The was the last global financial crisis
The international financial system has been radically altered since the worldwide depression of the late 1920s and early 1930s. This change is due in large part to the inception of the International Monetary Fund (IMF) and its subsequent control over the international financial system. In this paper I will examine the extensive role of the Bretton Woods system of exchange rates and the gold standard. Additionally, I will examine the role that the IMF has taken on since the demise of the gold standard.
To begin, we must examine the circumstances that surround the creation of the IMF, who the actors are and what each of their roles are as member countries. The IMF was created as a result of the worldwide market collapse that took place initially in October of 1929. The domino effect that took place when the first market crashed was seen to be a situation so severe that world powers felt that drastic measures needed to be taken to ensure that this was the last global financial crisis that the world would face. Its creation in 1944 was the beginning of a new era for the international financial system.
The creation of the IMF occurred at Bretton Woods along with the World Bank and the system of fixed exchange rates and the gold standard for currency. Under this system, the US dollar was tied to gold by a United States government commitment to buy it at $35.00 and ounce and sell to central banks at the same price (excluding handling and other charges). Other participating countries maintained the exchange values of their currencies at prices which were almost fixed in terms of the dollar (the values fluctuate normally not more than one percent on either side of their parities), with the result that exchange rates were almost universally fixed. Other governments carried out their commitments by selling internationally acceptable liquid resources when there was an excess demand for foreign currencies in terms of their own currencies, and by buying liquid resources when there was an excess supply. What constituted internationally acceptable resources for this purpose were gold, and other liquid assets denominated in key or reserve currencies, principally US dollars or UK pounds sterling.
The IMF was to ensure that these standards were being followed as well as being the lender for temporary deficits, and balance of payment problems. Each member country contributed a predefined amount, or quotas, of national currencies and gold. This quota also determines the voting power on the IMF and the amount of resources that they may draw on from the Fund.
Designed to foster monetary cooperation, the IMF sought to enforce strict rules of behaviour in a world based on the gold standard and fixed currency-exchange rates. The Fund had, in theory, strict rules regarding how much to lend and when it was to be repaid. In reality, however, the Fund had discretion to waive any normal limitations. In 1961 with the advent of the General Arrangements to Borrow (GAB), the Fund increased its ability to lend through arrangements to borrow from 10 major industrial countries. At the time, these agreements had enabled the IMF to have and additional $6 billion at its disposal.
The Gold Standard, in theory, functioned to limit the ability of governments to issue currency at will, hence decreasing the purchasing power of money. It existed before the Bretton Woods agreement, but was suspended for reasons that we will see later. If, for example, the US dollar were defined as equal to 1/20 of an ounce of gold, then the number of dollars that the United States could issue would be constrained by its holdings of gold reserves. Moreover, if the UK defined its currency, the pound sterling, as 5/20 of an ounce of gold, the fixed exchange rate between the US and the UK, quite obviously would be $5 USD=1 sterling. One specific problem with specie standards (that is a currency convertible into a standardised unit of a non-monetary commodity) is that the value of money is only as valuable as the specie backing it. When worldwide gold production was low in the 1870s and 1880s, the money supply grew slowly, leading to a general deflation. This situation changed radically in the 1890s following the discovery of gold in Alaska and in South Africa. The result was rapid money growth and inflation up until the outbreak of World War I. Furthermore, linking currencies to gold did not totally restrain governments from manipulating the value of their currencies. First, in order to finance expenditures by printing money, governments would frequently suspend the gold standard during times of war. Second, even without officially abandoning gold, some nations periodically redefined the value of their currencies in terms of gold. Instead of allowing for gold or foreign reserves to be consistently depleted, the countries would choose instead to devalue their currencies.
It might seem, by this previous line of argument that countries had no real restrictions on their behaviour when it came to currencies, since they could devalue them at will. However, there was a serious price to pay for devaluation. Should a country threaten to devalue its currency, a speculative attack on that countrys currency would surely follow as investors attempted to rid themselves of that currency. Such countries would ultimately lose large amounts of reserves. This is exactly what occurred in the UK in 1966 and 1967. Confidence in the value of the pound sterling crashed and the subsequent loss of gold reserves amounted to 28 million ounces. In one day alone (November 17, 1967) the British government lost reserves valued at over $1 billion.
On August 15, 1971, in the midst of a major international monetary crisis, President Richard M. Nixon announced a new policy suspending indefinitely the U.S.’s commitment to redeem gold for dollars. This commitment was the lynchpin of the international monetary system in which the U.S. dollar served as the key currency by which the value of other currencies would be determined. Nixon’s decision to break the link between the dollar and gold effectively pulled the rug out from under the other world currencies, forcing them to re-determine their values, and thus forcing devaluation of the dollar. This event is generally regarded as marking the demise of the system of fixed exchange rates. The fall of the Bretton Woods system represents an important transitional stage in the history of international economic relations. It represents a change from a hegemonic system dominated by the U.S. intended to lay the foundation for an open, competitive world economy to the current system of floating exchange rates and expanding global capitalism.
