Globalization and Stability: From Bretton Woods to the European Monetary System - Coursework Example

Globalization and Stability Introduction The end of World War II ushered in a new era characterized by increased international trade as world economies sought for external markets for a range of products. Prior to this period, particularly during the inter war period, countries had either favoured isolationist policies or dealing with a small clique of countries considered as friends. Therefore, the new approach to trade provided a basis for the rapid growth of international trade that also enjoyed a historical consistency for the period between the 1950s and 1960s. High volumes of merchandise exports as especially recorded for the countries outside the communist control with statistics indicating a rise from 53 billion US dollars to 112.3 billion US dollars from 1948 and 1960 (Kenwood and Lougheed, 1992). The exponential growth in world trade made it necessary that countries device exchange rate programs that respond to the financial needs of countries involved. The fore going essay presents an evaluation of the circumstances around the introduction of Bretton Woods system to determine whether it was doomed o failed or was an effective monetary union that created stability in international trade. The essay also includes the evaluation of European monetary system to determine its effectiveness as the successor of Bretton Woods system. Bretton Woods System One of the foremost attempts to align global financial systems was the introduction of the Bretton wood system, which was an initial monetary arrangement set to coalesce exchange rate stability of the classical gold standard with the advantage of floating rates found in ability to undertake national full employment policies. Therefore, the Bretton Woods System provided an essential monetary management policy for major industrial countries to make exchange easy due to the established standards. Given that the countries were just emerging from the Second World War, the monetary union was a significant attempt in returning the world into cooperation following the devastation of the war. Under the policies determined by the Bretton Woods System, the United States dollar played a significant role in international trade (Bordo, 1993). The function of the dollar included; functioning as the only currency that could be converted into gold on demand, acting as the reference point for other currencies and a global leader in transaction, intervention and reserve currency. This arrangement was important for the period as it ensured creation of stability in international trade due to a well-recognized mechanism for importing or importing goods and services before its application ended in August 1971 when the United States ended its support to the convertibility of its dollar s into gold (Elson, 2011). Evidence in support of the success of Bretton Woods System is an area that needs a re-evaluation due to a lack of conventional explanation for the rapid increase in international trade during the 1950’s and 1960s. A study of volume of international trade during this period indicates over 70% of all exports were from countries controlling developed economies with the countries also representing the nucleus of the Bretton Woods System implementation (Ashworth, 1987). Additionally, the golden period for the implementation of the Bretton Woods System, particularly the 1960s, coincided with rapid growth of international trade. Therefore, considering the world economy enjoyed export success during a time that also saw widespread application of the Bretton Woods System by most developed countries, the contribution of the system to this success should not be overlooked. European Monetary System (EMS) The EMS framework for European cooperation was launched in 1979 and was to provide a roadmap that would eventually result in formation European economic and Monetary Union (EMU) set under the Werner Report (1970). Formation of EMS was a result of attempt since the end of Second World War by European countries to stabilize their currencies. Introduction of EMS was also a response to the failure of Bretton Woods System that had been introduced to implement a system of fixed exchange rates. After the fall of Bretton Woods System, the United States reverted to floating exchange rates policy but European countries did not favour this move resulting in decision to have EMS as the new system for maintenance of the principle of stable exchange rates. Under the principles of EMS, member countries were to operate within the predetermined exchange rate mechanism that ensured all countries kept their exchange rates within bands. Countries were not allowed to let their exchange rates fluctuate beyond 2.25 percent from a specific central point. Operating under this framework was essential in creating stability, as members were not worried about sudden changes in currency value (Artis and Nixson, 2001; Cobham and Zis, 1999). Although largely successful, EMS also faced its share of challenges as firstly due to the required technicalities and secondly due to different levels of commitment demonstrated by different member countries, functionality of the EMS was dependent on countries agreeing on the correct rate of exchange. Additionally, member countries such as Britain were