Building Trust in the International Monetary System

In the years following the Global Financial Crisis, the debate on reforms to the international monetary system and the prospects for the dollar, which is at the heart of the current system, has gained momentum. The contrasting views on these issues reflect differing theories on the origin of international money. Just as in the national sphere, so in the international sphere the evolution of money has been characterized by the transition from commodity money to forms of money with an intrinsic value ever further removed from their face value. This transition has favoured a significant increase in the elasticity of the money supply with respect to changes in the level of productive activity. This, in a context where the prices of certain goods and services are rigid, has fostered economic growth. However, the introduction of forms of money with little or no intrinsic value inevitably raises the question of how to ensure the stability of their value over time. This problem is particularly pronounced at the international level given the absence of a supranational authority and it can only be achieved when a certain balance of power prevails in the international arena.

The prevailing theories on the evolution of international money tend to neglect the reasons and conditions of the transition of commodity money, where the currencies’ face value corresponds to its intrinsic value, to forms of money in which this correspondence diminishes to practically disappear completely, as is the case with fiat money. This latter type of money, although characterized by an elasticity of supply with respect to the level of production that is considerably higher than commodity money, can only be accepted if suitable institutional mechanisms guarantee the stability of its value. At the national level this guarantee is offered by the state. In the international context, an international money exists when the conditions of a political exchange exist between a leading country, which bears the costs of producing trust in the fiat money (and the international monetary system based on it), in exchange for exploiting the seigniorage right, and follower countries, which attribute little weight to the relative gains made by the leading country’s exploitation of the seigniorage right and, at the same time, derive significant benefit from the existence of an international money, and the growth in trade and output associated with it.

The first international monetary system with a clearly defined structure and “rules of the game” was the gold standard. This monetary system lasted from 1871 until 1914. The gold standard was based on a commodity money, gold, to which the adhering countries undertook to keep their currency convertible. This implied that, at least in the long run, governments would have to expand the quantity of money according to the growth of gold reserves. Prior to 1871, most advanced countries based their money on a bi-metallic system, which required a fixed parity between gold and silver. Various hypotheses have been made about the transition from bi-metallism to gold mono-metallism. This transition was associated with the process of state capacity building by advanced countries, taking on the role of guarantor of the stability of the new form of money, i.e. bank money, was part of this process.

With the First World War the classical gold standard ended. In the immediate post-war period, most advanced countries found themselves with price levels significantly higher than the pre-war period and experiencing marked exchange rate volatility. In this context governments became convinced of the necessity to rebuild an international monetary order by re-establishing a system similar to the gold standard: the gold-exchange standard. This system only lasted from 1925 until 1931. Various explanations have been given for its short life and subsequent collapse. Most scholars attribute the collapse of the system to the formation of strong trade unions and mass political parties which prevented the costs of adjusting imbalances being passed on to workers, as had been the case with the classical gold standard. This made the gold-exchange standard politically unsustainable in the long run. The introduction of a monetary system based on a form of money that favoured smoother adjustments of macroeconomic imbalances was also hampered by the balance of power that prevailed in the international arena after the First World War.

As the end of World War II approached, the Allies, and in particular the USA, were determined to create a new international monetary order. Many believed that, in the 1930s, the worldwide transmission of deflation and the frequent recourse by countries to competitive devaluations had contributed to the Great Depression.

The goal of the USA and Great Britain was to develop a new international monetary system. The crucial aspect of the system, based on the Bretton Woods Agreements of 1944, lies in the fact that, for the first time, it was an attempt at a “legalization” of international monetary affairs: a set of rules and institutions, shared and accepted by a large number of countries, that aimed at ensuring the functioning of an international payment system.

This made it possible to introduce, at the international level, innovative payment systems based, rather than on commodity money, as in the gold standard, on a fiat money, the dollar. Over time, the changing dynamics of inflation and productivity made the Bretton Woods system less attractive to the advanced countries, in particular the USA. On August 15, 1971 President Nixon suspended the convertibility of the dollar and the Bretton Woods system ended.

In the early 1970s, after the suspension of US dollar convertibility, there were attempts to return to a fixed exchange rate system. These attempts, however, failed. With the end of the fixed exchange rate regime governments’ discretion in managing monetary policy expanded significantly. The result, in the 1970s, was a high level of monetary disorder. The stability of the international monetary system was eventually restored through institutional reforms and changes in the conduct of individual countries’ monetary policy. From the second half of the 1980s onwards, a phase of low output volatility began.

In Europe, the need to ensure adequate internal exchange rate stability in an international monetary system of flexible exchange rates led European countries initially to develop an exchange rate agreement, the EMS, and subsequently to create the EMU in 1999. Since the mid-1990s, capital flows between countries have progressively increased and with financial globalization, emerging countries have been exposed, more frequently than in the past, to sudden stops and financial crises.

Some scholars argue that in the very near future the dollar will lose its exclusive role as “the” international money. However, at least at present, neither the euro nor the renminbi qualify as international money.

Although the dollar, in the post-Bretton Woods period, has maintained, if not indeed strengthened, its dominant role in the international monetary system, the system’s stability has been and is threatened by various factors. The first of these is the large amount of gross capital flows which makes it easier than in the past for the financial cycle to be amplified, leading to credit booms and systemic crises to occur. Secondly, in the current international monetary system it is possible that a shortage of international liquidity may occur. A third critical factor lies in the governance of the international institutions responsible for ensuring the stability of the international monetary system, in particular the IMF. In order to prevent these factors threatening the stability of the international monetary system, reforms are needed.

The international monetary system currently in force is a hierarchically organized system of flexible exchange rates. At the top of this hierarchy is the dollar, at a lower level the other reserve currencies and below that the other currencies.