The Bactra Review: Occasional and eclectic book reviews by Cosma Shalizi   117

Globalizing Capital

A History of the International Monetary System

by Barry Eichengreen

Princeton University Press, 1996 (revised printing 1998)

Turning the Wheels

This is a history of how the world has dealt with different sorts of money over the last century and a half or so. Since I find Eichengreen's story thoroughly convincing, I shall content myself with sketching out his analysis, which starts by dividing the period into four parts.

The first part is the era of the gold standard, stretching roughly from the mid-nineteenth century to the outbreak of the First World War. Owing to a never-corrected mis-calculation on the part of Isaac Newton in the early eighteenth century, Britain set the price at which it would buy gold to make into coins too low relative to that at which it would buy silver. This drove silver out of circulation, and quite involuntarily Britain found itself issuing all its precious-metal money in gold, and backing all its paper money by gold reserves. The pound sterling was, name not withstanding, equivalent to a certain specified mass of gold. Owing to a series of events which it has never been able to explain to anyone else's satisfaction, by the early nineteenth century Britain found itself in possession of a significant portion of the planet, incubating the Industrial Revolution, and the world's center of commerce and finance. Most of the world was doing business with Britain, and consequently found it extremely useful to tie their currencies to the pound, which meant tying them to gold. (Or rather, the people running most of the world found that useful; we'll come back to the costs of doing so presently.) By the beginning of the 20th century, most of the world's currencies, and certainly all of them in the major European countries and their colonial offshoots, were either directly "pegged" to a certain value of gold, or pegged to a currency which was itself defined in terms of gold.

This had profound effects on international trade and investment. Exchange rates were constant, which made commercial decisions much less uncertain. If you wanted to buy or sell goods and services in foreign markets, you only had to worry about what the going prices there would be, not how much your money would be worth. Money was fully convertible, so that if you invested in abroad, you could be much more sure of your ability to pull out later, and the terms on which you could do so. This, combined with the first really effective technologies of mass transport (steam engines) and telecommunications (telegraphs) led to a world economy where trade was as important, proportionately, as it had ever been, and more important than it would ever be again, at least until (perhaps) today.

There were certain requirements for the system to work. In almost all countries, the power to issue money was restricted to the government, and usually to a branch of it known as the central bank. (Technically, the central bank has often been a private corporation, but this is a more or less transparent legal fiction.) Given that there was a certain volume of currency circulating in the country, maintaining the gold standard meant there had to be a certain volume of gold available to the central bank, in order to redeem that money with metal. Normally the central bank could count on only a very small demand for gold at any one time, so the gold reserves did not have to match the money supply one to one, but the ratio was often pretty low, say one to two. (The value of this reserve ratio was often legally stipluated.) The other task of the central bank was to maintain its exchange rate; the ratios between two currencies had to equal the ratio between their gold contents. There are two stories about how this happened, the official one and the real one. But before we can get to either story, we need to look briefly at what the forces acting on exchange rates are.

The relative price of one currency, say Italian lira, in terms of another, say American dollars, reflects supply and demand, just like every other price. The more demand there is to change dollars into lira, the higher the dollar-price of lira; that price is the exchange rate. Now think about things which might affect that demand --- about the reasons you might want to change dollars into lira. First, you might want to buy goods or services which are being sold for lira. The total value of such goods purchased from abroad is Italy's exports. When we subtract the value of Italy's imports, its purchases abroad, we have the value of Italy's current account, which is also the net demand for lira for purposes of trade. Second, you might want to lend money, and find you can get higher rates in lira than in dollars. Third, you might be worried about the value of the money, and think that lira will retain more of their purchasing power than dollars will. (Recall that "lira" and "dollars" here are just place-holders.) So the events which will make the lira more expensive are: an increase in Italy's current account; an increase in Italian interest rates; or increasing security of the lira's value, say by a cut in inflation.