perceived as being less committed to implementation of the policies. Britain was initially reluctant to join EMS but become member in 1990 but had to leave again in 1992 due to inability to remain within the predetermined exchange rate limits (Cobham and Zis, 1999; Fratianni, von Hagen and Waller, 1992). The EMS framework provided ground for the formation of European Currency Unit (ECU) that was a reference point acting as a unit of account although not a real currency. The idea of ECU laid groundwork for development of the idea of a single currency achieved in 1999 when member states launched the Euro. Following a number of setbacks in the implementation of the EMS monetary union, of researchers started arguing for European integration based on the belief that an effective internal market created based on the Single European Act needed exchange stability. This stability was essential for member countries to enjoy efficiency and transaction cost savings with the most viable solution being pooling members’ monetary policies in a monetary union (Cobham and Zis, 1999; Fratianni, von Hagen and Waller, 1992). Consequently, the quest for a single market was linked to the establishment of EMU. While the linkage between internal markets and the process of monetary union were provided a clear argument in favour of moving from EMS to EMU, there were still some researchers who favoured the notion of currency competition (Hayek, 1979; Hayek, 1970). The British government also supported currency competition as seen in the 1990 Treasury proposal seeking the establishment of a thirteenth competitive European currency. Britain believed there was a possibility of success in establishing a hard ECU that will be managed by a newly instituted special monetary fund (HM Treasury, 1990). Hayek (1976) also supports a currency competition in what the author based on his argument that monetary union required an international monetary authority. According to Hayek (1976), having a monetary union had a negative impact on the monetary policies of concerned countries as these international authorities faced low levels of trust compared to national authority making it neither practicable nor even desirable. Padoa-Schioppa (1988) argues in support of the EMS noting specific areas that had achieved positive results since introduction of the system. The author notes the fall in inflation between the year 1980 and 1986 with the figure moving from 11% to 2% for the period. Additionally, the author notes changes in inflation rates with the differences between countries experiencing high inflation rate and that with low inflation rate reducing from sixteen to six percent. Although the period coinciding implementation of EMS also saw increased unemployment, Padoa-Schioppa (1988), members have no experienced increased protectionist pressure that characterized global relationships as world economies attempted to increased economic participation of citizens. According to Padoa-Schioppa (1988), the success of EMS can be attributed to the period of consolidation, which resulted in establishing essential practices, and interpretations required supplementing the written rules and regulations governing conduct by member countries. Three features are identified as being central to the achievements made by the EMS monetary union. Firstly, there were adequate provisions to allow combination of rules and discretions about the functioning of the system. Rules surround adherence to the predetermined margins between realignment while discretion relates to the period and the extent to which particular countries are willing to exercise the realignment process. Secondly, Padoa-Schioppa (1988) notes the existing exchange rates between European countries under the EMS monetary system are because of collective contribution between members. Countries no longer had the unilateral power to change exchange rate, as it was a function of the whole group. This function within EMS monetary system reflects a step ahead from the Bretton Woods system, which did not achieve a collective determination of exchange rates. Thirdly, Padoa-Schioppa (1988), points out the ease with which other policies could interact positively with the EMS as representing an important step leading to success of the monetary system. While assessing EMS’s credibility and support from member states, Talani (2000) introduces three levels of analysis comprising the political economy analysis, purely economic analysis and purely political analysis. These levels of analysis inform the reasons for support or opposition to the provisions of a monetary union. For instance, the author uses Britain and Italy to explain the two countries’ commitment to the policies contained in European Exchange Rate Mechanism (ERM). The Italian had begun to question the effectiveness of the policies due to crisis experienced by ERM, however, this uncertainty was only experienced at the level of pure economic analysis as the Italy still indicated its commitment to the achievement of objectives under EMU. The decision by Italy to support EMU is contrasted by events in Britain where despite the British government voicing apprehension about the effectiveness of the monetary system, the country still entered the ERM meaning the decision was against a structural interest of leading factions (Talani, 2012). According