The development of the international monetary system (2023)

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In response to the worst financial crisis since the 1930s, policymakers around the world are delivering unprecedented stimulus to support economic recovery and are pursuing a comprehensive package of reforms to build a more resilient financial system. But even this difficult schedule may not guarantee strong, sustainable and balanced growth in the medium term. We also need to consider reforming the backbone that underpins world trade: the international monetary system. My aim tonight is to help focus the current debate.

Although the causes of the crisis were many, its intensity and scale reflected unprecedented imbalances. Large and unsustainable current account imbalances in key economic areas have been an integral part of the vulnerability of many asset markets. In recent years, the international monetary system has failed to promote timely and orderly economic adjustment.

This failure has ample precedents. Over the past century, various international monetary systems have struggled to adapt to structural changes, including the integration of emerging economies into the world economy. In all cases, systemically important countries failed to adjust their domestic policies in line with the monetary system of the time. As a result, adjustment was delayed, vulnerabilities increased, and billing, when it came, was disruptive to everyone.

Policy makers must learn these lessons from history. The G-20's commitment to promoting strong, sustainable and balanced global demand growth, launched two weeks ago in St Andrews, Scotland, is an important step in the right direction.

What is the international monetary system and how should it work?

The international monetary system consists of (i) barter agreements; (ii) capital flows; and (iii) a set of institutions, norms and conventions governing its operation. National monetary policy frameworks fit and are essential to the global system. A well-functioning system fosters economic growth and prosperity through efficient resource allocation, greater specialization of production based on comparative advantage, and risk-sharing. It also promotes macroeconomic and financial stability by adjusting real exchange rates to changes in trade and capital flows.

To be effective, the international monetary system must provide sufficient nominal stability in domestic exchange rates and prices, and timely adjustment to shocks and structural changes. Achieving this balance can be very difficult. Changes in the geographic distribution of economic and political power, the global integration of commodity and asset markets, wars, and inconsistent monetary and fiscal policies all have the potential to undermine a monetary system. Previous systems could not encourage systemically important countries to adapt their policies in a timely manner. The question is whether the current effects of integrating a third of humanity into the world economy, however positive, will overwhelm the adjustment mechanisms of the current system.

There are reasons for concern. China's integration into the world economy alone is a far greater shock to the system than the rise of the United States at the turn of the century. China's share of global GDP has been growing faster and its economy is much more open.1Unlike when the United States was on the gold standard with all other major countries, China's managed exchange rate regime today differs from market-based floating exchange rates. History shows that systems dominated by pegged or fixed exchange rates rarely cope well with large structural shocks.

This failure is the result of two widespread problems: an asymmetric adjustment process and the downward rigidity of prices and nominal wages. In the short run, it is generally much less costly, both economically and politically, for surplus countries to run sustainable surpluses and build up reserves than it is for deficit countries to run deficits. This is because the only limit to the accumulation of reserves is their eventual impact on domestic prices. Depending on the openness of the financial system and the degree of sterilization, this can take a long time.2Conversely, deficit countries must deflate or reduce their reserves.

Floating exchange rates avoid many of these problems by offering a less costly and more symmetric adjustment. Relative wages and prices can quickly adjust to shocks through nominal exchange rate movements to restore external balance. When the exchange rate fluctuates and there is a liquid foreign exchange market, reserves are rarely required.3At its most fundamental, floating exchange rates overcome countries' seemingly innate tendency to delay adjustment.

A brief review of how different international monetary regimes have failed to manage this trade-off between nominal stability and timely adjustment provides important information for contemporary challenges.

The development of the international monetary system

the gold standard

Under the classic gold standard, the international monetary system from 1870 to 1914 was largely decentralized and market-based. Aside from a collective commitment by major economies to maintain the gold price of their currencies, there was minimal institutional support. While the adjustment to external imbalances should have been relatively smooth in theory, in practice it has not been without problems.4Surplus countries did not always conform to the system's conventions and sought to thwart the adjustment process by sterilizing gold inflows. Deficit countries found the adjustment even more difficult due to falling wages and price stability. Once the shocks were large and persistent enough, the consequences of the loss of monetary independence and asymmetric adjustment eventually undermined the system.5

The gold standard did not survive the First World War unscathed. Widespread inflation, fueled by money-financed war spending and major shifts in the composition of global economic power, undermined pre-war gold parities. In principle, there was no mechanism to coordinate an orderly return to inflation-adjusted exchange rates. When countries like Britain tried to return to the gold standard at overvalued parities in 1925, they had to endure painful wage and price deflation to become competitive again. While this would always be difficult, it became impossible when surplus countries thwarted reflation.

