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After 40 years
by Robert Mundell, Professor of Economics, Columbia University, and 1999 Nobel Laureate for Economics
International financial crises have been an on-and-off feature of the global economy in the past 40 years. Understanding how the international monetary arrangements came into play can point to ways of establishing a greater degree of control in future, argues Professor Mundell.
Forty years ago, when the OECD replaced the Organisation for European Economic Cooperation (OEEC), the world was very different. A major standoff was underway in the Cold War, there was a crisis in the international monetary system, and globalisation, if the word was used at all, meant freer trade within the “free world.”
In the past 40 years much has changed. The international monetary system broke down and flexible exchange rates led to increased international monetary instability. Social revolutions occurred in gender and race and the balance of terror of the Cold War ended with the fall of the Berlin Wall. The oil-price revolution of the 1970s effected a huge transfer of wealth and power to the Middle East. Computer and Internet revolutions transformed information technology and brought on productivity gains and cost reductions in every sector of economic life. The euro area brought into focus the new oligopoly of currency areas.
International monetary arrangements today are dominated by the currency triad of the dollar, euro and yen areas. These three areas together make up over 50% of world gross domestic product (GDP). Any changes in the “architecture” of the international monetary system will have to grapple with the instability of exchange rates between these areas.
In the post-war gold exchange standard, the major currencies were kept fixed to the dollar and the United States in its turn kept the price of gold fixed. The system broke down in the early 1970s because soaring dollar liabilities made convertibility of the dollar into gold impractical and the price of gold, after the inflations of three wars, had become unrealistic.
When in 1971 the US took the dollar off gold, it was the end of a long era. For more than 25 centuries gold or silver had been at the centre of the international monetary system and had kept inflation in check. The gold standard gave the world akind of monetary unity without explicit political unity. With, however, the centralisation of gold in the superpower in the two world wars, and the rise of the paper dollar as an alternative international money after the Second World War, gold ceased to be at the centre of the international monetary system.
For most countries the important issue was not so much the fate of gold, but the effect on exchange rates. When the US dropped gold, the other countries dropped the dollar, giving rise to fluctuating exchange rates. The international monetary system no longer acted in unison but as a collection of national monetary systems.
A short-lived attempt to re-establish a global currency area based on the inconvertible dollar foundered on disagreement between Europe and the United States over US monetary policy. Without consensus on the common rate of inflation, no currency area can survive. In 1973, therefore, generalised floating began. Later, in 1976, the IMF Board of Governors agreed to amend the IMF charter to allow for “managed” flexible exchange rates.
The adoption of flexible exchange rates was at most a second-best solution. It left much to be desired. Most countries had relied upon currency convertibility as the fulcrum of monetary discipline. Countries that had for decades anchored their currencies to the dollar had achieved the same degree of monetary stability as the United States. When these countries shifted to flexible exchange rates, monetary discipline broke down and many countries succumbed to rampant inflation.
The adoption of flexible exchange rates by the international monetary authorities failed to take into consideration the relevance of the size configuration of economies, the possibility of currency areas, and the inefficiency of 190-odd fluctuating currencies. How much more efficient it would be to have a common international money that could be used throughout the world.
It is ironic that generalised floating for most of the world coincided with steps in Europe in the opposite direction. The advent of the euro has already changed perceptions. The transition period demonstrated that a credible fixed exchange rate system could be effective in establishing common interest rates and inflation rates and eliminating speculative capital movements. Europe was now perceived as a zone of price stability and its new currency is coming to be accepted as a suitable anchor for other countries and a useful asset for central banks to hold in their reserve portfolios. Elsewhere, the euro example is studied to see if it could be a model for larger currency areas in Asia, Africa, the Western Hemisphere, the Middle East and the former Soviet Union.
Three Corrections
Present arrangements suffer from three major deficiencies. One is the absence of a global unit of account in which international debts and payments could be denominated and to which other or prospective currency areas could be anchored. A second is the absence of a world central bank to produce and manage the international currency and to conduct global monetary policy. The third is the absence of a mechanism or convention for stabilising exchange rates. Removal of all three deficiencies should be at the top of the agenda for international monetary reform.