Critical Importance of Understanding Global Financial Architecture – part IIFirst part of lecture is available from: https://bit.do/azifa.

1 SUMMARY OF THE FIRST LECTURE:

The first lecture discusses the Keynesian theory that the exact level of money in an economy is

critically important – too little leads to recessions, while too much leads to inflations.

Furthermore, domestic business cycles, and international financial crises are caused by pro-

cyclical behavior of current artificial systems of money creation and international trade. Standard

macro theories make it impossible to understand the economy because they assert that money is

neutral, and does not affect the real economy – exactly the opposite of the Keynesian idea that

the quantity of money is all important. Standard macro model currently in use throughout the

world have no explicit role of money, banks, and credit, even though these factors are of central

importance in understanding the world. Once we understand the vital role and function of money

within an economy, it becomes possible to understand historical events of the twentieth century –

whereas this is impossible using conventional macro theories. The first lecture summarizes how

the colonial system came into being, and the monetary arrangement for a hard currency at the

core and soft currencies in the periphery. This system of fiat currencies works fine within one

system of colonies, where the value of money is decreed by sovereign fiat. For trading between

different countries, the gold backed currencies were used. As European countries prospered by

exploiting resources throughout the globe within their colonies, inter-European trade increased.

The optimal quantity of money required for the domestic economy is not the same as that

required for stable international exchange rates. The pro-cyclical money creation which is

characteristic of the system creates cycles, and large cycles lead to crises on a routine basis.

World War I was partly caused by the breakdown of the colonial trading system due to the end of

expansion possibilities after the completion of the conquest of the globe. Efforts to restore the

gold standard after World War I failed. The second part of the lecture discusses the post World

War I history, with reference to the international financial architecture that emerged in the post-

Gold era after World War I.

2 HISTORY OF GOLD STANDARD

To pick a convenient (but arbitrary) date, we could say that the gold standard started in

1816, when Great Britain officially tied the pound sterling to a specific quantity of gold. After

two decades, in 1837, the U.S. followed suit, standardizing gold content of the dollar to match

international standards. As the global economy grew in importance, the US eliminated silver, and

went officially on a gold standard with fixed exchange rates around 1900. This put US in

harmony with international financial system to facilitate international trade. However, removal

of silver reduced the money stock and led to a recession in the US economy. In the early

nineteenth century colonial economic system, most trade was done within a colonial system. In

the late nineteenth and early twentieth century, with increasing globalization, the tensions

between domestic economy and international trade became increasingly apparent. While

booming economies required expanding money supplies, requirements of international trade

required fixed and stable reserves of gold to back the money. These tensions were among the

causes of the first World War.

Massive expenditures required by World War 1 forced both Great Britain and United

States to suspend exchangeability of currency for gold, thereby going off the gold standard.

WW1 ruined European economies, and depleted stocks of gold held by the governments. There

was a universal sentiment to try to go back to the pre-war prosperity, and massive efforts were

made to restore the gold standard as a key element of the pre-war global economy. These efforts

failed, and we will analyze the reasons for this failure in the second part of this lecture.

The Great Depression of 1929 led to massive and prolonged unemployment, in conflict

with dominant economic theories which state that the free market will automatically create full

employment. With a great effort, Keynes was able to escape the spell of these theories, and

create a new economics, which incorporated many deep insights about how the economy

functions. Unfortunately, mainstream economists failed to understand these insights, and reduced

Keynes to the simplistic idea that prices are fixed in the short run. See my articles on

Understanding Macro for further discussion and details. These two lectures are based on using

forgotten Keynesian insights about how money functions, to understand how the financial

system shaped the history of the twentieth century.

Post WW1, the conflict between needs of domestic economy, the gold standard, and the

international trade regime, became very severe. The ruined economies of Europe needed vast

investment, which could only be funded by deficit financing, and creation of money. However,

these measures were not compatible with maintaining a gold standard and fixed exchange rates.