During the Great Depression, the United States, with an open capital account and a commitment to the gold exchange standard, was unable to use monetary policy to offset the economic contraction.6Loyalty to gold meant deflationary pressures spread quickly from the United States, further weakening the global economy. Unable to adapt to these pressures, countries were forced to abandon the system. Although the deficit countries experienced the first crisis, all countries suffered the ultimate collapse, a lesson repeated in subsequent systems.

Bosque Bretton

The Bretton Woods system of fixed but adjustable exchange rates was a direct response to the instability of the interwar period. Bretton Woods was very different from the gold standard: it was managed rather than market-based; the adjustment was coordinated by the International Monetary Fund (IMF); there were rules rather than conventions;7and capital controls were widespread.

Despite these institutional changes, surplus countries still resisted adjustment. A harbinger of current troubles, countries often sterilized the impact of surpluses on money supply and domestic prices. As is the case today, these interventions were justified on the grounds that the imbalances were temporary and that the surpluses were more of a virtue than an "imbalance" anyway. In contrast, the zero limit for reserves remained a binding constraint for the deficit countries, which eventually ran out of time.

The Bretton Woods system eventually collapsed in the early 1970s after US policy became very expansionary, its trade deficit became unsustainable and loosening of capital controls began to put downward pressure on interest rates. Once again, all countries suffered from the aftershocks.

The current hybrid system

After the collapse of the Bretton Woods system, the international monetary system reverted to a more decentralized and market-based model. Large countries have floated their exchange rates, made their currencies convertible and gradually liberalized capital flows. In recent years, several large emerging markets have adopted similar strategies after struggling to manage fixed exchange rate regimes with increasingly open capital accounts. The transition to more market-driven exchange rates has improved control over domestic monetary policy and inflation, accelerated financial sector development and ultimately boosted economic growth.

Unfortunately, this trend was far from universal. In many ways, the recent crisis is a classic example of asymmetric adjustment. Some large economies have thwarted real exchange rate adjustments by accumulating huge foreign exchange reserves and sterilizing inflows. Although the original goal was to self-insure against future crises, reserving soon exceeded these requirements (Tabla 1). In some cases, sustained exchange rate interventions have primarily served to keep exchange rates undervalued and to encourage export-led growth. Indeed, given the magnitude of its economic miracle, it is remarkable that China's real effective exchange rate has not appreciated since 1990 (Graphic2).

The downside of these imbalances was a large current account deficit in the United States, exacerbated by expansionary US monetary and fiscal policies after the 2001 recession, global imbalances and massive capital flows that created the "puzzle" of very low long-term interest rates, which in turn fueled the search for yield and excessive leverage. Although concerns about global imbalances were frequently raised in the run-up to the crisis, the international monetary system again failed to advance the necessary measures to deal with the problem. The vulnerabilities just grew to breaking point.

A certain pressure remains. The financial crisis could have lasting effects on the composition and pace of global economic growth.8Because different growth and inflation prospects require different policy mixes, the right monetary policy for the United States is likely not the right one for most other countries. However, the countries with relatively fixed exchange rates and relatively open capital accounts pretend they are. As this divergence in the optimal policy stance increases, the strain on the system will increase.

The postponed adjustment will only serve to increase vulnerabilities. In the past, adjustment frustration on the part of surplus countries has led to deflationary pressures in the rest of the world. Similarly, today the burden of adjustment is shifting to others. Advanced countries, including Canada, Japan and the Eurozone, have seen their currencies appreciate significantly recently.

The net result could be a suboptimal global recovery, with the burden of adjustment in countries with large imbalances falling largely on domestic prices and wages rather than nominal exchange rates. History suggests that this process could take years and, in the meantime, could stifle global production and prosperity.

The way to follow

There are several ways to avoid these results.

The first is to reduce aggregate demand for reserves. Alternatives include regional reserve pooling mechanisms and expanded credit and insurance services at the IMF. While it makes sense to review IMF reforms, their impact on systemically important countries, which already appear to be significantly over-insured, would likely be marginal. As I will mention shortly, the G-20 process can have a greater impact.