The Fall of the Bretton Woods System
President Nixon’s announcement in 1971 and then the subsequent collapse of the system in 1973 were hardly spontaneous occurrences. The fall of Bretton Woods was simply the culmination of a chain of economic and political developments that were quite predictable. From flaws in the design of the system that made it inherently unstable, to the spin-off of international capital markets that exploited its weaknesses, the collapse of Bretton Woods was inevitable. Because of the U.S. pledge to back dollars with gold, the stability of the system was based on the ratio of foreign-held dollars to the value of gold held by the United States. If the amount of foreign dollars exceeded the amount of U.S. gold, the U.S. could not pay all of its claimants without changing the price of gold. So as the ratio of foreign dollars to U.S. gold increased, so did pressure to devalue the dollar. As such, the stability of the system was gauged by the U.S. balance of payments. Considering this, confidence in the dollar became an essential element of the Bretton Woods system. The decade following the signing Bretton Woods agreement would see the U.S. balance of payments shift from surplus to deficit, producing new pressures on the system.
From 1948 to 1958, several new and significant features surfaced in the international system. These features included development of new institutions for economic cooperation, dramatic economic growth in Europe, rising U.S. military spending, U.S. foreign aid to the Third World, and the emergence of U.S.-based multinational corporations (MNCs). These new additions to the international landscape “helped to generate the stability and prosperity that gave nations the confidence to participate in this liberal system.” But at the same time, each factor contributed to an outflow of dollars, pushing the U.S. balance of payments in the direction of larger deficits, meaning more dollars abroad and more potential claimants on U.S. gold, thereby destabilizing the system. The balance of payments difficulties posed a unique problem for the United States. As the hegemon of the system, the U.S. had an obligation to provide economic and military security for itself, its allies, and the system. In the 1960s U.S. leaders faced the dilemma of trying to solve the balance of payments problem while still fulfilling the country’s responsibilities as hegemon. The initial deficits of the 1950s, which were created through military and economic aid, were actually seen as beneficial at the time in that they “helped close the gap with the still economically weak Europeans.” By the end of the 1950s, Europe had recovered and the deficit became a problem. Before 1958 and 1959, large surpluses in goods and services and investment income had helped to offset the costs of providing foreign aid, military expenditures abroad, and private overseas investment. When the U.S. surpluses suddenly shrank, the payments deficit became even wider. Clearly the burden of hegemony was taking its toll on the United States.
One of President John F. Kennedy’s economic advisers warned, “we will not be able to sustain in the 1960s a world position without solving the balance of payments problem.” This assessment proved to be accurate as U.S. efforts to meet its global responsibilities further damaged its balance of payments, undermining its ability to act as hegemon.” The increase in U.S. deficits meant money was leaving the country and as such, it had to go somewhere. This is evidenced by the surpluses experienced by Japan and Western European countries, such as West Germany, which were growing rapidly. The surpluses, combined with the U.S. deficit, meant decreasing liquidity in the world economy, as the U.S., in its role as central banker to the world, had supplied much of the liquidity from its reserve assets, mainly gold.
To remedy this situation, a devaluation of the dollar would have been seemingly appropriate. However, the U.S. could not devalue the dollar without horribly upsetting the other currencies of the world. Another way to help correct the disequilibrium in world payments would have been to have surplus countries like Germany and Japan revalue their currencies, effectively devaluing the dollar in the process. Because these countries were persistently reluctant to change their own rates, the payments imbalances increased until a breaking point was reached in 1971. The fact that the surplus countries did not wish to revalue their currencies emphasizes an important flaw in the design of the Bretton Woods system. Orin Kirshner writes, “It was becoming uncomfortably clear that a system of fixed exchange rates, in which gold and the dollar…were the main components, was rather asymmetrical in its pressures for adjustment. The deficit countries were under pressure to adjust when they ran out of reserves and had to go to the IMF or to the central bankers for aid; but there were no similar pressures on the creditors to reduce their surpluses.”
