Doing Away with Evils in the International Financial System, Again

Seventy years ago President Harry Truman signed the Bretton Woods Agreements Act of 1945, officially creating the IMF and the World Bank. As Treasury Secretary Henry Morgenthau put it, the Bretton Woods agreements aimed to “do away with economic evils.”

One serious economic evil was the repeated competitive devaluations and currency wars. The British devalued the pound in 1931, and they gained a competitive advantage, but they slammed other countries’ economies in doing so. Other countries followed, including the US which devalued the dollar in 1934. These actions led to harmful government restrictions and interventions in other countries.  After trying such interventions, Italy, for example, finally devalued in 1936, matching precisely the US devaluation of 1934.

A second economic evil was the prevalence of “exchange controls,” in which importers of goods were forced to make payments to a government monopoly in foreign exchange, or confront multiple exchange rates and government licenses to export and import.

To deal with these problems the reformers developed a strategy. Each country would commit to two basic monetary rules.  First, they agreed to swear off competitive devaluations by having any exchange rate change over 10% from certain pegs be approved by a newly-created IMF. Second, countries agreed to remove their exchange controls, with a transition period because many had extensive controls in place.

With commitment to these two rules, the IMF would provide financial assistance in the form of loans.  Chicago economist Jacob Viner explained the deal: “Other countries make commitments with respect to exchange stability and freedom of exchange markets from restrictive controls while we in turn pledge financial aid to countries needing it to carry out these commitments.” He concluded that “It is largely an American blueprint for the post war economic world…. It seems to me a magnificent blueprint.”

In important respects the blueprint succeeded. Exchange controls were removed, though it took more than a decade, and the currency wars ended, though the adjustable peg system itself fell apart in the 1970s and gave way to a flexible exchange rate system.  The 1970s were difficult because monetary policy lost its rules-based footing and both inflation and unemployment rose. But in the 1980s and 1990s policy became more focused and rules-based and economic performance improved greatly.  By the late 1990s, many emerging market countries were adopting rules-based monetary policies, usually in the form of inflation targeting, and entered into a period of stability.

Unfortunately this benign situation has not held, and today the challenges facing the international monetary system resemble those at the time of the creation, including currency wars, as I explained here, and new interventions and controls.  In my view the problem traces to a departure from rules-based monetary policies at both the national and international level. These deviations not only helped bring on and worsen the global financial crisis, they have been a factor in the sub-par recovery and the recent global volatility.

So we need a new strategy, and it can build on the old strategy of the ‘40s.   We now have evidence that the key foundation of a rules-based international monetary system is simply a rules-based monetary policy in each country.  Research shows that the move toward rules-based monetary policy in the 1980s was the reason why economic performance improved in the 1980s and 1990s.  More recent research shows that the spread and amplification of deviations from rules-based monetary policy are drivers of current international instabilities.  And research shows that if each country followed a rules-based monetary policy consistent its own economic stability—and expected other countries to do the same—a rules-based internationally cooperative equilibrium would emerge.

As in the 1940s we should forge an agreement where each country commits to certain rules.  In keeping with today’s global economy, it would not be an adjustable peg system, but a flexible system in which each country—each central bank—describes and commits to a monetary policy rule or strategy for setting the policy instruments. The strategy could include a specific inflation target, some notion of the long run interest rate, and a list of key variables to react to in certain ways. Experience shows that the process should not impinge on other countries’ monetary strategies nor focus on sterilized currency intervention.  The rules-based commitments would reduce capital flow volatility and remove some of the reasons why central banks have followed each other in recent years.

Such a process would pose no threat to either the national or international independence of central banks.  It would be the job of each central bank to formulate and describe its strategy.  Participants in the process would not have a say in the strategies of other central banks, other than that the strategies be reported. And the strategies could be changed or deviated from if the world changed or if there was an emergency. A procedure for describing the change and the reasons for it would be in the agreement.

This reform is important, but supporting reforms are also needed.  A second reform would set up rules for eventually removing capital controls. Currently, 36 countries now have open capital accounts, but 48 are classified as “gate” countries and 16 as “wall” countries with varying degrees of capital controls.  The removal should be gradual and accompanied by adequate safety and soundness regulations. Though controversial, the reform would be conceptually the same as the agreement to remove exchange controls in 1944.

A third ingredient to the rules-based system would be a rule for the IMF itself to apply when making loans to countries.  The most practical way to proceed would be to restore the Exceptional Access Framework. This sensible rule was first put in place in 2003, but was broken in the case of Greece in 2010 when loans were made in a clearly unsustainable situation, contrary to the framework.

A fourth reform would wean the IMF from making unnecessary loans as part of its advice giving and monitoring activities.  When the real need is simply for the IMF to give advice to a country in implementing or monitoring reforms, there is no need for a loan.  The most practical way to proceed would be to greatly expand the use of the Policy Support Instrument which was introduced in 2005.

And finally there should be an inclusive process for selecting the next managing director of the IMF, who could well be from an emerging market country. The impacts of departures from rules-based policies have been particularly hard on emerging markets as explained by Agustin Carstens.

More details about these reform proposals can be found in my Truman Medal talk along with reform proposals for the many other institutions created in the 1940s.

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