Most countries choose austerity measures – starving the domestic economy to meet the needs of

international trade. However Germany went to the extreme in the opposite direction – it created

so much money that a hyper-inflation resulted, while making the Deutschemark worthless for

foreign trade. Although the USA had not suffered much damage from WW1, the US economy

was badly damaged by the Great Depression. The Post-Depression US President FDR banned

domestic use of gold, devalued the dollar, and moved to the gold-exchange standard (meaning

that only foreigners can cash dollars for gold, so gold is reserved for trade, not for domestic use

as currency). The gold-exchange standard permits for greater flexibility in domestic money

creation and deficits, without impacting adversely on stable exchange rates. See “The Impact of

Keynes” for a discussion of how Keynesian ideas influenced FDR to run deficits and use

expansionary monetary policy to counter the effects of the Great Depression in the USA. To

summarize, although a lot of efforts were made to restore the gold standard in the post WW1

period, these efforts failed, leading to the Bretton-Woods Agreement as a replacement measure.

3 THE BRETTON-WOODS AGREEMENT AND LONDON GOLD MARKET

As the efforts to re-establish the Gold Standard failed in the post-WW1 period, attention

turned to creating some alternative method of doing international trade, without gold standard.

This resulted in the Bretton-Woods Agreement in 1945, which established a gold exchange

standard and created two international organizations, International Monetary Fund (IMF) and

World Bank (WB). In the gold exchange standard, currencies were backed by gold at some

nominal values. However, only foreign Central Banks would be allowed to exchange currencies

for gold with the local central bank. In effect, gold would be used only for trade, and not for

domestic economy. In addition, the IMF was created to ensure the temporary trade imbalances

would not lead to disturbances in the stable fixed exchange rate system created by Bretton

Woods. It was suppose to monitor, and supply credits wherever necessary to ensure the stability

of the new financial architecture based on the gold exchange standard. Furthermore, it was

supposed to create SDR – special drawing rights – backed by a bundle of currencies, to ease

problems of shortage in international liquidity. The World Bank for Re-Construction and

Development had the mandate of helping to rebuild economies destroyed by the war, as well as

financing development projects on a global basis. The main characteristic of this set up was to

adopt a monetary policy by each economy, to maintain the exchange rate of domestic currency

within a fixed value (with a bound of 1 percent above or below in term of gold reserves of that

specific country).

Maintaining a gold exchange standard requires less backing than a full gold standard. The

US reduce gold backing of Federal Reserve Notes to 25.5 percent down from 40 percent earlier.

As a supplementary measure to support the gold exchange standard, the London gold market

which had been closed with the start of WW2, was reopened in 1954. The central banks of some

European countries (including Belgium, France, Italy, Netherland, Switzerland, West Germany

and United Kingdom) along with United States formed a London Gold Pool and agreed upon to

buy and sell gold at the rate of $35.0875 per ounce. The hope was that existence of an outside

option to buy gold at official rates would stabilize the gold exchange standard, creating

confidence, without necessarily requiring sales of large amounts of gold at the official price.

However, this hope could not be realized. Capitalistic trading systems are designed to

create cycles and crises, and one such led to a sudden raised demand for gold. When this proved

to be beyond the resources of the London Gold Pool, it was shut down. The governors of gold

pool announced that they will no longer buy and sell gold in the private market. Following this, a

dual pricing system emerged: (1) official transactions of gold between monetary authorities were

set at a fixed price level of $35 per fine troy ounce and (2) all other transactions were to be

conducted at a fluctuating price, determined by free-market forces. The U.S abolished the policy

of buying gold from and selling gold to the authorized dealers, to who license was provided by

US Treasury. Meanwhile, the gold backing of Federal Reserve Notes was eliminated. These

were all gradual moves towards liberating the dollar from the requirement of gold backing and

moving towards the dollar standard currently in existence.

3.1 THE NI XON SHOCK:The Vietnam War led to huge war expenses which were funded by printing dollars. A

threat by French President Charles De-Gaulle to ask for encashment of surplus dollars held by

France led the US president Nixon to announce that dollars would no longer be exchange for

gold. In August 1971, US terminated all buying and selling of gold and ended conversion of

foreign officially held dollars into gold. In December 1971, under the Smithsonian Agreement

signed up in Washington DC, the U.S. devalued the dollars by increasing the official dollar price

of gold to $38 per fine troy ounce. This effectively terminated the Bretton-Woods agreement,

and was labeled the Nixon Shock. Prior to the Nixon shock, the dollar was in use as a reserve

currency throughout the world, but with the understanding that dollars could be exchanged for

gold. After the Nixon shock, the unbacked dollar became the sole backing of currencies and a

reserve currency for the member states. This highly asymmetric system emerged by default;

many meetings to create a new post-Bretton Woods financial architecture were held, but failed to

reach any consensus. The default system is enormously favorable to the USA, as it replaces gold

by the dollar, and gives it an enormous amount of power. This may be the reason why all efforts

to arrive at a more symmetric and equitable financial system have been blocked by the USA.