to the analysis provided by Talani (2000), these levels of analysis do not represent static realities as there are grounds for various changes that affect expressed commitment to a monetary policy. At the level of political economy analysis, the author notes changes might be long-term as they are accompanied by significant changes in the structure of power. Italy is an example of this change where the country experienced transformations resulting from waning powers of trade unions while industrial organizations and banking institution enjoyed increased strengthened power after mid-1980. Support for monetary system also deferred depending on the interests of the socio-economic groups at particular time and the reality in specific countries. For instance by 1979, British economic sector did not favour entry of the country into EMS union, a situation which changed from mid 1980s when the confederation of British Industry started lobbying for the country’s entry into the ERM. The British Trade Unions also indicated wider support of the British entry into the monetary union by late 1980s with the Italian General Confederation of Labour, which had been avid resistant to integration of European integration also reversing its stance and supported EMU (Talani, 2000). Why Bretton Woods System was Doomed to Fail For a clear understanding of the contributions of Bretton Woods System, three criteria overall credibility, current account convertibility and exchange rate stability that must be met by effective currency union are discussed. Current Account Convertibility Existing current account limitations negatively affected bilateral trade in the early years although the restrictions eased as countries adopted improved measures for flexible international trade. In this case, evaluation of functionality of Bretton Woods system has been divided into two historical periods of pre-convertible era experienced between 1946 to 1958 and the convertible era covered from 1959 to 1970 (Bordo, 1993). Removal of restrictions on bilateral trade had significant impact on the design of the Bretton Woods system as it introduced a period of open multilateral trade that drove success of merchandise export during the period. The success enjoyed in international was a clear evidence of the disadvantages that global systems had endured before the change. According to Krugman and Obstfeld (2000) inconvertible currencies was a major impediment to international trade with the author citing an example of business between the French and Germans where citizens from France are not willing to conduct business with their Germany counterparts due to the inconvertible marks, were only usable subject to restrictions imposed by the German government. This situation was compounded by lack of market for inconvertible francs meaning it was impossible for a German get the French currency and use as payment for French goods. Therefore, the situation meant only exchange of goods for goods could be conducted under barter trade arrangement. The International Monetary Fund played an important role in enhancing currency convertibility through the provisions in Article VIII present in Articles of Agreement. Under the agreement, countries taking part in international trade were prohibited from imposing restrictions on current account payments or development of discriminatory currency regulations after five years, which was set as a transition period under Article XIV. While restrictions were eliminated from the current account payments, countries were still encouraged to limit capital account transactions. This was because during this early period, the IMF was mainly concerned with the establishment of mechanisms for rapid re-establishment of current account convertibility. North American countries seemed to have immediate response to the new arrangement with the U.S. and Canadian dollars achieving full convertibility by 1945. However, European countries seemed to be reacting to the changes slowly as the region faced challenges in convertibility attempts due to low levels of production for export products. Europe was yet to emerge from extensive damages to infrastructure and physical capital experienced during the war period. Low production of capital goods, foodstuff and other important merchandise meant the continent increasingly relied on importation of these products to satisfy domestic demand. Given the high volume of important compared to exports, European countries faced major trade deficits that rose from 5.8 billion US dollars in 1946 to 7.5 billion US dollars by 1947 (Eichengreen, 1996). These deficits implied the post war era Europe experienced a chronic shortage of dollar currency. Internal politics did not favour effort on convertibility of major currencies, as politicians were majorly concerned with establishing internal stability. Import restriction was therefore one of the important measures adopted by most European countries seeking to improve their trade balance. Supporters of the Bretton Woods System were hopeful that the IMF had the capacity to deal with these challenges particularly since the problem was mainly seen as resulting from lack of effective coordination among the countries. This was not the case, as meetings under the GATT framework did not result in meaningful solutions given the Europeans unwillingness to