Evolution of International Monetary System - Essay Example

?Evolution of International Monetary System support Mechanisms Introduction: After the world financial crisis, which had happened in the 1930s, policy-makers around the globe are developing constructive ideas to support economic recovery and are following a set of reforms to build a stronger financial system. However, there is a general feeling that this heavy agenda may not promise robust, workable, and balanced growth over the medium term. We must also consider the question of whether or not to reform the basic framework that underpins global commerce and economy: the international monetary system. International monetary system- meaning: “International monetary systems are sets of internationally agreed rules, conventions and supporting institutions that facilitate international trade, cross boarder investment and basically the reallocation of capital between different nations” (Gold, 1981). “Over the past century, different international monetary regimes have struggled to adjust to structural changes, including the integration of emerging economies into the global economy. In all cases, systemic countries failed to adapt domestic policies in a manner consistent with the monetary system of the day. As a result, adjustment was delayed, vulnerabilities grew, and the reckoning, when it came, was disruptive for all” (Check Against Delivery, 2009). The Evolution of the International Monetary System: Classical Gold Standard (from 1870 to 1914): Under the Classical Gold Standard, the international monetary system was largely decentralized and market-based. There was nominal institutional support, apart from the joint obligation of the major economies to maintain the gold price of their currencies. “Although the modification to external imbalances should, in theory, have been relatively smooth, in practice it was not problem-free” (Carney, 2009). Surplus countries did not always act according to the agreements of the system and tried to upset the adjustment process by purifying gold inflows. At the same time deficit countries found the regulation even more unfavorable because of the plunging wages and price stickiness. The gold standard did not survive until the First World War was over (The Spectator, 2010). Extensive inflation caused by money-financed war expenditures and major shifts in the composition of global economic power destabilized the pre-war gold parities. Moreover, there was no mechanism to consolidate an orderly return to inflation-adjusted exchange rates. “When countries, such as the United Kingdom in 1925, tried to return to the gold standard at overvalued parities, they were forced to endure painful deflation of wages and prices in order to restore competitiveness” (Check against Delivery, 2009). “During the Great Depression, the united states stay with strict norms of the gold-exchange standard, but gradually could not use monetary policy to offset the economic contraction” (Eichengreen & Franklin, 1992). Bretton Woods: In the 1940s, British and American policy makers decided to work jointly to design a new post war international monetary system, which would combine the benefits of a liberal international system along with the freedom for government to pursue domestic policies aimed at promoting social well being and employment to all. “The principal architects of the new system, John Maynard Keynes and Harry Dexter White, created a plan which was endorsed by the 42 countries attending the 1944 Bretton Woods conference. The plan involved nations agreeing to a system of fixed but adjustable exchange rates where the currencies were pegged against the dollar, with the dollar itself convertible into gold. So in effect this was gold – dollar exchange standard” (International Monetary Systems, 2010). The main feature of Bretton Woods’s system was: Simplicity and adjustability to the rates as well as the exchange rates was a real reflection of the instability of inter-war period. “It was more administered than market-based; also exchange rates adjustment was coordinated through the International Monetary Fund (IMF)” (Laurence, 2009, P.10-35). Even though there were considerable changes in the institutional level, surplus countries still resisted adjustment. In contrast, the zero bound on reserves remained a limitation for deficit countries, which eventually ran out as time went by. (Edward, 1960). “The Bretton Woods system finally collapsed in the early 1970s after U.S. policy became very expansionary, its trade deficit unsustainable, and the loosening of capital controls began to put pressure on fixed exchange rates. Once again, all countries suffered from the aftershocks” (Brettton Woods Systems, n.d). Hybrid System: “After the break down of the Bretton Woods