Page 1 of 2 Nero's ghost in Istanbul
By Hossein Askari
Long before the onset of the financial crisis, the International Monetary Fund
(IMF) was well on its way to becoming irrelevant in international finance and
international economics. Countries, even those with a low credit rating,
instead of turning to the IMF for balance of payments financing, were relying
more and more on private markets.
When it came to coordination of economic policies to improve global economic
conditions, the IMF dared not criticize the major economies, most notably the
United States, which was running large and unsustainable current account
deficits. The organization could admonish only countries that were too small to
matter in the global schemes of things.
Realistically, had the IMF taken a policy stand against the US, Washington
would have ignored what it had to say, but the fact
remains that the IMF did not take a stand in accordance with its mission.
At the same time, the IMF as an organization was itself in the midst of a
homegrown crisis. It was running large fiscal deficits and had resorted to mass
layoffs of about 600 employees. Its troubles had in part arisen from poor
management and distraction from its main mission - acting as the premier
monetary institution, responsible for short-term balance of payments financing,
monitoring exchange rate developments and dispensing unbiased policy guidance.
Instead, it had become an entity that was more focused on poverty reduction
(with some of its managers even calling on bishops for policy advice on poverty
reduction in the late 1990s).
Is an IMF that could hardly manage itself in a position now to manage the
global economy? Is an IMF that was blindsided and never saw the unfolding
financial disaster in a position to recommend what its members should adopt to
prevent future crises? Was the recent annual meeting in Istanbul sufficient to
create a rejuvenated IMF that could play an even more demanding role than
anything it had done in the past? First, some background.
The IMF was created in 1944 in the wake of the most dangerous monetary
instability that had characterized the inter-war period and culminated in a
devastating war. Even before the war ended, the major economic powers felt the
urgent need to establish international monetary order and stability to bury the
turmoil that had enveloped the world economy - competitive currency
devaluations and protectionist measures to boost exports and employment,
barriers to the cross-border flows of labor and capital and the absence of
international lending to ameliorate global conditions - and unemployment at
about 25% of the work force for a number of years.
The dollar was devalued relative to gold in 1934 from US$20.76 per ounce to $35
per ounce and then floated freely without gold convertibility. By 1936, there
was no economic power that was still on the gold standard. Instead a system of
freely fluctuating exchange rates had taken hold.
Countries with depreciating currencies were essentially under-cutting their
competitor countries and inflicting unemployment on others. Trade restrictions,
bilateral arrangements, and exchange control became the global landscape. The
principal architect of the Bretton Woods system, Harry Dexter White of the
United States, summarized the hard lesson: "The absence of a high degree of
economic collaboration among the leading nations will ... inevitably result in
economic warfare that will be but the prelude and instigator of military
warfare on an even vaster scale."
As hostilities were abating, two alternative plans for monetary cooperation and
stability were put forward in 1943. Both plans, with a view to economizing on
the use of gold by substituting foreign exchange in its place, were seen as a
revival of the defunct Genoa Plan that had established Gold-Exchange Standard
in 1922. John Maynard Keynes formulated his famous plan for an international
clearing union that would issue a common reserve currency called "bancor"
without calling any individual country to restore the gold standard.
As implied by its label, the bancor was to be linked to gold and used as a unit
of account and a currency for international settlement. National currencies
were to serve essentially for domestic transactions and the bancor for
international transactions. The clearing union would allow use of its bancor
resources for orderly balance of payments adjustment.
The IMF was created by 44 nations as a critical component of the alternative
proposal put forward by White, and was seen to restore the gold standard
(albeit with added flexibility to allow slight divergences in economic and
financial policies between countries) as it precluded exchange rate
manipulation for gaining competitiveness or curing external deficits.
The IMF required fixed exchange rates as an essential condition for monetary
cooperation and stability. Each signatory country had to define its currency in
gold and maintain its exchange rate within one percent from either side of
parity. Devaluation to correct a fundamental disequilibrium could not take
place without IMF approval.
To avoid deflationary measures or disorderly adjustment, a member country
suffering from temporary balance of payments disequilibrium had access to the
IMF resources on a limited and temporary basis. To maintain fixed exchange
rates, countries had to coordinate economic and financial policies. To avoid
crises when policies did diverge, countries had to adjust parities with IMF
approval. Cooperation among countries meant implementation of credit policies
that were restrictive enough not to strain the fixed exchange rate regime
(maintain exchange rates within the band around the fixed parity).
As in the Genoa Plan, the Bretton-Woods system was a gold-exchange system (with
currencies and gold as reserve assets) allowing currencies convertible into
gold, namely the US dollar, to supplement gold and economize on gold in
international payments. Thus the dollar had a special place in this setup and
the system would be classified as asymmetric - the dollar was a reserve asset,
and effectively the exchange rate of other currencies had to be within the band
around their fixed parity to the dollar. As a result, the US was free to pursue
any policy it wished while other countries had to pursue a policy (essentially
the same as the United States) that would maintain their exchange rate within a
narrow band to the dollar.
A number of monetary experts considered the 1922 Genoa Plan gold-exchange
system to be a major cause of the Great Depression. Such a system allowed
"external deficits without tears" for reserve currency countries. Facing no
balance of payments constraint, reserve currency central banks saw their gold
reserves well preserved; consequently, they allowed credit expansion to go
unchecked.
Credit expansion caused an economic boom in 1926-29; it enabled a rapid growth
of dollar and sterling liquidity, fueling excessive speculation that turned
into a stock market crash in 1929 and general bankruptcies thereafter.
The Bretton-Woods system essentially collapsed because countries did not
coordinate economic policies and the IMF did not play its envisaged role of
monitoring these developments. Specifically, the US (as the major reserve
currency facing no constraint or discipline) adopted deficit financing to fund
the Vietnam War, while the US was unwilling to devalue the parity of the dollar
to gold and other countries were unwilling to revalue their currencies relative
to gold.
The collapse of the system was manifested in the US exit from the gold standard
in 1971 because the US lacked sufficient gold to uphold dollar convertibility
and the dollar was no longer defined in terms of gold, and thus other
currencies that had fixed value in terms of gold did not have a fixed parity to
the dollar.
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