Kyle Inan - Evolution of the International Monetary System

most severe hyperinflation rates in their economies in the periods preceding the Great Depression. By 1971, the European countries wanted to form the “European Common Market” and decided to abandon the Bretton Woods System.

From 1971-1973, the Bretton Woods System became inoperable. In 1973, President Nixon cut the dollar system which allowed for the collapse and the disappearance of the link between the U.S. dollar and gold. The demise of this system has concretely taught us four important lessons: (I) the lack of operational adjustment mechanisms, (II) the great adversity of running a system of fixed exchange rates (or adjustable peg) in the presence of highly mobile international capital, (III) that there was strong international cooperation and close coordination among participating governments and central banks around the world which was very easily distinguishable from the last quarter of the nineteenth century since the possibility of international economic coordination or collaboration was virtually non-existent during the gold standard era. (IV) Even though there were strenuous efforts being made by the member countries to defend the parity, sustainability of this system turned out to be impossible as keeping the parity at a stable rate would require unparalleled foreign exchange market intervention as well as international support at all levels.

Post-1973 International Monetary System

After the collapse of the Bretton Woods System, the sudden rise of cross-border capital mobility has drastically transformed the very essence of international monetary relations. Throughout much of the operational phase of this system, much of the countries were able to avoid balance of payment deficits to some degree since they were able to avail themselves to the protection of the pegged exchange rates. This breathing space provided by the Bretton Woods agreement has also enabled countries to freely re-direct their monetary policies in the direction that they considered necessary.

Following the collapse of Bretton Woods, countries were completely free to control the supply of their own currencies. They could increase their money supplies without the backing of any precious metal required for that increase in the money supply. Governments also realized the fact that there was a profit to be made just by printing their currency. The profits made by governments are called “seigniorage.”

However, by the late 1970s, some countries have gotten too greedy for seigniorage, meaning that they allowed changes in their domestic currency largely. It was during this time when many countries have fixed their exchange rate systems.

Some of the benefits of this system included: (i) the minimization of uncertainty for the future exchange rates (ii) the assumption of a supervisory role by the monetary policy which would be responsible for keeping the money supply under control (i.e. self-imposed discipline on monetary policy (iii) The occurrence of a change in a country’s balance of payments is more likely under the fixed exchange rate system. However, it can be controlled by devaluation (one-time change).

Conversely, some of the costs that were associated with the system of fixed exchange rates included the following deficiencies: (a) First, under this system, monetary policy would not completely be independent. For instance, in the event of a severe recession, when a large increase in money supply is needed, fixed exchange rate regime would not allow it. (b) Second, monetary policy is most tempted to break the rule of not allowing the money supply to grow excessively. An example would be the “systemic risk” of irresponsible monetary policy. It is better to have a flexible exchange rate system, which would show the consequences of changes in the money supply on a daily basis.

On the other hand, those countries that were running independent monetary policies with floating exchange rates have selected to use some key currencies such the U.S. dollar ($), Euro (€), Japanese Yen (¥) and also what is called the Special Drawing Rights (SDRs).

The SDRs were created during the Bretton Woods system in 1969 as an alternative to the strongest currencies to support the fixed exchange rates regime (only to be issued by the IMF). The SDRs are basically an international reserve asset that was put to use under the guidance of the IMF when two of the major currencies: the gold and the U.S. dollar, fell short of achieving their intended objectives of underpinning the expansion of international trade and encouraging financial flows between the member countries.

The SDRs are generally allocated in proportion to the contributions of the members to the IMF. If a member country wants to contribute more than the required amount, then the IMF would issue SDRs to this member. The value of SDR is currently expressed in a basket of four currencies as opposed to the past where it was represented solely by the U.S. dollar. Today these are: the U.S. dollar, the Japanese Yen, pound sterling and the Euro. The use of the SDRs may vary depending on the need trading arrangements. For instance, if the U.S. government had a desire to export certain goods or a service from Japan and was reluctant to make a payment in U.S. dollars, the transaction can be made with the usage of SDRs since both countries are participating members of the IMF.

In brief, it is possible to argue that the post-1973 period was largely marked by three crucial turning points, which have shaped much of the historical structure of the international monetary system. The first significant event was the advent of the “European Currency Snake” (also referred to as the snake in the tunnel), the second was the eruption of the “Great Debate” between fixed exchange rates and floating exchange rates, and the third event encompasses the dynamic changes in the monetary policies of the U.S. Federal Reserve.

By the mid-1970s, a globalization trend emerged that simultaneously promoted free trade and the elimination of capital controls (i.e. reduction of barriers to trade). This trend, in essence, came into being with the ongoing development in the areas of telecommunications, information technologies, as well as with the rapid structural improvements in the financial markets.

The liberalization of exchange rates during this period has revived unpleasant memories of the post-WWI era where floating exchange rates have largely caused massive hyperinflation. “Europe, not the United States or Japan, was where floating currencies had been associated with hyperinflation in the 1920s. Europe was where the devaluations of the 1930 had most corroded good economic relations.” (Eichengreen, 2008, pg. 150)

Many European countries with the breakdown of the Bretton Woods system were reluctant to go back to a system of floating exchange rates. Therefore, in an attempt to devise a single currency band among European countries, the concept of the “snake in the tunnel” was introduced. This monetary policy was supposed to limit fluctuations among various European currencies and peg all the European Economic Community (EEC) currency bands to one another. The so-called snake provided a window of opportunity for the European currencies to trade with each other, especially with the Smithsonian agreement setting bands of above or below +/– 2.25% for maintaining the exchange rates, which allowed European currencies to fluctuate in relation to their individual rate against the U.S. dollar. However, the snake in the tunnel fell apart in 1973 with the free-floating of the U.S. dollar as a result of the --">