3.2 FLOATING EXCHANGE RATE AND GOLD STANDARDS: Massive overprinting of dollars to finance war expense, and de-linking of dollar from

gold led to a decline of confidence in dollars, and a turn to gold. There has been a great deal of

volatility in exchange rates, and in the price of gold since the Nixon Gold Shock. Initially very

few people believed that freely floating exchange rates would be a viable mechanism for

international trade. There were many efforts to stabilize exchange rates using different types of

“crawling peg” systems, but these were abandoned as each had flaws. The world has learned to

live with floating exchange rates. However, the consequences of this dramatic change in the

system of world trade have not been fully understood. This is because economic theories are

seriously primitive and deficient in this areas. Up to now, we have reviewed the history of the

emergence of the financial architecture for international trade until the beginnings of the modern

system. Now I want to turn to the paper by Eichengreen, which analyzes this experience and

distils deeper lessons. This is the subject of part II of this lecture.

4 RAGNAR NURSKE AND THE INTERNATIONAL FINANCIAL ARCHITECTURE ( PART II OF THIS LECTURE)

Barry Eichengreen (2017), in his working paper, titled with "Ragnar Nurkse and the international

financial architecture" analyzes the lessons from book of Ragnar Nurske with the title of

“International Currency Experience: Lessons of the Interwar Period: Economic, Financial and

Transit Department”. There was a transition from the pre-WW1 gold standard which “worked”,

to the post-WW1 period, where the gold standard broke down. It is worth noting that the gold

standard worked by sacrificing needs of the domestic economy for the sake of stable exchange

rates. This was possible because the wealthy financiers benefited from the global trading system,

while the biggest losers from the domestic economy, the unemployed laborers, were large in

numbers and suffered heavily, but did not have political power. Why did gold standard break

down and what lessons can we derive from this experience? That is the central question being

addressed by Ragnar Nurske, who distills this into 12 lessons, listed and explained below.

4.1 PRE-1914 AND POST-1920: DECLINE OF CONFIDENCE IN CENTRAL BANKS:

One of the main differences noted by Ragnar Nurske between the pre and post WW1

scenario was what he calls a decline in “Confidence” in Central Banks. This needs some

clarification. The Central Banks were willing to do everything to maintain stable exchange rates

and even at the cost of economic growth (including sacrifice of domestic economy) in the era of

Pre-WW1. In the post war era, the focus shifted from trade to rebuilding economies ruined by the

war (or the Great Depression, in case of USA). It was no longer a viable strategy to sacrifice

domestic concerns for the sake of stable exchange rates to facilitate trade. For example, after

going back on the Gold Bullion Standard in 1925, the Sterling came under increasing pressure,

partly because The Bank of England (BoE) had pegged the pound at too high a rate. In 1931, the

BoE refused to raise interest rates to protect of Pounds because of high unemployment, which

would become worse with higher interest. Instead, it abandoned the gold standard.

Prior to WW1, we could assume with confidence that the central banks’ (CB) would take steps to

protect it by raising interest rates, and other measures. Anticipating that the Central Banks would

act in this way, financier would move to buy the weaker currency, expecting it to strengthen.

This was a stabilizing capital flow, since it would re-inforce and strengthen the weakening

currency.

In the post WW1 era, this changed, as it became equally possible that the Cental Bank might let

the currency weaken, or devalue, in order to protect domestic economy. This led to de-stabilizing

capital flows, as financiers fled from weakening currencies, thereby further weakening them.

This phenomenon, of how capital flows depend on anticipations of Central Bank behavior, can

also be observed in modern times. For example, in the recent past, when Euro was weakening

after the Global Financial Crisis, Mario Draghi famously stated that we’ll do whatever it takes to

defend the Euro. After his announcement, Capital Flows changed directions – instead of selling

Euro’s financiers started buying Euro’s in anticipation that Euro would strengthen in the future.