Now for the official story, first promulgated by the great philosopher David Hume in an essay "Of the Balance of Trade". Suppose Italy and America are both on the gold standard, and (for simplicity) that they trade only with each other. Suppose Italy runs a current account surplus: that is, it sells more to the US than it buys. The US pays for the difference in gold, lowering its own gold supply and raising that of Italy. But each ounce of gold is equivalent to so many lira or dollars, so the money supply expands in Italy and shrinks in America. Assuming that production doesn't change, the same quantity of goods is being purchased with a larger amount of money in Italy, so Italian prices, whether in lira or in gold, will rise, and by the same reasoning those in America will fall. Assuming, what is generally the case, that people buy less of things when prices rise, Americans will now buy fewer Italian products, and Italians will buy more American ones, and this will tend to eliminate the current account imbalance, restoring relative prices to their original levels.

This is an extremely ingenious theory, and actually one of the first theoretical accounts of a feedback mechanism; maybe even the first. It became, as I said, the official story of how the gold standard was supposed to work --- automatically, reliably, without any real intervention by governments or bankers. The only problem with it is that it is false to fact: in the first place, it demands actual transfers of gold in large quantities, which didn't happen; in the second place, the system demanded almost constant government intervention.

The real story, as Eichengreen relates it, was more like this. Suppose, again, that Italy and the United States are both on the gold standard, so that they claim a certain fixed ratio between the lira and the dollar. Suppose further that demand for the lira drops, for whatever reason --- Italian interest rates drop, Italy runs a current-account deficit, the government prints money to pay for a war, or what-not. Lowered demand means that, left to itself, the exchange rate will decline. If the official prices for gold are not changed, at some point it becomes profitable to take dollars to Italy, buy lira, convert them to gold, ship that gold to the US, and then turn it into dollars again. This depletes Italy of gold, and so threatens the stability of its currency even more. To prevent this, the Italian central bank would have to somehow raise the exchange rate. To do this it must either increase the current account balance, or raise interest rates, or increase the purchasing power of the lira. Since little could be done about the current account in the short term, that leaves interest rates and the money supply. Raising interest rates is generally within the purview of the bank, through various instruments that we needn't go into here. It generally reduces the extent of economic activity --- debtors have to pay more on their loans and so spend less on other activities, business can afford less credit, unemployment rises, etc. Putting the brakes on the economy increases the purchasing power of money by lowering total demand for goods and services, but central banks also had the power to simply issue less money. Every bank-note was convertible into gold, but, as we saw, banks generally issued more notes than they had reserves to cover, on the theory that they would never have to redeem all the notes at once, though with legal limits on how far the supply of paper money could exceed the gold reserve. Between that outer limit, and issuing no notes at all, they had considerable room with which to set the money supply. Naturally, in the case of a currency for which demand was rising, all of these steps would have to be reversed.

Maintaining the gold standard thus often demanded contracting the economy, to the disadvantage, the very acute disadvantage, of the vast majority of its participants. As Eichengreen emphasizes (following the great work of Karl Polanyi), one of the reasons the gold standard persisted was that that vast majority had little or no say in how their countries were run, whereas those who benefited from the gold standard --- those active in international trade and investment --- had considerable power. This let central banks do whatever was needful to maintain the exchange rates without fear of the economic or political consequences. (This was least true in the United States, which was also the major country least attached to the gold standard, and where indeed the Populist movement of the 1890s nearly succeeded in jettisoning it.) In the long run, what killed the gold standard was the rise of European labor movements, which forced the various political elites to share power with broadly elected parliaments. This presently led to influential political parties representing labor and agrarian interests, which didn't care for contraction, deflation, and high interest rates. Eichengreen refers to this as the "politicization" of monetary policy, but I think it would be fairer to say that that policy had always been political, and now which set of interests it was to serve was being disputed.

The gold standard was thus, as Eichengreen says, a "historically specific institution," and by no means, as some of its deluded admirers think, a constant of nature. Democracy had probably doomed it anyway, but as it happens it found a more dramatic, not to say abrupt, nemesis: the Great War. The belligerent powers suspended convertibility, and used gold to buy resources from neutrals, especially the United States. Trade was disrupted, and such foreign investments as were not exploded were liquidated to raise cash, or expropriated. When the war in western Europe stopped in 1918 (it would continue in the east into the 1920s), America was only major power still on the gold standard. Exchange rates "floated": that is, they were the market prices for different currencies. They reflected the considered collective judgments of the currency markets on the "fundamentals" mentioned to earlier, modulated by the usual market factors of fear, conformism, rumor and folly.