system, all the countries think on an alternative model, called it as Hybrid Model” (Bordo, 1992).Under this model, countries have floated their exchange rates, made their currencies easily convertible and facilitated capital inflows. “Even though, this monetary policy was useful in many respects, many countries frustrated with the real exchange rates adjustments” (Bergsten, 2009). The main reason for this trend was that these countries had started accumulating enormous reserves and sterilizing the inflows. It was found that reserves had multiplied in number during the 9 years, for all the countries listed below. China is leading with reserves of 2454 Billion US Dollars and as a percentage of GDP, these reserves represent 49%. Table.1 International Reserves of Selected Countries   Reserves (US$ Billions) Reserves/GDP (%) Reserves/ Monthly Imports     2000 2009 2000 2009 China 2454.2 14.1 49.4 8.1 26.1 Russia 461.2 10.8 35.7 5.5 20.8 South Corea 274.2 18 32.4 6 8.2 India 273.8 8.7 22.2 6.6 10.2 Brazil 257.3 5.1 15.2 5.5 16.4 Switzerland 255.5 21.4 27.3 6 7.1 Thailand 146.8 26.6 52.5 5.5 10.6 Malaysia 94.8 30.5 50.5 3.6 8 Canada 55.4 4.5 4.1 1.4 1.6 (International reserves of selected countries, n.d). “The current account deficit in the US in the year 2001 led to the larger imbalances in the monetary system again” (Gavin, et al, 2010). The larger savings rate in other countries deepened this reserve phenomena and it led to massive capital inflows and low long-term interest rates. So, here, International Monetary System failed to implement the action needed to address this issue. The Evolution of the European Monetary Union: In 1979, the European Council approved the European Monetary System, which engaged an exchange rate mechanism (ERM) to inspire participating countries to keep the variations of their currency exchange rates within a satisfactory level. The established limits of the ERM were derived from the European Currency Unit. In 1988, Jacques Delors, the president of the European Commission led a committee, which suggested a proposal to extend full economic union, with the setting up of a European Central Bank and a single currency system that would substitute any present national currencies. The idea was to get monetary policies of the contributing countries that would conclude full union in the EMU. Strategies for the EMU were basically according to the requirements within the Maastricht Treaty, which originated the European Union. The Maastricht Treaty was contracted in 1992, and afterwards approved by all member states. Certain countries accepted the treaty through public vote, while other countries adopted the system of legislative vote. The Treaty implements the conditions, which all member states in the European Union must accept before they can join the EMU. These circumstances for EMU membership were considered essential because when the member states link the EMU, the national economic emergencies of one member state will disturb all of the other member states. To partake in the preliminary foundation of the EMU, each associate state had to meet the following five convergence criteria by the year 1998: “(1) The national legislation governing the country's financial system had to be compatible with the treaty provisions controlling the European System of Central Banks; (2) the country had to achieve a rate of inflation within 1.5% of the rates in the three participating countries with the lowest rates; (3) the country had to reduce its government deficits to below 3% of its gross national product; (4) the country had to keep its currency exchange rates with the limits defined by the ERM for at least two years; and (5) the country had to keep its interest rates within 2% of the rates in the three participating countries with the lowest rates” (Stauffer, 2011). Apprehensions about the EMU center around harm to national authority and each separate state. Some panic that the contributing states may not be able to prevent national economic crisis without the capability to lessen its national currency, and stimulate exports on this. Others worry that the contributing European states will be imposed to give tax breaks to cope with each other and that companies may have to lower salaries for their employees and to lower prices of goods that they produce. Like this, the EMU varies from the United States, which has both a single federal monetary policy and a centralized tax system. Critical measures to address the Imbalances in the global economy: First measure to be taken is that countries need to reduce the demand for reserves. As an alternative idea, a centralized reserve mechanism should be implemented under the management of IMF. US has an advantage of lower financing cost as the transactions are done in US dollars. So on the