This proved to be a self-fulfilling prophecy as Euro did strengthen. This was an example of a

stabilizing flow, in response to Central Banks commitment to defend a weak currency.

If Central Banks are not committed to maintaining stable exchange rates, then this goal is

impossible to achieve and must be abandoned. There a number of options which exist which

were in fact taken historically. One was to allow for greater flexibility in exchange rate targets,

as did occur in the post-war period. The second option is to form a monetary union, which again

stabilizes exchange rates and permits trade – this option was taken later by the European

economies. A disadvantage of monetary union is the loss of control over domestic monetary

policy, as the common monetary policy is dictated by the Central European Bank. This was one

the factors which led to Brexit, and which is causing troubles in the weaker economies of

Greece, Ireland, and some others.

4.2 EFFORTS TO DEFEND PEG MAY BE WORSE THAN FUTILE, WHEN CB LACKS CREDIBILITY:

When there is lack of confidence that the CB will do anything at all to defend the exchange rate,

then efforts to defend the pegged exchange rate might be the worse than useless. To explain why,

consider the following issues. Capitalist economics are subject to business cycles and crises, due

to procyclical creation of credit, as explained earlier. Because these cycles are not synchronized,

the Balance of Payments (BoP) for any country fluctuates randomly and can’t be predicted.

Thus, without any real structural changes, it might appear that the balance of payments has

moved in unfavorable directions – leading the excessive surplus in foreigners holds of domestic

currency. This would lead to a weakening of the currency, purely at random. In the pre-war era,

the Central Banks could be counted upon to defend the currency in this situation. It might do so

by raising the interest rates, attracting foreign financial capital. Anticipating such moves,

speculator would purchase the weak currency in expectation that it would go up.

In the post-war era, the same maneuver by the Central Banks could have an adverse effect

instead of a favorable one. If the Central Bank raises interest rates, it could be taken as a signal

of weakness, and tempt speculators to attack the currency in the hope of making profits from its

fall. Similarly, a falling exchange rate also gives signals of weakness and attracts speculators to

attack the currency. These are de-stabilizing capital flows, since speculators move out of, or

short, weak currencies, thereby weakening them further. This is what leads to the well-known

over-shooting phenomenon: when a currency weakens it goes down beyond the new equilibrium

before coming back up.

One of the most famous stories of this ability of speculators to attack is that of George Soros,

who broke the Bank of England by creating a huge Quantum fund which started selling pounds

in order to force devaluation. The BoE attempted to defend the pound and lost a billion dollars in

this attempt, which eventually failed, as they were forced to devalue; for details see “Go for the

Jugular”.

THE TRILEMMA OF MONETARY POLICYEichengreen (1999), in his book, titled “Globalizing Capital: A History of the International

Monetary System” stated that countries can have only TWO out of THREE things:

i. Democratic Political System

ii. International Capital Mobility

iii. Pegged/Stable Exchange Rates

A democratic political system means that we cannot use monetary policy to stabilize the

exchange rate at expense of the domestic economy. The voters will not accept this. If use

monetary policy for supporting the domestic economy, then our ratio of money to gold reserves

will vary, since we will change the money supply according to the needs of the economy. This

means that our exchange rates will fluctuate, since the gold backing of our currency fluctuates.

When the gold content of our currency goes up, people will buy our appreciating currency, and

they will sell our currency when the gold content goes down. If we want to have stable exchange

rates, and an independent monetary policy, then we have to prevent people from being able to

buy and sell our currency. This means imposing capital controls – putting restrictions on the

convertibility of our currency to gold or to any other foreign currency. With capital controls, we

can ensure the first two goals.

4.3 INTER-WAR SYSTEM BROKE DOWN BECAUSE CB FAILURE TO PLAY BY “RULES”:

Prior to WW1, there were well understood rules which were followed by all Central Banks to

ensure stable exchange rates, the central feature of the gold standard. In the post-WW1 period,

CBs failed to play by these rules due to which the gold standard, and the associated fixed and

stable exchange rates, could not survive. The pre-WW1 rules involved NOT sterilizing capital

flows. That is, if sterlings flow out of the economy leading to BoP deficit, then the BoE would

allow the resulting shortage of money to affect domestic economy. In this case the economy

would weaken due to loss of money, and this would lead to recession and lowering of demand

for foreign goods. This would work to weaken the pound and to reverse the BoP deficit, leading

to a return to equilibrium. This is similar to the famous Humean specie-flow mechanism, which

restores equilibrium in international trade – except that the Hume mechanism is purely

theoretical and does not actually work in practice, because of price rigidities. This failure of CBs

to sterilize capital flows leads to loss of control over domestic monetary policy, since the

quantity of money is now controlled by the inflows and outflows of capital. In the post-war era,