Another interesting development that played a large part in the breakdown of the Bretton Woods system is the Eurodollar phenomenon. The Eurodollar, or Eurocurrency (other currencies were also involved), market was a by-product of the large-scale accumulation of dollars in foreign banks following the shift from a dollar shortage (U.S. payment surplus) to a dollar surplus (U.S. payments deficit) in 1957-1958. It was then that London bankers decided to lend these dollars out, rather than return them to the U.S. (which would have helped to stabilize the situation by improving the U.S. balance of payments). “Thus,” Lairson says, “was born the Eurodollar…market — essentially an unregulated money supply.” When the U.S. government acted in 1963 to address this problem by enacting the interest equalization tax to slow the outflow of dollars for loans, U.S. banks then opened overseas branches to continue their foreign lending. Lairson writes, “because no single state could regulate it effectively and because of the unceasing U.S. payments deficits, a Euromarket system developed consisting of the dollar and other currencies, a system of bank credit, and a Eurobond market (bonds denominated in dollars floated outside the United States). A massive volume of funds emerged that, without much restriction, could move across borders in search of the highest yields available on a global basis.” The emergence of this new, unregulated concentration of capital made even more difficult than before for the U.S. to get a handle on the system.
Lairson suggests that two main reasons can be identified for the decline and fall of the Bretton Woods system. “First,” he writes, “the system was inherently unstable because the mechanisms for adjustment of exchange rates were so inflexible.” He states “the economic relations that developed after 1948 were structured by these fixed values even as the shift from U.S. surplus to deficit increasingly demanded adjustment of exchange rates.” He continues, “the world of 1971 was significantly different from the world of 1945-1950, but the Bretton Woods system made few accommodations to that reality.” Lairson’s second reason, which he regards as “perhaps most reflective of those changes,” was the “massive growth of the market power of international capital and its impact on fixed rates.” The transnational actors who emerged over the years reflect this notion. By 1973, the Eurocurrency market had grown to nine times the size of U.S. reserves. “Such an immense collection of resources,” he says, “was capable of overwhelming even concerted government action.” The immense pressure these forces put on the dollar and the fixed-rate system itself finally led to an international monetary crisis, forcing Nixon to temporarily take the dollar off the gold standard. Then on March 19, 1973, the system collapsed entirely, even while major efforts to reform the system were in progress. By this time, the powerful new transnational actors collectively lost confidence in the fixed-rate system and in the ability of governments to create any viable system. Finally, Kirshner states, “financial officials of the main industrial countries, including the United States, found it preferable, and inevitable, to let their exchange rates float. The Bretton Woods system was at an end.”
In hindsight, it becomes apparent that the Bretton Woods system, by the 1970s, had served its purpose and the time had come for it to give way to a system better suited to the realities of the time. The Bretton Woods’ agreements and institutions were designed to stabilize the world economy in the aftermath of World War II, so that countries could eventually interact, grow, and compete as equals in a world of open markets. This system, which was dependent on U.S. hegemony for its success, had progressed to the point where the distribution of economic and political power had become more widespread among other countries. This process can be viewed as a maturation of the international system as U.S. hegemony was no longer practical in the monetary system, and, as we would later see, it was becoming less necessary in other aspects of the international system. The move to floating exchange rates in Western economies forced the IMF to end its role as traffic cop of the world monetary system and to concentrate instead on providing advice and information to its members, which in 1998 numbered 182 countries.
That role was key in helping nations in Latin America, Africa, Asia, and Central Europe restructure their economies following the 1982 debt crisis. Here, we will focus on the effects of the debt crisis on Sub-Saharan Africa (SSA). Although much focus has been given to the effects of the 1982 debt crisis in Mexico and other Latin American countries, the effects on Africa have nonetheless been strongly felt, and the consequences of that period linger on today. In Mexico the crisis was solved in 1987 through the Baker plan, funded by the Japanese and private creditors. The plan was targeted towards the commercial debt of the countries to which the banks were most exposed-middle income countries. As a result of this initiative, commercial activity was no longer at risk and the threat of the Latin American countries forming a debt cartel was assuaged. In SSA, however, the effects of the crisis have not yet been addressed as wholly as the Baker plan did for the Latin American countries. Some questions have arisen regarding the role of the IMFs lending practices in the SSA region. Whether or not the IMF has focused enough on LDCs development and growth as their main objectives. While this was not the purpose for the creation of the IMF, many have sought to make it so.
Later the IMF sought a more ambitious role as an international lender of last resort to the world economy. The lender of last resort is an institution that will lend during times of financial crisis that will allow the market to return to equilibrium through its lending practices. Allan Meltzer has established five criteria that a lender of last resort at the domestic level must adhere to. We will use the analysis of Stanley Fisher, an important figure with the IMF to determine how these characteristics apply to the international case later on.
