International Money and Credit : The Policy Roles

INTERNATIONAL MONETARY FUND

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1984
• ISBN:
  9780939934270

NONE

1 Functioning of the Current International Financial System: Strengths, Weaknesses, and Criteria for Evaluation

THOMAS D. WILLETT ^*

I. OBJECTIVES FOR THE INTERNATIONAL MONETARY SYSTEM AND FRAMEWORK FOR ANALYSIS

The performance of the international monetary system must be judged in terms of how well it meets the objectives delineated for the system. From an economic perspective, these objectives parallel those of domestic monetary systems to help facilitate the process of specialization and exchange and the full utilization of resources. The need for an international monetary system arises from the existence of sovereign states whose domains do not exhaust the potential benefits from specialization and exchange.

From a positive perspective, the economic objectives of the international monetary system are usually expounded as the promotion of microeconomic efficiency in the allocation of resources (including the usefulness of money) and the macroeconomic objectives of achieving a satisfactory combination of low inflation and unemployment and high rates of economic growth.⁸ Viewed from an alternative perspective, international monetary systems have also been frequently evaluated in terms of their ability to handle particular problems which may arise from the operation of the system, particularly the problems of international liquidity, confidence, and adjustment. International monetary relations also have important political components. These include concerns with distributional effects and constraints on national sovereignty and more general political objectives, such as the enhancement of national power and prestige.

The emphasis on a political economy perspective also has implications crucial for the positive analysis of the behavior of governments in the operation of the international monetary system. This, in turn, has important implications for the practical relevance of various normative proposals. For example, there is a tremendous difference in the agenda for policy coordination and international monetary reform implied by an optimal economic policy framework which ignores collective decision making and implementation problems and one implied by a public choice approach which emphasizes such difficulties.

This section begins with discussion of the traditional economic criteria for evaluating the performance of the international monetary system: promoting microeconomic and macroeconomic efficiency and minimizing international liquidity, confidence, and adjustment problems. It then moves on to the analysis of distributional issues, national sovereignty, and other political considerations.

Microeconomic Efficiency

Our standard microeconomic criteria for judging microeconomic efficiency is the extent to which marginal social costs and benefits are equalized. Our theory suggests that with well-informed decision makers, competitive markets will tend to approximate this outcome in the absence of such conditions as externalities and public goods. In the international sphere, our analysis indicates a presumption in favor of free trade and investment in the absence of persuasive arguments that specific market failures exist.⁹ It furthermore shows that on economic efficiency grounds, the first-best solution to most market failures associated with arguments for international restrictions involve domestic, rather than international, policy measures. For example, the first-best policy measure for stimulating an infant industry is generally a direct subsidy rather than tariff protection. Where exchange rates are at equilibrium levels, it seems not unreasonable to use the extent of international trade and payments restrictions as a crude index of the magnitude of deviations from global microeconomic efficiency in international exchange. (It is, of course, possible for international restrictions to raise the economic welfare of one country at the expense of others.) However, where exchange rates deviate from equilibrium levels, there is a distortion in the price signals given to private economic actors which will tend to generate differences between private and social costs and benefits. In such circumstances, selective measures which tend to compensate partially for overvaluations or undervaluations of currencies may lead to increases, rather than decreases, in economic efficiency. Furthermore, even in the absence of disequilibrium exchange rates, economists’ views on the economic welfare effects of free international capital flows have been much more mixed than their views on the welfare effects of free international trade flows. The principal designers of the Bretton Woods system, John Maynard Keynes and Harry Dexter White, were both skeptical of the benefits of free international capital flows under many circumstances, and such views are still shared by a number of economists.¹⁰ For example, it has been argued that interest rate differentials often are not a good reflection of differences in the marginal productivity of capital and, hence, that taxes or controls to dampen international capital flows may carry relatively low efficiency costs.