CBs moved to protect the economy from the effects of such inflows and outflows by sterilizing

the capital flows. The empirical evidence Ragnar Nurske finds for this is that the Domestic

Assets and Foreign Assets of a Central Bank move in opposite directions. That is, when there are

capital inflows which expand the domestic money supply, the Central Bank contracts the supply

of money and thereby maintains the money stock at exactly the same level. This ensures that

domestic money supply is matched to the needs of the domestic economy. But sterilizing capital

flows means that the mechanism to equilibriate Balance of Payments will no longer function –

now the BoP could keep worsening, eventually requiring an adjustment in the exchange rates.

That is, maintaining an independent monetary policy, in presence of free flows of capitals,

requires allowing the exchange rate to adjust. Again, this illustrates the trilemma at work.

4.4 STRONG DEFLATIONARY PRESSURE ON CBS:

Contrary to global expanding trade in the pre-war period, the post-WW1 era saw a strong

deflationary pressure on the Central Banks. This was because war expenditures had reduced

supplies of gold in hands of CBs all over the world. Efforts to go back to the pre-war gold

standard led to substantial Under-Valuation of gold. These pressures were exacerbated by an

increase in CB demand for reserves because the increased volatility of the trading environment.

Reserves had been drained due to war, and were in short supply post war, At the same time,

increasing fluctuations in BoPs led to a higher demand for reserves to guard against unexpected

fluctuations. With reserves low relative to requirements, CBs needed to pursue deflationary

policies – contracting the money supply, in order to meet the reserve requirements for

maintaining stable exchange rates. However, this deflationary pressure created by the gold

standard conflicted with the needs of the domestic economy, which required an expansionary

policy to recover and rebuild economies damaged by the war. It is important to note that

alternative systems for international trade CAN BE devised which avoid this problem – indeed,

Keynes himself devised a suitable proposal, but it was shot down at Bretton-Woods in favor of a

system which gave central place to the US Dollar, and established the hegemony of the US over

international finance.

4.5 RESERVES IMMOBILIZED

Surprisingly, even though reserves were gathered for this purpose, it turned out that they were not very useful for BoP and Exchange Rate control in the post-WW1 scenario. This was due to a complex of reasons we now describe. To begin with, legal statues required some certain percentage of gold reserve backing for minting new currency. Using reserves would involve changing this percentage, running into legal obstacles. More importantly, if the drawing upon reserves was taken as a signal of weakness, it could trigger a run on the currency which would aggravate the problem that usage of reserves was meant to solve. This is another illustration of the concept of de-stabilizing capital flows. In the pre-war period, many central banks resorted to temporary suspensions of gold payment without any problems. This was because there was confidence that CBs would honor their guarantees in the long run, and because of this reason,

capital flows were stabilizing – capital flowed to strengthen weak currencies. In the post WW1 era, capital flow were de-stabilizing, and a signal of weakness could actually create the weakness. This same problem arises in the modern era, in a different form. The Bank of Korea did not want to allow reserves to fall below $200 Billion in 2008. The Bank of China did not want reserves to go below $2.8 Trillion – even though this was the IMF CEILING safe level of foreign exchange reserves for China. The de-stabilizing capital flows in the post WW1 period created the dilemma that the CB cannot use reserves when it needs them. Some solutions for these problems are: Currency Swaps between the two countries (bilateral swap agreement) and Credit provision by IMF to have a sound financial and economic condition of a country.

4.6 NO MECHANISM FOR INTERNATIONAL LIQUIDITY:

As we have seen, the total quantity of money is of critical importance for the domestic economy.

