International Finance and Open-Economy Macroeconomics

Theory, History, and Policy

Hendrik Van den Berg

• Publisher: WSPC
• Year: 2010
• ISBN:
  9789814365215
• Topic: Economics
• Subtopic: Macroeconomics
• Index: Economics

This historically-based textbook on international finance and open-economy macroeconomics provides a complete course on the theory and policies that shaped our international financial system. Utilizing the 1944 Bretton Woods Conference as a unifying theme, the book covers all the standard topics of international finance, such as foreign exchange markets, balance of payments accounting, macroeconomic policy in an open economy, exchange rate crises, multinational enterprises, international banking, and the evolution of our international financial system. The detailed international financial theory is presented in a lively manner that reflects the close relationship between actual world events and the development of economic thought.

The book also analyzes the causes of the 2008 international financial crisis and recession, encourages critical thinking about whether the current international financial system promotes human well-being, and concludes with a discussion on whether it is time to summon the world's financial leaders to another Bretton Woods Conference. In additional to providing students with a solid understanding of international finance and open-economy macroeconomics, the book is written in a reader-friendly style that makes it a good reference for anyone interested in the many fascinating issues related to our still-evolving global financial system and, more generally, our global economy.

The Instructor's manual is available upon request for all instructors who adopt this book as a course text. Please send your request to [email protected].

Contents:

• Introduction to International Finance:
  • Introduction
  • The Balance of Payments and the Macroeconomy
• The Foreign Exchange Market:
  • The Foreign Exchange Market
  • The Interest Parity Condition
  • Dealing with Exchange Rate Volatility: Hedging Foreign Exchange Exposure
  • The Microstructure of Foreign Exchange Markets
• Open-Economy Macroeconomics:
  • The Mundell–Fleming Open-Economy Model
  • The Supply Slide of the Economy
  • The Aggregate Demand/Aggregate Supply Model
• The History of International Financial Policy:
  • Exchange Rate Crises
  • More Exchange Rate Crises
  • The International Financial System: The International Gold Standard, 1870–1914
  • The Tumultuous Interwar Period: 1918–1940
  • Bretton Woods to the Present
  • The Euro and the European Union
• International Financial Issues:
  • Foreign Direct Investment and Multinational Enterprises
  • International Investment, International Banking, and International Financial Markets
  • The 2008 Financial Collapse and Recession: Is It Time for a New Bretton Woods Conference?

Readership: Undergraduate and graduate students in international finance; students in international economics; economists, financial industry professionals and government officials.

Part I

Introduction to International
Finance

Chapter 1

Introduction

There is the curious notion that the protection of national interest and development of international cooperation are conflicting philosophies — that somehow other men of different nations cannot work together without sacrificing the interests of their particular nation…. Yet none of us has found any incompatibility between devotion to our own country and joint action. Indeed, we have found on the contrary that the only genuine safeguard for our national interests lies in international cooperation.

(US Treasury Secretary Henry Morgenthau,
Bretton Woods, 22 July 1944.¹)

The night of 30 June 1944 was unlike any night Loyd MacNayr had experienced as a locomotive fireman for the Boston and Maine Railroad. As he fired up the steam locomotive on a siding in Springfield, Massachusetts, Loyd read the train orders that the engineer, Charlie Murphy, held up for him to see: “Run passenger extra Springfield to White River Junction. Has right over all trains”. The order meant that all other trains, even scheduled express trains, had to let them pass. Loyd was further surprised when the section foreman showed up to ride with them on the locomotive. This indeed was an important train!

The foreman told Loyd that the special train had already sped past many sidelined trains along the Pennsylvania Railroad from Atlantic City, New Jersey, through the outskirts of Philadelphia, and later underneath the Hudson River into New York City. Additional passengers had come on board to fill the train during a stop at Pennsylvania Station in New York. Then the train proceeded under the East River and north onto the tracks of the New York, New Haven and Hartford Railroad to Springfield, where Loyd and his fellow crew members were now waiting to head the train. When the train arrived in Springfield, the New Haven Railroad locomotive was separated from the passenger cars, and Loyd and his fellow crew members backed their Boston and Maine Railroad locomotive up to the long string of passenger cars. As soon as the couplers joined and the yard crew attached the brake hoses, they were given the signal to proceed. They rushed the train north through the Connecticut River Valley past Holyoke and Greenfield, Massachusetts, and onto Brattleboro and Bellows Falls, Vermont. The night was too dark for the passengers to see much of the beautiful New England countryside, but after the hot and steamy weather they endured in Atlantic City and New York City, they surely must have enjoyed the cooler New England air that blew through the open windows of the speeding train. Loyd's stint as fireman on the special train ended when the train reached White River Junction, Vermont, where another crew boarded the train to take it further north.

