credible. As a result, supplementary financiers are both able and willing to influence the Fund’s activities” (555). “The empirical section focuses on one element of the design of Fund programs that best isolates the influence of PFIs: a certain class of binding conditions, labeled ‘bank-friendly’ conditions, which specify that the country must pay back a commercial bank creditor as a condition of its Fund loan” (560). “In short, the supplementary financier suggests that PFIs will be able to influence the terms of Fund conditionality arrangements when they can generat3e a credible threat to withhold necessary supplementary financing if their demands are not met. The PFIs’ threat will only be credible under certain conditions: if they are organized and if the threat is ex post incentive-compatible” (562).

The method involves using 249 cases from 20 countries, which she claims are generally representative. Table 1 lists different examples of bank friendly conditions that may be attached to loans. Figure 1 graphs the rise of conditionality verses the rise of conditions that involve bank-friendly measures, and is quite telling. The dependent variable is binary: “whether or not a given conditionality agreement includes a bank-friendly binding condition” (565). The IVs are private influence, US influence, salary increase for IMF workers, reserve size, tranche, constant GSP, and year.

The results: “…these results lend support to the supplementary financier argument, and cast doubt on the realist and bureaucratic alternative arguments. There is a strong relationship between the PRIVATE INFLUENCE variable and the bank-friendly dependent variable. The next section clarifies how that relationship works” (573). Private influence is significant and positively correlated in three models, where overall r-squared is about 50% and the n is relatively low (76 in model 2). No other IV is relatively as significant and influential.

Gould then attempts to casually map this linkage. She examines Mexico and Turkey. She concludes that PFIs have been able to influence the Fund because the Fund is partially reliant on PFIs for their policy success.

Buria: The Bretton Woods Institutions

Buria, Ariel. (2005). "The Bretton Woods Institutions: Governance Without Legitimacy?" CSGR Working Paper No. 180/05.

This article starts out with a quote from Douglas North: “Institutions are not…created to be socially efficient; rather they, or at least the formal rules, are created to serve the interests of those with the bargaining power to create new rules” (2).

The voting structure of BWIs is examined in this article and it is found to be highly correlated with the influence of countries who contribute more quota money to funds. The attempt is to then create a different metric whereby countries could be given voting rights in these institutions. This new metric would do much to skew voting power away from traditional hegemons and towards newly industrializing countries. “…present day quotas…represented the economic structure of the world in 1944 are far from representative of the current sizes of economies, of their ability to contribute resources to the Fund or of their importance in world trade and financial markets” (5).

There was a quota review group. They attempted to make changes to this regime. However, while they were given a mandate to make these changes, they did not take into account developing countries (6). The review group was an iteration of vested interests having their way in an IO.

The first metric that Buria examines is the measurement of GDP in determining voting rights. “The majority favored conversion at market exchange rates, averaged over several years, but a minority preferred to measure GDP for purposes of the quota calculations using PPP-based exchange rates. They considered that market exchange rates do not necessarily equalize prices of tradable goods across countries, even after taking into account transport costs and quality differences, and that this creates an index numbers problem in which the GDP in developing countries is understated in relation to developed countries if market exchange rates are used” (9).

In this world, Japan is seen as being a higher potential contributor than China, France more than India.

The quota system is also skewed in favor of developing countries in that it does poor job of measuring inter-European trade.

Buria then shows that, “…the measurement of GDP in terms of PP favors an increase in the quota share of all developing countries by eliminating a measurement bias against them. The introduction of volatility as a factor in the quota formula also favors developing countries, particularly exporters of primary products” (16).

She then looks at the eroded legitimacy of BWIs. The Fund ahs lost all influence over industrial countries. International financial markets have given countries access to other forms of financing. There is a, “…growing chasm between shareholders and stakeholders, between those who determine IMF policies and decisions and those to whom those decisions and polices are applied” (18). Also, the rapid expansion of NICs is highlighted with their growing coffers of financial reserves.

In conclusion, this article claims that the quota formulas need to reflect a changed global economy, where the influence of the economic powers of 1944 is decreased and the influence of the economic powers of the 21^st century is increased. “…the determination of quotas is as much a political as a technical exercise” (26).

Notermans: Policy Continuity, Poilcy Change, and the Political Power fo Economic Ideas

Notermans, Ton. (1999). "Policy Continuity, Policy Change, and the Political Power of Economic Ideas". Acta Poiltica, 34(3), 22-48.

Notermans argues that changes in economic policy stem not from ideational forces, but from material forces. Ideational forces are brought into the picture to simply justify the policy decision. Additionally, different theoretical frameworks can be manipulated in various ways to justify the needed policy response to the material drivers that a nation confronts.

“This article argues that the view that new economic ideas determine the character of new policies reverses cause and effect. More specifically, three hypotheses are advanced: 1.) Ideas exert n independent causal influence on policies by providing for continuity rather than change because economic policy-makers cling to the ideas and policies that were adopted in response to a traumatic event, even if the original constellation justifying such policies has long disappeared. 2.) The changes in macroeconomic policy regimes during this century have been driven by the need to correct cumulative price level disturbances… 3.) Because the timing and character of a regime change is determined by developments in financial and labour markets, it is largely exogenous to the political system” (23).