This money can be created and managed by the Central Bank to match the needs of the economy

in exactly the right amount, subject to certain qualifications. In exactly the same way, the total

quantity of money available globally is of vital importance for the global economy and the

trading regime. However, there does not exist any organization which manages global liquidity,

and ensures that it is at the right level for the needs of the global economy. In a gold, or a gold

exchange standard, to create liquidity requires devaluations – this increases the price of gold,

permitting the creation of more money backed by the same amount of gold. If this was done in a

co-ordinated manner – all countries simultaneously agree to the same level of devaluation, this

would increase international liquidity without serious side-effects – some re-distribution of

income to holders of gold would take place. However, devaluations cannot be done piecemeal,

one country at a time, for many reasons. Whereas cooperative and coordinated devaluations

create a win-win solution, competitive devaluations create a lose-lose beggar-thy-neighbor

scenario, to be discussed later. For one thing, devaluation of a single currency signals weakness,

and creates de-stabilizing capital flows. For example, the post-WW2 era of 1950’s and 1960’s

called for an increase in global liquidity, which could be achieved by devaluing the dollar.

However, the USA was afraid that doing so would precipitate a run on the dollar, and therefore

refrained from doing so. In principle, the IMF was created for managing international liquidity,

but it has never been very effective in this regard. IMF was supposed to issue special drawing

rights (SDRs) for creating additional global liquidity. However, the Supply of SDRs did not keep

pace with Global GNP. So at the moment, the world still has no mechanism for managing global

liquidity to ensure that it is in conformity with needs of the global economy.

4.7 PRO-CYCLICAL LIQUIDITY:

We have discussed how there is no mechanism to manage international liquidity – that is, the

total stock of money available globally. In absence of a mechanism, the amount of liquidity is

controlled by factors similar to those which govern domestic liquidity. In both cases, these

factors create pro-cyclical behaviour. That is, when the global economy is booming, vast

amounts of liquidity is created, while when global economy is in a slump, liquidity is reduced

drastically. This pro-cyclical behaviour is harmful, because it can lead to crises in booms, and it

can lead to deeper and prolonged recessions in slumps. If there was a way to manage global

liquidity, we would like to manage it in a counter-cyclical way – cut liquidity in booms to

prevent over-heating which can cause crises and collapse of global economy, and increase

liquidity in slumps to pull the global economy out of recessions. Why does global liquidity

behave in a pro-cyclical way? To understand this, we need to understand better the nature of the

post-war financial system. Each of the hard currencies – dollars, pounds, francs, and

deutschmarks – was a reserve center. Central banks had to have reserves in dollars, or in other

hard currencies, to be able to handle BoP deficits. In times of global booms in trade, it was easy

to accumulate these reserves. It was also easy to sell CB Bonds in other currencies as required,

and raise large amounts of money in foreign currencies for reserves. This led to expansion of

global liquidity in booms. In slumps, the reverse was true. The Central Banks liquidated their

reserves of other hard currencies, and scrambled to build reserves in dollars or gold. But when

they liquidated reserves, it put pressure on other Central Banks to do the same. As every

scrambled to build up gold reserves to protect their currencies, this caused losses in gold at the

reserve centers, and corresponding reduction in money supplies, at precisely the time when

expansions were needed.

A parenthetical note on economic methodology: During my training at Stanford, I learnt that

business cycles were due to complex roots in the solutions of the differential equations which

characterize the economy. Modern RBC models provide the same ridiculous explanation. See my

discussion of a “Realist Approach to Econometrics” to understand why the dominant economic

methodology fails to provide satisfactory explanations – Our discussion above, based on

Nurske/Eichengreen’s analysis, explains the phenomenon in terms of actions of agents,

motivations, and institutional structures.

4.8 MULTIPLE RESERVE CENTERS & CURRENCIES:

Another major difference between the pre-WW1 system and post-war was the emergence of

multiple reserve centers. Prior to WW1, the Pound Sterling, firmly tied to gold, reigned supreme,

and was the central currency of choice. After WW1, multiple hard currencies emerged as

alternatives to the Pound. Depending on the level of gold backing, and on Central Bank

credibility, all of them attracted some following. Central Banks maintained reserves in all hard

currencies of countries which were trading partners. In numerous episodes, when the dollar

weakened, CBs would switch to other hard currencies and vice versa. This created a dangerous

unstability caused by speculative hopping from one currency to another according to judgments

about their relative strength, and future prospects. Extrapolating from this situation to that of

today, many observers believe that a newly emerging international financial architecture will

include USD, Euro, and Renminbi, which will create a dangerously unstable system. However

Eichengreen argues that there is historical evidence that multipolar systems can also be stable.