The results were generally pleasing to no one, and there was an attempt in the 1920s, led by the British and the French, to revive the gold standard. This revival lasted for five years, counting generously, and even then was nowhere near as effective as the pre-war system had been, simply because the political backing for it wasn't there. Various attempts to strengthen the international monetary system came to nothing, because none of the European powers were able to agree on anything, had no desire to agree even, and the Americans were pretending that the rest of the world didn't exist. (The history of western Europe between the wars reminds me of nothing so much as a dreary dormitory full of sullen adolescents, at least up to the point where the general desire for something interesting to happen is gratified.) When the Great Depression came, it killed the gold standard once and for all, but not until after many governments (notably the Hoover administration) had made things much worse by trying to maintain gold parity, raising interest rates and otherwise throttling the economy to do so. It was not until the situation was thoroughly desperate, and trade thoroughly wrecked by financial collapse and protectionism, that governments began to exploit the freedom to set interest rates and stimulate demand that floating exchange rates gave them.

The third period of Eichengreen's history runs from the close of the Second World War to 1973. Politically, this period was marked by the establishment of the Pax Americana, the very definite subordination of western Europe to American hegemony. (It's hard to feel sorry about this; the Europeans had spent several decades demonstrating their incompetence to run their own affairs.) One of the remarkable things about the American hegemony was the extent to which its institutions were planned out beforehand, and planned with considerable foresight at that. The pre-eminent instance is Vannevar Bush's design of the American R&D system, which has made the last half-century into the golden age of science and engineering. But the Founders --- including, in this case, the British, headed by Keynes --- also planned for the monetary system. It was not going to be automatic, or even something that you could pretend was automatic, but would very definitely require intelligent action and coordination. The system --- known as "Bretton Woods," after the hotel where its founding treaty was agreed to in 1944 --- would work as follows. Gold was firmly abandoned as a standard for exchange. (The US continued to maintain that the dollar was 1/35 of an ounce of gold, but that played no real role in the system.) Currency rates would fluctuate, but within narrow bands around set values. Maintaining those exchange rates while letting countries pursue what internal policies they liked would need capital for intervening in the currency markets. To this end they could draw on the newly-created International Monetary Fund, to which the member countries also agreed to subscribe capital, using this credit to buy or sell currency as needed to support the exchange rates. But the pegs were not, as under the gold standard, supposed to be cast in stone. They were supposed to adjust in cases of "fundamental disequilibrium", and new rates were to be worked out through mutual consultation mediated by the IMF. "Fundamental disequilibrium" meant, roughly, that the pegged exchange rates were seriously out of line with those dictated by long-term fundamentals; nobody was ever able to say what it meant in detail. (The same Bretton Woods accords created the World Bank, but since it plays essentially no role in the monetary system, it does not feature in Eichengreen's history, and we too shall save it for another day.)

Despite initial difficulties in the 1940s, when the European countries had more demand for American goods than they had dollars to pay with, the Bretton Woods system worked for about thirty years. It provided a remarkable combination of exchange-rate stability, free trade, and freedom for countries to adjust their monetary and fiscal policies to suit their internal needs, all of which were important in producing the post-war golden age. The key to making it work, as it turned out, was something that the Bretton Woods accords had committed their adherents to eliminating, namely controls on the international movement of capital. With currency markets rendered fairly small and illiquid, governments could maintain their exchange rates, pretty much, with only an occasional adjustment of the pegs. (These never happened through the IMF as planned, but nobody seems to have fretted about this much.) But the industrial countries had, practically speaking, phased out capital controls by the early 1960s, at least for purposes of trading on current account, i.e. in real goods and services. The problem was that there was no way to allow capital transfers for current-account purposes, without at the same time allow capital transfers for investment and sheer speculation. Regulations against that could be decreed, but enforcing them would have required a much larger commitment of resources, ingenuity, and intrusion into their citizens' lives than the post-war welfare states were willing to make. The currency markets, like all the other financial markets, thus gradually became larger, more liquid, and more technically sophisticated, and governments were less able to affect them by buying and selling currency.