offer concessions. The result of this failure was slow pace in full implementation of convertibility envisioned under the Bretton Woods System as instead of the projected five years, it took about ten years. Among the subsequent attempts to restore full convertibility necessary for success of the Bretton Woods System was the Marshall Plan, which introduced a number of steps to reverse the problem of dollar shortage. Under the Marshall Plan, Western European countries received up to 13 billion US dollars between 1948 and 1952 as reconstruction aid (Eichengreen, 1996). The funds were to play a significant role in financing the dollar deficit problem at a period when the European countries were to undertake maximum reconstruction in preparation for convertibility. The targeted European countries demonstrated positive results especially with members of Organization for European Economic Cooperation (OEEC) reporting a 39% rise in industrial production by the year 1952. Further OEEC countries doubled their exports while also reporting a 33% rise in imports and current account surplus for the same period (Solomon, 1976). Consequently, support from the Marshall Plan had significant impact on the European economy as it contributed to stable increase in growth rates by targeting improvement of productivity and confidence from investor (Eichengreen and Uzan, 1991). To respond to conditions within Europe, the European countries continued with restrictions on current account exchange until 1950 when the European Payments Union (EPU) was established to govern bilateral trade. Although the EPU was established to improve convertibility, it impact was not fully experienced in a global scale as envisioned by the architects of Bretton Woods System primarily because it narrowed scope to European countries. However, there was long-term effect as it contributed to enhancement of the intra-Europe trade as, which was an important objective for establishing the Bretton Woods system its quest for full convertibility. EPU proved effectiveness in elimination of currency restriction as European countries initiated increased their trade with the rest of the world as European countries enhance their balance of payment. This development led to elimination of distribution imbalances as the United States also experienced occasional current account deficits while the European countries displayed their willingness to restore full convertibility on 27 December 1958 (Elson, 2011). Consequently, the study of the performance of Bretton Woods system should be pegged on the understanding of other interventions in global monetary system. On its own, 1950s Bretton Woods System did not have the necessary policies needed to improve open bilateral trade. Part of the reason for this failure was because full convertibility was only possible under condition that the dollar shortage is solved while also drastically improving the intra-Europe trade. Marshall Plan aid was also another important factor in discussing the success of Bretton Woods System as it played an important role in alleviating the European economic challenges caused by dollar shortage in the post war era. Additionally, the EPU significantly led to improvement of conditions caused by European exchange control therefore, limiting the role of Bretton Woods institutions in restoring convertibility and rehabilitation of trade. Success of the Bretton Wood System was only possible after 1958 when convertibility had been achieved (Eichengreen, 1996). Exchange Rate Volatility The success of the Bretton Woods System can also be assessed based on its effectiveness based on the argument that effective currency unions must also provide a stable basis for conducting international trade. Available statistics indicates exchange rate volatility as having a negative impact on the level of trade conducted between selected countries (Rose, 2000). Based on this assumption, successful lowering of the exchange rate volatility would indicate a success of the Bretton Woods System. Implementation of the Bretton Woods system did not focus on full elimination of exchange rate volatility as the main role of the system was to enhance the monetary systems in order to prevent the similar problems as what was experienced in the interwar period while using the floating exchange rates. However, the system was to accomplish this while maintaining necessary flexibility needed to reverse potential disequilibrium. Initial studies of the role played by Bretton Woods System indicated a positive contribution towards elimination of exchange rate volatility. However, more recent studies such as one conducted by Reinhart and Rogoff (2002) have sought to indicate the ineffectiveness of the system. Based on comparisons of figures generated from IMF statistics on exchange rate against figures acquired from analysis of market conditions from 1946 to 1998, the researchers note a systematic widening of the gap between the two bases of comparison. Disparities in data indicating the exchange rate for the period is attributed to the fact that most countries undertook monetary policies that were deflationary therefore making it possible to cushion the official exchange rate from indicating depreciations in parallel markets. Therefore, following the market conditions was likely to indicate a widened difference since many