While it is clear that stable equilibrium exchange rates are conducive to efficiency and that exchange rate fluctuations due to destabilizing speculation are harmful, there has been relatively little analysis of the effects of exchange rate volatility that reflects changes in underlying economic developments and expectations about future developments. Using the criterion of efficient information processing that is frequently adopted in modern financial theory and the rational expectations literature, it is clear that such exchange rate movements, even if highly volatile, promote economic efficiency given underlying circumstances. This approach suggests that the focus of those concerned with improving economic performance should be on reducing this volatility of underlying economic conditions. Skepticism about the implications of this efficient-market view has focused both on the extent to which exchange rate movements have been dominated by efficient speculation and on whether there are not important externalities and rigidities in the goods and labor markets which would impose efficiency costs in other sectors of the economy. So far, relatively little progress has been made toward reconciling these opposing points of view.

While it is now generally accepted that we cannot safely assume that unchanged nominal exchange rates are a good guide to equilibrium exchange rates or that large, rapid movements in rates are necessarily the result of destabilizing speculation rather than reasonable shifts in expectations about economic fundamentals, wide divergencies of opinion exist about how closely the movements of flexible exchange rates have approximated equilibrium rates. In my judgment, the considerable amount of technical research on these issues has served primarily to suggest that one should be cautious about making statements that a particular exchange rate clearly is, or is not, close to an equilibrium level.¹¹ As will be discussed further below, different views about the predominant causes of the exchange rate fluctuations are probably the major cause of differences in judgments about how well flexible rates have worked.

Nor have we made considerable progress to date in evaluating the welfare costs of different patterns of deviations from equilibrium exchange rates. For example, what are the comparative efficiency costs of small, but persistent and growing, one-sided deviations from equilibrium, as might occur under a sticky adjustable peg, versus frequent large deviations which are of limited duration and which tend to average out.¹² Many have argued that there have been frequent large deviations under flexible exchange rates because of imperfections in private speculation or exchange rate overshooting owing to short-term variations in monetary policy.

We likewise still have not solved the decades-old controversy about whether pegged or flexible exchange rates are likely to stimulate more trade restrictions. My own view is that without the flexibility of exchange rates which we enjoyed (or suffered) over the past decade, we would have faced a higher level of restrictions. However, flexible rates certainly did not lead to as much liberalization as many advocates had hoped, and there have been cases in which it can be argued that exchange rate fluctuations have stimulated restrictions. Perhaps the strongest conclusion we can draw at this point is that whether the shift from the adjustable peg system to more widespread floating has led ceteris paribus to a marginal increase or decrease in the efficiency of international exchange, the effects do not appear to have been extremely large, especially in comparison with the beggar-thy-neighbor independent nationalistic economic policies of the 1930s.¹³ The evidence also seems consistent with the view that the choice of exchange rate regime is not one of the most important determinants of international restrictions.

Macroeconomic Goals

Traditionally, the macroeconomic aspects of the operation of the international monetary system have been considered in terms of the constraints which balance of payments adjustment requirements have placed on domestic macroeconomic policies. One of the major objectives of the Bretton Woods negotiators was to construct a system in which countries would not be forced to accept major inflations or recessions in order to convert disequilibrium nominal exchange rates into equilibrium ones. In such cases of fundamental disequilibrium, internal considerations were to have primacy over external ones, subject of course to the avoidance of beggar-thy-neighbor policies.

This desire to keep the requirements for international monetary balance from seriously impinging on domestic macroeconomic objectives typically has been shared both by Keynesians and monetarists. It is not a universally held view, however. A number of writers have been quite suspicious of the types of macroeconomic policies which may be stimulated by democratic politics and have sought to have the international monetary system impose discipline over domestic financial policies. Although most often associated with advocates of the return to some form of gold standard, such arguments are also frequently made for an international or regional return to pegged exchange rates per se. While it is not clear that flexible exchange rates will necessarily impose less discipline and stimulate greater inflationary pressures than typical forms of pegged-rate systems, the objectives of most of those who have engaged in the debate over discipline clearly fall into two diametrically opposed camps—those who seek to increase, and those who seek to constrain, the freedom of domestic macroeconomic decision makers.¹⁴ There is a similar opposition between those who view accommodation of divergent national priorities as a major objective and those who advocate instead a forced harmonization of policies. The arguments in both of these areas involve economic and political aspects which cannot be adequately resolved here. Suffice it to say that these different schools of thought will hold quite different views about the desirability of the degree of macroeconomic permissiveness of the international monetary system.