Stability of lack of it will depend on how we design the architecture of the emerging financial

system. This is another important reason to make a deep study of global financial architecture.

4.9 CENTER COUNTRY HAS SPECIAL RESPONSIBILITY:

Both in pre-WW1 era, and in the post-war era, the center country has special responsibility.

Since

the center creates global liquidity it is the responsibility of the Center to ensure global liquidity.

The Center has to pay attention to global economy together with the domestic economy.

Generally speaking, in the pre-war era, UK managed sterlings to accommodate the needs of the

sterling area. In the post-war era, the USA did not do likewise. After being hit by the Great

Depression, the US adopted an isolationist stance, and imposed the Smoot-Hawley tarrif, and

took other measures to help domestic economy at the expense of global economy. However,

these measures did not in fact provide relief, due to their beggar-thy-neighbor and lose-lose

features, to be discussed later. In contrast, the UK, which also suffered heavily from the Great

Depression, kept its economy open to the sterling area. This had the affect of making the post

GD recession milder in the UK, while the USA had the worst post GD experience.

4.10 ADJUSTMENT (CONFIDENCE/LIQUIDITY):

Three major issues must be considered in designing an international financial architecture.

Confidence refers to the expected behavior of Central Banks, which must conform to certain

rules designed to generate stability in the system – in particular, there should be coordination and

cooperation required to run a global system, rather than adversarial actions which harm others

for self-benefit. The need for Global liquidity management has already been discussed. The third

issue of great importance is the requirement of adjusting exchange rates from time to time, in

response to varying conditions of international trade. How these adjustments are made is of

critical importance to smooth functioning of the global financial system. Speculative attacks, and

financial crises, occur because of weaknesses in the method by which exchange rates are

adjusted. As already discussed, normally occurring business cycles can lead to deficits or surplus

in BoP. One has to distinguish between short term fluctuations and long run structural changes,

since the former do not require any change, while the latter does require an adjustment in the

exchange rate. While the concept of floating exchange rate is to allow the rate to be freely

determined by the supply and demand in the market, in practice, this method leads to very high

volatility which is harmful to the needs of stable trading patterns for exports and imports. Thus,

there is pressure on the Central Banks to manage the exchange rate, to keep it stable and smooth,

and to protect against speculative games of the type which often drive stock prices. Today the

system for adjusting exchange rates is very poor, because it has not been designed – rather it has

emerged by default due to a failure to design a global financial architecture following the

collapse of Bretton-Woods.

4.11 COMPETITIVE DEVALUATIONS: LOSE-LOSE:

Devaluations can be done for two different reasons. In general, it should be the goal of an

international financial system to ensure that in the long run the exports and imports balance for

all countries, without any surplus or deficit. If due to structural changes, the long term trade

position of a country changes, then it should change the exchange rate. (In principle, this is what

the IMF was setup to do, although this has not been very successful.) But there is another reason

why countries can devalue their currencies. When they devalue, aggregate demand for their

products increases, which could bring benefits by lifting their country out of recession. Also,

aggregate demand of citizens for imports from other countries decreases, and is switched to

domestic products. This process of import-substitution also increases aggregate demand, which

is helpful to the country in coming out of a recession. However, note that the price is paid by the

other countries – some of their domestic aggregate demand is diverted to the devaluing country,

and also some of the demand for their exports is reduced. This is called a Beggar-thy-neighbor

strategy, as one country benefits by causing losses to its neighbor. This is a lose-lose strategy

because the other country has means to defend itself – it can also devalue its currency to keep its

products competitive in world markets. When there is a general global recession, then there is

need of global coordinated actions to increase world liquidity and trade. The process of

competitive devaluations is harmful in this situation and leads to a lose-lose strategy, where both

parties lose from the process.

However, Nurske takes a deeper view – it is not always the case the devaluations are harmful.

First he notes that all countries which recovered in the post-war period did so using the

following three policies

(i) They went off gold standard, creating the possibility of using domestic monetary policy.

(ii) They depreciated their currencies to gain an edge in world markets

(iii) They used expansionary monetary policies to stimulate domestic economy.

In conclusion, depreciation CAN be a win-win situation as if it stimulates the domestic

production, and creates net productivity gains globally as well.