supply side, several alternative assets should be implemented. Therefore, the currency advantage would be shared if there were any competing currencies. Effective use of Special Drawing Rights (SDR): The SDR is neither a currency nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Using SDRs would give fairness in the exchange rates as no country could exploit the advantage of the reserve currency status. (Special Drawing Rights (SDRs), 2010). Conclusion: The crisis happened dut to the ignorance of challenges raised by previous international monetary systems. We have discussed mainly three monetary systems: the Classical Gold that it is that the adjustment mechanism system is not to be considered as a mechanism to the management of reserve assets. One of the effective approaches would be the centralized reserve mechanism. The implementations of this mechanism with IMF and the greater use of SDRs might be best suited to make possible a shift from the current hybrid system to an international monetary system, which supports more flexible exchange rates for all countries. Now after the implementation, this would be a balanced system, however, in the end, all nations would suffer when the system breaks down and the negative consequences that affect the global economy may take years to be removed and recovering the old economy would be an impossible task. All developing as well as developed economies, should accept their responsibilities for the open, strong and effective management of International Monetary System. Main function would be the timely recognition of any negative effects regarding a particular monetary decision on global economies and financial systems, as well as working to mitigate those before it amplifies adverse dynamics. So countries adopting a new policy should make sure that they submit it for peer review internally and then have the IMF do an external review. So a globalized economy with market-based exchange rates and effective utilization of reserves will lead to proper and harmonious external balance over time. Reference List Bergsten, F. 2009. The Dollar and Deficits: How Washington can prevent the Next Crisis. Foreign Affairs 88 (6) November/December 2009. Brettton Woods Systems, n.d. Routledge Encyclopedia of International Political Economy. Available at: www.polsci.ucsb.edu/faculty/cohen/?inpress/bretton.html [Accessed 30 April 2011]. Bordo, M. 1992. The Bretton Woods International Monetary System: A Historical Overview, in A Retrospective of the Bretton Woods System.chicago: University of Chicago Press, 3rd edition, P. 232-239 Carney, M. 2009. Mark Carney: The evolution of the international monetary system. [Online] Bank for International Settlements. Available at: www.bis.org/review/r091123c.pdf[Accessed 15 March 2011]. Check against Delivery, 2009. [Online] Bank of Canada. Available at: http://bankofcanada.ca/en/speeches/2009/sp191109.html [Accessed 15 March 2011]. Edward, R. 1960. Gold and the Dollar Crisis. New Haven: Yale University Press, P. 211-213 Eichengreen, & Franklin, B., 1992. Golden Fetters: The Gold Standard and the Great Depression, New York: Oxford University Press, P.115-135 Gavin, F. J, et al., 2010. The Politics of International Monetary Relations, The University of North Carolina Press (2003), 3rd edition, P. 265 Gold, J., 1981. Legal and Institutional Aspects of the International Monetary System: Selected Essays, Volume 1. [Online] International Monetary Fund. Available at: http://books.google.co.in/books?id=eT1alAdTxKUC&pg=RA1-PA238&dq=International+monetary+systems+meaning&hl=en&ei=xE16TcbEFcWHrAfj-Yi0BQ&sa=X&oi=book_result&ct=result&resnum=1&ved=0CDwQ6AEwAA#v=onepage&q=International%20monetary%20systems%20meaning&f=false[Accessed 15 March 2011]. International reserves of selected countries, n.d. [Online] National statistic agencies. Available at: http://www.bank-banque-canada.ca/en/speeches/2010/carney100910_table1.pdf [Accessed 30 April 2011]. International Monetary Systems, 2010. [Online] Management Paradise. Available at: http://www.managementparadise.com/forums/financial-management-fm/205154-international-monetary-systems.html [Accessed 30 April 2011]. Laurence C, 2009. Exchange Rates and International Finance (4th ed.). Prentice Hall. P. 10–40  Special Drawing Rights (SDRs), 2010. [Online] International Monitory Fund. Available at http://www.imf.org/external/np/exr/facts/sdr.htm: [Accessed 30 April 2011]. Stauffer, A., 2011. What is the European Monetary Union?. [Online] UIOWA. Available at: http://www.uiowa.edu/ifdebook/faq/faq_docs/EMU.shtml [Accessed 30 April 2011]. The Spectator, 2010. [Online] Business Spectator. Available at: http://www.businessspectator.com.au/bs.nsf/Article/Why-Bretton-Wood-II-will-flop-L9VEK?OpenDocument&src=sph12 [Accessed 30 April 2011]. Read More