Loyd read later that President Franklin D. Roosevelt and the Soviet Union's Joseph Stalin had met for confidential meetings around 30 June, so he assumed that it was them who had been on his special train. “I never realized it and I wish I'd kept the train order because Mr. Pearce [the section chief] said it was very unusual and I'd probably never see another like it”, he said some years later. We now know that Loyd's train was not carrying Roosevelt and Stalin. Rather, the passengers included the British economist John Maynard Keynes and the chief international economist at the US Department of the Treasury, Harry Dexter White. Loyd was surprised to learn many years later that the special train on 30 June 1944 carried several hundred economists and financial experts from 45 Allied nations. The passengers jokingly called the train “the Tower of Babel on wheels”, in reference to the many languages spoken by the several hundred international passengers on board.

After the crew change in White River Junction, the train continued north on the Boston and Maine Railroad until Whitefield, New Hampshire, where it was turned onto a short line to the resort community of Bretton Woods, New Hampshire. The passengers were then met by a long line of taxis waiting to carry them through the last mile of their journey to the Mount Washington Hotel.

The passengers on Loyd's train during that evening of 1944 were on their way to what is simply known as The Bretton Woods Conference. By the time two similar special trains carried the same group of delegates back to New York and Washington three weeks later, the Conference had completed what is still considered by many as the most enlightened and effective agreement for international cooperation. Even though he wrongly guessed who his passengers were, Loyd MacNayr was quite correct in assuming his train ride on 30 June had historical significance.

1.1 From War to Depression and Back to War

To grasp the importance of the Bretton Woods Conference, transport yourself back to 1 July 1944 for a moment. World War II was still raging. The Allied invasion of Normandy was just a few weeks old. There were the concentration camps, the millions of casualties on the Russian front, and the deadly naval battles in the Pacific between the US and Japan. Looking further back in time did not provide much comfort either. In the 1930s, the Great Depression had spread unemployment, hunger, misery, and a huge loss of prosperity throughout the world. The 1930s also saw the rise of fascism and militarism in Germany, Italy, Spain, and other countries, as well as millions of deaths under Joseph Stalin's brutal regime in the Soviet Union. And, before these disturbing events there was World War I, a war so devastating that it was described as “the war to end all wars”. The dismal economic and political events over the three decades before that last day of June 1944 clearly challenged the delegates of the Bretton Woods Conference to alter the course of history. The past 65 years of history suggests that they were successful.

1.1.1 The vision of the Bretton Woods delegates

The delegates of the Bretton Woods Conference shared a spirit of cooperation and a desire to design a new economic order that could avoid further wars and economic recessions. They knew that some international monetary and trade system had to be devised that would reverse the world's fall into poverty and conflict. Among the ideas being promoted by the United States — arguably the dominant nation at Bretton Woods given their leadership among the Allied countries fighting World War II — and their close ally Great Britain, was a system of pegged exchange rates to provide the exchange rate stability deemed necessary for the world to resume international trade. The proposed system of pegged rates was similar to a plan agreed by Britain, France, and the United States in 1937 in a belated effort to restore some of the international trade and investment flows that had been choked off in the 1930s by most countries’ restrictive international trade and financial policies. That 1937 plan did not have time to have the hoped-for effect on trade before the world began another world war. The idea of pegged exchange rates had been discussed by the delegates who rode on the train directly from the meeting of financial experts in Atlantic City.