4.12 FIXED EXCHANGE RATES LED TO QUOTAS ETC. The post-WW1 era illustrated another aspect of the trilemma. In situations where devaluations

were not possible, it because necessary to restrict capital and trade flows, in order to protect

stabel exchange rates and the domestic economy. Accordingly, economies which could not use

devaluation used capital controls and restrictions on trade to manage their economies. In

particular, this applies to Pakistan, where the Rupee was tied to the dollar and stable exchange

rates were maintained over long periods of time. To cope with domestic and trade imbalances

created by maintaining stable exchange rates, capital controls and trade barriers were both used.

4.13FEAR OF FLOATING: Both in pre-war and in post-war era, there was a general opinion that stable exchange rates were

required for international trade regimes, and globalization – free flows of trade and capital across

national boundaries – was both necessary and desirable as a means to prosperity. The gold

standard was abandoned only because it did not work, and not because there was any desire on

part of anyone to move to freely floating exchange rates. In fact, there was a general fear of

floating – the fear that the international trading system would suffer heavily if exchange rates

were left to the whims of the free market. The present system of floating exchange rates has not

emerged by any conscious desire to arrive at this goal. Rather, after the Nixon shock broke

Bretton-Woods, many attempts have been made to arrive at a new conscious design. These

attempts have failed for a variety of reasons, and the present system of floating exchange rates

has emerged by default, rather than by design or intention. See "The Failure of World Monetary

Reform 1971-74" by John Williamson, for some details on how attempts to reach agreement on a

post Bretton-Woods architecture for the international financial system failed.

4.14FLOATING EXCHANGE DID NOT LEAD TO FALL IN RESERVE REQUIREMENTS – BECAUSE OF NEED TO MANAGE FLOAT:

According to economic theory, the exchange rate should be determined by supply and demand in the floating exchange rate system. In this situation, the Central Bank need not play any role at all in determining the exchange rate, and hence it does not need to keep any reserves. This theoretical expectation was not borne out by the practical experience. As discussed earlier, completely free floating would lead to extremely erratic behavior of exchange rates. In 2016, about $5 Trillion were traded daily in the Foreign Exchange markets, while the volume of global trade is only around $60 Billion daily. The speculation in currencies overwhelms the quantity of trade, and speculation, instead of needs of trade would drive the exchange rate in this environment. This why todays system is a managed float, where CB s smooth out temporary fluctuations in order to maintain stable exchange rates. However, in order to manage floats, the Central Banks continue to need reserves, and reserves have not declined after the shift to floating exchange rates. The current situation also resembles the post-WW1 situation observed by Nurske, who also saw that dropping the gold standard and switching to float did not lead to the expected fall in the reserve requirements.

5 CONCLUDING REMARKSThis history of the gold standard goes up to the 1970’s and is valuable in understanding the historical experience of this first ¾ of the twentieth century. Significant changes took place in the last quarter with the emergence of financial capitalism as a replacement for industrial capitalism. The financial de-regulation which started in the Reagan-Thatcher era reached termination in 1999 and 2000 with repeal of Glass-Steagall Act and enactment of the Commodity Futures Modernization Act. It took only seven years for a major global financial crisis to emerge. Understanding monetary policy in the era of financial capitalism, floating exchange rates, and many other factors which are different requires more work. The present set of lecture only prepares the necessary background for this understanding. It is essential to know the history of how the current system emerged, because many of the institutional structures are accidents of history, and not products of design.

From this history, it should be clear that gold standard is far from an ideal system. It only worked for a few decades – say between 1880 to 1914 – and was part of the reason for the world war 1 which destroyed the system. Because the era was one of prosperity in Europe due to exploitation of the colonial system, people came to mistakenly associate gold standard with prosperity, and are still struggling to re-create this system. In fact, the gold standard is neither good for the domestic economy nor for the needs of international trade. Far better monetary systems for domestic economy, as well as better global financial architecture can be devised and in fact, have been devised. However, creating such systems requires generating consensus, and political will. This depends very much on understanding the defects of the present system and on the ability to present, articulate, and persuade people of the superiority of an alternative system. Doing so requires a deep understanding of how the current system works, and its defects, and how they can be remedied. In subsequent lectures, we will try to build on these foundations to bring the story of money upto date, to the twenty first century.