countries depended on capital controls or dual exchange rate markets after the Second World War. As a result of the more current data based on exchange rate determined by market conditions, there are enough evidence to indicate that the Breton Woods System was in fact highly volatile although realignment in the official rates led to masking of evidence of the discrepancies. Credibility of the Bretton Woods System Credible While current account convertibility and exchange rate volatility are important measures of success for a system of monetary union, the level of support it receives from the implementing countries is lends credibility to the system. When countries offer credibility to the system, its actual volatility and ease of exchange rate convertibility becomes secondary factors. Therefore, the level of credibility achieved by Bretton Woods System is an important indicator of the success it achieved during the process of its implementation. Based on this fact, the credibility of Bretton Woods system was greatly undermined by its design to depend on the US dollar and American gold reserves. The dollar suffered increased lack of confidence demonstrated by international trade during the 1960s, resulting in major difficulty for the Bretton Woods System. According the propositions made by Triffin (1960) the world trade would experience a period of insufficient monetary gold stock from early 1960s leading to the American monetary gold stock reducing compared to the country’s liabilities. The researcher used this analysis to provide his evaluation of the Bretton Woods System where he noted the potential pressure imposed on the American monetary gold stock would increase leading to increased preference of the dollar instead of gold. This condition would create the necessary ground for confidence crisis capable of eroding credibility of the system. The signs were already clear during this early period particularly since the united states foreign monetary liabilities had exceeded the country’s gold reserves for the first time in 1960 (Eichengreen, 1996). Among the programs that developed to respond to the increased reality of liquidity problem in the United States is the Special Drawing Rights (SDR), which represents an artificial reserve asset. Ultimately, the SDR framework was not implemented as by 1970 when it was allocated a solution had been established based on constant United States payments deficits that resulted in inflation of the volume of international reserves. However, given the circumstance under which persistent United States balance of payments deficits occurred it exemplified the problems of the Bretton Woods system, which was exposed as lacking mechanisms for initiating effective adjustments. The United States administration reacted to these conditions by introducing measures such as introduction of Interest Equalization Tax, which increased restrictions on United States residents wishing to invest abroad. This decision was based on the long held belief by senior administrators (The Kennedy and Johnson administrations) that capital exports were responsible for the widened balance of payments deficit. Following the introduction of current account convertibility, the United States administration faced an impossible task in attempting to enforce capital controls (Eckes, 2011). A number of researchers have attempted to investigate extent of credibility enjoyed by Bretton Woods System. A study by Obstfeld (1993) sought to evaluate the effect of capital controls from 1960 to 1971, a period coinciding with increased application of the Bretton Woods system. According to the researcher, the problems faced by deficit countries in their attempts to deal with liquidity crises was worsened by the defective capital mobility experienced during the period of Bretton Woods system. The weaknesses of the Bretton Woods System was apparent by the end of the 1960s as evidence indicated capital controls negative impact on interest rate differentials. Capital control failed to eliminate problems associated with flow out of capital while also giving countries temporary autonomy for control of internal policy but did not introduce effective adjustment mechanism. Conclusion From the foregoing, the Bretton Woods System was an important monetary union that enhanced the stability of international trade in a period when major economies especially in Europe were still grappling with the devastating effects of the Second World War. Analysis of current account convertibility, volatility of the exchange rate system and credibility of Bretton Woods System indicates there were two periods that had significant impact on the functioning of the system. While there was exponential growth in international trade during the 1950s and 1960s, a period that was also characterized by increased emphasis on the policies of Breton Woods System, this were not as a result of applying the monetary union. The failure of Bretton Woods System was evident in the attempts to introduce current account convertibility in Europe as it resulted in exchange rate volatility and a reduced credibility. Additionally, elimination of impediments to convertibility cannot be attributed to the monetary system, as the responsible institutions were independent from the Bretton Woods System. 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