At that meeting, leaders of the US and British delegations had debated, both formally and informally, the merits of different exchange rate systems and institutional arrangements that would be appropriate for the world following the end of the war. They had discussed an international central bank to provide reserves for countries and to defend the values of their currencies in the foreign exchange markets, and a development bank for funding the reconstruction of Europe and other countries devastated by the war. They also discussed establishing an international organization to promote the reduction of tariffs and other barriers to international trade. But there were still a number of potentially contentious issues to be decided. And, unlike the smaller meeting in Atlantic City, there were delegates from 45 Allied countries in Bretton Woods, including the exiled governments of France, the Netherlands, and several other countries still occupied by Germany or Japan. In order to maintain harmony among the countries that still had to work together to win World War II, the US hosts and the negotiators would have to carefully respect the national interests and pride of the different delegations.

Fortunately, unity of purpose prevailed in Bretton Woods. No doubt, the need to maintain unity among allies in the ongoing war helped to prevent dissention. At the same time, there was a strong desire among the delegates to avoid the mistakes made at the end of World War I, when the Paris Conference in effect planted seeds that grew into new conflicts, ultimately leading to a second world war. It was clear to many of the delegates that the attempt to restore the Gold Standard — the dominant international monetary system that had existed before the war — in the fragile post-World War I economic environment had caused substantial damage to many European economies. The rigid monetary policies mandated by the rules of the Gold Standard were also blamed for spreading the 1930 US recession quickly to other countries, thus creating the worldwide Great Depression. It was only too clear to many Bretton Woods delegates that opportunistic fascists such as Hitler in Germany and the militarists in Japan had exploited the poor economic conditions to consolidate power in their respective countries. According to Nobel laureate Robert Mundell:

Had the price of gold been raised in the late 1920s, or, alternatively, had central banks pursued policies of price stability instead of adhering to the gold standard, there would have been no Great Depression, no Nazi revolution, and no World War II.²

With a predominance of such sentiments, few delegates at the Bretton Woods Conference argued for a restoration of the Gold Standard.

The lead that the United States took in organizing the conference was also significant. After World War I, the US had displayed its isolationist tendencies by withdrawing from all international organizations created after the “war to end all wars”. Even though US President Woodrow Wilson was the major driving force in creating the League of Nations in 1919, US public opinion did not support his efforts, and the US Congress voted against joining the League of Nations. Between 1920 and 1932, Presidents Harding, Coolidge, and Hoover, in tandem with the Congress, further isolated the US from the global economy by raising tariff barriers to trade, reducing immigrant inflows, and blocking participation in other international organizations. The United States’ isolationist tendencies did not prevent the US economy from affecting the world economy, however. The US was the world's largest economy, and after the decline of Britain after World War I, the US had become a major source of international financing. It was the 1929 crash of the US stock exchanges that triggered the worldwide financial crisis that led to the Great Depression. It was not until after Franklin D. Roosevelt became President in 1933, that the US began actively seeking adjustments to the failing international monetary order and cooperating more closely with policymakers of other countries. However, this belated and very slow retreat from the rigid and isolationist US economic policies was not only too late to prevent the Great Depression, it was also too late to stop the world from separating into distinct economic camps. The economic disputes quickly became ideological disputes, and these soon became international political disputes. Another world war, this one even more destructive than the “war to end all wars”, eventually followed.

1.1.2 1 July 1944

When the delegates and their staff arrived at the Mount Washington Hotel in Bretton Woods on the night of 30 June 1944, the hotel had been reopened just for the occasion. Like most hotels, the Mount Washington had closed in 1942 when US entry into the war effectively shut down the tourism industry. Hotels and guest homes nearby were also pressed into service to house the delegates and their staff, some 700 people in all, plus reporters, secretarial staff, translators, and other support staff sent by the US government from Washington. The US Army's Military Police was assigned to perform various logistical tasks, and a large contingent of local Boy Scouts camped on the premises while serving as messengers, mail carriers, and cleaners during the conference. There were more than a few emotional arguments among the delegates and staff about who got to stay in the main hotel and who was assigned to other residences. The new manager of the Hotel was so overwhelmed by the task of handling the event that he resigned on the first day of the conference (rumor has it that he drank himself into a stupor and was dismissed).

Despite the logistical confusion, the conference got off to a quick start. Within hours of arriving, the American delegation met to determine their negotiating strategy. Trea...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Preface
• Contents
• Part I - Introduction to International Finance
• Part II - The Foreign Exchange Market
• Part III - Open-Economy Macroeconomics
• Part V - International Financial Issues
• index