On the supply side, several alternative reserve assets have been proposed. The motivation behind these proposals is mainly to redistribute the so-called “exorbitant privilege” that corresponds to the United States as the main supplier of reserve currency. This gives the United States an advantage in the form of lower funding costs in its own currency. This benefit would be shared (and possibly reduced altogether) if there were competing reserve currencies. This in turn could reduce this slightlyCollectiveImbalances of reserve currency countries.9 10

In the longer term, a system with other reserve currencies is conceivable in addition to the US dollar. However, with few alternatives poised to assume a reserve role, the US dollar can be expected to remain the primary reserve currency for the foreseeable future. Despite the overwhelming pessimism reflected in gold prices, the total gold inventory represents only $1 trillion, or about 10 percent of the world's reserves, and a much smaller proportion of the world's money supply.11The renminbi's prospects are questionable in the absence of convertibility and open capital markets, which would likely do much to ease pressure to switch.

Increased use of special drawing rights

At first glance, Special Drawing Rights (SDRs) would be an intriguing alternative reserve asset.12) The use of SDRs appeals to a sense of fairness in the sense that no country would enjoy the exorbitant privilege of reserve currency status. Like a multi-reserve currency system, it can reduce the aggregate incentives for countries supplying the SDR's constituent currencies to run deficits. Furthermore, there seems to be no technical reason why the use of SDRs cannot be expanded.

However, one wonders: for what purpose? Simply improving the role of the SDR would do little to increase the system's flexibility or change the incentives for surplus countries. By providing a simple swap of existing reserve currencies into a broader basket, SDR reserves could also further shift adjustment towards other free trade currencies and exacerbate imbalances in the current system. Indeed, through immediate diversification, SDR reserves could solidify some of surplus countries' existing strategies.

This would change if the proposal were taken to its logical extreme: the SDR as a single global currency. Apart from the fact that the world is not an optimal currency area (mainly due to the lack of free mobility of labour, goods and capital), this seems like a utopia. While the level of international cooperation has undoubtedly increased since the crisis, it would be an exaggeration to say that there is any interest in creating the necessary independent World Central Bank.13As a result, any future issuance of SDRs will likely be ad hoc.14

A backup account

Greater use of SDRs may be better suited to fostering the transition to a more stable international monetary system by facilitating any desired reserve diversification. The temporary establishment of an expanded substitution account with the IMF would allow large reserve holders to exchange US dollar reserves for SDR-denominated securities, thereby diversifying their portfolios. Since the IMF bears the exchange rate risk of the US dollar, a corresponding burden sharing between its members would have to be agreed.

A backup account would pose a significant moral hazard as reserve holders would be tempted to accumulate more. Furthermore, a substitution account would not address the fundamental asymmetry of the adjustment process. It therefore seems fundamental that a substitution account marks the transition from the current hybrid system to an international system characterized by more flexible exchange rates for all systemically important countries.

In general, alternatives to the dollar as a reserve currency would not significantly improve the functioning of the system. While reserve alternatives would increase adjustment pressures on the United States as “artificial” demand for its assets would be shared with others, the incentives for surplus countries that have thwarted adjustment would not change. That is the common lesson of the gold standard, the Bretton Woods system and the current hybrid systemWhat ultimately matters is the adjustment mechanism, not the choice of reserve assets.

With the adjustments that would automatically result from floating exchange rates or non-sterilized interventions being muted, the burden falls squarely on political dialogue and cooperation.

A practical solution: the G-20 and shared responsibility

The frame of the G-20 is moving in the right direction. It emphasizes countries' shared responsibility to ensure that their policies support "strong, sustainable and balanced growth". Under the framework, members agreed to conduct mutual assessments of their monetary, exchange rate, fiscal and financial policies, with support from the IMF and other international financial institutions. Finance ministers and governors will examine the impact of these policies on the level and patterns of global growth and risks to financial stability in a bid to agree on joint action by G-20 leaders in Canada and South Korea next year to prepare.

There are several reasons why this peer review process has the potential to develop common understanding and encourage action in a variety of countries. There is a clear schedule. A comprehensive set of guidelines is being considered. Policy makers at the highest level are directly involved, with international financial institutions playing a supporting rather than a leading role. Finally, the discussions will take place in the G-20, where all major economies are represented and where China has taken a very constructive leadership role.