The Bretton Woods system was finally undone by the most destructive venture of the Pax Americana, its criminal war in Indochina. The Kennedy, Johnson and Nixon administrations were all determined both to have that war, and the rest of the Cold War military establishment, and domestic expansion, particularly in election years. Demand, in other words, was stimulated by government purchases of both guns and butter, and the result was inflation. This could have been controlled either by raising interest rates or increasing unemployment, but neither was politically acceptable. But the fact that American inflation was significantly higher than that of (in particular) Germany made dollars relatively less attractive than deutsche marks. Under the Bretton Woods system, this probably qualified as a fundamental disequilibrium, and should have been resolved by moving the pegs, lowering the dollar price of marks (and other allied currencies). This, too, was unacceptable to the US, so in the early 1970s there were a series of speculative attacks on the dollar, and unsuccessful attempts to patch up the Bretton Woods system without addressing the fundamental problems. The end came early in that ominous year, 1973, when by unspoken but common consent pegs were abandoned and currencies left to float as they would.

Thus began the present era of the international monetary system, like much of the modern world, with the ignominious collapse of a useful work of mid-century optimism and intelligence, to the accompaniment of bluster from Richard Nixon. Large economies, like those of the United States and Japan, or ones with little dependence on foreign trade, found they could get on tolerably well with floating exchange rates --- that is, provided they didn't care, much, about what their exchange rates were, they could maintain (effectively) free trade and freedom of internal maneuver.

Small, trade-dependent economies had a choice of evils. On the one hand, they could let their currency float, but this introduced a major source of uncertainty into their economic lives, with large costs. On the other hand, they could try pegging their currency to some larger and more stable one (the dollar, the mark, the yen, or, in Africa, the French franc), only now without the support of the international system or indeed of other countries. But then maintaining the peg essentially dictated their internal economic policies, and could force them in quite perverse directions.

Sharpening the trade-off for the small countries were the growth in international trade, owing to improved logistics and low tariffs in the industrial countries, and the growth of the financial markets, owing to improved telecommunications and computing. By the 1990s, trade as a proportion of the world economy had climbed back up to the levels attained under the gold standard, and was much larger in absolute terms. The potential benefits to trade were thus very tempting. But relying on them would make exchange rates important to the economy, and thus exchange-rate variability imposes the usual costs of uncertainty. That is, floating exchange rates eat away at the benefits to free trade. On top of this, the resources of the financial markets now dwarfed those that governments could bring to bear. Again by the early 1990s, the volume of daily currency trading was about fifty times the total daily output of the world economy. In such circumstances, maintaining a peg that the markets don't believe in --- or don't want to see sustained --- is simply not possible, at least not through actions within the markets.

The trade-off here has come to be expressed by the idea that governments can "pick any two" of exchange-rate stability, free trade, and freedom to set monetary and fiscal policy. The gold standard combined the first two; the Bretton Woods system combined the first and the last, and collapsed when free trade led, as under modern conditions it seems it must, to free capital flows. Since 1973, countries like the US and Japan have been able to combine the last two. European monetary unification (treated superbly in Eichengreen's' ch. 5, at least up through 1996) is a compromise. The European currencies will be fixed against the euro and each other, and float together against the rest of the world. In turn, the EU as a whole will be able to have an independent economic policy, but individual European countries will not, any more than individual American states do. America is sufficiently integrated economically that it makes sense for us to have a common fiscal and monetary policy. Whether Europe is so integrated, nobody really knows. (Another thing nobody knows is whether prolonged exposure to a common set of policies will integrate it.) What is certain is that, at least prior to the official commitment to the euro and so locking-in exchange rates, the attempt at integration made European currencies vulnerable to repeated speculative attacks, and the (generally unsuccessful) attempts to maintain exchange rates were very costly.