In recent years, the traditional view of balance of payments considerations as a constraint on domestic macroeconomic policies has at least partially given way to analysis from the standpoint of open economy macroeconomics. This perspective emphasizes the short-term and medium-term effects of exchange rate and balance of payments developments on inflation-unemployment relationships and on the state of activity in the economy. The adoption of flexible exchange rates has been perhaps the major force behind this shift in perspective, although analysis along these lines was quite prevalent well before the 1970s. Ideally, from the perspective of a single country, an international monetary system which serves as an automatic stabilizer for domestic economic fluctuations, while limiting the importation of disturbances from abroad, would be preferred. From a global perspective, it would be preferable to have a system which does not itself generate disturbances and which, on average, yields a net stabilizing influence from uncontrolled disturbances while preserving countries’ freedom to engage in domestic policy actions to counter the effects of disturbances, whether of domestic or foreign origin.

The different aspects of these criteria may, of course, conflict in particular situations. Depending on the particular patterns of disturbances and the structure of the economies in question, either pegged or flexible exchange rates may provide the best-short run macroeconomic environment for a particular country or aggregation of countries.¹⁵ In two-country Keynesian models, it has been shown that depending on the particular disturbance in question, both countries could enjoy more stable output with pegged exchange rates or with flexible rates, or there might be conflicts of short-run interest so that one country would be better off with a pegged rate and the other with a flexible rate. The analysis becomes even more complicated when inflation-unemployment relationships are taken into account. In general, exchange rate movements which worsen inflation in the short run will stimulate output (once the initial perverse J-curve effects on the trade balance are reversed) and vice versa, but there has been relatively little analysis of possible effects on differences in medium-term inflation-unemployment trade-offs, and the short-term and medium-term effects may be quite different. For example, maintaining a pegged rate in a booming economy may have the favorable effect of reducing inflation in the short run, but at the expense of contributing to an artificial ratcheting-up of real wages which will worsen future inflation-unemployment relationships.

The choice of international monetary regimes may also have important influences on the effects of macroeconomic policy instruments. In traditional IS-LM, open-economy theoretical models, a shift from pegged to flexible exchange rates will strengthen the effects of monetary policy on aggregate spending, while the strength of fiscal policy will be increased or decreased, depending whether international capital mobility is low or high.¹⁶ Similarly, with respect to international policy coordination, under pegged exchange rates expansionary monetary or fiscal policy at home generally will have an expansionary effect abroad (although the magnitude of these effects is often a matter of some dispute), while under flexible rates, expansionary monetary policy will have a contractionary effect abroad. Fiscal policy will still influence foreign economies in the same direction as at home, but the magnitude of transmission will be influenced by whether the degree of capital mobility leads to an appreciation or depreciation of the exchange rate.

The international monetary regime can also have an important influence on the way in which spending changes break down between price and output effects in the short run. For example, with exchange rate flexibility, the effects of exchange rate movements on the prices of traded goods will speed up the aggregate price responses to changes in monetary policy, steepening the short-run inflation-unemployment trade-off. While this has often been taken as an argument that flexible rates will be more inflationary than pegged rates, it s...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Acknowledgments
• Contents
• Introduction
• 1. Functioning of the Current International Financial System: Strengths, Weaknesses, and Criteria for Evaluation
• 2. International Liquidity and Monetary Control
• 3. International Balance of Payments Financing and Adjustment
• 4. The SDR and the IMF: Toward a World Central Bank?
• 5. Is There an Important Role for an International Reserve Asset Such as the SDR?
• 6. International Moneys and Monetary Arrangements in Private Markets
• 7. Use of the SDR to Supplement or Substitute for Other Means of Finance
• 8. What Are the Scope and Limits of Fruitful International Monetary Cooperation in the 1980s?
• 9. Summary of Findings
• 10. Special Drawing Rights and Plans for Reform of the International Monetary System: A Survey
• 11. The Evolving Role of the SDR in the International Monetary System
• 12. Possible Further Improvements in the Existing SDR
• 13. Evolution of the SDR Outside the Fund
• Biographical Sketches of Participants
• Author Index
• Footnotes