The first is that the central bank is the only lender of last resort in a monetary system such as that of the United States. Second, to prevent illiquid organizations from closing, the central bank should lend on any collateral that is marketable in the ordinary course of business when there is no panic. It should not restrict lending to paper eligible for discount at the central bank in normal periods. Third, the lenders loans, or advances, should be made in large amounts, on demand, at a rate of interest above the market rate. This discourages borrowing by those who can obtain accommodation in the market. Fourth, the above three principles should be stated in advance and followed in a crisis. Finally, insolvent financial institutions should be sold at the market price or liquidated if there are no bids for the firm as an integrated unit. The losses should be borne by owners equity, subordinated debentures, and debt, uninsured depositors, and the deposit insurance corporations as in any bankruptcy.
The argument for the need of an international lender of last resort rests not only on the volatility of capital markets but on the inherent financial panics that ensue from them. The importance of regulating these volatile markets was seen at Bretton Woods through the controls over capital inflows, yet it could not regulate the capital outflows. Fisher argues that not only does there need to be an international lender of last resort, but that increasingly the IMF has been playing that role since it first assumed that position in the international bailout of Mexico in 1995. Fisher proceeds to dismiss the argument that the lender of last resort need necessarily be a central bank. He divides the category of lender into two when financial crisis occurs. On the one hand, there are crisis lenders, who could be central banks. Fisher argues that there exists no requirement for them to be central banks. The only requirement is that enough liquidity exists within a particular institution such that it is able to supply the loans necessary to return the market to equilibrium. On the other hand we have crisis managers who are responsible for directly managing to whom the loans are given, and how best to deal with the crisis at hand. Fisher argues that in terms of international crises the IMF is perfectly suited to deal with such crises both as a crisis lender and as a crisis manager.
Clearly the role of the IMF as international lender of last resort has presented itself, initially Mexico and as we will see the structure has been established for these activities to continue. In return for the imposition of an economic austerity plan in Mexico, the fund, along with the U.S. and other major industrial countries’ central banks, provided credit lines and other facilities totalling $47.8 billion. Although the assistance gave rise to criticism that the IMF was bailing out international investors and not the Mexican economy, the fund in 1997 and 1998 increased the amount each member contributed and expanded its lending activities further by establishing a $47 billion line of credit–called the New Arrangements to Borrow–with two dozen countries.
The increase in borrowing authority would allow troubled IMF members to draw well in excess of what would normally be allowed, a move that was well timed. In the 1990s capital had flooded into emerging economies–such as Thailand, Indonesia, and South Korea–with little attention to borrowers’ creditworthiness. When economic problems started to occur, foreign and domestic investors alike rushed to get their money out of those countries. In the ensuing panic, currencies and stock and bond markets imploded, cutting off financing and swiftly throwing entire economies into recession. The crisis persisted, even amid billions of dollars in IMF and Western loan commitments. With the IMF estimating that world economic growth was only 2.2% in 1998, half what it had forecast in late 1997, it became apparent that more forceful moves would be required. Along with the IMF’s fortified capital base and widened lending authority, it still was unclear whether widening the disclosure of emerging economies’ foreign-currency reserve levels, publicizing their growth estimates, and announcing capital inflows and outflows would help forestall the next crisis–much less put a decisive end to the one that drew headlines in 1998. This was because the entire face of international finance had changed since the IMF was created.
Financial flows were once controlled by a handful of major banks that could be easily corralled into restructuring problem loans in cooperation with relatively modest IMF assistance. In the late 1990s, however, flows were dominated by thousands of banks; securities firms; and mutual, pension, and hedge funds that could move capital in and out of countries with a click of a computer mouse. The number of countries seeking international investment, meanwhile, had proliferated, as had the diversity of debt, equity, and other financial instruments. This array of investors and instruments made coordinating any response to financial crises “extremely difficult,” concluded Moody’s Investors Service Inc., a major global credit-rating agency.
The IMF, meanwhile, continued to face criticism that it was secretive in its dealings, undemocratic in its makeup, and unresponsive to the needs of poorer members. Many critics noted that the economic austerity programs that were typically attached to any IMF assistance were not always appropriate. In some cases spending cuts only deepened local recessions and made the task of necessary financial and industrial restructurings all the more difficult.
Some economists, including Jeffrey D. Sachs, the director of the Harvard Institute for International Development, believed the IMF should permit countries to essentially go bankrupt, imposing formal suspensions of loan payments while creditors and debtors negotiated the value of the loans and determined whether any loans could be exchanged for equity. During the negotiations a troubled country could continue to obtain new financing and exporters could conduct business, selling their goods and earning foreign currencies vital to a country’s economic revival.
Suggestions such as these, if they were accepted, might require years to be put into practice. If the crisis of 1998 had one lesson, it was that nothing short of “a cooperative effort by the entire world community is needed to repair the major shortcomings in the global system,” according to IMF chair Camdessus . The question was whether the repairs would be performed quickly enough to enable the IMF and its backers to cope with the next financial implosion.
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