The framework discussions would be complemented by the successful implementation of the G-20's financial reform agenda. These reforms, together with the Financial Stability Board's (FSB) peer review process and external reviews by the IMF, couldperceivedsystemic stability and thus reduce the accumulation of reserves.

Canada's macroeconomic strategy and the G-20 framework

Canada will bring to these discussions one of the strongest financial systems in the world and a macroeconomic strategy that contributes to sustainable and balanced global growth. Our economy is one of the most open and our crisis response policy has been one of the most aggressive. Starting from the strongest fiscal position in the G-7, Canada's fiscal stimulus will total 4 percent of GDP this year and next. The monetary stimulus was timely and unprecedented.

As a result of these policies, the IMF expects Canadian domestic demand to be the strongest in the G-7 next year. With a current account that has widened from a surplus of 2 percent of GDP in the first quarter of 2006 to a deficit of 3 percent today, Canada is doing its part to rebalance global growth.

In line with the goals of the G-20 framework, Canadian policy is guided by transparent and consistent frameworks. The Canadian government has announced a budget plan to bring its budget back into balance by 2015. In this context we see the exchange rate.

A floating exchange rate is a key element of our monetary policy framework. It allows Canada to pursue an independent monetary policy consistent with our own economic circumstances. While there is no target for the Canadian dollar, the bank does care about why the exchange rate is moving and the potential impact on output and inflation. The challenge for the bank is to understand the reasons behind currency moves, incorporate them into our views of other data, and set a course for monetary policy that aims to balance aggregate demand and supply and keep inflation on target.

In today's environment, such statements are more important than usual.

Recent indicators are pointing to the beginning of a rebound in Canadian economic activity after three consecutive quarters of strong contraction. This resumption of growth will be supported by monetary and fiscal stimulus, rising household wealth, improving financial conditions, rising commodity prices and stronger business and consumer confidence.

However, heightened volatility and continued Canadian dollar strength are pointing towards a slowdown in growth and moderate inflationary pressures. Our dollar's current strength is expected to more than offset the favorable developments since July over time.

On October 20, the bank reiterated its conditional commitment to maintain its overnight interest rate target at the effective floor of 1/4 percent until the end of June 2010 in order to meet the inflation target.

Put simply, the Bank looks at everything, including the exchange rate, through the prism of achieving our inflation target. For example, we see a risk that a stronger-than-expected Canadian dollar, fueled by global portfolio moves away from US dollar assets, could add significant drag to growth and put additional pressure on low inflation. As I mentioned earlier, currency moves could reflect current challenges in the functioning of the international monetary system, which could result in adjustment pressures shifting to a handful of currencies.

Whatever happens, the bank retains considerable flexibility in conducting monetary policy at low interest rates, consistent with the framework we outlined in our April report.Monetary policy report.

If downside risks materialize, the Bank will use this flexibility to the extent necessary to meet our price stability mandate. If upside risks materialize, the Bank will also act to meet our price stability mandate. While the underlying risks of our October economic forecast are more or less balanced, the Bank believes that the overall risks of our inflation forecast are skewed slightly downwards due to the fact that it operates at the effective lower bound.

Diploma

In summary, this crisis was caused in part by a failure to address the same challenges that have plagued previous international monetary systems. The common lesson of the gold standard, the Bretton Woods system and the current hybrid system is that what ultimately matters is the adjustment mechanism, not the choice of reserve assets. In this sense, any further use of SDRs could be better suited to facilitating the transition from the current hybrid system to an international monetary system characterized by more flexible exchange rates for all systemically important countries.

While surplus countries can delay adjustment, all nations end up suffering when the system collapses. In the current environment, rising tensions could drive protectionism in both trade and finance, or alternatively, heavier sanctions.15The negative consequences for the global economy would be significant.

All countries must live up to their responsibility to promote an open, flexible and resilient international monetary system. Responsibility means recognizing spillovers between economies and financial systems and working to mitigate those that could amplify adverse dynamics. It means subjecting its fiscal policies to peer review within the FSB and external review by the IMF. Basically, this means pursuing consistent macro policies and allowing real exchange rates to adjust to achieve external equilibrium over time. In fact, in a world of global capital, all systemically important countries and common economic areas should move towards market-based exchange rates.

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