All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

Globalization

In the aftermath of the Asian crises that began in 1997 there has been a good deal of emphasis focused on the international monetary system and the IMF.  Krugman in a 1999 article in Foreign Affairs notes that there is a problem - what he refers to as a trilemma.  A nation can simultaneously achieve only two of the following three goals - convertibility of currency, stability of currency value, and independent monetary policy.  To understand the problem, consider the decision by the central bank of the US to lower interest rates to stimulate spending [we will discuss this in the section on money in the 1970s].  If investors are free to move their currency, this will prompt investors to move their money elsewhere in search of higher rates of return.  The decrease demand for US dollars will put downward pressure on exchange rates.  Either the government will "fix" the exchange rates or it will need to bar capital flows or it will need to keep interest rates in line with those in other countries.  It cannot simultaneously select three independent policies. 

Monetary and fiscal authorities have at their disposal a wide array of policy tools that can be directed toward achieving domestic goals such as low unemployment, high growth, and low inflation. One can expect, however, that achievement of the domestic goals does not necessarily coincide with the goal of international balance, and that in most instances the pursuit of international balance will not be the policy maker's primary concern. The mechanics of the gold standard are quite simple and can be demonstrated with a simple example. If a country were running a trade surplus, there would be a natural mechanism that would reduce imports and/or increase exports. This would be achieved by making the country's exports more competitive internationally or increasing the appetite of the country's citizens for imports.  In both cases the likely 'medicine' would be restrictive macro policies that will lower income and raise unemployment. Given that it is likely that the domestic considerations weigh far more heavily than international balance on the decisions of policy makers, we can expect that governments will not be motivated to maintain an international balance and that problems would be likely to emerge.

An example of the potential conflict between the goals of domestic and international balance was the situation in Brazil following the Asian crises in 1997-98.  Following a dramatic fall in the exchange rate of Thailand's bhat, a wave of currency depreciations swept across Asia and then into Latin America.  Brazil, in its effort to maintain the value of its currency [the modern equivalent of staying on the gold standard], raised interest rates above 30 percent in an effort to attract foreign capital and avoid a devaluation of the Brazilian currency - the real.  The result was a steep cut in aggregate demand that pushed the economy into a recession.    

A second example would be the problem facing England in 1992.   Unemployment was high in England and Germany had just raised interest rates.   The English could either raise interest rates to maintain international balance or they could maintain existing interest rates and let the value of the currency fall.   In this instance it was the domestic situation that took precedence and the English maintained interest rates and let the pound depreciate.

In the first decade after its creation the IMF played a minor role in the reconstruction of Europe and the chronic European trade deficit which accompanied it. As the US led the rebuilding of Europe it ran a substantial trade surplus which created a severe dollar shortage problem that was too large for the IMF to handle. The solution was to be found in the Marshall Plan of foreign aid. The US aid was to be designated simply as a gift. The IMF concentrated on devaluations, the most notable being the round of devaluations by most of the non dollar currencies in 1949, and on making loans to Latin American countries. By 1958 Bretton Woods system looked strong as the dollar shortage had been eliminated and the European countries had finally declared their currencies convertible.

It is at this time that we saw the emergence of Eurodollars, dollars deposited in any foreign bank that remain denominated in dollars. Eurodollars became popular because these deposits were not subject to the normal reserve requirements and because they offered the rapidly expanding multinationals a convenient alternative to US banks.

In the early 1970s members of the EC agreed to move toward complete European Monetary Union by 1980. The first step was initiated in 1972 with the 'snake in the tunnel', but it failed quickly and any movement toward a union was put on indefinite hold. The idea regained support in 1978 as Germany and France became interested in creating a 'zone of monetary stability' in the face of a weakening dollar. This represents the origin of the European Monetary System (EMS). In addition to revitalizing the concept of the snake, there was an initial attempt to create a European monetary unit, the ECU, and discussion of coordinating macro policy. As for the reserve regime, there are also very few rules concerning appropriate reserves. At the present time foreign exchange are the primary reserve asset with dollars accounting for approximately two-thirds of the reserves. There are also SDR's, which have not been issued since 1981, and ECU's, issued by the European Monetary Co-operation Fund to members of the EMS.

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