“In spite of fundamental theoretical differences between the two approaches, it is possible to derive Keynesian-type policies from neoclassical views and vice versa” (26). Notermans believes that, no matter what ideational approach you use, you will be able to manipulate that to produce any economic policy result. This means that people are just responding to material forces, and that ideational forces are tossed about. Eventually, this can be seen as securing economic policy that is more in line with neoclassical models, which tend to reflect reality more accurately. “Hence, policy convergence with the (long-term) neoclassical model is complete: macroeconomic policies need to prioritize price stability, and unemployment is to be tackled by supply-side policies” (27).

Notermans posits in section 4 of his article that ideas do not have a causal influence, even if different policy makers who hold different ideas posit different policies. This could simply mean that their interests diverge and that they are responding to material forces that they encounter. After making this claim, Notermans goes on to say that, since ideas are insufficient to explain macroeconomic change within the economic policies of Europe, he will propose a Darwinian approach. This approach claims that ideas are not of interest, and only policies that respond to price stability will have any worth.

Only firms who respond to the dictates of the market will survive. However, a Darwinistic approach must take into account the idea of path-dependency, as opposed to pure environmental determinism. “…because the behavior an individual market actor faces is largely determined by the behavior of the other market actors, the case for environmental determination of economic outcomes is much weaker than commonly assumed” (32).

However, this aside, the current nature of the market necessitates price stability as the mechanism of Darwinistic selection and adaptation. “In a world where money serves as a store of value, price flexibility no longer necessarily serve s as the device through which markets will quickly return to equilibrium Instead, excessive changes of the general price level may severely disrupt the willingness to engage in productive activity and hence precipitate rather than mitigate economic crises” (33). Therefore, price stability is the holy grail, and markets will orientate around that for material reasons.

“Whereas ideas play no significant role in explaining regime changes, they do play an important role in accounting for regime inertia” (37). “In sum, to the extent that ideas do influence the development of macroeconomic management their influence is generally moderate as they tend to perpetuate a given regime even if the conditions which gave rise to that regime have long disappeared” (37).

Notermans goes on to highlight this ascertain by looking at the cases of Britain, France and Sweden and highlighting how their transitions towards policies of price stability reinforce his theses. However, he also notes that these characteristics are not always going to necessarily be in play, and that a different set of material forces could come along and change the way that economic policy is made.

Frieden: Global Capitalism: Its Fall and Rise in the Twentieth Century (Chapter 15)

Frieden, Jeffry A. (2006). Global capitalism : its fall and rise in the twentieth century (1st ed.). New York: W.W. Norton. (Chapter 15)

This chapter is an interesting and lively telling of the causes and the tension surrounding the movement away from the gold standard by Nixon in August of 1971. This policy change represented the unraveling of the Bretton Woods agreement made amongst many of the Western Allies in the last stages of WWII. Part of this agreement was that the US dollar would be convertible to gold at the rate of 35$ per ounce.

The decision was made by Nixon amid pressure from both the international monetary order and domestic policies. The expectation was that the dollar would be devalued. This was causing a run on the dollar, as people tried to convert it to gold before the devaluation occurred. The US could have countered this effect. This would have involved a, “raise in interest rates, cut spending, restrain wages and profits, and drive the economy into recession” (340).

After Nixon made the move to fiat money, the dollar devalued rapidly. However, everything returned to normal after successive devaluations in 1973. This effectively killed the Bretton Woods agreement.

“The Bretton Woods system combined freedom to address national concerns with international economic integration” (342). It was an agreement born out of WWII. It created a situation that Frieden highlights as eventually causing the following trends that eventually brought about its own demise. Firstly, it created a regime whereby international finance could gain footing, strength and influence. The second change that brought about the death of Bretton Woods, as highlighted by Frieden, was the pressure that was subsequently placed on the dollar by the strength of economic recovery, especially in Japan and Western Europe.

Eventually, the cause of the rupture in the international monetary order stemmed from the success of the Bretton Woods agreement, and because the US eventually placed domestic economic policies above the international agreements regarding gold convertibility. “The US government was simply unwilling to trim its economy to fit its currency commitments under the Bretton Woods system and chose instead to bring the system to an end” (346).

The effects of the movement away from gold convertibility were seen throughout the world. Some of these effects able to be felt in policies that evolved to create nationalist economic protection in developed countries that did not rely on the antiquated gold standard. Other effects were occurring in less developed countries. The process of development in the 70’s can be seen generally to have caused deficits, inflation, political upheaval, urbanization and inequality. These effects were not universal, as East Asia was able to escape them to a degree. Additionally, Frieden highlights the changes in the socialist world in the 70’s and the insecurity that arose there.

“The postwar era ended in the early 1970s. The developed capitalist world had come out of World War II with a compromise that blended international economic integration with national policy independence, the market with the welfare state” (359). This sounds much like Ruggie’s Embedded Liberalism thesis. The 70’s represented a rupture away from post WWII development. Frieden ends by making the claim that, while the 70’s saw a hemorrhage in the development of developed countries, less developed countries and socialist countries, this was after each of these respective groups were very successful in achieving what they wanted after WWII: respectively, an international trade and finance integration, industrialization, and industrialization.