The situation outside the industrialized world is, naturally, different. These countries are, frankly, still marginal to the history of the monetary system, so that Eichengreen gives them little space, and most of that to the nearly-industrialized countries of east Asia. Briefly, then: these countries faced the same trilemma as everyone else. Since they depend heavily on --- and have made incredible use of --- exports to the industrial core, foregoing free trade is not an option for them, and the uncertainty-costs of floating exchange rates were thought prohibitive. Still, they also relied heavily on fiscal and monetary policies to manage their economies, and by all reasonable accounts this government intervention is responsible for a large share of their astonishing growth. Essentially, they thought they could get away with it because all the fundamentals were in their favor, because there was no reason for the market to want to devalue their currencies. For obscure reasons, however, the collapse of a real-estate bubble in Bangkok cascaded into a speculative attack, first on the Thai currency, and then essentially all the currencies of the region, including, bizarrely, that of South Korea; also Russia, and very nearly Brazil. The IMF and the U.S. Treasury Department delivered advice --- and tried to enforce policies --- out of the handbooks of the Hoover administration. It was a senseless and hurtful episode from which the region still hasn't recovered, and nearly the only beneficial effect of which was to finally topple the Suharto dynasty of American satraps in Indonesia (leaving behind, however, a regime thoroughly implicated in their corruption and massacres).

At this point, hoping that I still have your attention, I want to break off from refracting Eichengreen's argument to venting opinions purely on my own account, at least for the next two paragraphs, complaining about the present monetary system. The markets have rather spectacularly demonstrated that they do not rationally evaluate fundamentals (and not merely in Asia in 1997--1998, but in Mexico in 1994--1995, etc., etc.). The need for those engaged in actual trade to hedge against currency fluctuations makes professional hedgers reasonably rich, and the fluctuations themselves make a few speculators spectacularly rich; but money spent on hedging is, from a social point of view, essentially unproductive, and done only in a "lest worst befall" spirit. The social costs of the present system go well beyond those of hedging, and the benefits are not readily apparent, even to people like George Soros.

I hope that the present monetary system will be reformed, drastically and soon, because there is an alternative which is at once technically feasible, politically viable, and far, far worse: that is protectionism, notably advocated in this country by the likes of Pat Buchanan, Roger Milliken, and Ralph Nader. It would, it is true, eliminate those who effectively extract rents from the uncertainties of trade and exchange, but it would replace them by those who extract rents from tariffs and other barriers to trade, and at least the traders are forced to be internationalists. Moreover, protectionism would eliminate the gains from trade, which would probably be bearable in the case of the US and possibly (if the Common Market were preserved) of Europe, but not of Japan or the rest of the industrialized Pacific Rim, to say nothing of the many poor countries which actually are developing thanks to exports and foreign capital. (Restoring the gold standard would vie with protectionism for vicious stupidity, but, despite the support of the editorial pages of the Wall Street Journal, that, at least, has no political chances at all.)

As I said, such remarks are considerably beyond what Eichengreen ventures, at least in the book. (I have not yet laid hands on his proposal for reforming our financial architecture, but I look forward to doing so.) He merely, in his last pages, notes that the present system satisfies few, but that what ought to be done, let alone what will be done, is, as usual, completely unclear. This is the only unclarity that Eichengreen permits himself, and it's one which is not unworthy of an analytical hyistory. Otherwise he is completely lucid, rigorous, well-documented, and reasonably readable, though not in the same league as Galbraith, Krugman or even J. Bhagwati. (Those not familiar with monetary and economic jargon will probably need more background than the glossary gives, but not very much more.) This book will become the classic history of how we got ourselves into this mess.

viii + 227 pp., tables and graphs, footnotes, bibliography, index of names and subjects
Economics / Modern History / Politics
Currently in print as a hardback, US$40, ISBN 0-691-02880-X [Buy from Powell's], and as a paperback, US$16.95, ISBN 0-691-00245-2 [Buy from Powell's], LoC HG 3881 E347
17--18 April 2000; last update 9 February 2007 (thanks to Aaron Swartz for pointing out a typo)