International Monetary System

International Monetary System

The international monetary system consists of

Exchange rate arrangements;

Capital flows; and

A collection of institutions, rules, and conventions that govern its operation.

Domestic monetary policy frameworks dovetail, and are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the efficient allocation of resources, increased specialization in production based on comparative advantage, and the diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates to shifts in trade and capital flows.

To be effective, the international monetary system must deliver both sufficient nominal stability in exchange rates and domestic prices, and timely adjustment to shocks and structural changes. Attaining this balance can be very difficult. Changes in the geographic distribution of economic and political power, the global integration of goods and asset markets, wars, and inconsistent monetary and fiscal policies all have the potential to undermine a monetary system. Past systems could not incent systemic countries to adjust policies in a timely manner. The question is whether the current shock of integrating one-third of humanity into the global economy – positive as it is – will overwhelm the adjustment mechanisms of the current system.

There are reasons for concern. China’s integration into the global economy alone represents a much bigger shock to the system than the emergence of the United States at the turn of the last century. China’s share of global GDP has increased faster and its economy is much more open.1 As well, unlike the situation when the United States was on the gold standard with all the other major countries, China’s managed exchange rate regime today is distinct from the market-based floating rates of other major economies. History shows that systems dominated by fixed or pegged exchange rates seldom cope well with major structural shocks.

This failure is the result of two pervasive problems: an asymmetric adjustment process and the downward rigidity of nominal prices and wages. In the short run, it is generally much less costly, economically as well as politically, for countries with a balance of payments surplus to run persistent surpluses and accumulate reserves than it is for deficit countries to sustain deficits. This is because the only limit on reserve accumulation is its ultimate impact on domestic prices. Depending on the openness of the financial system and the degree of sterilization, this can be delayed for a very long time.2 In contrast, deficit countries must either deflate or run down reserves.

Flexible exchange rates prevent many of these problems by providing less costly and more symmetric adjustment. Relative wages and prices can adjust quickly to shocks through nominal exchange rate movements in order to restore external balance. When the exchange rate floats and there is a liquid foreign exchange market, reserve holdings are seldom required.3 Most fundamentally, floating exchange rates overcome the seemingly innate tendency of countries to delay adjustment.

Bimetallism

In economics, bimetallism is a monetary standard in which the value of the monetary unit is defined as equivalent both to a certain quantity of gold and to a certain quantity of silver; such a system establishes a fixed rate of exchange between the two metals. The defining characteristics of bimetallism are

Both gold and silver money are legal tender in unlimited amounts.

The government will convert both gold and silver into legal tender coins at a fixed rate for individuals in unlimited quantities. This is called free coinage because the quantity is unlimited, even if a fee is charged.

The combination of these conditions distinguish bimetallism from a limping standard, where both gold and silver are legal tender but only one is freely coined (example: France, Germany, or the United States after 1873), or trade money where both metals are freely coined but only one is legal tender and the other is trade money (example: most of the coinage of western Europe from the 1200s to 1700s.) Economists also distinguish legal bimetallism, where the law guarantees these conditions, and de-facto bimetallism where both gold and silver coins actually circulate at a fixed rate.

The Gold Standard

In today’s national economies and the current international monetary system, fiat currencies are the norm. With no backing other than the full faith and credit of the govern-ments that issue them, the evolution of today’s money began with the introduction and ac-ceptance of paper money in the seventeenth century in the form of receipts for deposits of gold in the Bank of Amsterdam. The growing role of the state and its ability to tax and impose tariffs to provide metallic backing made it possible to instill confidence in issues of bank notes convertible into gold and silver and paper currencies spread across Europe as a more convenient vehicle for payments than coins. Bank notes thus became the standard currency for transactions within national economies in the eighteenth and nineteenth centuries.

The Gold Exchange Standard

Towards the end of the 19th century, some of the remaining silver standard countries began to peg their silver coin units to the gold standards of the United Kingdom or the USA. In 1898, British India pegged the silver rupee to the pound sterling at a fixed rate of 1s 4d, while in 1906, the Straits Settlements adopted a gold exchange standard against the pound sterling with the silver Straits dollar being fixed at 2s 4d.

Around the start of the 20th century, the Philippines pegged the silver peso/dollar to the U.S. dollar at 50 cents. This move was assisted by the passage of the Philippines Coinage Act by the United States Congress (March 3, 1903). A similar pegging at 50 cents occurred at around the same time with the silver peso of Mexico and the silver yen of Japan. When Siam adopted a gold exchange standard in 1908, this left only China and Hong Kong on the silver standard.

When adopting the gold standard, many European nations changed the name of their currency from Daler (Sweden and Denmark) or Gulden (Austria-Hungary) to Crown, since the former names were traditionally associated with silver coins and the latter with gold coins.

It is probable that the success of the gold standard also depended on a parallel development that emerged out of the mechanisms the industrializing countries used to ‘manage’ the gold standard—the development of the gold exchange standard. This monetary system differs from the gold standard in that international reserves consist of both gold and convertible currencies so that the system can function with less gold.

Another difference is that, because those convertible currencies tend to be invested in interest-bearing financial assets, the gold exchange standard includes a mechanism that allows for growth in world reserves independent of increases in gold production. The use of a mixture of foreign exchange assets and gold as components of reserve holdings was not just a post-World War I phenomenon. The Scandinavian countries had entered into agreements to use one another’s currencies as early as 1885. By 1913, some 15 central banks held about 12% of their reserves in the form of foreign exchange assets

The mechanisms for settlement of foreign exchange holdings evolved throughout Europe with the development of financial markets and central banks. A government (treasury or central bank) bought and sold foreign exchange in transactions with its own private sector, becoming the creditor by drawing down or building up its own holdings of foreign exchange. This permitted the development of a larger role for the public sector in controlling international payments as these transactions replaced the earlier and less efficient transfers of gold reserves to net out holdings of bills of exchange between private banks in different countries.